24th February 2017

Citi Central Europe Economics View: We believe that a more efficient way to raise economic growth in the medium term would be via structural reforms | Global Economic Forecast

After two decades of strong economic expansion, Central Europe has entered a period of significantly slower growth, Citi says in their Central Europe Economic View. Demographic and structural indicators suggest this trend could be difficult to reverse without reforms. They identify some areas that deserve particular attention. First, efforts should be focused on increasing labour market participation by raising the effective retirement age or attracting women to the labour market. This would likely help slow the pace of decline in the working age population.

Second, CESEE economies could try to offset the negative impact of the shrinking labour force by boosting capital accumulation. This could include efforts to boost saving rates and fix some institutional weaknesses that are obstacles for private investment. Finally, the growth could be kept at a higher level if CESEE succeeded in boosting productivity through innovation and more efficient allocation of resources, including for example a shift in the labour force from less to more productive sectors. The progress in this respect has been very modest and it may take time before serious reforms are undertaken.

We think, Citi says, these unfavourable demographic trends are unlikely to reverse in the near term. Even if fertility rates were to increase significantly it could be 20 years before there is any positive impact on economic growth. To put it differently, despite Central European governments’ success in boosting fertility rates, such efforts would do little to eliminate challenges faced by the CESEE in the coming 5-10 years.

Based on the above structural factors, we ranked Central European countries according to their performance in terms of demographic trends, institutional environment or investment/productivity outlook. The ranking shows that the risk of a significant slowdown in the long term is lowest in Czech Republic, while highest in Croatia or Bulgaria. Needless to say these conclusions can change if adequate structural reforms are implemented in particular countries.

In the near term we see a risk is that policymakers may not realize the slowdown is structural. If the authorities misinterpret the data and treat economic weakness in the region as a consequence of cyclical forces, the policy response may be incorrect and ineffective. Since the Euro Area and other developed markets are struggling to boost growth by monetary easing it may be easy for CESEE policymakers to conclude that the right answer for the region is supportive monetary and fiscal policies. However, if we are right that the region is facing a period of lower potential growth because of structural factors, such measures would likely fail and expansionary monetary policy without structural measures may lead to a pickup in wage push inflation and deteriorating fiscal positions over time. Far from calling for monetary tightening, we simply believe that a more efficient way to raise economic growth in the medium term would be via structural reforms. 

Some snaphosts related to the Czech Republic:

According to Citi, the most obvious way to increase labour supply in the coming years and avoid demographic drag on growth is by boosting labour participation. Indeed, CESEE economies, with exception of the Czech Republic, have labour participation rates below the EU-wide average. If the labour force shortage results in a fiscal deterioration, some changes in the social system (like a long parental leave in the Czech Republic) could eventually be changed. 

In Czech Republic, the government is currently discussing the introduction of a ceiling to the retirement age (65 or 67) as it is currently linked to the life expectancy without limit. For example if the change is not implemented, the Czech author of this note could get the regular pension after reaching 67 years and 8 months and his children in their average age of 72 years and four months.

Also, Citi says that lower income convergence rates will likely keep emigration rates at elevated levels in the coming years, resulting in a vicious cycle. At the same time immigration is unlikely to provide significant additional labour supply. The CESEE economies, with the exception of Czech Republic, have the lowest share of non-national immigrants in the resident population among the EU. In our view this can be explained by lower income levels, language hurdles and lack of political will (so far) to address demographic problems by immigration.

Except Czech Republic, all CESEE countries seem to have problems with either the flexibility of the labor market or the efficient use of talent.  In addition, all CESEE countries, except Czech Republic, suffer from an inefficient use of talent owing to a lack of reliance on professional management, retaining and attracting talent, among others. We think that these countries are unlikely to address these wide ranging structural problems in the medium term.

In Central European economies, investment rates have been either below Euro Area levels (Poland, Bulgaria) or only slightly above (Czech Republic, Hungary, Slovenia). Even in the latter case the difference is most likely too small to allow for a quick catch up in terms of capital stock. We think that in the future, it may be difficult to raise investment rates to levels that would allow for sufficiently high levels of capital accumulation.

Capital transfers from the EU lifted cumulative GDP growth significantly since 2004.the biggest boost to growth by EU funds in Hungary, where cumulative GDP growth would have been 10% lower from 2004 without EU-funded investments. Even Poland and the Czech Republic show a 4-5% cumulative gain in real GDP growth since 2004. Rough estimates suggest that a reduction in gross EU funds by 10% would reduce GDP on average by approximately 0.3% percentage points in Central Europe (average calculated for Bulgaria, Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia) while the second round effects could amplify the impact.

Also, Citi says, the lack of improvement in the financial market development score for these countries in the
last ten years also signals that a quick-turnaround is unlikely in the medium-term. Among the eight countries we consider, only three of them have shown an improvement in their scores (Czech Republic, Poland and Romania) and the improvements were relatively minor (0.2 points on average) while the average score fell by 0.4 points over 2005-16. All in all, we conclude that it would be unrealistic to expect a marked increase in private investment activity for most of the CESEE countries in the medium term as they are likely to continue facing major hurdles. 

Whatever measure of innovation we choose the CESEE ranks poorly, perhaps with the exception of Czech Republic. The data shows that domestic expenditure on Research and Development is only a fraction of spending of that in more advanced EU economies (Figure 38). We reach similar conclusions when we use other measures, like share of personnel employed in R&D or number of patents per head of population

As the population ages, the fiscal burden is also likely to rise. Out of the CESEE countries Slovenia seems to face serious fiscal sustainability challenges, while Romania, Poland, Slovakia, Czech Republic and Bulgaria face moderate risks. Hungary appears to be in a somewhat better position due to recently implemented reforms to the pension system which seem to provide Hungary with more headroom (official projections show the public pension fund only turning into deficit after 2035). 


In their February 2017 Global Economic Outlook and Strategy, Citi cut their 2017 GDP growth forecast for the Czech Republic by 0.2pp to 2.8%YY and increased their 2017 CPI inflation forecast slightly to 2.6%YY, they expect inflation higher in H1-2017, but then slightly lower again in H2-2017. Though the consumer price growth accelerated to 2.2%YY in January and it not only due to the non-core segment, the CNB did not sound as hawkish as in Nov-2016. Moreover, the Q4 GDP data disappointed with 1.7%YY growth, Citi says. While higher unit labour costs and adjusted core CPI point to a more hawkish CNB, weaker profitability is likely to keep the CNB vigilant about eventual premature FX floor exit. Hence, for the time being, Citi keeps their timing for the FX floor exit in Q3-2017, but they do not rule out Q2-2017 if the acceleration in the adjusted core CPI or real economy dynamics becomes more robust in Q1. Actually, Citi's call for Q3-2017 is less robust than a month earlier.

Despite a January surge in the FX interventions the CNB did not seem to be stressed and it even did not discuss the negative rates at its February meeting. The massive increase in the CNB´s FX reserves is likely to make the koruna volatile after the FX floor exit, though the increase this year was not only about the “speculative flow”. Citi updated the levels of the EURCZK that could make the CNB to act after the FX floor exit.

Members of the American Chamber of Commerce in the Czech Republic