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CEE: A Region of Increasing Divergence Following a strong start to 2014, challenges to growth are rising in Central and Eastern Europe but differentiation is of increasing importance.

CEE: A Region of Increasing Divergence

by Dan Bucsa, CEE Economist, UniCredit Bank AG

Following a strong start to 2014, challenges to growth are rising in Central and Eastern Europe but differentiation is of increasing importance. Central Europe has achieved an impressive amount of consolidation over recent years, putting economies in a much better position to take advantage of global recovery in activity. Countries in South East Europe have lagged on reform and growth is set to remain more muted. Turkey remains amongst the growth leaders in the region, supported by a strong public sector and banking sector balance sheet but is vulnerable to external shocks. In Russia, our concerns surrounding the medium- to long-term growth outlook have increased significantly as geopolitical tensions undo a multi-year period of progress on trade and financial liberalisation.

Central Europe benefits from a number of advantages, including flexible and competitive labour markets, a role as a key part of EMU’s (European Monetary Union) and in particular Germany’s industrial production engine and access to another round of EU funds aimed at agriculture, infrastructure and human capital. In contrast with other emerging market regions globally, many of the newer EU states have done a considerable amount of work to improve competitiveness, budget and current account balances over recent years. And as the EMU banking system recovers, the newer EU states stand to benefit both directly and indirectly given that foreign owners remain dominant.

All of the above means that the recovery in activity that has been under way since mid-2013 should continue. Investment recovered in many Central European economies even before the start of the 2014-2020 EU fund programming period. Hungary and the Czech Republic are two examples of countries that continue to benefit from foreign direct investment to their tradables sector, supporting strong growth in industrial production and exports. The combination of narrower budget deficits and improving government revenues also means that fiscal policy is no longer acting as a significant drag on growth – as has been the case in the past – while interest rates are at record lows and set to adjust upwards only gradually. Data over the course of 2Q14 acts as an important reminder of the fact that the speed of recovery will at times slow, with events in Ukraine posing a significant risk to the outlook. Nonetheless we expect the recovery to continue over the coming quarters. A temporary weakening of demand from the Eurozone could be offset by stronger domestic demand in 2H14.

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