Central & Eastern Europe: Improving Institutional Quality Crucial for Economic Outlook

Such progress in enhancing governance institutions is vital for CEE-11 given declining rates of growth potential and reliance on foreign capital for investment, including crucially on disbursement of EU funding, which is contingent on governments’ respect for the rule of law.

The region’s declining growth potential reflects now higher average income levels and declining contributions of labour to economic growth in view of demographic ageing. At the same time, earlier high FDI inflows to CEE-11 are presently in structural decline, suggesting maturing consumer markets, largely exhausted potential for privatisations and completion of large-scale physical infrastructure projects.

CEE governments’ governance and abilities to execute sound policies under scrutiny

CEE governments’ abilities to develop and execute sound policies leveraging their skills bases, improving productivity and strengthening the role of domestic capital markets for investment are under scrutiny.

Latest indications of institutional health in CEE-11 are mixed and reflect diverging institutional developments, judging by recently updated World Bank Worldwide Governance Indicators (WGI) – including as regards the rule of law and regulatory quality.

Rule of law has declined in Poland since 2014, and more recently in Hungary, but has improved in the Baltics. Poland and Hungary’s WGI scores are now around marks of countries such as Romania on subject of the application of the rule of law.

However, regulatory quality has remained sturdy in the region

Regulatory quality, defined as a government’s ability to formulate and implement sound policies in support of private-sector development – as the WGI category with the highest correlation with the level of investment of an economy – despite some decline, has, however, remained sturdy across the region.

Against this backdrop, the investment of Next Generation EU financing – and governments’ success in spending EU funds productively – will prove essential in determining economic outlooks in the CEE-11.

The European Commission has postponed approval of Hungary’s and Poland’s recovery programmes

The EU Commission has postponed approval of national recovery plans of Hungary and Poland, although we expect EU authorities to ultimately unlock EU recovery funding to Hungary and Poland after the countries have addressed rule-of-law concerns identified as part of EU-wide economic policy coordination.

Diverging trends in institutional quality may become increasingly relevant for the credit rating outlooks of countries such as Poland and Hungary as well as that of Romania should soundness of political institutions notably deviate from country fundamentals, materially affecting potential for economic growth and sound governance in the future.

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Levon Kameryan is Senior Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, Director at Scope Ratings, contributed to writing this commentary.