Analysis-War, energy and politics hamper Eastern Europe's efforts to keep deficits in check

By Libby George and Gergely Szakacs

LONDON/BUDAPEST, May 7 (Reuters) – The Romanian government’s political implosion this week in a no-confidence vote has cast a shadow over a region grappling with rising debt, defence spending and energy costs that are unsettling investors and ratings agencies alike.

Romania, whose budget deficit last year amounted to 7.9% of gross domestic product, the highest ‌in the European Union, has thus far narrowly avoided “fallen angel” status – a downgrade to a below-investment-grade credit rating.

But elsewhere in Eastern Europe, too, looming deficits are causing concern: S&P downgraded Slovakia ‌last month due to its rising budget deficit; Poland is spending billions more zlotys on defence without compensatory spending cuts elsewhere; and the new government in Hungary said its budget deficit could widen to nearly 7% of GDP; and the Czech Republic is targeting a plan to exempt billions of crowns in spending from fiscal rules.

Faced also with soaring energy prices, caused primarily by the Iran conflict, domestic political uncertainty and rising borrowing costs, countries in the region are being closely watched by investors and ratings agencies.

“We are concerned about any combination of weakening fundamentals, challenging governance, weak political majorities, or lack of political majorities,” said Alvise Lennkh-Yunus, head of Sovereign & Public Sector Ratings, Scope Ratings.

NO CONFIDENCE, NO CLEAR SOLUTION

The outgoing government of Romanian Prime Minister Ilie Bolojan passed a budget in March with painful reforms – from unpopular spending cuts to tax hikes – to rein in the budget deficit. This staved off, for now, large-scale ‌investor flight.

“We were strongly bullish (on Romania). Now we are mildly bullish,” said Juan ⁠Orts, CEEMEA Economist at Societe Generale. “All of the reforms, the painful reforms, the VAT increases, the excise tax increases… all of this has been done.”

However, Orts and others – including inside Romania – are worried about next year, amid a possible slowdown in reforms and a potential ratings downgrade.

“It’s probably going to be messy and it’s ⁠probably going to result in not strong fiscal consolidation,” Orts said.

Romania’s largest employers’ association, Concordia, said in a statement that a prolonged political crisis could cost the country more than 100 billion lei ($22.3 billion) over five years by stripping it of its investment-grade rating and blocking access to EU funds.

Concordia added that Romania was already “in a fragile moment” from an investment perspective.

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Romania is hardly alone.

“Fiscal risks have been the key credit risks for CEE sovereigns for a few years now,” said Karen Vartapetov, S&P Global’s Lead Analyst for CEE & CIS Sovereign Ratings.

“The stagflationary impact of the global energy price shock, together with energy-related support measures, will likely add pressure to CEE fiscal positions, ‌already stretched by high defence spending and generous social transfers.”

Poland’s budget deficit is close to 7% of GDP due in large part to a more-than-doubling of defence spending since Russia’s full-scale 2022 Ukraine invasion.

While economic growth of more than 3% – notably high for Europe – offers some protection, Orts said Poland was doing “the absolute bare minimum when it comes to fiscal consolidation”.

Slovakia last month received its S&P ratings downgrade due to elevated fiscal deficits, before proceeding to slow its own plans to reduce the 4.34% deficit “to avoid an overly restrictive fiscal policy.”

“Poland’s fiscal position appears among the most challenging in the region,” said Magdalena Polan, head of Emerging Market Macroeconomic Research at PGIM.

“… high deficits and rising debt levels appear to create a floor below which bond yields may struggle to fall,” she said.

FUEL, FIREPOWER AND FISCALS

The situation is echoed outside the region.

The ‌combination of higher defence spending and soaring energy prices has pushed up deficits across Europe, said Steffen Dyck, senior vice president with ratings agency Moody’s.

Tax cuts on fuel or outright subsidies aimed at shielding citizens are hitting budgets in many countries.

“But it also has an impact on growth,” he said.

Pressures are not equal though, Dyck and others noted; the Czech Republic, with strong institutions and one of the lowest budget deficits in the region, is shielded, for now.

Poland’s economic growth will provide something of ‌a buffer, while Hungary’s positive political momentum and improving ties with the EU under incoming Prime Minister Peter Magyar have given investors and ratings agencies grounds for optimism.

So far, markets have mostly been responding to such domestic factors.

Hungary’s bond yields have fallen and its typically sensitive forint currency has rallied following Magyar’s defeat of veteran eurosceptic leader Viktor Orban in the April 12 election, while Romania’s leu currency plumbed fresh lows and bond yields jumped over the renewed political uncertainty in Bucharest and the deficit concerns.

But Moody’s has negative outlooks for Romania, Poland and Hungary, and Dyck said they ‌remain among the most exposed countries to the conflicts in Ukraine and the Middle East.

Recent investor enthusiasm for the region is more muted, said Orts.

“They want to be bullish,” he said. “It’s the same classic story: they have to have political stability. Get the politics right, and then reduce the deficit.”

($1 = 4.4815 lei)

(Reporting by Libby George in London and Gergely Szakacs in Budapest, additional reporting by Marc Jones and Luiza Ilie, editing by Karin Strohecker and Gareth Jones)

Analysis-War, energy and politics hamper Eastern Europe’s efforts to keep deficits in check

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