The Vienna Institute for International Economic Studies (wiiw) has for the third time in a row this year hiked its 2021 CEE growth forecasts as the region continues to bounce back from the COVID-19 pandemic.

In its autumn forecast, the wiiw raised its prediction for 2021 growth across the 23 countries of Central, Southern and Eastern Europe region by 1.2 percentage points from its July forecast to 5.4%.

This means that in 2021 the CESEE region is likely to grow significantly faster than the euro area (which it forecasts to grow by 4.8%). Moreover, for two thirds of CEE countries, the pre-crisis level of 2019 was already exceeded in the second quarter.

“We are seeing a much stronger, better recovery than we expected,” Richard Grievesen, deputy director, told a webcast to announce the forecast on October 20.

Grievesen said 2022 would be a “much more mixed picture” with a “mild growth slowdown” to an average of 3.7%, caused by base effects, monetary tightening and more significant external headwinds.

In 2023 growth is forecast to slow further to 3.5%. Convergence with Western Europe, which has slowed since the global financial crisis, will continue “but at a slower rate”, said Grievesen.

However, the wiiw also pointed out that downside risks had increased, highlighting a severe worsening of the COVID-19 pandemic, hasty budget consolidation and forthcoming US monetary policy tapering.

Grievesen said the key reason for the upgrade was that in CEE  “governments have given up trying to restrict the pandemic”, and restrictions are now much looser than in Western Europe, where the hard-hit service sector is anyway a more important part of the economy. As the fourth wave of the pandemic breaks on the region, Latvia is so far the only country to have reinstated a lockdown. 

The strongest growth in 2021 is predicted in Turkey (9.1%), Montenegro (8.4%) and Moldova (8%), with the lowest in crisis-hit Belarus at 2.5%. The biggest revisions were in Estonian growth (up 3.6pp) and Turkish growth (up 3.3pp). The only downgrades were in Macedonia (down 0.6pp to 3.5%) and Ukraine (down 0.5pp to 3.8%).

In 2022 the strongest growth is predicted for Croatia (5%) and Poland (4.9%), as well as in Montenegro and Kosovo (4.8%).

For Russia, after 4% growth this year, wiiw predicts 3% in 2022 and 2.8% in 2023. Grieveson was bearish on Russian long-term growth, which he put down to the poor business environment and the government’s tight fiscal policy, which was motivated by a determination not to become indebted to Western creditors.

“Stability is prioritised over growth,” he said. “In the last five years Russia has been more or less the slowest growing economy in the region,” he noted. “It will return to this weak performance in the next few years.”

Looking at the whole region, the wiiw says the main driver of growth is private consumption. With an average growth of 14.5%, it expanded massively in the second quarter. Investment also increased by almost 18%, on average, in this period. Exports are also picking up markedly on the back of the global upswing and the recovery in tourism.

On the downside, industrial production is suffering from material shortages (for example of semiconductors in the automotive industry), as well as higher commodity and energy prices, much of which is currently being absorbed by firms and not being passed on to consumers.  

Employment is again approaching pre-crisis levels in many countries, and Croatia, Latvia, Hungary, Poland and Slovenia have already reached or exceeded this level.

However, the wiiw report says, the coronavirus (COVID-19) crisis has left scars in the labour markets, with underemployment higher than before the pandemic, and unemployment remains a problem in many countries, especially in the Western Balkans.

At the same time, there are labour shortages in some countries, notably EU member states of the region, but also in Montenegro, Serbia and Russia.

“Labour shortages are very much back,” Grievesen said, pointing to the Czech Republic as once again having the worst problems in this respect. “We have been surprised how quickly the topic of labour shortages has returned,” he said, noting that the fundamental problems of low birth rates and labour migration to Western Europe because of income differentials are still present. “These labour market problems will persist.”

Looking ahead, the wiiw predicts that transfers from the EU’s Recovery and Resilience Facility (RRF) will be an important growth driver. The EU’s RRF will be especially important for example in Romania, where transfers from the programme – worth a total of around €29bn – could in theory generate additional yearly growth of up to 3.1 percentage points until 2026.

“In reality, however, the economic effect of the reconstruction fund will be significantly lower,” predicts Vasily Astrov, wiiw senior economist. “On the one hand, because the economies of the region cannot fully absorb the money, and on the other, because the EU transfers will in part merely replace the funding of investment projects from national budgets.”

Rising inflation is already becoming a challenge for policymakers, with inflation rates 3 to 4 percentage points higher than at the beginning of the year, but the wiiw argues this is likely to be a transitory phenomenon.

Its views contrast with those of the UK’s Capital Economics, which issued a research note last week saying that Central and Eastern Europe is one of the regions of the world where the risk of sustained higher inflation in the next few years is greatest. “The combination of a cyclical recovery in demand for labour alongside structural labour shortages will feed into stronger wage growth and keep inflation above central banks’ targets,” Capital Economics said. 

Faced with rising inflation, many central banks have already reacted by raising interest rates, and further interest rate steps are likely to follow. This has already led to government criticism of central banks, notably in Czechia and Hungary. Nevertheless, real interest rates continue to fall, given the rising inflation.

“Central banks are very much following the Fed/ECB narrative that this is transitory,” Grievesen said, adding that there is “not much evidence of overheating on an aggregate level, except in property markets”.

In Czechia and Lithuania, property prices have risen by 16% and 15% respectively since the start of the pandemic, and still show an upward trend.

‘This [central bank tightening] should also cool the overheated and primarily credit-financed real-estate markets in many places, some of which are showing signs of bubble formation’, says Astrov.

However, there is a risk that further tightening of monetary policy in export-dependent countries in Central Europe such as the Czech Republic could put up the value of currencies and weaken export competitiveness against the euro area, especially as ECB monetary policy will for the time being probably remain ultra-expansive, said Astrov.

Grievesen said shortages of key components and rising commodity prices, together with labour shortages and a potential worsening of US-China trade relations, could push inflation higher. “This could drive inflation that leads to monetary tightening that kills recovery and causes financial instability,” he warned.

He also cautioned against premature fiscal tightening. The fiscal response to the COVID-19 pandemic had been “rather good” he argued, though budget deficits throughout the region have ballooned to an average of 6.3% of GDP in 2020 and an estimated 4.5% this year. A premature reduction in government spending could jeopardise recovery in a number of countries, especially in the Western Balkans and the successor states of the Soviet Union.

Another risk was that tapering of monetary policy in the US could dampen the recovery, by making dollar financing more expensive. Grievesen said Turkey was most at risk of a hard landing here, followed by Romania. Turkey, the second biggest economy covered by the wiiw, is already predicted to slump from 9.1% growth this year to 3.8% in 2022 and 2023.

“But the while region will feel the impact [of Fed rate rises], mainly in terms of borrowing costs,” he said.