Rebuilding Central Europe’s Lost Relevance in European Integration
13 May 2021
The Visegrad Group is one of the worst-hit places in terms of COVID-19 casualties. But the V4 industries demonstrated a degree of resilience in the wake of the pandemic. This offers hope that in 2021 the region should regain its economic shine if the virus allows it.
Until September 2020 many people thought that the EU’s Central and Eastern European nations might have had some sort of immunity against COVID-19 – either through luck, less intensive social contacts or – as one hypothesis suggested – thanks to past tuberculosis vaccinations. The fatality rates from COVID-19 were very low in Poland, Czechia, Slovakia and Hungary.
The autumn, however, changed everything. The pandemic hit CEE societies with severity. Poland topped the EU ranking in terms of excess deaths, which is the most reliable measure of a death toll caused by the virus. Czechia, Hungary and Romania fared only slightly better.
Yet, not everything was doom and gloom over the last months of 2020. While societies suffered, economies were recovering – at least in some important sectors. Consumer sentiment plummeted, but famous Purchasing Managers’ Index (PMI) indicators of industrial sentiment surprisingly rose.
While the service sector closed down, the industrial sector was flooded with new orders and factories worked at almost full capacity. One reason for the surprising revival of production in autumn was that consumers worldwide substituted expenditures on services with purchases of goods.
Germans, French and Italians could not go to the cinema, restaurant or theatre, so they spent more on furniture, home appliances and car repairs. The Visegrad economies are huge suppliers of such products.
Thus, 2021 began with mixed fillings in Central and Eastern Europe. COVID-19 is still ripping through societies, causing fear and deaths. But there are signs that economies started adapting to increased uncertainty. The introduction of vaccines against the coronavirus causing COVID-19 has created economic optimism.
The hopes run high that this year will bring booming growth. After an estimated gross domestic product (GDP) contraction of five per cent in 2020, the consensus indicates that 2021 will bring a rebound of almost five per cent in the region. Some investment banks forecast that it can even be much higher.
Many hopes and fears present in the CEE are common to all societies and economies around the World. The main reason for optimism is vaccination and adaptation.
Although the vaccination campaigns started very slowly, most people willing to take a jab should be able to do so by late summer or early autumn. Even in a cautious scenario, immunity gained through infections or vaccines should substantially reduce the COVID-19 pandemic’s severity.
When uncertainty subsides, the flood of demand should be unleashed. The financial situation of most consumers is pretty good because the unemployment rates were kept low by huge fiscal support.
At the same time, consumers saved intensively during 2020 and will have strong spending power in 2021. This is called a pent-up demand – the income that was excessively saved will probably be spent soon.
All that will happen only if the virus does not mutate in a way which would obstruct herd immunity among the populations. The possibility of such mutations is the main risk visible on the horizon.
There are also trends which are specific to the CEE countries, including positive factors and important threats.
When it comes to regional factors, the main reason for optimism is that the global industry’s supply chains have survived in good shape. This is important because Poland, Czechia, Slovakia and Hungary are very much export-driven economies.
Ernst & Young, a consultancy company, estimates that as much as two-thirds of the economic growth in Poland in the recent decade was caused by external demand – either directly or through so-called ‘backward linkages’ (an exporting firm driving demand for components and services locally). In other countries, the impact is probably even higher.
When the COVID-19 pandemic started, many economists feared that global supply chains would break and the CEE growth model would collapse. In April, the World Trade Organization predicted that global exports would fall by 15 to 30 per cent in 2020 and that seemed like an underestimation.
Fortunately, the reality came out to be much more optimistic. The global exports fell by circa eight per cent, and CEE exports recovered most of the spring losses during the autumn revival phase.
In October, Poland, Czechia and Slovakia registered positive goods’ exports growth on year on year terms. The strength of industrial relations should sustain a strong recovery in the Visegrad region when the COVID-19 pandemic is brought under control.
The resilience of global business links has been also demonstrated in the services sector. Although the total exports of services declined substantially because of the freeze in tourism travels, the important subsector of business services in CEE registered an increase in foreign demand.
Over the last decade, the region became a destination for IT, financial, legal and HR outsourcing for the largest global banks. They employed circa half a million people in well-paid jobs in the CEE, which generated positive spillovers in the local economies and allowed those large banks to cut their costs in the wake of the financial crisis.
The COVID-19 pandemic has not stopped the trend of relocating important services to Central and Eastern Europe.
The region, therefore, maintained its strengths, which are mainly related to its increasing role in the global hierarchy of production of goods and services. On top of that, there is one factor which can be a true growth booster – the EU’s Next Generation Programme.
For four years, the CEE countries will receive annual transfers and cheap loans equal to about 2.5 to three per cent of their GDP. These are in addition to traditional EU funds, which entitle the region to transfer equal to 1.5 per cent of GDP per year.
The Next Generation Programme should increase GDP growth by one percentage point over the next few years, which means a third or quarter of expected growth rate.
The risk that the epidemic does not subside, the virus mutates or the vaccinations stumble due to bad organisation dwarfs any other challenges visible on the horizon.
The whole EU could treat such scenarios as a threat, but for the CEE region, it would be a double problem. Not only the economies would be stuck in a recession, but also the financial resilience of emerging markets could be undermined.
So far financial investors have not called the credibility of CEE governments into question – government bond yields are low, the demand for new issuance is high and unconventional monetary policies have been met with understanding. But if a deep recession transforms into depression, then things might change.
If the common belief in the immediate win over the COVID-19 pandemic evaporates, investors might want to shelter in safe havens, like the Eurozone or the US. Weaker markets could experience currency devaluation, inflation and instability.
Hungary is the most vulnerable country because of its relatively low sovereign rating and high public debt. Czechia and Slovakia should be the most resilient to any such shocks. Poland is somewhere in the middle.
There is, however, one factor that should protect Central and Eastern Europe from financial storms, even if epidemic prolongs – very high current account surpluses. The current account is a balance of all transactions between a country and the World (exports and imports, investment income, transfers etc.) and measures dependency on foreign capital.
Countries with large current account deficits are deemed vulnerable to sudden changes in investors’ sentiment because they are dependent on borrowing abroad, whereas countries with surpluses are treated as more resilient because they are creditors.
The CEE countries are among those with the highest surpluses in the European Union, after going through a decade-long path from deep deficits. The financial storm today would have a much milder impact on the CEE in comparison with 2009.
But there are other risks on the horizon. One of them is the green revolution and the tightening of the EU’s climate policy goals. It brings hope to the world, which needs an audacious approach to climate change, but at the same time generates risks for some countries and sectors.
The CEE countries are vulnerable to possible shocks in energy prices because the region specialises in producing relatively high energy-intensive and low-margin products. The region, especially Poland, is not as advanced in the transformation to new energy sources as Western countries. Huge investments should help to bridge that gap, but the scale of those investments is beyond any recent experiences.
Climate policies could also raise another type of risk – shifts in automotive supply chains in directions that would disadvantage the region. Electric cars require different technologies and components than traditional, combustion engine cars, and the global landscape of technology and production also looks different. Europe is very strong in combustion engine technology but very weak in electric batteries technologies – Asia and the US dominate that market.
If the electric cars market develops faster, then Europe could lose its competitive edge. Czechia and Hungary are the most vulnerable to such changes because they produce more ready-made cars and engines than Poland. Germany would also lose in such a scenario, and that should offer some political hope: nobody in Europe is interested in a very fast expansion of electric cars (expansion yes, too fast expansion – no).
The last risk for the CEE is political. The quality of democratic institutions has been gradually eroded in the region over the last few years. It has not hurt economic growth, so investors and companies have not paid too much attention to the process.
However, the change of the US president – from Donald Trump to Joe Biden – could result in a much harsher pressure being put on semi-authoritarian governments, and could also encourage the EU to take a much tougher stance on the cases of breaching the rule of law in the CEE. Investors might pay more attention to the political environment when both the US and the EU start behaving differently.
Overall, the chances that appear in 2021 are much more pronounced than the risks. A strong revival of economic growth is around the corner, whereas structural shifts that could pose a long-lasting threat to Central and Eastern Europe are much more hypothetical.
But 2020 taught us that we should never forget about such hypothetical threats.
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