OUTLOOK 2023: Central Europe and the Baltic states

OUTLOOK 2023: Central Europe and the Baltic states
In Poland, relations with the EU could worsen in the short term ahead of the elections this autumn, but if voters then unseat the Law and Justice Party of Jaroslaw Kaczynski (pictured centre), the country could realise the promise of its new geopolitical position. / bne IntelliNews
By Robert Anderson in Prague January 9, 2023

This outlook is part of bne IntelliNews' annual series of reports looking ahead to what 2023 holds for the countries in our region. Read the full report here or download the pdf at the bottom of the article.

The two most important events in Central Europe in 2022 were, first, the invasion of Ukraine by Russian dictator Vladimir Putin, and, secondly, the long-awaited hardening of the European Union ’s stance towards the breach of its values by the radical right-wing regimes in Poland and Hungary.

The invasion boosted the significance of the region (particularly Poland) through its role as a supply base for Ukraine, its sheltering of many refugees, as well as for its foresight in long warning of the threat from the Kremlin during a period when many in Western Europe were continuing to counsel appeasement.

However, the region struggled to cash in this new potential clout inside the EU and Nato because of the deepening rift between Brussels and Budapest and Warsaw.

Many expected – and Viktor Orban counted on it – that the EU would give up prosecuting Hungary and Poland’s flagrant breaches of the rule of law because of the need to present a united front to Russia.

Nevertheless, the bloc has stood firm and will withhold both Recovery and Resilience Facility (RRF) and Cohesion Funds until both countries fulfil a series of key reforms this year. Orban has blinked and agreed to the EU’s demands; Poland has yet to do so amid infighting within the ruling coalition. 

By threatening to hold up financial flows if the rule of law is breached and EU money put at risk, the European Commission finally seems to have found a credible weapon to fight the populist contagion.

In Hungary, despite winning re-election in flawed elections in April, Orban ended the year isolated within the EU and even within the Central European Visegrad Group because of his continuing links with Putin and his refusal to give significant help to Ukraine. As Russian influence in Europe has collapsed, Orban has cut a lonely figure as one of Putin’s last remaining friends, together with Aleksandr Vukic’s Serbia. Even the election of radical right-wing allies in Italy and Sweden last year has so far done little to ease his isolation because they do not agree with his stance on Russia either.

This year will show whether Hungary can continue to balance its EU membership and its close relations with the Kremlin or whether it will finally have to make a choice as the war drags on.

In Poland, relations with the EU could worsen in the short term ahead of the elections this autumn, but if voters then unseat Jaroslaw Kaczynski’s Law and Justice Party the country could realise the promise of its new geopolitical position by becoming a key player in Brussels.

In an optimistic scenario, if both countries head back to the political mainstream, the whole region could finally become much more embedded in the EU; however, in a pessimistic scenario, Budapest and Warsaw could once more unite against Brussels and the region could instead suffer a new wave of self-defeating populism as the cost of living crisis bites.

Leading the downturn

Turning to the economic outlook, Central Europe is currently facing rocketing inflation and recession, at a time when the region has barely emerged from the downturn caused by the COVID-19 pandemic.

As a region heavily dependent on Russian energy, Central Europe is entering the downturn earlier than Western Europe. Rises in energy prices – in large part due to the Ukraine war and the sanctions on Russia – have pushed up inflation, increased external deficits, squeezed businesses and households, and pushed most economies into recession. The region’s downturn is forecast to last until the middle of this year, followed by feeble growth.

The Baltic states already entered recession (two consecutive quarters of quarter-on-quarter negative growth) around the middle of 2022 and are not expected to emerge from it until mid-2023.

Czech GDP growth turned negative in Q3 and is expected to also be negative in Q4, meaning the economy is probably already in recession. According to ING, the country will suffer the deepest recession in the region.

Hungarian growth also already turned negative in Q3 and is expected to be negative in Q4, putting the economy in recession. It is then forecast to be close to zero for much of 2023.

Poland could suffer negative growth in Q1 but is currently predicted by most economists to return to growth in Q2. This should help the populist Law and Justice Party ahead of the elections in the autumn, particularly if the government and its central bank try to engineer a pre-election boom as in Hungary.

Slovak growth remained in positive terms in Q3 and the economy is currently forecast to escape recession but with minimal growth.

At the same time, Central Europe is suffering the highest inflation in the EU because of the high weighting of food and energy prices in its CPI baskets, with the rise in consumer prices reaching 25% year on year in Estonia in August. Wages are not keeping up, with workers in all countries suffering falls in real wages. 

Central banks have reacted to the soaring inflation by hiking interest rates, which is depressing investment. On the positive side, as the region began tightening monetary policy earlier than Western Europe – in June 2021 – economists expect central banks led by the Czech CNB to start loosening monetary policy beginning in the middle of the year.

Fuel for populism

For citizens, the fall in real wages comes on top of lingering discontent with the region’s slowness in catching up with Western living standards, particularly since the global financial crisis. Only Czechia (at 92% of the EU average GDP/capita on a purchasing power parity basis in 2021), Estonia and Lithuania (89%), have almost converged with EU levels – and are ahead of Spain, Portugal and Greece – while the remaining Central European countries still all hover around 70-75%. Czechia is the only CEE4 country classified by the IMF as an ‘advanced economy’ rather than an ‘emerging economy’.

Some low-income groups – notably pensioners, rural dwellers, those with less education and skills – already felt they had not benefited from the transition from Communism since 1989. The risk is that they are becoming permanently disaffected with democracy and will keep voting for populist parties, which are already in power in Hungary and Poland, and are leading the opposition in Slovakia, Czechia and Estonia.

Radical right-wing populism continues to be fuelled by social disparities created by the transformation from communism, the cultural shock from accession to the EU and its values – on issues such as LGBT rights – as well as phantom fears about migration and other topics spread by misinformation. 

This growing disgruntlement could also spill over into the international sphere, because patience could run thin with the cost of imposing sanctions on Russia in terms of higher energy prices, as well as the burden of looking after hundreds of thousands of Ukrainian refugees.  At a demonstration in Prague in September, 70,000 protested against the government, but speakers also railed against sanctions, refugees, the EU and Nato.

To contain discontent, most governments have put in place energy price caps at a heavy cost, sometimes funded by windfall taxes. But across the region opposition parties are calling for governments to do more, at a time when budgets are already stretched from dealing with the pandemic.

The challenge of helping citizens cope with the cost of living crisis is also accentuating tensions in the ruling coalitions, with Estonia’s Prime Minister Kaja Kallas reconstructing her government in June and the Slovak coalition being brought down by a vote of no-confidence in mid-December.

But the risk of a new populist wave in Central Europe is limited, given that only in Slovakia is there a real danger of populist parties seizing power this year. Former premier Robert Fico could return to power at snap elections sometime in the middle of the year, but his left-wing nationalist Smer party will struggle to find allies.

In Estonia, the radical right-wing EKRE party is expected to do well in April’s general election, but Kallas’ Reform Party is still far ahead in the opinion polls.

 In Czechia, polls indicate “centrist populist” Andrej Babis would lose the run-off of this month’s presidential two-round election to either of the two main government-supported candidates.

Moreover, this cost of living crisis may not necessarily benefit the existing radical right-wing governments in Hungary and Poland, precisely because they are the ones that are struggling to cope with it. Populist governments such as Hungary's were among the worst performers in the COVID-19 pandemic, and they are now being found wanting by the current cost of living crisis.

In fact the country facing the gravest economic challenge is Orban’s Hungary itself, with the forint the worst performing European currency last year.

Orban is now in a very weak position to protect Hungarians’ living standards because his pre-election spending spree had already pushed up inflation and blown out the budget deficit.

According to ING, “high levels of public and net foreign debt, combined with fiscal and current account deficits potentially raise concerns about medium-term sustainability, especially in an environment of rising interest rates”.

Hungary’s future economic stability will now depend on fulfilling the milestones to release EU funds, the flow of which will narrow the budget and external deficits and boost the economy and international confidence in the forint. But if the European Union maintains its surprisingly tough stance and the milestones actually work properly, these reforms will also start to undermine Orban’s semi-authoritarian regime, making the country’s future political ‘stability’ much more interesting and the next elections potentially much fairer.

 

 
 

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