The macroeconomic outlook for CEE economies remains solid. After bottoming out in mid-2023, economic growth has rebounded, supported by domestic demand on the back of disinflation, wage growth, and loose fiscal settings. S&P Global Ratings expects that CEE GDP growth will also benefit from a pick-up in the eurozone, as well as strong net foreign direct investment and EU fund inflows. The latter will overfund CEE economies' modest current account deficits, if any, after the region underwent a strong external rebalancing following the energy price shock in 2022.

Natural gas prices are well below their peak two years ago and the region is set to enter the second winter in a row with full gas storage. Provided Russian pipeline oil supplies to some CEE countries are restored following a temporary disruption in July 2024, the broader energy-supply outlook for the region looks secure.

All CEE central banks have started to ease their monetary policies. This, coupled with the start of monetary easing in the eurozone and a likely forthcoming first rate cut by the U.S. Federal Reserve, is containing exchange rates and government financing pressures. These factors, along with generally low government and external debt, support our CEE sovereign ratings.

For the first time since 2020, the balance of outlooks on our 11 CEE sovereign ratings is positive, meaning that positive outlooks exceed negative outlooks. Nine sovereigns have a stable outlook, while Croatia and Bulgaria still have a positive outlook. No CEE sovereign has had a negative outlook after we lowered the ratings and stabilized the outlooks on the three Baltic sovereigns, Estonia, Latvia, and Lithuania, in May 2024.

One dark spot in the region's otherwise strong credit outlook is CEE sovereigns' weak fiscal positions. Romania, Slovakia, Hungary, and Poland, among other CEE sovereigns, continue to run some of the highest fiscal deficits of all 85 sovereigns that we rate in Europe, the Middle East, and Africa (EMEA). Fiscal pressures stem from generous social transfers during electoral cycles, but also from elevated defense spending and interest bills.

Otherwise, we see five key risks for CEE sovereign credit quality in 2024-2025:

• Weaker growth than we expect in the euro area;
• Lower EU fund disbursements;
• Slow fiscal consolidation;
• Monetary policy missteps; and
• Elevated geopolitical tensions and domestic political volatility.

Table 1

Risk 1: A Protracted Period Of Low Growth For Key CEE Trading Partners

We project that real GDP growth in the region will average 2.4% in 2024 and 3.1% in 2025, thanks to recovering domestic demand.   While these projections are marginally weaker than our expectations at the start of this year, our economic growth narrative for the region remains unchanged. After a near full-year recession in 2023, we expect the CEE economies to rebound in 2024 on strengthening private consumption, and to expand further next year, supported by recovering investment and external demand.

That said, uncertainty persists over the growth prospects of the region's key trading partners in the eurozone.   The likelihood of a recession in developed Europe is relatively low, as the region has absorbed the rise in inflation and interest rate shocks and the labor market remains tight. We project that eurozone GDP growth will accelerate to 1.4% in 2025 from 0.7% this year, as lower commodity prices rebalance terms of trade, support disinflation, and contribute to the recovery of real incomes (see "Economic Outlook Eurozone Q3 2024: Growth Returns, Rates Fall," published June 24, 2024, on RatingsDirect). However, given permanently higher interest rates, elevated energy prices, and thinner savings buffers, there is a meaningful risk of the eurozone economy suffering an extended period of subpar growth.

A potentially weaker economic recovery in the eurozone, and particularly in Germany, could hurt CEE economies' growth prospects.   Although CEE economies depend less on Germany than two decades ago, it remains the region's biggest export market, not least due to the deep integration of CEE manufacturing with German auto supply chains (see chart 1). Lower energy costs helped the German economy to emerge from recession in the first quarter of 2024, thanks to a recovery in production in energy-intensive sectors. However, high-frequency data on Germany's manufacturing sector (the new orders index, for example) remains weak.

We forecast that Germany's real GDP will expand by a mere 0.3% in 2024 and remain subdued at 1.2% next year. Regional growth prospects could suffer further if Germany's economic weakness proves structural and protracted, reflecting permanently higher energy costs, technological shifts in the auto industry, weak demographics, and underinvestment. This weaker growth could pressurize CEE public finances at a time when government funding costs remain high.

Chart 1

What to watch

• Data on exports and manufacturing performance (including purchasing managers' indexes) in CEE countries, the eurozone, and Germany;
• Labor market trends;
• Economic sentiment data; and
• Investment data.

Risk 2: Weaker EU Fund Disbursements

All CEE countries except Hungary have unlocked full amounts of EU funds.  The region is eligible for significant EU transfers in 2021-2027, with the stock of available funds per country ranging from between 15% to over 40% of annual GDP (see charts 2 and 3). Since the publication of our previous outlook in December 2023, both Poland and Hungary have been able to tap some EU funding facilities following delays due to the European Commission's rule-of-law concerns.

Unlike Poland, which has unlocked all available EU funds on the back of the new government's effort to meet the associated reform targets, over 40% of total EU cohesions funds available to Hungary (€21.9 billion, or 11% of 2024 GDP) are still frozen. The risk of their permanent loss remains tangible should the institutional reforms that the European Commission requires not materialize. In this scenario, Hungary's medium-term growth prospects, balance of payments, and fiscal positions could suffer.

Chart 2

Chart 3

The utilization of EU funds will require sustained policy efforts and fiscal prudence.   Institutional and administrative constraints have limited some CEE sovereigns' ability to use EU funds, resulting in a slow pace of fund utilization. For example, on average, only 25% of Recovery and Resilience Facility (RRF) allotments to CEE sovereigns had been disbursed by June 2024. Addressing institutional constraints requires concerted policy measures. Such measures may prove challenging to implement in countries where doing so could test the stability of government coalitions--such as in the Czech Republic, Slovenia, and Poland--or in countries going through electoral cycles (see chart 4).

Parts of EU funding--like RRF disbursements--are also tied to the EU's view on the sustainability of public finances, among other conditions. This means adhering to EU-agreed fiscal consolidation paths. Under the current settings, sovereigns can tap RRF funds no later than end-2026.

Chart 4

What to watch

• Progress on disbursements from the EU RRF; and
• The European Commission's assessment of CEE countries' reform progress in the context of some EU funding facilities.

Risk 3: Slow Fiscal Consolidation

We project that CEE sovereigns' fiscal deficits will remain wide until 2025, derailing government plans to reduce debt.   Our conservative fiscal projections for CEE sovereigns have worsened in the course of this year. We now expect an average fiscal deficit in the region of 4.5% of GDP in 2024, compared to our expectation of 4.1% at the start of the year, and 4.0% of GDP in 2025, compared to 3.3% previously (see chart 5). This is due to a softer GDP recovery, but also to costly public wage and pension hikes amid ongoing electoral cycles.

Chart 5

Additional pressures stem from defense spending, which, in some countries, exceeds the North Atlantic Treaty Organization's (NATO's) target of 2% of GDP (see chart 6). 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 spending commitments will contribute to fiscal deficits of 2.5%-6.0% of GDP in 2024, with Romania, Slovakia, Hungary, and Poland among the 15 countries with the widest fiscal deficits of the 85 sovereigns we rate in EMEA. Rating pressures for CEE sovereigns could increase if other shocks, including the fallout for investor confidence, EU fund disbursements, and economic growth, compound the fiscal risks.

Chart 6

The European authorities and financial market forces will likely incentivize fiscal conservatism, but consolidation will take longer.   High deficits have prompted the European Commission to recommend an Excessive Deficit Procedure (EDP) for seven EU member states, including three CEE counties: Hungary, Poland, and Slovakia. Romania has also been under an EDP since 2020. Under the updated fiscal framework, the European Commission will require these governments to prepare and deliver credible medium-term fiscal-adjustment plans to ensure they meet the EU fiscal thresholds, including a general government deficit of 3% of GDP.

Even though the enforcement of fiscal rules in the EU has been uneven in the past, the EDP could serve as an anchor for governments' fiscal policies, given their indirect impact on RRF disbursements. In addition, we believe that governments will likely try to avoid the adverse effects that protracted fiscal weakness could have on investor sentiment, and ultimately, on government funding conditions.

CEE government debt will increase, albeit from a moderate level, and the cost of debt servicing will be higher than in the past.   We expect government debt as a share of GDP to increase for most CEE sovereigns in 2024-2026, and remain permanently higher than pre-pandemic levels in the medium term (see chart 7). The only exceptions are Slovenia and the Czech Republic, where we expect debt to stabilize thanks to cost-containment measures and fiscal reforms, and Croatia, where conservative fiscal management and high nominal GDP growth will allow the government to put debt firmly on a declining path.

Chart 7

Still, overall public debt in CEE countries is just below 50% of GDP on average, a moderate level compared to many global peers and countries in Western Europe. That said, with higher funding costs, interest costs as a share of GDP will increase by 1.7x-1.8x in 2024 compared with 2021. CEE government bond yields have dropped from their peak in 2022. However, they will remain higher than in the recent past and show elevated volatility depending on domestic and global interest-rate developments, exchange-rate trends, and investor sentiment (see chart 8).

Chart 8

What to watch

• Countries' fiscal performance data;
• Fiscal adjustment plans by countries under an EDP;
• Pre-election tax and expenditure proposals;
• Individual countries' budgetary discussions for 2025; and
• Global central banks' policy decisions.

Risk 4: Monetary Policy Missteps Amid High Underlying Price Pressure

Headline inflation has slowed substantially across the region, approaching official targets, but will likely pick up in the second half of 2024.  After a sharp decline that started in early 2023, we expect headline inflation to pick up in the coming months as domestic demand strengthens, tax cuts and energy price caps are reversed, and the high base effect fades.

Moreover, there is a risk of underlying inflation staying above central bank targets (generally 2%-3%) beyond 2024. This is because core inflation remains sticky and now exceeds food and energy inflation (see chart 9). This is not least due to generous fiscal transfers that support consumption, but also to the region's structurally tight labor markets amid a rapidly shrinking labor force (see chart 10).

Chart 9

Chart 10

Even if we expect monetary easing to continue in CEE countries, it will be gradual as central banks remain cautious.   Following pronounced disinflation, CEE central banks started to normalize their policies last year, much earlier than their peers in advanced economies. However, elevated core inflation and loose fiscal settings will likely slow the pace of policy easing in the region.

Given global central banks' cautious stance and a relatively high exchange-rate pass-through to domestic prices in CEE countries, regional central banks will find it difficult to decide whether to make further policy rate cuts. This makes the likelihood of monetary policy missteps greater than usual. Higher-for-longer inflation in the region could de-anchor long-term inflation expectations and undermine external competitiveness and economic growth.

What to watch

• Headline and core price developments;
• Labor market trends;
• Global central banks' monetary policy decisions; and
• Countries' medium-term fiscal plans.

Risk 5: Elevated Geopolitical Tensions And Domestic Political Volatility

An escalation of geopolitical tensions could rapidly increase security and macroeconomic costs for CEE countries.   Our baseline remains that Russia's war of attrition in Ukraine will continue throughout this year, with both sides deploying their expanding military arsenals. 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, an escalation of the war could disrupt supply chains and commodity production. Since some CEE economies, including Hungary and Slovakia, still depend on Russian gas and oil, an extended disruption of Russian energy flows could lead to new economic, external, or fiscal pressures beyond our baseline projections. The effects of a protracted war and broader geopolitical risks could also weigh on the Baltic countries' small and open economies.

Finally, the emergence of a more isolationist U.S. administration after the presidential election in November 2024 could test European security settings. In light of CEE countries' proximity to the Russia-Ukraine war zone, all these factors could have adverse macroeconomic repercussions for the region, including higher risk premiums on domestic assets.

Political polarization in CEE countries could weigh on reform efforts and reduce policy predictability.   Although the European parliamentary elections led to the centrist parties retaining a majority in CEE countries and the EU overall (see chart 11), high political fragmentation and volatility in some CEE countries--Poland, Romania, and Bulgaria, among others--could further erode policy effectiveness and predictability. This, in turn, could undermine governments' ability to tap available EU funds, since such funds are contingent on the achievement of policy targets.

Another consequence could be setbacks to reforms. Such setbacks may undermine medium-term growth and fiscal consolidation plans. Hungary and Slovakia are examples, but the risk is similarly applicable to other CEE sovereigns. Setbacks could also complicate the delivery of long-standing policy goals, for example, Bulgaria's accession to the eurozone (see "Bulgaria's Eurozone Entry's Still Likely Despite Government Collapse," published April 3, 2024).

Chart 11

What to watch

• The evolution of the Russia-Ukraine war;
• The West's commitment to support Ukraine;
• Domestic pre-election policy debates;
• Post-election government formation and policy agendas; and
• The outcome of the U.S. presidential elections.

Related Research

• EMEA Emerging Market Sovereign Rating Trends Midyear 2024, July XX, 2024
• Sovereign Risk Indicators, July 8, 2024; a free interactive version is available at http://www.spratings.com/sri
• Economic Outlook Emerging Markets Q3 2024: Growth On Track, Policy Risks Rising, June 24, 2024
• Economic Outlook Eurozone Q3 2024: Growth Returns, Rates Fall, June 24, 2024