CEE sovereign ratings have been resilient since the start of the war, but the balance of outlooks is negative.  Our negative rating actions in the region have mostly focused on outlook revisions (not on rating levels). Since February 2022, we revised our outlooks to negative on Slovakia and Hungary to reflect risks to their economic, fiscal, external and inflation performance in light of their elevated dependence on Russian energy supplies amid limited alternative supply routes, as well as their high exposure to weakening external demand from key trading partners in Europe. Our revision of the outlook to negative on three Baltic states in December 2022 pertained to the rising risk that war will impose increasing security and economic costs on these small economies bordering Russia. By contrast, in July we raised our ratings on Croatia to 'BBB+' from 'BBB-' to reflect the country's upcoming eurozone membership, which will see it benefit from the ECB's monetary policy flexibility and the eurozone's deep capital market. In January this year we lowered our ratings on Hungary to 'BBB-/Stable' from 'BBB/Negative' on the impaired policy flexibility of the fiscal and monetary authorities (see "Hungary Downgraded To 'BBB-/A-3' From 'BBB/A-2' On Inflation And External Pressures; Outlook Stable", published on Jan. 27, 2023).

Given the scale of the shock triggered by the Russia-Ukraine war, we may need to revise some of our baseline macroeconomic and rating assumptions for CEE sovereigns, implying an erosion of sovereign credit quality.  Barring extreme scenarios, including direct military conflict between NATO and Russia, here we highlight five broad sets of risks to our baseline rating expectations, which could individually or collectively weigh on sovereign ratings (see our current ratings in table 1 and baseline macroeconomic projections in table 2). These include a sharp economic downturn amplified by a broader European recession; CEE governments' reduced ability to benefit from EU transfers; elevated fiscal deficits; balance of payments pressures; and suboptimal monetary policy choices. We acknowledge, however, that uncertainty about the evolution of the war and the proximity of CEE to the conflict complicates policy analysis and medium-term forecasting.

Table 1

Table 2

Risk 1: A deeper and longer economic downturn and higher inflation

Protracted stagflation in advanced Europe, including Germany, could amplify the downturn in the CEE, likely pushing most CEE economies into a full-year recession in 2023 and increase inflationary pressures.  This scenario could weigh on CEE sovereigns' fiscal, external, and monetary profiles. Considering increased risks to the global economy, we have developed a downside scenario for selected CEE economies (see "Central and Eastern Europe: Growth Freezes, Risks Mount," published on Nov. 10, 2022). We base our scenario assumptions on the realization of several potential events: continuation of the Russia-Ukraine conflict; the cutting off of remaining gas supplies to Europe; and significantly tighter monetary policy in the U.S., the eurozone, and the U.K. These events would spread to the CEE via trade, energy supply, financial, and confidence channels, and could amplify existing macroeconomic pressures for the region. The resulting negative deviation from our baseline growth projections would be the highest for Slovakia and lowest for Poland (chart 1), with most CEE economies in the sample, apart from Romania where growth will be marginally above zero, contracting in full-year terms, posing difficult trade-offs and challenges for policymakers.

Chart 1

Despite the recent easing of European gas prices, recession could be even deeper and inflation higher in some CEE economies should Russia decide to halt oil deliveries to Europe or if the EU's embargo on Russia's crude and petroleum products results in fuel shortages.  Czechia, Slovakia, and Hungary are particularly vulnerable. These landlocked counties and their oil refineries depend heavily on Russian oil via the Druzhba pipeline and are temporarily exempted from the EU's Russian oil embargo that started in December 2022. This was followed in early February by an embargo on Russia's petroleum products. Despite the ongoing diversification of oil supplies, Russian oil shortages would likely prompt governments to provide additional fiscal support to the economy, undermining their fiscal positions and putting public debt on an upward path in an environment where government funding costs are higher than before. The immediate energy supply risks for this winter have subsided partly due to the mild weather conditions, but the outlook for winter 2023-2024 is uncertain because Russian energy flows to Europe are likely to remain severely reduced and the remaining dependency on Russia energy will take time to be eliminated. Depending on the country-specific combination of energy supply shocks as well as policy responses, downward pressure on some sovereign ratings could emerge.

Risk 2. Delays in EU fund allocations and constraints on their absorption by governments

The ability of CEE governments to secure and use funds available under different EU facilities remains to be seen.  Since CEE countries joined the EU in the mid-2000s, EU grants have comprised between 2%-4% of their GDP annually, supporting public investment, growth, and income convergence. The region has again become eligible for significant EU transfers in 2021-2027, with the stock of available funds per country ranging between 20% to almost 50% of national GDP (see chart 2). These funds will flow from three main sources: the previous EU Multiannual Financing Framework (MFF) for 2014-2020, under which funds are available until 2024; the EU MFF for 2021-2027, and NextGenerationEU (NGEU), including the Recovery and Resilience Facility (RRF). Unlike in the past, however, there are risks to the flow of some of these funds given the European Commission's (EC's) increasing willingness to link their disbursement to compliance with the EU institutional principles in the face of institutional erosion in parts of CEE.

Chart 2

Hungary and Poland are particularly exposed to risks of delays to some EU funds, in our view.  The EC has temporarily frozen a portion of EU transfers to Hungary under the EU's Rule of Law Conditionality Mechanism. The release of these funds is contingent on the successful implementation of specific reforms. Meanwhile, Poland could see the first disbursement of RRF funds postponed until late this year or even 2024 due to the EC's unresolved concerns over the Polish judicial reforms. In both cases, the delays appear to have been one of the factors driving nonresident investor sentiment, causing swings in exchange rates and government bond yields. Our baseline is that the two countries and EU authorities will likely find a compromise, unlocking the funds, given the compelling economic and geopolitical reasons for doing so. That said, a material and protracted reduction in EU transfers could weigh on growth, balance of payments, and fiscal outlooks not only in 2023 but also in the medium term. We have long highlighted such developments as one of the downside factors for these sovereigns.

Even if EU funds are fully unlocked, their absorption will require sustained policy efforts.  With a few exceptions, the absorption rate of EU funding has been relatively low (see chart 3). For some CEE sovereigns, the ability to use EU funds has been limited by institutional and administrative constraints (including in Romania and Bulgaria). Addressing them requires concerted policy measures that could prove challenging in counties with fragile government coalitions (Romania, the Czech Republic, and Slovakia) or those facing the start of electoral cycles (general elections in Poland and a snap parliamentary election in Slovakia in autumn 2023, and 2024 in Romania).

Chart 3

Risk 3. Loose fiscal policies risk keeping deficits wide, pushing up government debt

CEE governments have rolled out emergency measures that we expect will delay fiscal adjustment well into 2024.  Contrary to our prewar forecasts, we project most CEE governments in 2023 to continue running wide general government deficits (see chart 4). This will result from decelerating nominal GDP and revenue growth, but also mounting fiscal pressures, stemming from a number of areas including:

• Measures to protect households and businesses against elevated energy prices that range from 2% of GDP in Slovakia to around 3% of GDP in the Czech Republic.
• Spending associated with hosting the more than 2 million refugees from Ukraine who have arrived in CEE since the start of the war.
• Higher defense spending following governments' commitments to meet or even exceed the NATO defense spending target of 2% of GDP (Poland, for example, is targeting 4% of GDP in defense spending in 2023).
• Election-related social transfers and tax cuts.

Governments that have fiscal space, such as the Czech Republic's and Poland's, could perhaps afford these additional costs if they prove to be one-off.  We expect Poland to run a fiscal deficit of close to 6% of GDP in 2023--the highest in over a decade excluding during the pandemic in 2020. The Czech Republic is set to post a deficit of around 4.4% of GDP. In both cases, we assume fiscal policy normalization from 2024. Others, like Hungary, with high debt burdens and elevated funding costs, or Bulgaria that operates a currency board exchange rate arrangement and needs to maintain fiscal conservatism, will likely stay fiscally cautious or attempt to consolidate their fiscal deficits.

Chart 4

Chart 5

Wide fiscal deficits could put government debt on an upward path in the medium term, contrary to our baseline expectations.  Even though we expect supportive fiscal policies to help avoid a deeper slowdown in CEE in 2023, this will come at a cost. Government debt levels in some CEE countries will likely increase, eroding efforts to rebuild fiscal space as the pandemic wanes (see chart 5). More importantly, cost-of-living pressures could amplify political fragmentation and incentivize governments to relax their prewar medium-term fiscal consolidation targets, especially in the face of the heavy election schedule.

Uncertainty about macro-policy paths and high fiscal borrowing needs could put upward pressure on government borrowing costs at a time when interest rates were already high.  If anything, we expect CEE governments' interest bills as a share of GDP to rise and even double between 2021 and 2023 in the case of Poland. Despite available free cash cushions and generally strong access to capital markets and pan-European international financial institutions, further increases in interest rates will likely complicate government funding plans this year. We note, however, that the rise in the effective cost of servicing the existing stock of debt will be more gradual as governments have been able to lock-in low interest rates and extend debt maturities in previous years (chart 6).

Chart 6

Risk 4. High energy costs, slowdowns in key trading partners, and loose fiscal policies risk fuelling current account deficits and weakening external liquidity and exchange rates

The negative terms of trade shock has substantially weakened CEE sovereigns' current account positions.   After years of current account surpluses supported by strong services exports, most of the CEE sovereigns started to run wide current account deficits because of adverse terms of trade, decelerating exports, and still strong domestic demand--owing to strong labor markets and loose fiscal policies. In fact, in 2022 we estimate that many CEE sovereigns posted their highest external deficits of the last 15 years, with deficits in Hungary and Romania approaching 7% and 9% of GDP, respectively.

The current account deficits will moderate in 2023 as energy price pressures subside and domestic demand weakens, but will remain elevated.  This could potentially lead to a shift in the external funding mix toward debt, including more volatile portfolio inflows, or it could prompt central banks to further deplete foreign exchange reserves. Until recently, the current account deficits in CEE have been primarily funded by EU grants and net FDI. Both could take a hit in 2023. In some cases, the adverse scenario of wide external deficits and weaker non-debt flows could weaken external liquidity. This in turn could weigh on regional exchange rates, resulting in inflationary pressures in those economies where the exchange rate pass-through to consumer prices is high.

Risk 5. Suboptimal monetary policy choices amid high uncertainty and tight labor markets

2023 will test the credibility of CEE central banks amid decelerating growth, high inflation, and unsynchronized fiscal policies.  Monetary authorities are facing the dilemma of trying to walk a fine line between taming above-target inflation, mitigating economic fallout, and preserving financial stability at a time when major central banks, including the European Central Bank, are pursuing monetary tightening. The task for CEE central banks is further complicated by structural inflationary pressures stemming from the region's historically tight labor markets amid demographic pressures and high emigration.

High uncertainty makes the likelihood of policy missteps greater than usual.  If anything, emergency measures announced by the Hungarian National Bank (MNB) in October 2022--only two weeks after it communicated the end of policy rate hikes--demonstrate the complexity of challenges for regional policymakers. Back then, MNB raised the effective interest by 500 basis points to 18% and committed to directly covering foreign currency needs stemming from energy imports to ensure financial stability in the face of a rapidly depreciating exchange rate. The risk of similar market-enforced changes in the monetary policy path cannot be excluded in other economies, in our view.

Fiscal measures to support households and businesses could weaken monetary policy's disinflationary impact.  Unsynchronized fiscal and monetary policy measures risk de-anchoring inflation expectations, forcing central banks to tighten policy more aggressively, triggering harsher economic downturns. In this scenario, the credit profiles of some sovereigns could suffer from weaker fiscal metrics, eroded monetary credibility, persistently high inflation and exchange rate pressures, and weakening external competitiveness.

The escalation of the Russia-Ukraine war could amplify the above risks and impose greater macroeconomic costs on CEE sovereigns

The proximity to the conflict and the small sizes of CEE's highly open economies expose the region to risk of escalating geopolitical tensions.  There is much uncertainty regarding how the conflict might develop, but at present there seems to be limited prospects for an imminent resolution. We acknowledge that NATO membership and NATO's increased troop presence in the region serves as a strong anchor to CEE's security position. Even if the direct confrontation between NATO and Russia is not our base-case scenario, protracted tensions or their escalation including via non-conventional means raise the risk of unforeseen accidents and rapidly rising security and macroeconomic costs to sovereigns. Additional spillovers from the conflict zone could lead to new economic, external, or fiscal pressures beyond what we already expect in our baseline projections.

Related research

• EMEA Emerging Markets Sovereign Rating Trends 2023: Through A Glass Darkly, Jan. 26, 2023.
• Central and Eastern Europe: Growth Freezes, Risk Mount, Nov. 10, 2022
• Sovereign Risk Indicators, Dec 12, 2022; a free interactive version is available at http://www.spratings.com/sri