I. Recent Developments, Outlook, and Risks

International Monetary Fund. European Dept.
Published Date:
May 2016
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After solid growth in 2015, the Central, Eastern and Southeastern Europe (CESEE) region is now heading into choppy waters. Lower euro area and U.S. growth, tighter global financial conditions, and continued weakness in many emerging economies are creating headwinds. Nonetheless, near-term growth is expected to remain robust in most CESEE countries outside the Commonwealth of Independent States (CIS), thanks to strong domestic demand. At the same time, output contraction is projected to moderate in the CIS, as the shocks that hit the Russian and Ukrainian economies gradually reverberate less and activity stabilizes. While downside risks are now more pronounced than in the fall of 2015, policies in most economies will need to rebuild room for maneuver.

A. Recent Developments

Most of the region outside the CIS continues to register robust growth, despite weakening external demand, particularly in emerging markets (EMs) (Figure 1.1). Accommodative macroeconomic policies, improving financial intermediation, and rising real wage growth have been behind the region’s mostly consumption-driven rebound.

Figure 1.1.CESEE: Growth and the Labor Market

Sources: Haver Analytics; and IMF staff calculations.

Note: CEE = Central and Eastern Europe; CESEE = Central, Eastern, and Southeastern Europe; CIS = Commonwealth of Independent States; SEE = Southeastern Europe. Due to data limitations, SEE non-EU excludes Bosnia and Herzegovina. GDP growth contributions are calculated using series’ that are not seasonally adjusted. H is the average of the two quarters in respective periods. For SEE non-EU, a breakdown for GDP components is unavailable (and is estimated) for Kosovo for 2015Q4, hence there is a small difference between total growth and growth added up from the GDP components.

  • Growth picked up in much of Central and Eastern Europe (CEE) in the second half of 2015 on account of supportive demand policies and increased absorption of EU Structural and Cohesion Funds (Figure 1.1). Similarly, most SEE countries saw stronger growth despite political uncertainties and financial sector spillovers from Greece in some cases. However, private investment remained subdued. In EU countries, public investment contributed strongly to growth in a race to utilize EU Funds before their expiration in 2015 (see Fall 2015 REI for details). Despite improving labor markets and lower oil prices, growth slowed in the Baltic countries, reflecting weaker demand from Russia.

  • Buffeted by plunging oil prices and sanctions, the Russian economy went through a sharp contraction. Other CIS countries were hurt by domestic political and financial woes, as well as spillovers from Russia. Output contraction appears to have moderated in 2015:Q4 partly due to policy responses (Box 1.1). While exchange rate depreciation has facilitated external adjustment, this has happened mostly via import contraction. Exports of the CIS countries seem to have benefitted little given the high share of commodities, supply disruptions, still-low compliance with EU import standards, and dependence on other CIS markets.

  • Turkey saw a strengthening of domestic demand, benefiting from a series of accommodative policy measures and the relaxation of macro-prudential regulation.

Labor markets outside the CIS have strengthened considerably in recent years (Figure 1.1). Unemployment rates have fallen significantly across all sub-regions. The most dramatic turnaround has been in the Baltic economies where rates are now in the single digits. Despite some remarkable gains, unemployment rates remain elevated in non-EU SEE countries. Empirical estimation suggests that, on average, a 1 percentage point increase in the GDP growth rate was associated with a decline in the unemployment rate of about 0.15 of a percentage point in the first year, and about 0.4 of a percentage point after three years. Falling unemployment has occurred in the context of improving employment and labor force participation rates in the region.

Estimates of potential output, output gaps, and actual unemployment rates suggest that cyclical recovery may be near completion outside the CIS, but there is considerable uncertainty around estimates of economic slack. Average potential output growth for the region has declined to 2 percent from over 4 percent in precrisis years. Against a backdrop of diminished potential output growth, output gaps now appear closed or positive for many countries (Figure 1.2). In the Baltics and some CEE countries, a closing of the output gap seems consistent with developments in unemployment, wage growth, and recovery of credit and housing prices as well as some price pressures on non-tradables. However, the range of estimates of potential output is quite wide (Podpiera, Raei, and Stepanyan, forthcoming) and other indicators of economic slack – such as very low headline and core inflation – point to further excess capacity.

Figure 1.2.CESEE: Estimated Output Gaps, 2015

Sources: IMF World Economic Outlook database; and IMF staff calculations.

Note: Output gaps in this figure reflect IMF country desk estimates. A largely closed gap indicates an output gap narrower than −1.5 percent; a small gap is between −3 and −1.5 percent; and a large gap is wider than −3 percent. These estimates are roughly in line with various model-based estimates (the multivariate filter and production function approach) in the majority of cases. For Bulgaria, Latvia, and the Slovak Republic, the model-based estimates tend to show a positive gap.

The CESEE region saw a massive flow of refugees on the way from war-torn countries to Western Europe. Few migrants stayed and applied for asylum in CESEE, and hence the impact on growth and fiscal developments has been limited. The notable exception is Turkey that is currently hosting more than 2.5 million refugees, and where the economic impact of refugees has been quite noticeable on several fronts. Most refugees had left camps by end-2014 and started to join the labor market, exerting pressure on unskilled segments in rural areas close to the Syrian border. Following the dialogue with the EU, refugees were allowed to work legally with some limitations starting in January 2016. Some evidence suggests that refugees also brought some small-scale investments into the Turkish economy.

Headline and core inflation are very low in CEE, SEE and the Baltic countries, but still high in Turkey and the CIS (Figure 1.3). Low inflation likely reflects the lagging impact of excess capacity, including relatively flat Phillips curves, declining commodity prices (including their indirect and second-round effects) and low global inflation, notably in the euro area. In the CIS economies, inflation remains in the double-digits, with a noticeable spike in Ukraine reflecting exchange rate depreciation. Russia saw some moderation in both headline and core inflation in 2015:H2 in response to tighter monetary policy and weak activity. Amid buoyant activity and accommodative macroeconomic policies, inflation remained elevated in Turkey.

Figure 1.3.CESEE: Inflation Developments

Sources: Haver Analytics; European Commission; Consensus Economics forecasts; and IMF staff calculations.

Note: CEE = Central and Eastern Europe; CESEE = Central, Eastern, and Southeastern Europe; CIS = Commonwealth of Independent States; SEE = Southeastern Europe. Core inflation excludes energy, food, alcohol and tobacco.

Like other EMs, much of the CESEE region faced net capital outflows in 2015 (Figure 1.4). In addition to continued deleveraging by Western European banks, portfolio flows came under pressure in the second half of the year. Russia and Turkey accounted for the bulk of bond outflows, though cumulative bond outflows from CESEE, excluding Russia and Turkey, since May 2013 “taper tantrum” were not as large as outflows from other EMs. More recently, portfolio flows have turned positive. At the same time, net FDI flows have remained positive outside Russia, with Turkey seeing some strengthening on account of investment in the financial sector.

Figure 1.4.CESEE: Financial Sector Developments

Sources: Haver Analytics; Bloomberg; and IMF staff calculations.

Note: EMBIG = Emerging Markets Bond Index Global; EPFR = Emerging Portfolio Fund Research; LATAM = Latin America.

1/ Simple average of pair-wise correlations of daily changes in CDS spreads using a rolling 30-day window.

The financial turbulence of early 2016 softened asset prices in CESEE, although less so than in other EMs. The CESEE countries saw falling equity prices and a widening in sovereign credit spreads but the moves tended to be less dramatic than in other EM regions (Figure 1.4). Also, exchange rates outside the CIS remained stable against the euro. More recently, correlations of movements in credit spreads between CESEE countries and major EMs have increased, suggesting greater scope for spillovers to the CESEE region from financial shocks elsewhere.

CESEE countries’ lower susceptibility to financial market turbulence is mostly explained by improved economic fundamentals relative to precrisis years. Internal and, especially, external imbalances appear smaller than in a number of other EMs. Most countries in the CESEE region have drastically improved their current account (CA) balances, with the average CA deficit in the region at 2 percent of GDP in 2015, compared to 12 percent in 2008. Only a handful of countries still show a sizable CA deficit, notably Turkey, Belarus, and some non-EU SEE countries. Similarly, apart from Turkey and the CIS, countries are more advanced in their credit and deleveraging cycle compared to EMs outside the region (see Fall 2015 REI for details).

B. Outlook

Growth is projected to fare better in 2016 compared to 2015, mainly on account of a more moderate recession in Russia and a gradual move to a modest expansion in the rest of the CIS (Figure 1.5). The new projections are somewhat lower than those in the fall of 2015, as lower oil prices are weighing on the Russian economy, including by requiring more fiscal adjustment. Growth in other CIS countries, in turn, is revised down because of lower exports to Russia and additional fiscal adjustment. Elsewhere, weaker foreign demand is largely offset by stronger domestic demand, which is being helped by lower commodity prices. The outlook for 2016 across the region is as follows:

  • In the CEE subregion, growth rates are projected to move sideways or ease somewhat. The key factors are weaker external demand growth and a diminishing absorption of EU Structural and Cohesion Funds.

  • For most SEE countries, growth is projected to be broadly unchanged or to strengthen. In Romania, a cyclical upswing is underway and growth is projected to strengthen supported by wage increase, low fuel prices and VAT reduction. In Serbia, growth is expected to accelerate as the pace of fiscal policy tightening slows and structural reforms start to take effect under the IMF-supported program.

  • In the Baltics, growth will pick up on the back of a waning drag from exports to Russia.

  • In the CIS, output contraction is expected to moderate. Despite some tentative signs of economic stabilization, the unexpected oil price decline in mid-2015 and a correction of growing fiscal imbalances likely mean that the Russian economy will stay in recession in 2016. At the same time, Ukraine is expected to record positive growth supported by diminishing macroeconomic imbalances and a less challenging geopolitical situation.

  • Turkey is projected to turn in another year of strong growth. A 30 percent minimum wage increase and accommodative policies mean that both growth and external imbalances will be more elevated than previously expected.

Figure 1.5.CESEE: GDP Growth Forecasts and Revisions

Source: IMF country team estimates.

Note: CEE = Central and Eastern Europe; CIS =Commonwealth of Independent States; EU = European Union; SEE = Southeastern Europe. Highlighted cells mark downward revisions. Panel 2 shows revisions for 2016 growth projections relative to the fall of 2015.

1/ Domestic policies include monetary policy, credit conditions, and fiscal policy (incl. EU Structural and Cohesion Funds).

Inflation is projected to gradually rise but stay low outside the CIS and Turkey and the revisions are mostly to the downside with the notable exception of Turkey (Figure 1.6). The large share of food and energy products in the consumption basket along with falling prices for these products is dominating inflation dynamics in many countries. In 2016, several CESEE countries have experienced stronger wage growth, including large minimum wage hikes, which mostly reflect tightening labor markets. Estimates show that about a quarter of average wage growth in CESEE countries during 2012-15 was associated with minimum wage developments (Box 1.2). This could imply noticeable increases in average wages in countries where the coverage of minimum wages is high, but is not projected to fundamentally alter the inflation dynamics in the near term. For CIS countries, 2016 inflation projections are roughly unchanged as upward price pressures from exchange rate depreciations are largely countered by downward pressures from contracting domestic demand. In Turkey, inflation for 2016 has been revised up to 9.8 percent from 7.9 percent, with wage hikes and accommodative macroeconomic policies boosting excess demand.

Figure 1.6.CESEE: Inflation Forecasts and Revisions

Source: IMF country team estimates.

Note: CEE = Central and Eastern Europe; EU = European Union; SEE = Southeastern Europe; CIS =Commonwealth of Independent States. Highlighted cells mark downward revisions. Panel 2 shows revisions for 2016 inflation projections.

1/ Domestic policies include output gap, changes in taxes, and inflation expectations.

C. Risks

While the recovery in CESEE has taken hold, risks to the outlook have risen. Although the main sources of downside risks remain largely unchanged, these risks have become more pronounced, with a tightening in financial conditions, weaker global growth prospects and rising political risks across the region:

  • Tighter or more volatile global financial conditions: Sovereign credit-default swap (CDS) spreads appear compressed relative to economic fundamentals and according to standard econometric models. Increased market volatility may result in rising borrowing costs and a pickup in portfolio outflows, particularly affecting those with high fiscal financing needs (Figure 1.7). Financial volatility may rise appreciably should the British voters choose to leave the EU in June. In addition, further weakness in European bank asset prices may heighten pressures on these institutions to cut exposures to the CESEE region. While foreign banks still own three-quarters of CESEE banking systems, dependence on parent funding has dropped significantly. Because domestic lending is now largely funded by local deposits in many countries (Figure 1.7), the impact of lower foreign bank flows on the real economy is likely to be less disruptive.

Figure 1.7.CESEE: Vulnerabilities to External Financing

Sources: Bloomberg; and IMF staff calculations.

1 Positive values for CDS spread compression mean that actual CDS spreads are below their model-based medium-term norms.

  • Structurally weak growth in the euro area: A slowdown in growth in the euro area poses a significant risk for the region given the one-to-one link between euro area and CESEE growth on account of their many economic and financial linkages.

  • Significant slowdown in China: Countries linked to the German supply chain (mostly in CEE sub-region, but some in SEE) are likely to be affected via lower exports (see Fall 2015 REI for details). In addition, there may be financial sector spillovers if the slowdown affects investor sentiment for EMs. Commodity exporters, notably Russia, are also likely to be affected via deteriorating terms of trade. However, to the extent China’s slowdown reflects rebalancing from investment-led growth to a more consumption-based growth, there may be positive spillovers through higher export demand over the medium-term, especially for non-commodity exporters.

  • Sharp rise in migrant flows and related instabilities due to security dislocations in the Middle East: While this risk may be non-trivial, the impact is likely to be limited to a few countries, particularly with the closure of the Balkan migrant route. The risk is non-negligible for Turkey, where refugee flows may increase in the near term. With the Balkan route now closed, migrants may try to search for alternative routes.

  • Rising political risks: A number of CESEE countries have experienced political instability (notably, Ukraine, Moldova, Kosovo and FYR Macedonia) (Box 1.3). Several other countries have seen the rise of populist parties in recent elections fueled by anti-establishment sentiment that may entail some policy reversals. With a number of countries facing elections in the near-term, risks of political instability may be on the rise. Furthermore, a risk of the UK exiting from the EU could further increase support for euroskeptic parties and resistance to economic integration.

Euro area stagnation would have the largest impact on CESEE growth. According to the IMF staff’s assessment, the risk of euro area stagnation, should it materialize, would likely have medium-to-high impact on over half the countries in the region (Figure 1.8). Weaker growth in major EMs could delay the recovery in commodity prices and have negative effect on Russia.

Figure 1.8.Downside Risks to Outlook: Likelihood and Impact

(Percent of all responses)

Source: IMF country team survey.

Note: The relative likelihood of risks reflects IMF staff’s subjective assessment of the risks surrounding the baseline. “Low” indicates a probability below 10 percent, “Medium” indicates a probability of 10 to 30 percent, and “High” indicates a probability of 30 to 50 percent. EM = emerging market. The relative impact is based on country-specific assessments; the map shows distributions across countries based on the IMF country team’s assessments.

Box 1.1.CIS: Weathering Internal and External Shocks1

In the face of multiple shocks, the countries in the Commonwealth of Independent States (CIS) adopted a range of policies to stabilize their economies and financial systems. Since late 2014, these economies have been buffeted by declining commodity prices, geopolitical tensions and domestic political instability. Output contraction started in Ukraine in 2014, while the other countries entered into recession in 2015. Policy measures used by the CIS countries included, to varying degrees, allowing greater flexibility in the exchange rate, accompanied by an increase in the policy rate and some intervention in the foreign exchange market to prevent a free fall in the exchange rate, and generally tighter fiscal policies. In Russia, policies were also adopted to stabilize the financial sector, with temporary regulatory forbearance and liquidity support. Ukraine introduced temporary restrictions on capital flows to ease balance of payment pressures, and provided liquidity support to banks followed by comprehensive recapitalization and restructuring. Moldova closed three failed banks and also intervened occasionally in the foreign exchange market to limit excessive volatility (Table 1.1.1).

Table 1.1.1.CIS: Policy Measures to Stabilize the Economy
Allow exchange rate flexibilityYesYesYesYes
Raise policy rateYesYesYes, also higher reserve requirementsYes, reserve requirements were increased.
Foreign exchange market interventionVery limited after moving to a floating exchange rate regimeForeign exchange sales were limited to meet central government needs and critical energy importsLimited to smoothing volatility
Financial system supportTemporary foreign exchange liquidity provision and other support to banks. Temporary regulatory forbearance on loan classification, provisioning, and valuation accountingTemporary liquidity support to banks followed by comprehensive recapitalization and restructuringProvided extraordinary public support (12 percent of GDP) to three failed banks, ultimately closing them and initiating asset recovery procedures
Capital controlsAdministrative measures on foreign exchange transactions were introduced, and capital controls tightened
Fiscal policyLimited stimulus in 2015Fiscal deficit narrowed in 2014 and 2015Higher headline government surplus in 2015Lower cash deficit in 2015
Source: IMF country reports.
Source: IMF country reports.

Exchange rate depreciation has helped improve the trade balance and price competitiveness, despite an initial hit to inflation. While all CIS countries experienced large nominal depreciations, real effective exchange depreciations during 2014-2015 were sizable only in Russia and Ukraine (22 and 17 percent, respectively), but more modest in Belarus and Moldova (about 2.5 and 1.5 percent, respectively) due to very high inflation. The move to flexible exchange rates and supportive policies helped these economies rapidly reduce external imbalances mostly through import compression. Imports have declined significantly in all four countries, with non-energy imports declining by a cumulative 25-51 percent during 2014-15 (Figure 1.1.1). The large depreciations corrected most of the pre-existing exchange rate misalignments in these countries. Despite improved price competitiveness, overall exports saw limited benefits due to a high share of commodities in exports (in the case of Russia), weak demand for heavy equipment (in the case of Belarus), still low compliance with EU import standards (in the case of Moldova and Ukraine), as well as supply disruptions, trade restrictions and weak demand in other CIS markets (in the case of Ukraine) (Figure 1.1.2). Non-energy exports showed signs of stabilization or modest recovery in 2015. Even though inflation soared in the aftermath of depreciations, it stabilized in the second half of 2015 as exchange rate stability took hold.

Figure 1.1.1CIS Non-energy Exports and Imports, 2013-2015

(Percent; four-quarter change; 2013:Q1=100)

Source: Haver Analytics; and IMF Country Teams

Note: CIS=Commonwealth of Independent States

Figure 1.1.2CIS Exports by Major Categories and Destination, 2013

(Percent of total)

Source: Haver Analytics; and IMF Country Teams

Note: CIS=Commonwealth of Independent States

1/ This Box was prepared by Yan Sun.

Box 1.2.Recent Minimum Wage Developments in CESEE Countries1

After a period of restraint during the global financial crisis, minimum wages since 2012 have been rising faster than average wages in most CESEE countries. The pace of increase has been sharp particularly in Turkey, and some Baltics and SEE-EU countries. Minimum wages are typically set by the government, sometimes in consultation with social partners. Based on limited available data, about 10-20 percent of workers earn the minimum wage in CESEE. While minimum wage policy can provide protection to low income workers and avoid abuse of company power, sharp minimum wage hikes may undermine external competitiveness and hamper job creation, particularly for low-skilled labor and in labor-intensive industries.

Figure 1.2.1.CESEE: Minimum Wages

(Percent of average wage)

Sources: Eurostat; IMF World Economic Outlook database; national authorities; and IMF staff calculations.

Figure 1.2.2.CESEE: Minimum wage and gross wages

(Percent annual average change for 19 EU countries, 2001-13)

Sources: Eurostat; and IMF staff calculations.

Minimum wage hikes could contribute to overall wage growth directly and indirectly through spillovers. About ¼ of average wage growth in CESEE countries over 2012-15 is associated with minimum wage developments. In particular, the elasticity of average wage to minimum wage is found to be around 10-40 percent, based on a variety of cross-country, firm level, and sector level estimates with the high impacts related to cases where coverage of minimum wage is high. The Wage Dynamics Network Survey of the European System of Central Banks also noted that about a fifth of firms in the survey reportedly would have to increase the wages of employees above the minimum wage as the minimum wage rises, thus emphasizing the spillovers of minimum wage increases on overall wages.

Some negative impact on the employment of youth and low-skilled workers can also be expected, particularly in countries with a high relative minimum wage. IMF staff analysis finds that some negative employment effects start to materialize when the minimum-to-average wage ratio exceeds 40 percent. The effects could potentially increase toward higher minimum-to-average wage ratios, reflecting their non-linear nature.

The impact on competitiveness is uncertain and worth monitoring. For the period of 2009-13, when minimum wage increases were smaller, firm level analysis reveals that tradable sector firms appear to absorb higher labor costs, and experience somewhat lower profit and employment growth, as they restrain price increase in order not to lose competitiveness. The impact of the currently larger increases of minimum wages, however, are uncertain and worth monitoring.

1/ This Box was prepared by Faezeh Raei and Piyaporn Sodsriwiboon based on the forthcoming IMF Working Paper.

Box 1.3.Political Stability Risks in CESEE1

Political stability risks appear to have increased across the CESEE region. In order to track political risks in CESEE, we use the Economist Intelligence Unit’s (EIU) “Political Stability Risk” indices, which evaluate a “range of political factors relating to political stability and effectiveness that could affect a country’s ability and/or commitment to service its debt obligations and/or cause turbulence in the foreign-exchange market.” These indices take values from 0 (very low risk) to 100 (very high risk) and are constructed for all countries in the world. At present, in almost half of all CESEE countries, the EIU political stability risk indices are above 50. The EIU indicators suggest that political risks are particularly high in the European CIS countries, Turkey, and, to a lesser extent, in the non-EU SEE countries. In terms of changes, risks have increased in the past year in Poland, Turkey, Belarus, Moldova, and Montenegro and decreased in Serbia, Albania, Bulgaria, Latvia, Romania and Russia (see Figures 1.3.1 and 1.3.2).

Figure 1.3.1.Economist Intelligence Unit Political Risk Score, March 2015

Figure 1.3.2.Economist Intelligence Unit Political Risk Score, March 2016

While political stability risks in some of the larger CESEE countries are well known, such risks are also prominent in several smaller CESEE countries, such as Moldova, FYR Macedonia and Kosovo:

  • FYR Macedonia has been in an open political crisis since the April 2014 elections when the main opposition party boycotted Parliament alleging vote rigging. In early 2015, the opposition leader released tape recordings implicating top state officials of the ruling coalition in vote rigging, large-scale government abuse of power, and corruption which led to the resignation of top officials. A political agreement brokered by the EU and the US late last summer is being implemented with elections expected later this year.

  • Moldova has been in the midst of political, economic, and financial turmoil since late 2014, with three cabinet changes within one year. Political instability has been amplified by the revelation of a large-scale fraud in the financial sector. This resulted in a collapse of three large banks, with a cost to the budget of around 12 percent of GDP and a significant loss in reserves.

  • In Kosovo, political tensions have been high since October 2015, when the government signed agreements brokered by the EU towards normalization of relations with Serbia. The opposition has vowed to block all parliamentary activity and to stage protests until the government resigns.

Political uncertainty and instability can have macroeconomic ramifications by dampening investors’ interest and raising concerns about possible changes in economic and other policies, which can then lead to a sovereign rating downgrade. The latter channel was highlighted in January 2016, when Standard & Poor’s downgraded Poland’s foreign credit rating, warning that recent moves “weaken the independence and effectiveness of key institutions.”

1/ This Box was prepared by Bas Bakker and Krzysztof Krogulski.

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