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New Europe Weekly

The public finance challenge

Fri, May 22 2009, 06:58 GMT
by Lars Christensen

Danske Bank A/S  |  View company's profile

Recently the European Commission published its spring forecasts for the EU economies. The report among other things sheds light on how the drop in economic activity will affect public finances in the membership – including in Central and Eastern Europe.

In the CEE countries in particular the worsening of the outlook for public finances is a key challenge for two reasons. First, it makes it nearly impossible for most of the new EU member states to fulfil the public finance criteria for euro adoption. Second, given the continued weak appetite for CEE assets in the global markets, it will become hard to find enough investors to fund the increased public deficits in CEE.

The Commission’s forecast gives a clear indication of the importance for public finances of the sharp drop in economic activity in CEE. It is especially notable how large the impact of a drop in economic activity is on public sector debt ratios. For example, according to the Commission’s forecast, public sector debt ratio to GDP will rise by a staggering 30.1 percentage points of GDP from 2008 (19.5% of GDP) to 2010 (50.1% of GDP) – and this might even turn out to be an optimistic forecast as GDP is likely to contract by a lot more in 2009 than the Commission’s forecasted drop of 10.3%. Latvian GDP numbers for Q1, which were published after the publication of the Commission’s forecasts, showed a drop of 18%. Taking this into account, we would not rule out the possibility that Latvian public debt could rise to nearly 60% in 2010. See our forecasts for public debt in the new member states in the table on the right. These forecasts takes into account the weaker than expected Q1 GDP numbers in a number of CEE countries.

There is no doubt that Latvia is by far the hardest hit country in the region in terms of the drop in economic activity and the negative impact on public finances, but it is also clear that unless corrective measures are put in place all of the new EU countries will have public deficits exceeding 3% of GDP and therefore none of the new member states will fulfil the Maastricht criteria on the public deficit and therefore not qualify for euro entry. It will be a key fiscal challenge for all of the new member states to bring their public finances in order and reduce the deficits to sustainable levels. This effort, however, is being hampered by two factors. First, the depth of the GDP contraction not only increases public deficits but also significantly increases the debt-to-GDP ratio. Second, it is well known that the political business cycle is quite strong in many CEE countries. Hence, normally governments in the region have loosened fiscal policy prior to election years. A number of countries in the region will have general elections in 2009 or 2010: Bulgaria (July 2009), Czech Republic (October 2009), Hungary (April 2010), Slovakia (June 2010) and Latvia (October 2010).

Concluding, the CEE countries are facing serious fiscal challenges and upcoming elections in a number of countries will make it hard for governments in the region to push ahead with fiscal austerity measures – after all, it is hard to convince the electorate to accept tighter fiscal policies when the economy is already in deep recession and unemployment is rising sharply.

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Published on  Fri, May 22 2009, 07:03 GMT

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