Green islands in the storm

According to estimates by the East Capital fund, freezing an economy for one month lowers GDP by just over 4 pct and the effect increases exponentially as time passes. If a second lockdown can be avoided the CEE region has the chance to make a quick recovery

One of the reasons for this is because these markets have less exposure to the tourism industry, but the main reason is the fact that all the countries of the region were in a relatively healthy economic condition when the pandemic started. Their healthy macroeconomic fundamentals mean that they can look to the future with guarded optimism.

CEE economy remains healthy

Firstly, they mostly have low public debt levels of under 50 pct – except for Hungary, where the public debt is over 70 pct. This allows them to be more generous with their support programmes, by offering either low interest loans that can be partially written off or direct subsidies without repayment. Secondly, these countries each have the advantage of a stable banking sector with high capital reserves (which means low risk) and high rates of return (unlike in Western Europe). As a result the banks will be able to absorb the shock caused by the economic changes. Thirdly, CEE countries were also lucky because the coronavirus virus reached them later than countries in Western Europe and as a result governments had more time to react.

None of this changes the fact that the expansion of fiscal policy has strained budgetary resources. There is no doubt that with the widening public deficit and the end of the economic boom, public debt is going to rise in relation to GDP. Balancing the public finances is most likely going to require introducing higher – and maybe even more progressive – taxes.

According to estimates by the Vienna Institute for Economic Studies (WIIW), the economic slowdown resulting from the coronavirus pandemic in the CEE region will be deeper than after the world economic crisis of 2008. GDP across the region is expected to fall by 6.1 pct, which compares to a drop of 5.6 pct in 2009. Moreover, the recovery is to be slower with growth of 2.8 pct expected in 2021 compared to 4.4 pct in 2010. The countries that are to see the biggest declines in GDP will be those in the Balkans, including Croatia (-11 pct), Slovenia (-9.5 pct) and Montenegro (-8 pct), but also Slovakia is expected to see a large drop (-9 pct). On the other hand, countries that are less dependent on tourism and foreign trade will see smaller slides. GDP in Kosovo is expected to fall by 4.4 pct, while in Serbia the decline should be around 4 pct.

Poland and the Czech Republic are only expected to suffer moderately, with both their economies expected to contract by 4 pct. The rankings drawn up by ‘CEOworld Magazine’ appear to agree with such predictions, with Poland being the third most attractive investment destination in the world, behind only the UK and Singapore. The rankings covered 80 countries in which only three European countries (Poland, the UK and the Czech Republic) found themselves in the top ten. Although it stated this at the beginning of the year, before the pandemic started, ‘CEOworld Magazine’ has already pinpointed Poland as a country to invest in.

Real negative interest rates (taking into account inflation) are likely to be in place for some time and so it is difficult to say when we are going to return to “normality”. On the one hand, a number of factors should result in deflationary pressure, such as rising unemploymment, reduced consumption as a result of increased savings and rising debt. On the other hand, the złoty as well as other currencies in the region have weakened considerably in relation to the euro and the dollar, which should result in a rise in the price of imports. The European Commission predicts that by the end of the year inflation as measured by the Harmonised Index of Consumer Prices will come to 2.7 pct in Poland, which represents a 0.6 pct rise on the previous year. The commission also predicts rises in inflation for other countries across the region, but Poland is to see the highest, with some forecasts going as high as 4.5 pct in Q4 2021. Inflation is not expected to surpass that of eurozone, but its rise should be a little slower. By the end of the year it is projected to be 0.6 pct and for 2021 should be around 1.3 pct.

Support needed from the EU

In contrast to 2008, the impact of the coronavirus will be far more serious for the economy than for the financial markets. For this reason the European Commission has implemented unprecedented measures to help the crisis response of its member states. However, not all the countries of the region are in the EU. Ukraine, Moldovia and other non-EU countries in the Balkans have found that the flow of money from abroad (including remittances and foreign investment) on which they are dependent has slowed. They also have limited internal financing resources, so the support of international financing institutions such as the IMF and the EBRD will play a key role in bringing them out of recession. The countries of the Visegrád Group appear to be in a somewhat better situation and can more easily afford financial stimulus. Also, if required, they can increase their debt due to the strength of their credit ratings.

When it comes to the capital market, European stock exchanges did not enjoy such a solid bounce as Wall Street did. The pan-European Stoxx 600 index has risen by almost 32 pct since the chaos of mid-March, but it is still 12 pct down on the beginning of the year. By comparison, in the US the S&P 500 has risen by 42 pct and returned to the same level as in January. Companies in traditional industries are seeing a price-to-earnings ratio in single figures, while their price-to-book value has remained below 1, which suggests these stocks are significantly undervalued. Although fire sales on European markets are considered to be out of the question, valuations have been modest, especially compared to the madness that has ensued across the ocean. This means that there are considerable opportunities for long term investors – those who practise value investing. In order to attract capital in Europe, companies now need to seek out different sources of revenue, since diversification is extremely improtant in a extremely uncertain environment. Moreover, with the current interest rates on bank deposits, the turnover and absorption of stock exchanges should rise as they may become the of the few accessible places to put away savings. In the long term this could have a positive effect, because capital markets still play too limited a role in financing EU businesses.

Not so bad in the CEE

One side effect of the pandemic that the CEE region should benefit from what should be a new hand of cards. The region has a chance of becoming a favoured target for direct foreign investment This is because many companies are looking to outsource some of their production from various parts of the world to Europe in order to avoid future supply disruptions resulting from dependency on a handful of producers. In all likelihood the outsourcing of services to the CEE region will also rise. The cake is about to be cut up once again and this should benefit the region, which should be able to take a larger piece for itself, in this case, by taking a significant slice of the global supply chain.

“This is good news for the CEE region, particularly the Visegrád countries and Romania in terms of manufacturing, and the Baltics for services,” claims Richard Grieveson of the WIIW.

The countries in the region are also taking advantage of the boom in the digital economy that has resulted from the crisis. In search of savings to offset their recent losses, they are moving towards greater automation based on artificial intelligence.

Companies are also turning away from offshoring in favour of nearshoring partly because over the past decade labour cost in China have risen dramatically, According to the ‘Covid-19 & the CEE’s Industrial Upside. Europe’s Near Shore Powerhouse’ report by Colliers International, only Poland and Hungary have labour costs that are greater (but not by much) than China. Romanian costs are similar and in Bulgaria they are clearly lower. By comparison, labour costs in production in Germany are around three times higher than in the Czech Republic. In Slovakia they are four times higher than in Hungary, while Polish labour costs are around six times higher than in Romania and almost eight times higher than in Bulgaria.

Covid-19 has also been accelerating the diversification of investment. Investors are giving more weight to environmental and social factors as well as ESG management issues (environmental, social and governance). This is also being enhanced by the European Green Deal, with the EU aiming for a carbon neutral economy by 2050. This attempt to tackle climate change will go hand-in-hand with further digitalisation, since both reinforce one another. The Next Generation EU support programme the union has drawn up in the wake of the pandemic is of an unprecedented scale and has provided a large boost to push these transformations through. This will, however, require the full mobilisation of both the industrial and financial sectors. European funds will help shape the social economic environment of Europe over the coming decade, but this by itself will not be enough, just as no government can handle the current situation on its own.

The private sector will be of key importance when it comes to financing the green transformation. The first challenge for governments is to provide incentives to invest in sustainable development. For this reason the EU is to promote new forms of partnerships with industry in order to direct how public support is used. These will mainly involve cooperating over how to allocate public and private resources as well as building up new value chains.

Dark clouds on the horizon?

Changing the tack of the economy entails the risk of creating orphaned assets: natural resources, infrastructure and whole industries could suddenly lose their value being superseded by new technology, while fossil fuels production could be abandoned completely. This is a risk faced by the region, despite the improvements to its infrastructure over the last ten years. Poland will also have to bite the bullet when it comes to its coal industry. However, this leaves investors looking at interesting opportunities resulting from the restructuring of the energy sector, because the Polish government will not be able to do this by itself, even with EU subsidies from the Just Transition Fund.

Labour markets in the CEE-6

Salaries in the CEE region are several times smaller than in Western Europe and, in recent years, have been surprisingly comparable to markets such as China. Silviu Pop, the head of research at Colliers International Romania, explains: “As for the level of labour costs for manufacturing operations Romania is now comparable to China. Poland and Hungary are not significantly higher while Bulgaria remains well below this level. This is not to say that these markets compare in terms of critical mass, diversity of products and peak output complexity but from a cost and geographical (near-shoring) perspective, there is certainly some upside to be found in the CEE region”. To this, Kevin Turpin, the regional director of research for the CEE region at Colliers International, adds: “To put things into a different context, labour costs in Germany for manufacturing are around 3 times higher than in the Czech Republic and Slovakia, around four times higher than Hungary’s and Poland’s, almost six times that of Romania’s and almost eight times greater than Bulgaria’s.”

Productivity has more than kept up with this increase in salaries. In all CEE countries, the gap between value added per employee and labour costs has actually widened significantly between 2004 and 2018. It is worth noting that Romania’s spread between value added per employee and labour costs is just a fraction below China’s, with the other CEE markets trailing not too far behind.