This is a guest article written by Senior Director of EMEA, Nigel Rendell, at Medley Global Advisors, a world-leading independent macro policy research specialist service for institutional investors such as hedge funds
Where might you look in Europe for relative economic outperformance in the coming years? Even before the outbreak of Covid-19, much of the continent struggled to generate more than fairly minimal growth rates. Several countries are still nursing very high public sector debt burdens, the product of the global financial crisis from more than a decade ago, that has now been made worse by the pandemic.
In the search for outperformance, an excellent place to start is with the larger economies in Central Europe – Poland, Hungary, Czech Republic and Slovakia (CE4). These countries will see living standards improve further, aided by grants and transfer payments from the European Union (EU) and the benefits of foreign direct investment, making Central Europe a geared play on European - and global - growth.
Under the auspices of EU membership, the CE4 countries have independent central banks, financial transparency, and institutional credibility. Furthermore, at a time when governments across the globe are being forced to spend to support their economies during the pandemic, public debt levels in Central Europe are low compared to much of the rest of the continent.
Into the EU fold
The CE4 was part of a group of 10 countries that joined the EU in May 2004. Among the CE4 countries, Slovakia’s economic progress was remarkably rapid; quickly meeting the Maastricht convergence criteria and adopting the euro as its national currency in 2009.
Keen to avoid the financial costs of being part the single currency, when large amounts of funds were needed to hold the Eurozone together, the other three Central European countries have been less enthusiastic about replacing their national currencies. They see euro membership as a vague longer term goal rather than a near term requirement. But in practice, all three currencies – zloty, forint and koruna - track the euro closely. This has provided the best of both worlds: ensuring a welcome degree of exchange rate predictability for both exporters and importers while avoiding contributing towards the bailout costs for those Eurozone members hardest hit by the global financial crisis.
Fuelled by substantial grants and transfer payments from the EU, foreign direct investment and a cheap labour force compared with Western Europe, Central Europe has been a strong economic performer over recent years. In the past decade (2010-2019), before the effects of Covid-19 drove economies into recession, real GDP in the CE4 increased by more than 40%, two-and-a-half times faster than in the EU as a whole.
This relative economic outperformance will continue in the future. Labour costs in Central Europe are still around a third of what they are in Germany or France. Over the past decade and a half, many multinational companies, both from within Europe and further afield, have built production and manufacturing bases in CE4. Borderless trade within the EU means there is a ready market place of 450 million consumers on the doorstep as well as road and rail connections stretching across the continent that provides a comprehensive distribution network.
The motor manufacturers were quick off the mark, setting up assembly lines for passenger and commercial vehicles and manufacturing major components, such as engines and gearboxes. Household names such as VW, Daimler, BMW, Toyota, Hyundai, Suzuki, Jaguar Land Rover and Fiat have all invested heavily in this part of the world.
In turn, this has led to the growth of a network of local companies supplying large global brands with thousands of individual items that go into the production process. For example, in the Czech Republic and Slovakia vehicle production and the associated output of components accounts for more than 10% of GDP, with the sectors in both countries employing several hundred thousand workers.
Export or die
For a large majority of firms operating in Central Europe, exports are an essential part of the business. With a relatively small domestic market place and without selling abroad, many companies would fail to reap economies of scale. Slovakia has a population of just 5.5 million, but the combination of economic necessity and its geographical location means that it has one of the highest export-to-GDP ratios globally, at 96%.
Hungary and the Czech Republic have slightly larger populations, at around 10 million each. However, exports are still the focus of attention, close to 80% of GDP, with typically a third of all goods and services destined for Germany. Poland has a larger domestic market – some 38 million consumers – but manages to export the equivalent of 52% of GDP (which is double the equivalent ratio for the UK).
This concentration on external demand means that Central Europe is a natural outperformer when the world economy is growing. Even in times of weaker global growth, the region tends to perform comparatively well, mainly due to EU transfer payments and its ability to attract longer term capital. Business and consumer optimism may be in short supply at present, but the rollout of the Covid-19 vaccine suggests that an economic pick-up - if not around the corner – is at least visible in the middle distance.
Dealing out the cash
A further source of optimism for the region is the recent news that the 27 EU member states have finally approved its €1,800bn budget and Covid-recovery fund. Despite initial objections from the Polish and Hungarian governments, payments will – in a typical roundabout EU fashion - be dependent on countries abiding by the rule of law and endorsing the spirit, as well as the principles, of membership.
This should temper further nationalistic moves in Warsaw and Budapest, where governments have clashed with Brussels over judicial reform, media restrictions and social issues. For Poland and Hungary, the prospect of forfeiting EU funds by perpetually standing in the way of a budget deal was tantamount to cutting off your nose to spite your face.
The agreement allows the European Commission to raise funds through the capital markets, disburse cash to ease the virus's financial burden, and set in motion the next seven-year budget process, stretching out to 2027. Poland and Hungary, along with the Czech Republic and Slovakia, have been significant beneficiaries of EU budget funding, adding, according to some estimates, as much as a percentage point per annum to CE4 economic growth over the past seven years.
Finally, it is worth highlighting that public sector debt levels in the region are either low or modest compared with many other countries in the EU, providing greater scope for ongoing fiscal support. The Hungarian debt ratio is the highest in the region at around 70% of GDP, with the equivalent figures for Poland and Slovakia near 60% and the Czech Republic somewhat lower at 40%. These numbers are all considerably below the EU average of 90% and a far cry from those of the worst offenders, Greece (190%) and Italy (150%).
In summary, the CE4 economies are set to remain strong outperformers in the future. Governments in Western Europe might be content to see their economies grow by an average of 1-5-2% per annum over the coming years, but this would be mundane for Central Europe. The region has the capacity to expand at twice this rate, as it reaps the benefit of EU funding, ongoing capital inflows and cheap costs of production, ensuring that the process of economic convergence continues unabated.