Investment-led growth in the CESEE countries: a base effect or signs of a paradigm shift

The period since the outbreak of the crisis corresponds roughly to the time-span estimated as the average time it takes for countries to recover from an economic crisis induced by a deep financial crisis.

The impact of the external environment on developments in the countries of Central, East and Southeast Europe (CESEE) will be characterised by the following features over the next couple of years:

  • A relatively subdued recovery in the euro area and more rapid growth in the United States and other advanced economies;
  • Gradual reform processes relating to EU governance and policy coordination and their contribution to the recovery of the banking sector and economic activities;
  • Uneven growth at the global level with Asian and other emerging economies displaying comparatively high growth rates;
  • A gradual shift of US monetary policy (‘tapering’) and its ripple effect on international financial flows, revealing the vulnerability of a sub-set of emerging economies with weak current accounts and debts accrued over previous years;
  • Commodity prices and energy price developments remain flat (implications of the current Ukraine crisis and related developments with Russia not accounted for).


Five to six years have elapsed since the global financial crisis erupted; it is now time for Europe to set out on the path to recovery. The period since the outbreak of the crisis corresponds roughly to the timespan which Carmen Reinhart and  Kenneth Rogoff estimated as the average time it takes for countries to recover from an economic crisis induced by a deep  financial crisis ‘(see their widely discussed study This Time Is Different: Eight Centuries of Financial Folly (Princeton  University Press, 2009)’. In fact, the advanced economies are expected to record positive growth in both 2014 and 2015. This holds true for the euro area which is expected to grow at 1.2% in 2014 and 1.8% in 2015 after having gone through a period of recession in 2012 and 2013 – with GDP growth rates of - 0.7% and 0.4%, respectively. This is in contrast to the United States which started out on the road to recovery at an earlier stage, registering growth rates of 2.8% in 2012 and 1.9% in 2013 and is expected to grow at close to 3% in 2014 and 2015.


The current external economic environment appears to favour growth in the CESEE countries. With even the economies of Southern Europe, such as Spain and Italy, emerging from recession (see Figure 1) in tandem with world output growth picking up speed from its current level of 3.0% and rising to expected rates of 3.7% in 2014 and 3.9% in 2015 (International Monetary Fund, World Economic Outlook WEO Update, January 2014), the mild recovery in the euro area will engender a  global economic climate that also favours growth in the CESEE countries. Three factors, however, will restrain European growth at its current low level.

  • the lack of progress in dealing with the issue of ailing European banks, linked as it is to the very slow progress  towards establishing a banking union in the euro area, where bank consolidation remains almost wholly within the purview of national authorities;
  •  the persistent nature of the fiscal consolidation process which has – in the eyes of policy-makers – taken on even  greater urgency on account of the ever increasing levels of debt resulting from low growth and the periods of recession in previous years; and
  • the disinflationary – in some countries deflationary – climate that acts as a drag on both deleveraging and spending.


Over the past few quarters GDP growth in Central, East and Southeast Europe (CESEE) has been rather weak. That notwithstanding, in the course of 2013 most CESEE countries registered an upward movement in economic activity compared to the previous year, when the region suffered the second dip in the double-dip great recession. Those developments also tracked the fragile recovery in the euro area. In the first quarter 2012, almost half of the CESEE economies re-entered negative territory year-on-year; by the fourth quarter, average growth was close to zero. From the first to the final quarter 2013, the  average annual economic growth rose from 1% to 2%. Preliminary figures for the fourth quarter 2013 suggest that almost all CESEE countries have returned to positive territory, the most notable exception being Croatia stuck at the bottom of the  regional league. Both economies had been constantly shrinking since the fourth quarter 2011. The top performers in 2013 were the economies on the fringes of Europe, such as Kazakhstan, Latvia and Turkey. The three countries registered growth rates of some 4-5% that might however prove unsustainable, at least in the case of Turkey, confronted as it is by a sell-off in emerging markets.


With the exception of the Baltic countries and the European periphery, household consumption has been flat. In the Baltic countries, a wage rebound is fuelling household expenditures. Moreover, this trend is likely to continue in the years to come, as Baltic governments have announced their intention to raise minimum wages and unfreeze public sector wages and pensions in an attempt to make up for the misery suffered under the previous harsh austerity measures. In other former Soviet republics, current consumption growth is partly creditfuelled. Consumption was high in 2013; it is also expected to continue to lead GDP growth throughout our forecast period 2014-2016 − albeit at a somewhat slower rate compared to previous years. This projection holds only partly true for Turkey, which, having registered strong consumption growth in 2013, will have to rely more on net exports in 2014 and beyond, following a marked devaluation of the national currency in recent months. However, in all the other CESEE economies, private consumption has stagnated or even dropped over the past few quarters. Even though future quarters might bring some improvement, overall private consumption will not necessarily lead the way out of the slump.



In the core CESEE countries, net exports have been on the rise; however, the increase is mostly due to stagnating or falling imports attributable to weak domestic demand. Monthly trade data suggest that since mid-2013, the majority of CESEE economies have recorded negative import developments in euro terms compared to the previous year. The other countries in the region recorded hardly anything other than stagnation.

Only Serbia enjoyed a marked increase in imports. This is mainly related to the rise in production of the new 500L model at the Fiat automotive assembly plant in Kragujevac. For the same reason, Serbia was the only CESEE country in late 2013 to record high double-digit nominal export growth rates year-on-year. Export growth rates of around 10% were registered in Albania, Romania and Bulgaria in the second half of 2013. The remaining countries fall into two discrete groups: a central group with little or no growth in exports; and a peripheral group of former Soviet republics (including Latvia and Estonia) as well as Turkey, Montenegro and Croatia, all of which were recently confronted by a significant shrinkage in nominal exports. In the latter case, the contraction is related to the shipyards being downsized after Croatia joined the EU and thus had to comply with the Union’s anti-subsidy rules. In the case of the smaller economies in the peripheral group, lack of growth is often related to production problems in one major enterprise, as evidenced by production grinding to a halt in Liepajas Metalurgs in Latvia. In the larger countries in the peripheral group, dependence on (falling) world commodity prices is an issue. Overall, for the most part, real trade developments resemble nominal trade developments. Despite improved growth prospects in the euro area, the region’s main trading partner, we do not expect an increase in net exports in the core CESEE countries in 2014 and beyond, since imports are likely to rebound once private consumption picks up, however slightly.


In a number of peripheral countries, the net export outlook differs somewhat, as domestic household consumption cooled off recently. Furthermore, at the same time, some of those countries had to devalue their national currencies.


Investment seems to be pulling out of the doldrums. Apart from some of the former Soviet republics and Macedonia with its humongous monuments programme, all of which have recorded more or less solid rates of growth in gross fixed capital formation for quite a while, the core CESEE economies have only recently departed troubled waters. In the final quarter 2012, the bulk of NMS and Western Balkan countries still faced contracting real investment rates. Only more recently did some of them manage to reach calmer patches and record positive investment growth in the third quarter of 2013. However, at that very point in time, which in most cases is our last point of reference, some of the major economies in the region were still disinvesting, as evidenced by the Czech Republic, Slovakia, Romania, Serbia and Ukraine. Investments also dropped in Russia – the Sochi Olympics notwithstanding. Nonetheless, the general expectation is that investment has bottomed out and by and large will start increasing throughout most of the CESEE countries in 2014 and beyond.

While this might also be a statistical base effect, there is every reason to believe that there is more to it than that. Higher growth forecasts for the euro area might prompt exporters across the region to start modernising and expanding production facilities. When the EU multiannual financial framework (MFF) for 2007-2013 neared its close, the NMS started applying for as many EU-funded projects as possible in order to increase the absorption rate of the funds allocated. As a consequence, we can expect a substantial increase in EU-funded investment projects over the period 2014-2015, when on the one hand, disbursement of funds from the earlier MFF will continue and on the other hand, the new MFF for 2014-2020 will only be at a very initial stage. Given that most of the projects have to be co-financed by national governments, we can also expect public capital investment to increase markedly.


In net terms, government activity in the region appears to be more supportive of growth than its reputation for ‘austerity’ would suggest. About half of the CESEE economies are characterised by expansionary revenue and expenditure policies. The other economies pursue ‘loose’ revenue policies, but adopt a tough austerity stance where expenditures are concerned. In net terms, however, only Hungary and Romania have put a public sector choke on the economy. Nevertheless, results have to be interpreted with caution as comparing the two years is rather like taking a snapshot: an approach that is invariably somewhat arbitrary.


However, in all likelihood, the assumed expansionary revenue stance is largely due to the impact of automatic stabilisers. In the wake of the crisis in most CESEE countries, both direct (income taxes) and indirect (VAT and excise duties) tax revenues decreased as income and consumption went down. However, it would appear that a few countries, more precisely Romania, Ukraine, the Czech Republic and Hungary, have actively increased indirect tax rates. Interestingly enough, all four economies ran a flexible exchange rate regime that allowed for a certain degree of nominal cushioning in the event of external shocks during the crisis. That flexibility might have granted them more manoeuvring space in fiscal matters, which they  apparently used to introduce counter-cyclical consumption tax increases. It is also interesting to note that throughout the crisis no major changes in the exchange rate regime were to be observed in the CESEE countries, with the exception of Ukraine and Kazakhstan, both of which moved from fixed to flexible exchange rates.


Although automatic stabilisers have also done what is expected of them in terms of social expenditures, almost all CESEE governments have introduced massive cuts in public investments. With the exception of Hungary, all the countries in the  region (given data availability) have by and large demonstrated a sense of social responsibility and have permitted an increase in social expenditures in the course of the crisis, hence the negative indicator relating to their social expenditure  austerity measures. In stark contrast thereto, most governments have greatly reduced their public capital investments in such areas as transport infrastructure, schools and hospitals, as well as public utilities (to name but a few). Those investments are often the first items in a budget that can be cut without a major public outcry at a time of economic crisis when tax revenues are dropping and social benefit claims exploding. Once again, it is interesting to consider possible differences in fiscal policy choices in the light of the exchange rate regime in use. A loose cluster of flexible exchange rate economies would appear to have been less generous in terms of social expenditures, yet less austere in terms of cuts in public capital investment.


Whereas during a boom period public and private investment would appear to be unrelated, that relationship is very different in times of crisis, when public investment has the potential to kick-start private investment. As a matter of fact, the correlation coefficient between pooled private and public gross fixed capital formation (GFCF) growth rates in the precrisis boom period 2000-2008 was virtually zero, a positively sloped regression line emerges from the scatter plot for the crisis period 2009-2012. The interpretation goes as follows. A 1 percentage point year-on- year real increase in public gross fixed capital formation is related to a 0.6 percentage point increase in private GFCF, for the sample of CESEE economies during the crisis period. Although a causal relationship is difficult to prove and reverse causality might be an issue, we conjecture  that, in periods of increased uncertainty, the private sector is loath to invest, whereupon public investment has to take the lead, with private investors following in its slipstream.


High interest rates constitute a major impediment for many investors in the CESEE countries. The so-called ‘Taylor Rule’ is both a positive and normative rule of thumb used to assess central bank interest rate policy. In its original basic form, the nominal policy rate should be the sum of the inflation rate, plus the ‘output gap’ and the ‘inflation gap’ both weighted by 0.5, and the equilibrium interest rate. The central bank policy rate (or average lending rate, if no policy rate exists) in the vast majority of CESEE economies is far too high compared to the Taylor Rule  estimate. According to the latter, most of the countries should have a negative nominal interest rate: something that obviously poses a problem on account of the zero lower bound. A group of Western Balkan economies with fixed exchange rate regimes display particularly high interest rates. There may be several reasons for this, such as high-risk premia, the need to defend the current exchange rate or the ongoing deleveraging process and stricter lending standards. At the same time, increasingly large amounts of private investment might be financed via the cash-flow.


On a positive note, by and large confidence in the economy can be seen to be on the rise, as is industrial production. With only few exceptions, across the region the final months of 2013 displayed steady growth in gross industrial production  year-on-year. On average, industrial production in the CESEE countries had already started rising as of late 2012. The mean indicator of industrial confidence however, only commenced increasing in mid-2013. Furthermore, when considering that indicator over a longer time-series, it would appear to have rather weak forwardlooking properties. However, in addition to assessing recent production trends, the indicator should also refer to current order book and stock levels. It should also point to expectations relating to future production, selling prices and employment. Nonetheless, the general trend seems to ‘point north’.


Anecdotal evidence suggests that in several CESEE economies major infrastructure projects are being initiated or planned.  They include traditional public transport infrastructure such as modern motorways, typically financed from the state budget with support from the EU Trans-European Transport Networks (TEN-T) initiative. In Romania several motorway projects are scheduled for completion by 2018. In March 2013 Slovakia announced five new motorway tenders worth EUR 1.2 billion. Furthermore, in Montenegro a 170 km motorway programme valued at EUR 2 billion should get underway this spring - with substantial Chinese involvement.


Chinese construction companies together with Chinese investment banks are also building several coal-fired power plants across the Balkans. These include the 300 MW plant in Stanari in Bosnia and Herzegovina, the 350 MW unit Kostolac B3 in Serbia and the new 500 MW block in Rovinari in Romania. The Chinese are also mooting plans to build a 500 MW unit in Osijek, Eastern Croatia, but these are as vague as those for another 500 MW thermal power plant in Plomin in Western Croatia. Moreover, in Montenegro a tender has been issued for a second block with a capacity of with 300 MW at the thermal power plant in Pljevlja, while in March 2014 a tender for the new 600 MW plant in Kosovo can be expected. The largest coal-fired power plant project in the region is probably the project in Opole, Poland, where a consortium, including the major participation of French Alstom, has recently started building two units with a combined capacity of 900 MW at a cost of EUR 1.3 billion. A number of the projects listed above have to be seen as replacement investments as the older units approach the end of their current life cycle. The Balkans also dispose of a number of smaller hydro-power projects. One of the larger  projects is the construction by Norway’s Statkraft of the Devoll Cascade 240 MW hydropower plant. Scheduled for completion by 2018 at a cost of some EUR 500 million, the project is being executed under a build, own, operate and transfer (BOOT)  concession agreement.


Moreover, several nuclear power stations are being planned in the region. In Bulgaria, the discussion revolves around either extending the existing plant in Kozloduy or building a new complex in Belene. Similarly in Romania, there are plans afoot to complete a third and fourth block at the Cernavoda nuclear power plant. Poland also envisages building two new plants with a capacity of 3,000 MW each at a cost of some EUR 11.8 billion.


The obsolescent Soviet-type nuclear reactors in Paks in  Hungary will have to be shut down in some twenty years. The Hungarian government has thus signed a contract with Russia’s Rosatom for the construction of two new blocks starting in 2015. 80% of the total costs will be covered by a EUR 10 billion credit line from Russia.


In Slovakia, a third and fourth block (each with a net capacity of 440 MW) at the Mochovce nuclear power station are already under construction. Estimated to cost EUR 3.8 billion, the project is scheduled for completion by 2015. Blocks 1 and 2 are to be shut down sometime around 2030.


A boost in investment is essential to higher GDP growth, which, in turn, is desperately needed, if the inordinately high  unemployment rates are to be reduced. In many CESEE economies youth unemployment is at an unacceptable level. The situation is particularly critical in the Western Balkans, where among those who have completed their schooling (age group 25-29), current unemployment rates range between 20% and 40% − and even higher. Those levels are comparable to the levels prevailing in the southern EU economies. NMS youth unemployment rates hover around 10% and 20%, which is in the median range by European standards. Similar to the countries in Northern and Central Europe, a number of CIS economies and the Czech Republic display unemployment rates of less than 10%. It is important to note that youth unemployment is not the sole reason for social conflict in the region, the lack of jobs for the young can certainly act as a catalyst, as evidenced by the recent outbreak of social unrest in Bosnia and Herzegovina.


Overall, wiiw expects GDP in the CESEE countries to pick up speed and grow on average by 2-3% over the forecast period 2014-2016: a major driving force rooted in an upward reversal of public and private investment. The question remains, however, whether investment-led growth in the CESEE countries is merely a base effect of a few replacement investments or an indication of a profound paradigmatic shift. Increasing evidence suggests the latter for a number of reasons. During the ongoing economic crisis, public investment was severely reduced. However, in times of extreme uncertainty, the private sector is hesitant to invest. Hence, the public sector has to take the lead. It seems that the time for action has now come. This holds especially true for the NMS, where towards the end of the previous year, additional efforts were made to raise the absorption rate of the funds allocated within the context of the EU MFF for 2007-2013 that was about to come to a close. Over the remaining disbursement period of the biennium 2014-2015, substantially higher amounts of EU-funded investment are to be expected. Given that, in most cases, national co-financing is also required, CESEE public capital investment will increase. Apart from a number of transport infrastructure projects, a host of thermal power plant projects are in the pipeline, as are several major investments in the construction and expansion of nuclear power plants across the region.


Apart from public and semi-public infrastructure investment initiatives that have the potential to spur subsequent private investment, improving  growth prospects in the euro area, the CESEE economies’ main trading partner, are likely to encourage export industries in the region to modernise and increase their capital stock. This should help avert a lapse into a deflationary spiral and foster a shift towards better equilibrium with lower unemployment rates over the medium term. However, substantial downward risks include possible effects from the current Russia-Ukraine conflict; in particular, the interruption of energy supplies, potential  trade embargoes or additional interest rate risk premia. All this could adversely affect investment-led growth in CESEE.