Loss of open borders poses threat to trade in central and eastern Europe

As clouds gathered over emerging markets in August because of concerns about prospects for China’s economy, central and eastern Europe seemed to be something of an economic haven.

But in recent months the lines of migrants streaming through the Balkans — bringing concerns that Europe’s Schengen passport-free zone could come under threat — and a political shift to the right in Poland, the region’s biggest economy, have called that haven status into question.

Yet the fundamental outlook in CEE, especially for the 10 countries that have joined the EU in the past decade or so, remains relatively robust, buoyed by the recovery in the eurozone, its biggest trading partner.

Much of the region is maintaining its revival from the 2008 global financial crisis. As central and eastern Europe continues on its path towards convergence with western European income levels, it is still outstripping eurozone growth, even if this remains below pre-crisis levels.

The Czech Republic is expected to expand at more than 4 per cent this year, Poland, Slovakia and Romania at above 3 per cent, with Hungary not far behind. Growth has returned in the Balkans and the states of the former Yugoslavia, though it remains weak in Serbia and Croatia.

The big exceptions are Russia and Ukraine. The Ukrainian economy, after post-revolutionary dislocation and the Moscow-backed conflict in the country’s east, is forecast to contract by double digits this year on top of a big decline in 2014.

Russia, meanwhile, is expected to shrink more than 4 per cent this year, suffering from what Herman Gref, chief executive of Sberbank, the country’s biggest lender, calls “three black swans”: low oil prices, western sanctions over Ukraine, and the long failure to modernise its economy.

Prospects elsewhere for central and eastern European countries remain positive for next year, says Lubomir Mitov, chief economist for the region at UniCredit. Recovering labour markets should help boost domestic demand and confidence. “They have made a lot of progress of terms of competitiveness,” he says of CEE countries in the EU. “They have all really increased their share in trade, and growth has now moved to investment and consumption. And they have no macroeconomic imbalances.

“Fiscal deficits are under control and inflation is non-existent, so they also have policy space to add growth.”

The scandal that erupted in September over Volkswagen cheating in emissions tests led to widespread fears of knock-on effects on the auto industry, a mainstay of CEE manufacturing.

Although these concerns have not materialised so far, the migrant and refugee crisis has provoked genuine tensions between old and new Europe.

Moreover, following the terrorist attacks in Paris in November, border controls could be reintroduced within the EU, affecting CEE countries that have benefited from the free movement of goods and people.

Countries in south-east Europe, above all, meanwhile have borne the brunt of migrants passing through, prompting Hungary to build razor-wire fences on its borders with Serbia, which does not yet belong to the EU, and Croatia, which is a member state.

Since they are transit countries, rather than destinations for migrants, the economic overall impact so far has been muted. But if more countries follow Hungary in erecting barriers, the danger remains that important industries in central and south-east Europe, such as manufacturing and tourism, could suffer.

“The migrant crisis threatens to rupture the EU as a whole. It has put at risk the Schengen agreement,” warns Mr Mitov, referring to the EU’s passport-free zone.

He adds that the migrant crisis is the first problem on which the EU has really not been able to reach an agreement.

The crisis also helped boost the majority of the conservative Law and Justice party in elections in Poland last month, despite Poland’s record as central and eastern Europe’s most consistently successful economy, growing by more than one-third just since 2007.

Markets are concerned the new government could borrow some of the controversial policies of Hungary’s populist Fidesz party, seen as unfriendly to foreign investors, and fear that, if this happens in Poland, it could spread to others.

Law and Justice called during its campaign for taxes on banks and large retailers, both foreign-dominated sectors, similar to those imposed in Hungary, though Poland’s new economy and finance ministers are both moderates.

Analysts fear, too, that Poland’s new government may be less willing to undertake the structural reforms needed to encourage investment, or to raise productivity growth and stimulate the shift towards a more “knowledge-based” economy.

The European Bank for Reconstruction and Development noted in its annual Transition Report, published this month, that despite the region’s attractiveness and progress in tackling fiscal imbalances since the financial crisis, investment rates are lower than in other emerging market economies.

The EBRD estimated an annual investment “gap” of $75bn in its 36 countries of operation. That included holes of $28.1bn in central Europe and the Baltic republics; $16.5bn in south-eastern Europe; and $11.6bn in eastern Europe and the Caucasus, excluding Belarus, which, despite its recently re-elected authoritarian president Alexander Lukashenko, attracts more investment than expected.

“This investment gap is casting a serious shadow over the region’s long-term growth prospects,” says Hans Peter Lankes, the EBRD’s acting chief economist. “In order to boost investment and close that gap, new funding sources need to be explored.”

The bank says the boom-bust cycle of credit-fuelled expansion followed by the financial crisis has left many of its countries of operation with “dual economies”. Some parts of the private sector are over-indebted while others lack access to credit or equity. Fixing that means tackling high levels of non-performing loans in many CEE countries. It requires a continuing shift from financing in foreign currencies to local currency credit markets and encouraging higher domestic savings levels.

More diverse capital flows, from non-European emerging markets and advanced economies are needed, the EBRD adds. The EBRD also sees a greater need for equity financing, and particularly private equity, in a region where many companies have relied on bank lending.

Robert Manz, chairman of the CEE task force for Invest Europe, an association that represents private capital, says both private equity fundraising and investment activity in the region grew sharply in 2014. But, he acknowledges, there is “still a lack of institutional investors inside the region, from within central Europe”.

“By and large, the capital coming into central Europe is basically imported capital,” adds Mr Manz, who is also managing partner of Enterprise Investors in Warsaw, a private equity firm.

He says investors sometimes wonder how to define central Europe since parts of it have already moved beyond being an emerging market. “Institutional investors have to take a pretty close look at it and that’s what we’re trying to encourage them to do. We think the story has a little bit fallen off of their radar,” he says, adding: “There are a lot of reasons why this region will continue to perform well.”