Orbán's dream in danger - The glory days of CESEE are over

In a comprehensive research note published last week on Central, Eastern and Southestern Europe (CESEE), Citi’s analysts painted a dreadful picture on the growth model of the region, which could ruin Prime Minister Viktor Orbán’s multicoloured dream, as well. Over the last few years, Orbán kept coming back to his conclusion that the growth engine of Europe is in Central Europe and will remain so for another 10-15 years. The analysis calls into question the long-term objective of Hungary’s economic policy, namely that the country will catch up with Austria 25 years from now.

Growth model that broke down

Citi’s economists make a shocking statement right at the very start of their analysis.

“The growth model used for last 20 years by Central European economies does not seem sustainable anymore."

Without additional reforms, capital accumulation is unlikely to accelerate significantly because of insufficient domestic savings, slower FDI inflows and prospects of lower EU funds. Also, the demographic situation is deteriorating and will likely weigh on growth in the coming years. Finally, it may be difficult to boost productivity growth sufficiently to keep growth buoyant in the future.

The analysts noted that since 1990, Central Europe has gone through a process of rapid economic convergence towards Western European income levels while the gap in GDP per capita narrowed substantially (Figure 1).

Initially the catch up process was possible thanks to inflows of foreign direct investments (FDI), improvement of managerial skills, absorption of technology from Western Europe and the re-allocation of resources towards more productive sectors, combined with the advantage of low paid skilled workers.

Later, favourable financial conditions in the run up to 2008 were also important drivers behind high economic growth. Figures 2-3 show that key contributors to growth were capital accumulation and - with exception of Bulgaria and Croatia - also improved total factor productivity (TFP). Demographics have been less supportive than in other EM economies as the previously positive impact from the increased labour force has weakened in recent years, the economists added.

Then the economists give a detailed outlook on economic growth in the region, breaking the factors down to the labour force, capital accumulation and productivity.

Shrinking labour force

Unlike many other emerging markets, Central Europe has never really enjoyed demographics that would likely boost economic growth, the economists said.

“In recent years, the contribution of changes in labour force to GDP growth, was close to zero or negative and the growth came mostly from rising (total factor) productivity or capital accumulation (Figure 3)."

The analysts added, however, that according to demographic projections, CESEE is likely to see a further sharp drop in the working age population, more so than in any other EU countries (Figure 5).

European Commission estimates that between 2013 and 2025, the CESEE working age population will shrink by around 8.9%, which implies a 0.7% decline per year on average.

Demographics which are unconducive to economic growth are a common characteristic of CEE countries. Bulgaria, Poland, Croatia and Romania are particularly extreme examples in this group. This trend is partly due a rising number of Central Europeans who reach retirement age at the same time as very low fertility rates in the region, the economists said.

In their view, these unfavourable demographic trends are unlikely to reverse in the near term.

“Even if fertility rates were to increase significantly it could be 20 years before there is any positive impact on economic growth. To put it differently, despite Central European governments’ success in boosting fertility rates, such efforts would do little to eliminate challenges faced by the CESEE in the coming 5-10 years."

The economists claim the most obvious way to increase labour supply in the coming years and avoid demographic drag on growth is by boosting labour participation. Indeed, CESEE economies, with exception of the Czech Republic, have labour participation rates below the EU-wide average. This is partly due to low activity by women or people with low education. Measures to boost labour participation could potentially offset the negative impact resulting from population ageing, though in most countries it would not be sufficient to reverse the trend.

According to the analysts’ estimates an increase in labour participation rates to Euro Area levels over the next ten years would increase the labour force only in case of Hungary and Romania (Figure 8). In other countries such measures would merely limit the decline in the labour force.

“However, if the labour force shortage results in a fiscal deterioration, some changes in the social system (like a long parental leave in the Czech Republic) could eventually be changed."

Citi’s economists estimate that maintaining participation rates at the 2013 level would imply a 5-13% decline in the CESEE labour force by 2025, a scenario that would likely lead to sharp weakening of potential growth.

Against this backdrop, the analysts think that increasing the labour participation rate could be possible in several ways including:

• increasing retirement age,
• extending (active) life expectancy that could in turn allow a higher retirement age,
• disincentives for early retirement and allowing a more flexible active employment policy and avoiding promises of early retirement for ’election’ sensitive employees (e.g. miners, police),
• improving family care infrastructure, thus making it easier for women to return to the labour market.

They also acknowledge, though, that the process of raising the retirement age is likely to be very slow as governments are reluctant to adopt unpopular measures.

The analysts mention Hungary as a positive example, for implementing a pension reform in 2010, which gradually increased the retirement age and tightened eligibility for early retirement. This has increased the number of active labour force by 9% since 2009 and is largely responsible for a slower than projected decline in the working age population in Hungary relative to the neighbouring countries in the coming decades.

However, they also pointed out that due to the lack of appropriate skills, part of the additional labour supply has been stuck in government fostered work programs and have failed to effectively increase the available workforce, leading to labour shortages in the more prosperous regions of Hungary.

Also, in their view relatively low life expectancy in CESEE countries is another hurdle to increasing the retirement age. Median life expectancy for CESEE countries (77 years) is about 4 years lower than EU28 median (81 years). Life expectancy in Bulgaria and Romania is below 75 years. “This suggests to us that boosting the quality of healthcare and subsequently raising life expectancy should be among the main priorities for these countries."

On top of the aforementioned, outward migration is another factor behind the shrinking labour force. According to a recent IMF study (May 2016) emigration in the CESEE countries has reached over 6% of working age population since 1990 and cumulative real GDP growth could have been 7 percentage points higher on average in the absence of migration during 1995-2012. Moreover, the emigration of high-skilled and young workers could further aggravate other challenges for these countries leading to labour shortages in an increasing number of sectors, they added.

“[...] lower income convergence rates will likely keep emigration rates at elevated levels in the coming years (Figure 14), resulting in a vicious cycle."

In addition, all CESEE countries, except Czech Republic, suffer from an inefficient use of talent owing to a lack of reliance on professional management, retaining and attracting talent, among others.

We think that these countries are unlikely to address these wide ranging structural problems in the medium term.

This is what we have written about in a recently published article:

Will this help us?

Even with a shrinking labour force, economic growth could be generated from higher capital accumulation, the analysts said.

“After all, despite years of gradual economic convergence towards Western European levels, CESEE economies still have a relatively low capital stock which leaves room to catch up."

They added, however, that a rapid increase in investment is easier said than done. They reminded that for years investment rates in the region have been lower than in countries that went through a successful convergence process like Ireland among the EU member states.

We think that in the future, it may be difficult to raise investment rates to levels that would allow for sufficiently high levels of capital accumulation.

Lack of domestic savings is one of important obstacles to low saving rates in Central Europe compared to other countries that went through a rapid convergence process.

“A low domestic saving rate is one of the reasons why in the past, investment growth in the region was financed by foreign savings, which was reflected in rising external debt, high inflow of FDI and a high current account deficit. Since the global financial crisis, Central Europe has gone through a significant adjustment in external accounts and it seems neither investors nor policymakers in the region are ready to accept a growth model based on significant external borrowing again. So far, the region hasn’t had a chance to realize what a lack of foreign funding can mean for growth because the drop in FDI inflows coincided with a gradual increase in EU fund inflows that was visible after 2008 EU funds were used to improve infrastructure and finance some of investment projects by Central European firms."

According to Citi estimates, capital transfers from the EU lifted cumulative GDP growth significantly since 2004. They said their methodology shows

the biggest boost to growth by EU funds in Hungary, where cumulative GDP growth would have been 10% lower from 2004 without EU-funded investments. Even Poland and the Czech Republic show a 4-5% cumulative gain in real GDP growth since 2004.

Citi’s economists have warned that access to generous EU funding is not likely forever. They reminded that the current seven year EU financial funding plan will end in 2020 and they are “increasingly concerned" the next budget will be less favourable for Central Europe.

“Apart from purely economic factors there are also political considerations that suggest a less generous budget for the region. Over last year Central European countries have been vocal in their opposition against European migration policies, in particular the plan to relocate asylum seekers. In this situation it is hard to imagine how CEE governments could use the argument of European solidarity during the budget negotiations. The overall strategy of opposing closer EU integration is not likely to help either."

The analysts noted that public debt levels may also constrain the substitution of EU capital transfers by own resources of infrastructure loans provided by the EU. This suggests that countries with higher or rising debt and fiscal deficits, like Hungary and Poland, have limited options to avoid a sharp fall in public investments without increasing fiscal imbalances.

The economists wonder whether a pick-up in private investment could offset the likely reduction in public investment activity in the medium term. They have doubts for various reasons:

• relatively low growth outlook,
• high non-performing loans,
• constraints in the banking sector,
• risk of continued cross-border bank deleveraging,
• problems in access to financing,
• unsupportive business environment,
• elevated risk premium and interest rates.

Also, the lack of strong institutions is likely to curb private investment activity for most CESEE countries.

“ All in all, we conclude that it would be unrealistic to expect a marked increase in private investment activity for most of the CESEE countries in the medium term as they are likely to continue facing major hurdles."

At least this magic potion will save Hungary

Even if, as the analysts argue above, a fall in the labour force cannot easily be stemmed and capital accumulation is unlikely to accelerate sufficiently, CESEE countries could still boost their potential growth by increasing productivity, Citi’s economists conclude.

They underlined that post-2008, the slowdown in growth potential is largely due to slower growth of total factor productivity (TFP), efficiency with which inputs are used in the production process. They believe efforts should be focused on reversing this trend.

“Strong productivity growth enjoyed by CESEE countries at the earlier convergence phase was relatively easy to achieve either through importing technologies from more advanced economies or by implementing Western European management standards. For economies that spent decades under communism this was enough to boost growth quickly. At a risk of over simplifying the picture, at an earlier stage of the catch up process, even building a semi-modern factory would have been sufficient to significantly boost output and productivity, as existing stock of capital was outdated. Having used the available sources of productivity growth and moved somewhat closer towards the technology frontier, this process has become more difficult for CESEE."

The economists see three major sources of additional total factor productivity increase:

• It could be done by shifting resources to the more productive sectors. “Given that CESEE have a relatively high share of workers in low-productivity sectors like agriculture this process could be supportive for productivity growth in the region. The process is already happening naturally as workers from rural areas gradually migrate to urban areas, while urbanization rates are still low in CESEE. The increased dominance of manufacturing exports, especially in the car industry has been one of the major sources of productivity growth in CESEE in the last few years."
• Productivity could also be boosted by improving key bottlenecks of the economy. “Various indicators suggest that competitiveness of the region and its attractiveness to business is negatively affected by institutional factors and infrastructure. In particular an improvement in the legal system (faster and more efficient proceedings, better protection of legal rights) could boost efficiency." Combating corruption should also be stepped up, they said.
• Productivity growth could be positively affected by innovation. “Whatever measure of innovation we choose the CESEE ranks poorly, perhaps with the exception of Czech Republic."

Based on the above structural factors, the analysts ranked Central European countries according to their performance in terms of demographic trends, institutional environment or investment/productivity outlook.

“The ranking shows that the risk of a significant slowdown in the long term is lowest in Czech Republic, while highest in Croatia or Bulgaria. Needless to say these conclusions can change if adequate structural reforms are implemented in particular countries."

The ranking shows Hungary is doing relatively well in the region.

In the near term Cit’s analysts see a risk is that policymakers may not realize the slowdown is structural.

“If the authorities misinterpret the data and treat economic weakness in the region as a consequence of cyclical forces, the policy response may be incorrect and ineffective. Since the Euro Area and other developed markets are struggling to boost growth by monetary easing it may be easy for CESEE policymakers to conclude that the right answer for the region is supportive monetary and fiscal policies. However, if we are right that the region is facing a period of lower potential growth because of structural factors, such measures would likely fail and expansionary monetary policy without structural measures may lead to a pickup in wage push inflation and deteriorating fiscal positions over time."

Far from calling for monetary tightening, the economists simply believe that a more efficient way to raise economic growth in the medium term would be via structural reforms.

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