CEE sovereigns will continue to face fiscal pressures over the next two years. Along with other credit pressures, this could weigh on our sovereign ratings (see "CEE Sovereign Outlook 2024: Five Risks To Watch," Dec. 14, 2023). The cost of debt has risen and 2023 deficits proved much larger than we had expected. In fact, some CEE sovereigns still have among the highest deficits in EMEA following four years of elevated deficits in the wake of the pandemic and amid the Russia-Ukraine conflict. As fiscal fallout from these shocks fades, and assuming there is a policy effort toward consolidation, we expect CEE sovereigns will reduce their fiscal deficits in the medium term. This should see their debt-to-GDP ratios stabilize at still low-to-moderate levels compared globally.

Some fiscal risks, such pre-election spending, are not yet reflected in CEE sovereigns' budgets. Several challenges, which are reflected in current fiscal plans, will prove difficult to overcome, not least pressures related to rising interest costs. Brighter fiscal prospects relate to sovereigns' generally favorable debt profiles and a VAT rebound.

Baseline: Deficits Will Reduce, Debt Will Stabilize, But Interest Costs Will Rise

Two shocks--first the pandemic, then the Russia-Ukraine conflict--weighed heavily on CEE public finances in 2020-2023.  The latter in particular has affected CEE sovereigns more than many other sovereigns given their geographical proximity--leading to high refugee inflows and a hit to business confidence--and their (previously) high energy dependence on Russia.

Our current projections see most CEE sovereigns consolidating their fiscal deficits through 2026, but only gradually.  Deficits will narrow to about 2.8% of GDP on average by 2026 (GDP-weighted average) from an estimated 4.7% in 2023. Coupled with still-high nominal GDP growth, this will mean debt levels will stabilize or decrease as a share of GDP between 2023-2026 for seven out of the 11 CEE countries we rate, even if--except for Croatia and Slovenia--they are permanently higher than in 2019. Given high interest rates, this will also permanently raise debt costs as a share of total budget revenues. We expect interest costs will exceed 5% of revenues in 2026 on average, compared to 3.2% in 2020 and 4.8% in 2023 (all weighted by GDP)--but range between 0.9% in Estonia and almost 10.0% in Hungary.

Chart 1

Only a few countries will report rising debt after 2023 (Estonia, Bulgaria, Slovakia, and Poland) but even in these cases debt levels will remain low to moderate in a global context. However, delays in fiscal consolidation in combination with other risks could weigh on CEE sovereign credit ratings over the next two years.

The Main Fiscal Risks: Pre-Election Spending And Higher Inflation

CEE sovereigns face a heavy election schedule over the next two years, which will likely trigger some pre-election spending.  Six out of the 11 will hold a general election (parliamentary or presidential) over the next two years; five have scheduled regional or municipal elections; and all will participate in EU elections in 2024. CEE sovereigns--perhaps except for the Baltics--tend to heighten their fiscal spending ahead of elections. For example, Hungary's pre-election spree in 2022 saw government debt, net of liquid assets, increase by almost 10% of GDP, which was far more than all the other CEE countries and resulted in economic overheating. Czechia reported the second-highest increase in net debt that year, at 6% of GDP. The electoral cycle also weighed on Slovakia and Poland's fiscal positions in 2023. Romania recently announced a substantial increase in pension spending ahead of its four elections in 2024, which could keep deficits above 5% of GDP over the next two years (see "Romania's Proposed Pension Law Would Derail Medium-Term Fiscal Consolidation," published Nov. 23, 2023). We believe other governments will also raise spending ahead of elections, which they do not fully reflect in current budgets.

Higher-than-anticipated inflation, including via further global energy price shocks, remain a fiscal risk.  Possible commodity price shocks could prompt governments to extend or introduce new fiscal measures to support households and businesses. Like elsewhere in Europe, CEE governments have intervened in energy markets over the past two years, often at great expense to taxpayers. Energy price support schemes to the private sector, albeit reduced, still weigh on budgets particularly in Hungary, Poland, and Romania. According to the think-tank Bruegel, CEE countries allocated almost €50 billion for energy support measures for households and private companies (excluding utilities) between September 2021 and January 2023--equivalent to almost 2% of their combined GDP during that timeframe. Importantly, this figure excludes pre-existing measures such as the energy price caps in Hungary, which typically cost governments the most but are harder to measure.

Higher-for-longer inflation could also weigh on public finances.  The flipside of an expected rebound in domestic demand is the risk of more persistent inflation for longer, even if--absent a shock to energy and food prices--we do not think price increases will come close to those of 2023. Demand pressures, amplified by tight labor markets amid one of the world's worst demographic outlooks, bear the risk of keeping inflation high. Although inflation often translates into higher revenue due to high nominal GDP growth, the net effect on fiscal outcomes was negative in 2023. For 2024 and beyond, higher inflation could delay monetary normalization (and keep interest costs above current projections), weigh on private consumption and so depress value-added tax revenue, and likely require governments to raise specific spending above current budgets. This could include social transfers, most importantly pensions, which are indexed to inflation or wage growth in most CEE countries; and public sector wages, if they are to keep pace with those in the private sector.

The Known Struggles: Higher-For-Longer Interest Costs And Defense Spending

Monetary policy tightening has raised the interest rate environment globally and, in turn, the cost of government debt.  Inflation levels in CEE were among the highest globally, peaking at over 20% in the Baltics and 26% in Hungary. This led CEE central banks to raise rates higher than those of the U.S. Fed or the European Central Bank. Leading the pack, the Hungarian National Bank maintained an effective policy rate of 18% between October 2022 and May 2023. This, in turn, greatly increased government debt costs.

CEE's financing costs will remain higher than developed markets' and consume an increasing share of government revenues over the next few years.  Although monetary policy rates have stabilized or started to decline in some CEE countries, government funding costs will remain high given underlying price pressures. Coupled with a rising stock of nominal debt on the back of high fiscal deficits, this will permanently elevate interest bills even as a share of rising revenues. Moreover, as seen in the last few years, we anticipate government funding costs could experience greater volatility depending on domestic and global interest-rate developments, exchange-rate trends, and investor sentiment (which is, not least, sensitive to the evolution of the Russia-Ukraine war).

Chart 2

Defense spending is more pressing in CEE than for most peers globally.  Given their proximity to Ukraine, most CEE governments have committed to defense spending well above NATO's 2% of GDP requirement. Typical CEE defense budgets will be 3%-4% of GDP over the next few years, which, for many, doubles or triples such spending compared to 2014 (in % of GDP terms). This is particularly so for the Baltics, Poland, Slovakia, and Hungary.

Chart 3

Fiscal Supports: Favorable Debt Profiles, VAT Rebounds, And EU Fund Inflows

Table 1

CEE sovereigns' debt profiles remain broadly moderate, compared globally.  First, overall public debt levels in CEE will remain just below 50% of GDP (by GDP-weighted average). Second, the average maturity of CEE debt is between five years in Poland and 10 years in Slovenia; this is comparable to most developed Western European countries and has limited refinancing needs. Lastly, and contrary to 15 years ago, CEE sovereign debt is predominantly in local currency--except for Bulgaria, which runs a peg to the euro and has low overall debt--and is held domestically. The share of foreign currency central government debt ranges between 6.7% (Czechia) to 54.5% (Romania) for non-eurozone members. As an outlier Bulgaria reports a share of 75.1%, most of which is hedged to the euro, which means that shifts in exchange rates bear lower risks.

A VAT revenue rebound, backed by strengthening domestic demand, will underpin consolidation efforts across CEE, in our view.  Indirect taxes, such as VAT, play a key role in CEE finances, generally representing close to one-third of central government revenues. When high inflation weighed on private consumption in 2023 and VAT revenue generally fell short of expectations, this weakened fiscal outcomes particularly in Hungary and Romania. We project a strong economic rebound in 2024 across CEE, mostly driven by strengthening domestic demand and resilient labor markets. This will translate into rising VAT revenue. Despite risks to our economic projections (including higher-for-longer inflation), we believe strong VAT revenue will be a key component of fiscal consolidation next year for all CEE sovereigns. Some, like Romania, will also be trying to reduce the informal economy.

Strong EU fund inflows will support growth and supplement government finances.  In 2024, the final payments from the Multiannual Financial Framework (MFF) 2014-2020 will arrive; cohesion funds from new EU funds under the MFF 2021-2027 will pick up; and the EU will disburse substantial funds from the Recovery and Resilience Facility (RRF). Under EU budget projections, CEE countries are eligible for between 15% and 40% of GDP through 2027.

It appears likely that payments of suspended EU funds will resume for Poland and Hungary from next year.  The new Polish government will focus quickly on mending relations with the European Commission (EC). This could unblock €60 billion of RRF funds and €85 billion of MFF funds, totaling 17% of Poland's GDP, through 2027. Likewise, the EU's recent favorable assessment of Hungary's judicial reform progress has made available over €10 billion of previously frozen funds. Further reform progress, along the lines of horizontal and sectoral enabling conditions and anti-corruption measures, could unlock further funds under the MFF 2021-2027 and the RRF. In total, Hungary is still to receive €21 billion under the MFF 2021-2027 and grants of €5.8 billion under the RRF.

Reinstated EU fiscal rules will serve as policy anchor for CEE.  The reinstated Stability and Growth Pact--a set of fiscal rules for EU member countries--in 2024 means key limitations on public finances will remain largely unchanged: 3% of GDP for fiscal deficits and 60% of GDP for general government debt. Ultimately, all EU members will be required to meet these targets, even if consolidation plans agreed by the EC explicitly consider individual macroeconomic circumstances and could take some time. The disbursement of RRF funds is indirectly tied to a government's compliance with these fiscal rules.

Table 2

Related Research

• EMEA Emerging Markets Sovereign Rating Trends 2024: Stabilizing Ahead Of A Year At The Polls, Dec. 13, 2023
• CEE Sovereign Outlook 2024: Five Risks To Watch, Dec. 14, 2023
• Romania's Proposed Pension Law Would Derail Medium-Term Fiscal Consolidation, Nov. 23, 2023