Regional outlook little changed despite contagion from global bond sell-off

The market sell-off, which started in the US bond market and spread to global equity markets, has also hit the Central European region. Not only are the regional bond and equity markets under pressure, but so are the foreign exchange markets, this time surprisingly led by the (fundamentally sound) Polish zloty.

While the massive shift in yield curves has forced us to take a reality check and adjust our forecasts for long(er) rates, we have left our outlook for policy interest rates (in Central Europe) unchanged. The reason for this is that the actual macro figures have been very much in line with our expectations and there has been no reason to change the macroeconomic outlook for the regional (CEE) economies. In this respect, it will be prudent to wait for the GDP results for the first quarter of this year before making any changes.

Political stalemate in Bulgaria could delay its euro entry

After less than a year of normal governance, Bulgaria is again in a pre-election situation. So, the next early parliamentary elections will be held together with the elections for European Parliament on June 9. The last government was elected on June 6, 2023 with the supporting votes of the pro-Atlantic coalition between GERB-SDS and PP-DB. They had an agreement for Mr. Nikolay Denkov to be the first the Prime Minister (PP-DB) for 9 months. The post would be taken over by Mrs. Maria Gabriel (GERB-SDS) for next 9 months. In accordance with the agreement, Denkov resigned, but the partners failed to agree on the priorities and composition of the government of Gabriel. Following the rules of the constitution, amended by the coalition partners, the president appointed a caretaker government (already from a list of possible candidates), while the parliament continued functioning (according to the amendments). However, the issue of a problematic governance will probably remain also after the snap elections, given the polls and the red lines between the parties. It is quite likely the caretaker government would rule longer.

The political instability significantly complicates the conduct of purposeful national policy. Thus, the achievement of full membership in Schengen and the Eurozone will probably take time, as both imply clear priorities and targeted steps to achieve them. More specifically, the Denkov government's idea of (having) a convergency report in autumn and eurozone membership in mid-2025 seems currently no longer very realistic. If Bulgaria manages to fulfil the inflation and budget deficit criteria, EMU membership on January 1, 2026 looks increasingly convincing.

Slovakia at risk of another credit downgrade

The sovereign risk premium on Slovak government bonds has reached the highest level since the ECB started monetary-policy normalisation after the pandemic in 2020. The credit spread widening is not just due to the gradual tightening of the monetary policy, but due to loose domestic budget policy too. The shift in interest rates from negative territory to around 4.5% has led lead to a significant rise in the interest cost of debt service. Hence, the gross public debt has risen from 28.6% of GDP (2008) to 56% (2023) since joining the Eurozone (see figure CEE1). True, the highest level of debt to GDP was reached at the 61.1% level in 2021, but this was mainly due to the pandemic. Subsequently, the debt declined thanks to higher nominal GDP growth caused by the inflation shock (and higher than planned growth in indirect taxes). On the other hand, the general government deficit has remained close to 5% over the last 4 years (except for 2022). According to the Independent Fiscal Council, this all has worsened the long-term sustainability of Slovak public finances. In addition to the reasons mentioned above, the ageing of the population is also a factor and will accelerate in the next decade. At the same time, fiscal restrictions have focused on weakening the private second pension pillar, while there have been no serious spending cuts implemented. The government only promises to implement an austerity package of roughly 1% of GDP only in 2025.

However, it is uncertain whether these measures will be enough for the financial markets. Credit risk spread on Slovak 10-year government bonds have risen to multi-year highs and are the second highest in the Eurozone after Italy. Meanwhile, the Fitch agency has already downgraded the country by one notch to "A-" in December 2023 and a further downgrade is imminent from Standard and Poor's (currently "A+"). S&P's grade is still one notch higher than Moody's (“A2”) and two notches higher than Fitch's ("A-”).

However, in addition to underlying public finances’ development, disputes with the European Commission over the rule of law and the protection of EU funds have also taken centre stage. The new government (of PM Fico) quickly changed the criminal law after coming to power and abolished the Special Prosecutor's Office, which had been in place for two decades. This resulted in rather strong warnings from the Commission. Hence there is even a risk of delays in the disbursement of, or even possible loss of, EU funds (Recovery and Resilience Fund/EU funds). This would be very unpleasant, and it’s no wonder that the Slovak Ministry of Finance has already reduced its forecast for the 2023-2024 RRF disbursement by about €1.2 billion (or about 1% of GDP per year). So, the Fico government will face the challenge of how to maintain the inflow of EU funds, which has helped to generate GDP growth, while starting a credible and sustainable consolidation of the fiscal accounts.