CEE States Spur EU Economy but Roil Its Politics

Economies of former Soviet bloc countries are buoyant, but leaders increasingly flout European policies.

After half a decade spent struggling with the fallout from the global financial crisis, the countries of Central and Eastern Europe (CEE) have finally caught a tailwind. Thanks to slow but steady recovery in Western Europe, the 15 former Soviet satellites and Yugoslav republics are seeing revived demand for their exports. Plunging prices for imported commodities have tamed inflation and allowed central banks to cut interest rates. Sound macroeconomic policies combined with moderate leverage in both the public and private sectors have given these countries’ economies a further lift, helping them to grow at an average rate of 3.4 percent in 2015 and a projected 3.1 percent this year, according to Vienna-based Erste Group Bank. Last year unemployment fell below 10 percent, on average, even as wages rose in line with expanded GDP.

This recovery is likely to run for some time yet, driven by rising consumer demand and public infrastructure investment, economists and investors believe. “It should be another two or three years before the peak of the region’s economic cycle,” says Juraj Kotian, head of CEE macro research at Erste. “We’ve so far seen a creditless recovery, with growth much more balanced than in the past.” The region’s vitality also promises to inject a bit of juice into the tepid recovery in Western Europe, which is growing at half the East’s pace.

Politically, however, Central and Eastern European countries are providing anything but a positive impulse with their open flouting of many of the fundamental tenets of the European Union. In 2010, Hungary launched a brash experiment in building an “illiberal state based on national foundations,” to quote Prime Minister Viktor Orbán. His Alliance of Young Democrats, or Fidesz, party, upended basic EU standards for the independence of the judiciary, press, civil service and central bank. Orbán levied “crisis taxes” that have become semipermanent on industries dominated by foreign investors, particularly banks. “Liberal democratic states cannot be globally competitive” and would lose out to “successful” nations like China, Russia and Turkey, he declared in 2014.

The EU, which Hungary joined in 2004, largely tolerated such heresy in a country of fewer than 10 million people. But similar behavior spread last year to regional giant Poland, home to 38 million. The Law and Justice Party, or PiS, swept presidential and parliamentary elections in 2015, establishing the first outright legislative majority by any party since the collapse of Communism in the late 1980s. PiS leader Jaroslaw Kaczynski, along with President Andrzej Duda and Prime Minister Beata Szydlo, have followed Orbán’s playbook closely, with the notable exception of cozying up to Vladimir Putin’s Russia.

Since taking power the PiS has defied the country’s Constitutional Court — “the bastion in Poland of everything that is bad,” according to Kaczynski — by blocking five judges elected by the previous, Civic Platform–led government in its last days and replacing them with its own appointees. The party transferred control of state broadcasting from a BBC-style independent board to the Treasury Ministry, extracted the equivalent of one third of annual profits from Poland’s banks and laid the groundwork for “regaining the banking sector and the media” from foreign owners, as Szydlo put it in a speech. Still pending is a plan to convert mortgages denominated in foreign currencies — mostly Swiss francs — to zloty, another potential blow to already reeling lenders.

Politicians elsewhere in the region have bared nationalist teeth in response to an influx of Syrian refugees and a German-led effort to impose migrant quotas on every EU member. Slovak Prime Minister Robert Fico ran for reelection in March on the slogan “We will defend Slovakia,” then formed a coalition including the Slovak National Party, whose rhetoric stokes suspicion of the country’s Hungarian and Roma minorities. Czech President Miloš Zeman has described the refugee surge as an “organized invasion” whose goal is to “gradually control Europe.” Zeman told one TV interviewer, “Let [Muslims] have their culture in their countries and not take it to Europe.”


The combination of reactionary politics and buoyant economics puzzles many analysts. “It’s strange to see this backlash against Europe just when the benefits of being in Europe are becoming so clear,” says Josef Janning, who heads the Berlin office of the European Council on Foreign Relations (ECFR). “It’s probably a leftover from a frozen past.” Fear that demons of the totalitarian past will triumph runs deep among these countries’ dissenting citizens. “My personal, unofficial view is that we are in the hands of a band of psychopaths,” says Jacek Kucharczyk, president of the Institute of Public Affairs, a Warsaw think tank, referring to the PiS government. “They are very clearly pursuing an antidemocratic agenda.”

Investors at a safe distance are much more sanguine. “You’re finally seeing the economic convergence really kick in, and that’s not going to stop,” says Jacob Grapengiesser, a partner at Stockholm-based East Capital International, which has some $2 billion invested in Eastern Europe and Turkey. “Politics will not ruin the party for the economies.”

Orbán has proved a better economic steward than his provocative tone might suggest, analysts say. Hungary’s unemployment rate has shrunk by 4 percentage points since 2010, to 7.1 percent, while government debt has declined steadily and the country’s current-account balance swelled from near zero to a surplus of 5.0 percent of GDP last year. Budapest moved toward peace with international financial institutions last year, signing a memorandum of understanding with the European Bank for Reconstruction and Development (EBRD). Orbán’s government pledged to “refrain from implementing new laws or measures that may have a negative impact on the profitability of the banking sector” and to gradually reduce bank taxes.

Meanwhile, there is no reason to believe disaster is in the offing for Poland, says David Aserkoff, emerging Europe equity strategist for J.P. Morgan in London. “We might wish for something more ordinary or orthodox, but the PiS has not overpromised much more than anyone else,” he says. “I don’t think the policy will be as bad as some people think.”

The past quarter century provides grounds for such optimism. Most of the 91 million people of Eastern Europe emerged from the Soviet shadow with little experience of democracy or capitalism. A multitude of newly hatched political parties contended for power, then formed and disbanded a dizzying array of governing coalitions.

Yet across the former Warsaw Pact, governments all handed over power at the electorate’s will, allowing democratic traditions to take root. This included prior stints in government for both Poland’s PiS (2005–’07) and Hungary’s Fidesz (1998–2002). The republics of the former Yugoslavia followed a similar trajectory once the horrific civil wars of the 1990s ended. “The word which comes to my mind when I look at Central Europe is ‘respect,’” says Alain Pilloux, vice president for policy at the London-based EBRD, which celebrates its 25th anniversary this year. “When you see the courage they had to move forward, I can only tip my hat.” (Read more: EBRD, at 25, Targets New Markets and Green Investment Goals)

The region is an economic success story, too. Poland’s GDP has risen nearly ninefold since the country’s Communist days, according to the World Bank; that record rivals the growth of Asian tigers like Indonesia and Thailand. Some of Poland’s neighbors have done nearly as well. “Of eight countries around the world that have moved through middle income toward high income, excluding a few small oil states, four of them are in East Central Europe,” says Erik Berglof, head of the Institute of Global Affairs at the London School of Economics and Political Science, and a former EBRD chief economist. “This is the main takeaway of the 25-year period.” The other three stars are the Czech Republic, Hungary and Slovakia — Poland’s partners in the Visegrad Group, named after the Hungarian castle where leaders met in 1991 to plan their post-Communist future.

The success of Central and Eastern Europe depended heavily on inspiration and aid from Western Europe, which was more robust economically and confident in its own ideals. The promise of joining the EU kept the region’s fractious politicians in line for the first 15 years or so after Communism, says Jacques Rupnik, a Romanian-born professor of political science at Sciences Po university in Paris. “There was an elite consensus in the ’90s and early 2000s focused on EU accession,” he says. The Visegrad Four achieved this goal in 2004, along with the Baltic republics of Estonia, Latvia and Lithuania, and the tiny, ex-Yugoslav state of Slovenia. Romania and Bulgaria followed in 2007 and Croatia in 2013, bringing the EU to its current complement of 28 members.

Economically, Eastern Europe threw its doors open to foreign investors, embracing privatization and signing liberal accords on trade and investment with the EU. Erste and competitors such as Austria’s Raiffeisen Bank International, France’s Société Générale and Italy’s UniCredit jumped at the chance to expand beyond their cramped home markets and quickly outfitted the East with a ready-made modern financial system. Automakers, from Germany’s Volkswagen to, most recently, Jaguar Land Rover, capitalized on the region’s technically proficient but cheap workforce to build a modern manufacturing base. Slovakia, population 5.4 million, now produces more cars per capita than any country in the world, according to Milan-based UniCredit.

The EU still takes 80 percent of Central and Eastern Europe’s exports and remains its dominant investor, finding bargains despite rising wages. “Scandinavian tech start-ups are hiring programmers in the Baltics at one fourth the salary level,” East Capital’s Grapengiesser says. “Renault builds cars in Romania at one fifth of French labor costs.”

The region still enjoys EU largesse, as well. Transfers from Brussels, mostly development funds, amount to some 3 percent of GDP in Hungary and Poland. Free movement of labor within the EU has proved to be another boon for the East. More than 2 million Poles live abroad, according to Warsaw’s own estimate, most of them economic migrants to richer EU countries. In London you’re as likely to have your coffee served or your plumbing fixed by a Pole as by a Briton.

Notwithstanding all that the EU has done for its newest members, the bloc’s moral authority across the CEE region has dwindled since the heady days of accession. “After a crisis that came to us from what were supposed to be the most advanced and sophisticated world markets, we take lectures we get from them with a much bigger grain of salt,” says Miroslav Singer, governor of the Czech National Bank. In addition, the EU has lurched from crisis to crisis since 2008, organizing hasty bank bailouts, improvising to contain a sovereign debt crisis that spread from Greece across much of the bloc’s periphery, grappling with a surge in refugees and a rising threat of terrorism — all against the background of anemic growth and stubbornly high unemployment. “The EU economy has stumbled to the point where the new members say to themselves, ‘Why are we giving up all this sovereignty for sort of nothing?’” J.P. Morgan’s Aserkoff says.

The prosperous Visegrad states are voicing their doubts, both economic and cultural, the loudest. The open economy that Brussels pressed on them put too many assets in foreign hands, Poland’s Economic Development minister, Mateusz Morawiecki, explained in February while unveiling his government’s Action Plan for Responsible Development of Poland. Outside companies control half of the country’s industrial production, 60 percent of its banking assets and two thirds of its exports, he said, and they transfer €22 billion ($25 billion) in profits out of Poland every year. “Foreign capital is extremely important and welcome, but there has to be a balance if we want to keep healthy growth,” Morawiecki said.

A key instrument for achieving this balance will be the new Polish Development Fund. The ministry says it will create the fund to “obtain capital on preferential terms offered by international financial institutions” and invest it in a resurgent Poland Inc., building domestic muscle in industries from armaments to information technology. To pare back the foreign banking presence, Finance Minister Pawel Szalamacha is encouraging acquisitions by the country’s remaining state-owned lender, PKO Bank Polski, and its dominant insurer, PZU. Last month PZU subsidiary Alior Bank bought Bank BPH from GE Capital, a subsidiary of downsizing General Electric Co., for $330 million.

Euro zone expansion appears to be one more casualty of the turn against Brussels. Slovakia adopted the euro in 2009 along with Slovenia and the Baltic republics, but the other three Visegrad states are in no rush to follow, even though their accession treaties oblige them to do so eventually. “It would be difficult for us to contemplate entering a euro zone that is changing all its own institutions when we are doing fine on our own,” says Czech central banker Singer.

Romania, Eastern Europe’s second-most-populous country, with 20 million people, asserts that euro entry remains a long-term goal. “Of all the countries in the region, we are the most pro-European,” says Bogdan Olteanu, deputy governor of the National Bank of Romania. But he says Bucharest will not try to join until the country’s per capita GDP reaches two thirds of the euro zone average, up from just over 50 percent currently. Olteanu estimates that will take at least six more years.

Culture is arguably the biggest divide between the newly assertive Eastern Europe and the West. This is seen most visibly in Poland, where PiS gained power thanks to a wellspring of support among conservative Catholics. “The previous government implemented a left-wing concept, as if the world had to move toward a mixture of cultures and races, a world of cyclists and vegetarians who use only renewable energy sources and combat all forms of religion,” Poland’s Foreign Affairs minister, Witold Waszczykowski, told German newspaper the Bild earlier this year. “This has nothing in common with traditional Polish values: love of the country, faith in God and a normal family life run by a man and a woman.” Poland’s top diplomat offered this wide-ranging indictment to explain why his government was transforming state media into “national institutions of culture.”

Such passion might have seemed frozen in the past, but German Chancellor Angela Merkel and EU authorities helped melt the ice by insisting on a refugee quota system last fall, the ECFR’s Janning says. “The EU could and should have been a bit smarter than trying to shove the refugees down these countries’ throats in a union that is supposed to act democratically,” he says. (Janning’s alternative: a refugee fund to which all EU states would contribute proportionally to their GDP.)

Poland and its neighbors run some risk in biting the European hand that feeds them. “They are playing with fire confronting the EU,” says Sciences Po’s Rupnik. “Anyone who knows the history of Eastern Europe knows they never had it so good.” But official Europe seems bent on patience and forbearance for the moment. “We have a quite constructive and pragmatic dialogue with the current authorities in Poland,” the EBRD’s Pilloux says. “I have a rather moderate view of the situation.”

One reason for this soft pedal is that the EU has more-urgent problems elsewhere: securing borders against terrorists and refugees, and bracing for the U.K.’s June referendum on whether to remain in the union. “The situation in Eastern Europe is quite serious, but Brexit is a much more important focus for the EU right now,” says economist Berglof, using the common shorthand for Britain’s possible departure.

In any case, the EU lacks instruments for disciplining political backsliders. The union drafts its budget once every seven years. The current one is set to run until 2020, and CEE beneficiaries will be able to draw down funds for two years after that. The arrangement makes it difficult to threaten to withhold transfers to illiberal Poland or Hungary. Some of Brussels’ distributions can be delayed if a receiving country’s budget deficit exceeds the Maastricht Treaty ceiling of 3 percent of GDP. Poland will likely approach that threshold as the PiS fulfills an election pledge to pay families 500 zloty ($135) a month for each child, and may exceed it if the government makes good on other promises, such as cutting taxes and restoring a retirement age of 60 for women and 65 for men. The previous, Civic Platform government had enacted a gradual increase to 67 for both sexes.

Romania’s budget deficit also may exceed the 3 percent level as the dominant parties — the Social Democrats on the left and the National Liberal Party on the right — head toward an election clash this fall. Victor Ponta resigned as prime minister in November in the face of mass protests following a Bucharest nightclub fire that the public blamed on endemic official corruption, but he is back leading the Social Democrats into the upcoming vote.

Bucharest primed the economic pump last year, combining tax cuts with a double-digit hike in public sector salaries that quickly spread to private employers. That has made Romania Eastern Europe’s fastest-growing economy, which Erste projects will expand by 4.1 percent this year. But the central bank is nervous about overheating and worried about the impact of pending legislation that would convert Swiss franc mortgages to the Romanian currency, the leu, at 2007 exchange rates —an effective 50 percent haircut for banks. “We have never seen the economy in such good macro shape, but also never seen so many dangers,” National Bank deputy governor Olteanu says.

Violations of the 3 percent deficit guideline are commonplace across Europe. J.P.Morgan’s Aserkoff counts 37 over the past decade, including infractions by establishment pillars Germany and Austria. The likely consequences for a noneuro member would be mild. “This is more about being massaged by the European Commission,” Erste’s Kotian says.

Brussels may not shell out to support illiberal democracy forever, though. Talks on the 2020 EU budget begin just two years hence, in 2018, with Western donors likely to be less openhanded. “The next negotiations should be very tough, very contentious,” says the ECFR’s Janning. “After 2020 it’s a new game.”

Private investors may exact a price from the Eastern rebels more quickly. Foreign direct investment has already weakened across the CEE states, failing to regain the peaks it reached around EU accession. “The problem of FDI is the main negative for the region at the moment,” the EBRD’s Pilloux says. “The wave from large Western European companies has not been followed by medium-size companies. The mittelstand is looking more to Southeast Asia and China,” he adds, referring to Germany’s small and medium-size enterprises.

Taxes that soak multinationals and one-party states that erode the rule of law will not help matters. Investment in Hungary has dropped more precipitously than in its neighbors since 2012. The country’s overall FDI actually contracted by $9.8 billion, or 9 percent, in 2014, the last year with full statistics, according to Banco Santander. A 2015 EU report concluded, “Frequent and unpredictable regulatory changes, often resulting in new entry barriers in certain sectors, are worsening investors’ perception.”

Poland could head down a similar path, judging by PiS’s first six months in power. “It’s evident that the investment environment has deteriorated,” says Martin Miszerak, a onetime privatization minister who now runs a Warsaw consulting firm. “The government does not really understand that actions taken outside of economic policy, like the Constitutional Court, can affect the investment climate.”

Eastern Europe also has a lot to lose from any amendment of the Schengen Agreement, which guarantees borderless traffic throughout most of the EU — an outcome that its leaders’ anti-Muslim declarations may make more likely. Three quarters of Hungary’s exports to the EU, for instance, cross two or more national borders, Erste’s Kotian says, while 5 percent of the Slovak workforce commutes to Austria or another neighboring country. Erecting barriers against the menace of Islamic terrorism will hurt the East’s economies.

The everyday economic integration of 28 nations stretching from the North Atlantic to the Black Sea is one of unified Europe’s greatest achievements, and one now taken for granted. Yet the clamor for more national sovereignty, spreading in both the East and the West, has convinced most observers that Europe’s goal of “ever closer union” is a dead letter. That objective dates to a 1983 declaration by what were then ten member states, and it was reasserted in the 2007 Treaty of Lisbon. The U.K. achieved a formal exemption from this goal in February — one of the concessions Prime Minister David Cameron wrested from Continental colleagues to prepare himself for the Brexit referendum.

The talk today is of a two-stage, if not multistage, Europe, though different observers have their own conceptions of what this might look like. Sciences Po’s Rupnik sees the 19 existing euro zone states moving genuinely closer, edging toward a joint fiscal system to complement the shared currency, while Eastern Europe heads toward a more flexible partnership. The ECFR’s Janning sees a more restricted “core Europe” built around Germany and the Benelux states, with “allies joining it on a more issue-specific basis.” EU members will increasingly evade questions that require unanimous approval and will build new “coalitions of the willing” around specific issues, Janning says.

In theory, the EU can retain the essentials of its common market without forcing constituent states to accept refugees or embrace “cyclists and vegetarians.” The U.S., Mexico and Canada have been joined for two decades by the North American Free Trade Agreement, while each remains free to conduct its own foreign and civil rights policies.

The path to less intrusive union is not simple for Eastern Europe, however. Without overbearing parents in Berlin and Brussels, the region would need to depend on its own political resources to cement its newborn freedoms of enterprise and ideas. It would need to depend more on its own financial resources for investment, and for strengthening its militaries to deter an increasingly assertive Russia. U.S. and German rejection last month of Poland’s request for North Atlantic Treaty Organization bases, and President Barack Obama’s refusal to hold a one-on-one meeting with Duda when the Polish president was in Washington for a Nuclear Security Summit at the end of March are potent signals in this respect. Disillusioned with an EU they strove for 15 years to join, Central and Eastern European electorates seem to be pushing for a looser union. They may live to regret it.•