Economic Outlook Deteriorates as Peace Agreement Remains Uncertain

Growth forecasts for Eastern Europe deteriorated this month as panelists turned pessimistic yet again. Last month’s upward revision to the region’s 2014 growth forecast was the only upgrade in over a year. FocusEconomics Consensus Forecast panelists have now cut their projections for the region by 0.2 percentage points over the previous month. Not only has this completely wiped out last month’s upgrade, but the projected 1.3% GDP growth marks a new low for the region.

The Reason: Conflict in Russia and Ukraine

As in previous months, deteriorating prospects are mainly due to downward revisions for Russia and Ukraine, as the negative economic impact of the ongoing conflict is becoming increasingly evident. Moreover, six additional countries out of the fourteen surveyed experienced downward revisions. The forecasts for four countries remained unchanged and the forecasts for two economies improved. Prospects over the medium term also remain dismal. The panel cut the regional GDP growth forecast for 2015 by 0.3 percentage points over last month to 2.1%, which marked the tenth drop in a row and mainly reflected a deteriorating outlook for Russia.

First step Toward Conflict Resolution

A breakthrough ceasefire agreement that Ukraine and the pro-Russia separatists reached on 5 September raised hopes that the conflict in eastern Ukraine may finally come to a close. The truce paves the way for peace talks that could bring an end to the armed conflict that has cost more than 3,000 lives and has brought Ukraine to the brink of political and economic collapse. However, occasional fighting around Mariupol in the days following the ceasefire is threatening to derail the fragile truce and could jeopardize the peace talks.

Outline of Ceasefire after Talks between Poroshenko and Putin

The peace negotiations follow the outline that President Vladimir Putin laid out after holding talks with Ukrainian President Poroshenko. The outline promises to maintain Ukraine’s territorial integrity but grants a “special status” for the eastern parts of the country, including a large degree of autonomy. While the outline seeks to reconcile the diverging interests of all parties involved, reaching a final agreement that is also accepted back home will not be easy. Poroshenko faces the challenge of justifying the outcome of a peace agreement to Ukrainians, many of whom fear that the government is conceding to Russia. Putin, on the other hand, needs to present an agreement that the Russian public considers as having been worth the fight. Failing to do so would undermine his popularity, which surged to record highs in the wake of the annexation of Crimea.

Ukraine’s Economic Situation Worsens, while New Sanctions Expected for Russia

At this stage of the conflict, FocusEconomics Consensus Forecast panelists remain skeptical about Ukraine’s economic outlook as the likelihood of reaching a peace agreement is still unclear. The panel expects the economy to contract 6.2% this year, which is down 0.9 percentage points from the previous month’s projection. However, panelists do see the Ukrainian economy rebounding to a 0.8% expansion in 2015.

Despite the ceasefire, pressure on Russia continues to mount. Following alleged incursions by regular Russian troops in eastern Ukraine, the European Union approved a new round of sanctions on 8 September. The measures won’t enter into force for several days so that EU leaders can first assess the implementation of the cease-fire agreement and the peace plan. Depending on the situation, the EU will review the agreed sanctions in whole or in part. The United States has also prepared a new round of sanctions, but is waiting for the EU sanctions to enter into force. If implemented, the new EU measures will expand the sanctions that were imposed at the end of July, which included Russia’s energy sector for the first time. Even the new sanctions, however, don’t target companies involved in gas production and transportation, which are critical to Europe’s energy supply. Meanwhile, Russia warned that it may block international flights through its airspace if the EU goes ahead with the new measures.

Conflict Makes Russian Economy Struggle

As in Ukraine, the outlook for the Russian economy hinges on the peace agreement negotiations. Failure to reach an agreement, along with ongoing support for the pro-Russian separatists, would likely take a heavy toll on the Russian economy, as Western governments would probably continue to increase the scope and depth of the existing sanctions. The looming threat of the country’s ever-deepening isolation has already eroded investor confidence. Therefore, economists remain skeptical about Russia’s growth prospects despite the recent positive developments. FocusEconomics Consensus Forecast panelists cut their GDP growth forecasts for 2014 by 0.2 percentage points and now see the Russian economy expanding a paltry 0.2%. Forecasts for 2015 were cut by an even larger 0.6 percentage points, resulting in a projected GDP growth rate of 1.0%.

Eastern European Inflation Inches Down, but Higher Inflation Expected at Year-end

Regional inflation inched down from 5.7% in June to 5.6% in July. However, the first data for August show inflation picking up again in Russia, Turkey and Ukraine, suggesting that the rising inflation trend that has been observed since the beginning of the year remains in place. In light of persistent price pressures, the Turkish Central Bank decided to maintain its main policy rate unchanged at its 27 August policy meeting and only lowered the marginal funding rate. Meanwhile, Hungary’s Central Bank kept its base rate unchanged and announced that the easing cycle, which involved 24 consecutive interest rate cuts starting in August 2012, has come to an end.

Inflation expectations for this year continue to rise. Driven by higher inflation forecasts for Russia, Turkey and Ukraine, the average forecast for the region has risen, even though inflation projections for the remaining eleven economies have declined. On balance, the inflation projection for Eastern Europe reached 5.6% this month, which was up from the 5.4% that was expected last month. In 2015, inflation is expected to fall back to 4.8%, which is up 0.2 percentage points over last month’s projection.

Note: This is an excerpt from the FocusEconomics Consensus Forecast Eastern Europe –September 2014. Published September 9th, 2014. The full report (164 pages, covering 14 major economies in Central and Eastern Europe is available for immediate download at the FocusEconomics Online Store). For more information and a free sample of the report please visit our website.

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