The macroeconomic outlook for CEE sovereigns is stronger than 12 months ago. Risks have abated amid lower energy prices, underpinning disinflation and decreasing external deficits. The region also entered the winter with full gas storage and is now less reliant on Russian energy supplies than before.

After growth bottomed out in mid-year 2023, we project CEE economies will recover in 2024 on the back of disinflation, stabilizing financial conditions, and strong net foreign direct investment (FDI) and EU funds inflows (see table 1). Nominal GDP growth should help keep government debt at comparatively moderate levels even if fiscal settings remain loose in most CEE countries amid a heavy election calendar. Coupled with more visible monetary policy paths in the U.S. and eurozone, exchange rates and government financing pressures remain manageable.

Out of 11 rated CEE sovereigns, six are on stable outlooks.   In autumn 2023, we revised the outlook to positive on Croatia, reflecting its solid growth outlook and fiscal resilience, and on Bulgaria, amid its increased likelihood of eurozone accession. In May 2023, we also revised the outlook on Slovakia to stable from negative on abating risks to energy security and economic growth.

In contrast, we downgraded Hungary in January 2023, in response to pressures on its fiscal and monetary policy flexibility; the outlook is now stable. Our outlooks on the three Baltic states--Estonia, Latvia, and Lithuania--remain negative, reflecting further economic and security risks due to the Russia-Ukraine war.

We see five key risks for CEE sovereign credit quality.   These include: protracted weakness in the euro area, uncertainty over EU fund disbursements, delayed fiscal consolidation, sticky inflation, and the potential for rising populism and elevated geopolitical tensions.

Table 1

Risk 1: Exposure To Ongoing Weakness In The Eurozone

We expect CEE economies to expand almost 3% next year after stalled growth in 2023.   Five out of 11 rated CEE sovereigns will record a full-year recession in 2023--namely, the Czech Republic, Estonia, Hungary, Latvia, and Lithuania. This brings average real GDP growth for the region to just 0.8%, one of the weakest rates since the global financial crisis, excluding pandemic-ridden 2020. We project CEE growth will average 2.7% in 2024 and be primarily driven by recovering private consumption and investment as inflation subsides and net FDI and ample EU grants flow in . Given the weak performance of core eurozone countries, which are CEE's main trading partners, the contribution of net exports to 2024 growth will be negative in most CEE economies. We forecast eurozone GDP growth will remain slow at 0.8% and 1.5% in 2024 and 2025 accordingly (see "Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing," published Nov. 27, 2023, on RatingsDirect)

Should the eurozone, and particularly Germany's, economic underperformance deepen and continue for longer than expected, medium-term growth prospects will be hurt in CEE.   Although CEE economies depend on Germany less than 20 years ago, it remains the region's biggest export market, not least due to the deep integration of CEE manufacturing into German auto supply chains (see chart 1). Regional growth prospects could suffer even more if Germany's weakness proves structural and protracted, reflecting permanently higher energy costs, technological shifts in the auto industry, weak demographics, and underinvestment. This weaker growth could pressure CEE public finances in an environment where government funding costs are at multi-year highs.

Chart 1

What to watch

Data on exports and manufacturing performance (including purchasing managers' indexes), labor market trends, economic sentiment data, and investment data.

Risk 2: Uncertainty Over EU Fund Disbursements

We expect all CEE countries will benefit from EU funds in 2024, but risks remain for Hungary.   The region is eligible for significant EU transfers in 2021-2027, with the stock of available funds per country ranging between 15% and over 40% of annual GDP (see charts 2a and 2b). But in some cases, the European Commission (EC) has delayed or partly frozen access to some facilities in response to what it views as institutional erosion. Unlike in Poland, where we expect EU funds will be disbursed early next year following the likely formation of the new government, risks of further delays or even permanent cuts to portions of EU funds are high for Hungary. Our baseline scenario is that Hungary and the EU authorities likely find a compromise to unlock the funds, given the compelling economic and geopolitical incentives for both sides. That said, a material and protracted reduction in EU transfers could weigh on Hungary's growth, balance of payments, and fiscal outlooks in 2024 and the longer term.

Chart 2a

Chart 2b

The utilization of EU funds will require sustained policy efforts and fiscal prudence.   For some CEE sovereigns, the ability to use EU funds and channel them into effective spending has been limited by institutional and administrative constraints. Addressing these issues requires concerted policy measures, which may prove challenging in countries where the stability of government coalitions could be tested--such as Bulgaria, the Czech Republic, Slovenia, and Poland--or those facing the start of domestic electoral cycles on top of the European Parliament elections in June 2024 (see table 2). Among other conditions, parts of EU funding--like Recovery and Resilience Facility (RRF) disbursements--are also tied to the EU's view on the sustainability of public finances. This means adhering to EU-agreed fiscal consolidation paths.

Table 2

What to watch

Progress on disbursements from the EU RRF, including the EC's assessment of Hungary and Poland's reform progress.

Risk 3: Delayed Fiscal Consolidation

CEE fiscal deficits will remain among the highest in Europe, the Middle East, and Africa (EMEA) next year, derailing government plans to reduce debt.   This is largely due to a few policy decisions passed by governments in recent years. They include fiscal support measures against rising inflation and higher energy costs, such as tax cuts and higher social spending, as well as higher borrowing costs. But also additional defense spending, which in some countries exceeds North Atlantic Treaty Organization (NATO) 2%-of-GDP commitments; Poland is targeting 4% of GDP this year and the Baltic states are likely to spend close to 3% of GDP annually in the next few years. These will contribute to fiscal deficits of 2%-5% of GDP in 2024, with Romania, Slovakia, Poland, and Hungary among the 20 countries with the widest fiscal deficits of all 85 rated EMEA sovereigns (see chart 3a).

Chart 3a

Chart 3b

In some countries, electoral cycles could exert additional fiscal pressures.   In Romania, for example, such risks could materialize should higher pension spending, which was legislated ahead of four elections next year, not be accompanied by offsetting fiscal measures (see "Romania's Proposed Pension Law Would Derail Medium-Term Fiscal Consolidation," published Nov. 23, 2023). We expect Poland's public deficit will remain wide at 5% of GDP in 2024, after 5.6% of GDP this year, as the incoming government tries to deliver its pre-election fiscal pledges. Downside rating pressures for CEE sovereigns could increase if similar fiscal risks are accompanied with other shocks including fallout for investor confidence, EU fund disbursements, and growth.

Government debt stock in most CEE countries remains moderate, but the cost of servicing it has increased.   We expect debt as a share of GDP to increase for some sovereigns in 2024 (see chart 3b) but note it will still stay below levels seen at many global peers and for countries in Western Europe. That said, with higher funding costs, interest costs as a share of GDP will increase 1.7x-1.8x in 2024 compared with 2021. CEE government bond yields have recently eased compared to last year's peak. However, we anticipate they will remain higher than the recent past and experience elevated volatility depending on domestic and global interest-rate developments, exchange-rate trends, and investor sentiment (see chart 4).

Chart 4

What to watch

Current fiscal performance data; national stability or convergence programs published by the EC in spring 2024, which will include medium-term fiscal projections by individual countries; discussion on EU-wide fiscal rules; the EC's decision on excessive deficits procedures; and global central banks' policy decisions.

Risk 4: Slower Disinflation Amid High Underlying Price Pressure

Inflation slowed to single-digit growth in all CEE countries by September-October 2023 from multiyear peaks last winter, but underlying price pressures remain high.  This was primarily on declining commodity prices, monetary tightening, and a high base effect (see chart 5). We expect the pace of disinflation to moderate next year as domestic demand strengthens and past tax cuts and energy price caps are reversed. Moreover, there is a risk that underlying inflation stays elevated above central bank targets (generally 2%-3%) beyond 2024. This is because core inflation has declined at a much slower pace, not least due to structurally tight labor markets amid one of the weakest demographic outlooks globally.

Chart 5

Even if we expect monetary easing will continue in CEE, central banks face difficult policy dilemmas in 2024 and beyond.   Central banks are trying to support economic growth via monetary easing, while attempting to slow inflation to their target ranges amid generally tight monetary policy globally. With disinflation gathering pace, some CEE central banks (Poland, Hungary) have started to normalize their policies, and we expert others to follow (the Czech republic and Romania). However, sticky core inflation, loose fiscal settings, and high uncertainty over the global macroeconomic outlook make the likelihood of policy missteps greater than usual. Higher-for-longer inflation could de-anchor long-term inflation expectations, and undermine external competitiveness and economic growth.

What to watch

Headline and core price developments, commodity price trends, labor market trends, the monetary policy decisions of global central banks, and government decisions on inflation-containing measures and administered prices.

Risk 5: Rising Populism And Elevated Geopolitical Tensions

If the Russia-Ukraine war escalates, for example, due to unforeseen accidents, this could rapidly increase security and macroeconomic costs.   The conflict is likely to last until year-end 2024 at least, with a military stalemate remaining the most likely outcome as both sides resign themselves to an extended war. We do not consider it likely that the war will spread beyond Ukraine's territory or result in direct confrontation with NATO countries. At the same time, war-related macroeconomic risks could return, including further shocks to energy imports, given that Hungary, Slovakia, and the Czech Republic are still dependent on Russian energy, including natural gas and/or pipelined oil. This could lead to new economic, external, or fiscal pressures beyond our baseline projections.

Past shocks have polarized domestic political landscapes, reducing policy predictability.   Cost-of-living pressures and still-sizable income gaps between CEE and Western Europe might pave the way for isolationism, further political fragmentation, and erosion of policy effectiveness and predictability. One consequence could be hampered access to EU funds since these are increasingly conditional upon the EC's view of rule-of-law compliance. Another consequence could be setbacks to reform momentum in CEE, which may undermine medium-term growth and complicate fiscal consolidation. Over the longer term, sustained unorthodox policy proposals--including on sectoral taxes or central banks' institutional settings--could gradually erode investor confidence and weaken investment and growth.

What to watch

The evolution of the Russia-Ukraine war; the West's commitment to support for Ukraine; domestic pre-election policy debates, post-election government coalition formation, and policy agendas; and the outcomes of the U.S. presidential and EU parliamentary elections.

Related Research

• European Developed Markets Sovereign Rating Trends 2024: Fragile Growth, High Debt, Dec. 13, 2023
• EMEA Emerging Markets Sovereign Rating Trends 2024: Stabilizing Ahead Of A Year At The Polls, Dec. 13, 2023
• Sovereign Risk Indicators, Dec. 11, 2023; a free interactive version is available at http://www.spratings.com/sri
• Sovereigns: What Are The Credit Implications Of Intensifying Conflicts And Political Disruption? Dec. 4, 2023
• Economic Research: Economic Outlook Emerging Markets Q1 2024: Challenging Global Conditions Will Constrain Growth, Nov. 27, 2023
• Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing, Nov. 27, 2023
• Romania's Proposed Pension Law Would Derail Medium-Term Fiscal Consolidation, Nov. 23, 2023
• Central And Eastern Europe Banking 2024: Solid Performance Buffers Mounting Risks, Nov. 21, 2023
• Poland's Incoming Government Faces Tough Policy Choices, Oct. 18, 2023
• Slovakia's Elections: New Government, Old Challenges, Oct. 4, 2023