Tale of two recoveries as emerging Europe and Asia escape Covid’s grip

By Phil Thornton

In pre-Covid days, analysts would measure the economic outlook for emerging markets through matrices such as debt, interest rates and unemployment. Nowadays the first consideration is the impact of the deaths, hospitalisations and lockdown caused by the pandemic.On this score, emerging Europe and central Asia is in a bleak place: it remains among the emerging market and developing economy (EMDE) regions with the highest cases and deaths per capita.According to the World Bank’s benchmark global economic prospects report, published on the eve of the EBRD meetings, the true death toll is probably even higher, with excess death statistics indicating double-digit percentage increases in deaths relative to pre-pandemic years in half of the region’s economies.Borrowing from Charles Dickens, Ayhan Kose, director of the World Bank’s prospects group, sees a tale of two recoveries with the best of times for advanced economies and the worst of times for emerging and developing economies.Within that divide, there are further divisions. Growth in Eastern Europe is projected to be the weakest among sub-regions, rising only to 1.9% in 2021 and 2.8% in 2022 — far behind the 4.7% and 4.4% forecast respectively for EMDCs overall.

This contrasts with the western end of the EBRD’s area of operation where the bank projects growth in central and eastern Europe (CEE) to rebound to 4.6% in 2021 and to retain that pace into 2022, supported by a recovery in trade as activity improves in the euro area.On top of that, countries such as Bulgaria, Croatia, Hungary, Poland and Romania have benefited from membership of the European Union and the sizeable fund packages for members states. Oxford Economics sees the EU’s fiscal boost in the form of grants and loans at beneficial interest rates in the Next Generation fund and bolstered EU budget benefiting CEE economies particularly strongly, although countries’ ability to disperse the funds efficiently may prove to be a problem.The Vienna Institute for International Economic Studies — known by its German acronym wiiw — sees a similar split with CEE benefiting from both inward investment and rising inflows of EU funds but also the increasing pace of vaccinations.Serbia and parts of the CEE that are inside the EU are proceeding relatively well with inoculations, but — based on current rates — Ukraine, Moldova and parts of the Western Balkans will take years to vaccinate their populations, it says.“International solidarity on vaccines is going to be crucial to help the poorer parts of central, eastern, and southeastern Europe to exit this crisis, but unfortunately we don’t see much of that at the moment”, says Richard Grieveson, wiiw’s deputy director.Part of the reason for the rebound is the fact that it is bouncing back from a slump of 3.7% in 2020, the worst for any sub-region of Europe and central Africa other than south Caucasus. [See graph, page 8]The challenge for policymakers who are using the increasingly over-worn phrase “build back better” is to deliver a strategy that both cements the economic rebound of these countries but also prepares them for a rapidly changing structural environment.One vision for a new model for economic growth comes from the European Investment Bank (EIB), which has identified the need for what it calls a “twin transition” towards a greener and more digital economy. This shift, it believes, will stimulate economic growth in the near term and create jobs — for those countries that are prepared to undertake reforms.In its keynote annual investment report, the EIB says that many regions that will be affected by the much needed push towards digitalisation and a greener economy are located in CEE, pointing to a need to re-examine economic growth models if these countries’ economies are to continue converging with the rest of the EU.However, it is concerned that regions at high risk from both the digital and green transition are primarily located in CEE. Their growth models need to be re-examined if their economies are to continue converging with the rest of the European Union.“For sure, the region is definitely facing some challenges and some particularly strong challenges in terms of this twin transition,” says Debora Revoltella, the director of the EIB’s economics department. “Digital and green [economics] are a challenge — and a long lasting challenge — but they also offer some opportunities.”The EIB found that areas with the greatest risk exposure to this double transition risk were clustered in CEE countries, with some 55% of CEE regions exposed to high twin transition risks, compared with 23% in southern Europe and 15% in northern and western Europe.All of the regions in the “very high risk” group — defined as being in the top fifth for both risk types — are in central, eastern as well as southeastern Europe. In contrast, no CEE region is included in the 20% of regions that have the lowest risks from automation and the green transition.The EIB highlights Bulgaria, Hungary, Slovakia and Romania as particularly exposed to the twin risks of digitalisation and greening.The agenda is shared by the EBRD, whose five-year strategic and capital framework up to 2025 heralds three strategic themes — transition to a green economy; accelerating the digital transition; and equality of opportunity.

But all these grand ambitions may come to naught if the region is hit by a surge in inflation, weakening government finances and so drawing money away from long-term investment — a fear that has risen to the top of economists’ agendas as the European summer has started to heat up.According to the World Bank, of the 17 European and central Asian monetary authorities with inflation targets, nearly half reported headline inflation above the upper end of their target band in early 2021. As a result of those inflationary pressures, banks have hiked interest rates in a third of the region’s economies thus far in 2021.The recent sharp increase in global commodity prices is a particular issue for the CEE and southeastern Europe, says Gieverson at wiiw, given that a larger share of the consumer price basket in the region is weighted towards those items than is the case in western Europe.Kose at the World Bank says that while the decline in inflation in the early stages of the pandemic was the most muted for a recession period, the rebound since has been the most aggressive. “As economies normalised, commodity prices increased and we had supply disruptions around the world,” he says. “One thing is clear — by the end of the year we will see higher inflation in emerging markets and developing economies.”Price pressures in Central Europe are building from a broad range of sources, says Liam Peach, emerging Europe economist at Capital Economics. “While most of these are likely to be temporary, the issue is that countries were experiencing stubbornly high inflation before these pressures emerged,” he says.But he echoes Kose, saying strains in global supply chains have intensified as demand for goods has been accompanied by shortages of raw materials and supply bottlenecks in key manufacturing countries, pushing up prices.“The key concern now for central banks is the extent to which these price pressures will be passed through to consumer prices,” Peach says.

Bond yields have risen in tandem, especially as officials have started to highlight the dangers of rising inflation. Local bond yields in Poland and Hungary, for example, have risen sharply following hawkish comments from officials. Both countries also saw inflation rise in April. Meanwhile, a surge in inflation, especially in Ukraine — the sub-region’s largest economy — triggered more restrictive monetary policy in early 2021.But for countries that borrow on the open market, a more worrying challenge is the rise in US long-term rates that would push up borrowing costs for those countries weighted towards dollar funding. Last month US Treasury Secretary Janet Yellen caused a stir by saying interest rates “will have to rise”.The extent to which central banks are able to continue to engage in monetary stimulus will depend on inflation; there are signs that this will rise somewhat this year but will remain low by historical standards. Rising interest rates will hit countries that that have understandably increased debt to underwrite the cost of measures to support parts of their economies hit by Covid-19.The fiscal response to the pandemic, together with last year’s contraction in output, is expected to leave median public debt at 54% of GDP by end-2022 — nearly 15 ppts higher than in 2019 — according to the World Bank.There are other worries. The banking sector remains fragile amid high dollarisation in some economies, with sharp currency depreciations and weak activity having eroded bank asset quality.The outlook, therefore, remains very uncertain for a region that has been through so many ups and downs over the last 30 years. The withdrawal of domestic macroeconomic support measures will be weighing on the regional recovery while the uneven vaccine rollouts will foster inequalities between countries.The risks to growth are on the downside, especially if the pandemic takes longer than expected to abate, external financing conditions tighten, or policy uncertainty and geopolitical tensions rise further.Just as the legacy of Communist rule hung over the region in April 1991 when the EBRD took on its mission, so the long-term consequences of the pandemic will exact a price. The challenge to policymakers is to, once again, help the region regain a secure economicfooting.