Central and Eastern Europe: Russia’s War in Ukraine Defines Mounting Economic Risks This Year and Next

The economies in the region will continue to grow for the full calendar year in 2022 and 2023 under Scope’s baseline scenario, despite the risk of technical recession in multiple countries.

Across the region’s 11 EU member states, full-year growth will average 3.8% this year and 3.3% in 2023 (Figure 1), supporting stable credit outlooks of many sovereign borrowers. Growth will also continue in Georgia, Serbia and Turkey. However, growth of Turkey of 5.8% in 2022 and 3.5% in 2023 is set against a backdrop of weak governance, making high inflation worse and piling pressure on the country’s external accounts. Such factors increase the risk of financial crisis, underpinning Scope’s downgrading of Turkey’s foreign-currency ratings to B- with a Negative credit Outlook in March of this year.

Russia’s and Ukraine’s economies have observed deep economic recession

Russia’s economy faces an exceptional set of circumstances following its escalation of the war in Ukraine in February. The Russian economy will be significantly damaged by its decoupling from the West in the long run, leading to collateral damage for other CEE economies near-to-medium run. Inflation will accelerate even as growth slows from the second quarter of this year.

We foresee L-shaped recovery in Russia medium run, with the economy having entered severe recession this year equivalent to around a 10.5% annual contraction followed by a long phase with weak or no growth. We see the recovery in rouble as unsustainable, given it is partially based upon capital controls. From 2023, an EU boycott of Russian oil will hold material adverse implications for the value of the currency.

Ukraine’s economy is on course for contraction of nearly a third after Russia’s escalation of the war. On 22 July, we revised Ukraine’s foreign-currency ratings to C (one notch above default), from CCC, and placed foreign-currency ratings under review for a developing outcome as the government in Kyiv seeks the restructuring of Eurobond debt and GDP-linked securities.

Figure 1. Real GDP growth rates*, %

Adverse impact of war on CEE growth arrives via three main channels

The impact of the war on growth in CEE will remain severe during third and fourth quarters of this year, gradually decreasing by the end of the year but lingering well into 2023, via three main channels.

First, higher prices for energy, food and other commodities near term are pushing up inflation, squeezing household and corporate budgets and placing further strain on external-sector and government finances. Most CEE economies are net energy importers and are heavily exposed to elevated and volatile European gas and oil prices.

Secondly, western sanctions on Russia and Russia’s retaliatory measures are causing crucial shortages of key inputs and creating logistical bottlenecks, such as lengthier delivery times, contributing to considerably higher input prices. EU plans to shed dependence on Russian energy could squeeze government budgets as energy-sector investment rises.

Finally, greater financial-market uncertainty is a further challenge amid less robust investor sentiment and the risk that the Federal Reserve and ECB tighten monetary policy even faster, resulting in further capital outflows from emerging markets, higher financing costs and exchange-rate volatility.

External security risks for CEE, with many countries bordering Russia and/or Ukraine, have increased since escalation of the war although NATO membership reduces the likelihood that the conflict spills over to borders of the CEE countries of the alliance.

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Levon Kameryan is an Associate Director in Sovereign and Public Sector ratings at Scope Ratings GmbH and lead author of the rating agency’s CEE Sovereign Outlook. Giacomo Barisone, Managing Director of Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.