For the region as a whole, overheating concerns are overdone, but watch out for Romania and Turkey
Concerns of overheating economies in Central Europe and Turkey have risen since H2 2017. Several countries have posted high and accelerating GDP growth rates, notably Turkey (+11.1% y/y in Q3), Romania (+8.8%), Poland (+4.9%) and the Czech Republic (+4.7%). In Central Europe, this was accompanied by tightening labor markets (rapidly declining unemployment and surging wages).
In Turkey, however, high wage growth came along with an increase in unemployment. Combined with recovering energy prices, rising wages contributed to a rapid rebound in inflation in Central Europe and double-digit price growth in Turkey. Nonetheless, central banks across the region did not hike their key policy interest rates in 2017, with the exception of the Czech Republic. Indeed, as energy price-related base effects waned, inflation leveled off in most Central European countries at end-2017 and remained within the respective central banks’ inflation target ranges. Yet, there is a risk that second-round effects of rising wages will boost core inflation and thus consumer prices in the course of 2018 if monetary policy stays too loose for too long. This has already happened in Romania, where inflation continued to rise until December (3.3% y/y) and is forecast to increase further. In Turkey, inflation eased to 11.9% y/y in December from the 14-year high of 13% in November, but this is still well above the central bank’s 5% target.
Another cause for overheating concerns has been the significant pro-cyclical fiscal stimulus in Romania and Turkey. Romania has also seen a markedly rising current account deficit in 2017 (expected at -3.2% of GDP), though it is fully covered by net FDI inflows. Turkey’s notoriously high current account deficit also rose to almost -5% of GDP in 2017, and to make matters worse, only 19% of it is covered by net FDI inflows. Other countries in the region have kept their fiscal and current account balances at adequate levels.
On a positive note, private sector credit growth has remained in check in Central Europe, below the long-term EM average of +10.5% y/y. However, in Turkey it surged again to +23% y/y at end-2017. To summarize, Romania is facing significant overheating risk, driven by surging wage growth and pro-cyclical fiscal stimulus. In January, the central bank began to take action, with a tentative 25bp hike in its key policy interest rate. More tightening is expected to reign in risk. Turkey is a different story. Strong cyclical swings in GDP growth and inflation, along with rapid credit expansion and large current account deficits have marked ongoing economic imbalances for at least 15 years now, reflecting continued high country risk rather than overheating. Only in the past 2-3 years, there has been a return to imprudent fiscal policies, which only adds to the country’s problems.
Overheating guide for key Emerging European economies