Central Europe’s Limping Tigers

It is easy to forget that Greece was not the sole victim of the economic turmoil that has been shaking the European Union since 2008. The post-communist nations in the east of the EU suffered, too. True, they never felt a pinch comparable to the Greek one. Still, after 2008, the once booming region—in the 2000s, its countries were known as the “Central European tigers”—saw a sudden reversal of fortune. With one exception (Poland), the EU newcomers saw sharp reductions in both gross domestic product and domestic consumption, weak industrial production, and increases in public debt.

But now, after a couple of years of economic uncertainty, central Europe’s economy has bounced back—at least if the statistical data are to be believed. The first half of 2015 brought promising signs: major economies in the region grew by 3 to 4 percent, rates not seen for some of them since 2009. Hungary and Romania were at the forefront of the trend, with around three percent and nearly four percent growth in GDP, respectively, in the first half of 2015. Both also enjoy record low unemployment, at 7.8 percent and 6.8 percent, respectively, in 2014.

Hungary and Romania represent stark opposites in terms of their approach to the crisis.

Hungary and Romania are neighbors with similar economies based on exports, a cheap labor force, and high foreign investment. They also share a difficult past and a degree of historical tension, which still affects their relations with each other. Moreover, they represent stark opposites in terms of their approach to the crisis. Hungary has worked under Prime Minister Viktor Orban to adopt a managed and centrally planned form of capitalism, while Romania has opted for increasing neoliberalism in tune with German Chancellor Angela Merkel’s preferred austerity measures.

UNORTHODOX

Orban introduced his so-called unorthodox policy in 2010 by breaking off cooperation with the International Monetary Fund (IMF) and a few other financial institutions, whose aid of 20 billion euros he intended to replace with investment from eastern countries such as Azerbaijan, China, and Russia, which would not come with such strict terms. The decision turned out to be a somewhat poor one, since the eastern opening never brought the economic fruit expected by the government: no major new investment materialized during this time, with the possible exception of a controversial deal with Russia on the construction of two new blocks at the Paks Nuclear Power Plant. Meanwhile, total export to non-EU countries grew by over 20 percent, a proportion that could have been easily achieved without the change of political orientation. 

The “unorthodox policy” was not just an aid play. In fact, it also included a mixture of steps that the IMF highly recommended and some that the IMF clearly opposed. The former included a higher value-added tax (increased from 25 percent to 27 percent in 2012) and a reduction of many social benefits, such as unemployment benefits and pension bridges, both reforms to bring the budget under control.

Among the economic initiatives that neoliberal economists did not like were nationalizing strategic assets, primarily in the energy and financial sectors, and levying higher taxes on the banking, telecom, insurance, and retail sectors, as well as on foreign-owned media. The Orban government even proposed an Internet tax that spawned public outrage and did not go into effect. To improve Hungarians’ purchasing power, the government also pegged the national currency, the forint, to the euro and Swiss franc at an unrealistically favorable exchange rate. All of these moves drastically increased the role of the state in the economy.

The public protested some of Orban’s moves, but owing to the lack of a credible opposition that could make use of the public’s discontent, not much happened. The government remains in place, and corruption has increased while media freedom has deteriorated, at least according to Transparency International and Freedom House.

Orban’s “unorthodox policy” exacerbated his already poor image abroad, but it has since started to bear some fruit. The program has also slowly attracted some supporters in central Europe—for instance, in neighboring Slovakia, where the government seemed to be using Orban’s playbook when it adopted a 0.4 percent bank tax, introduced legal restrictions on foreigners acquiring agricultural lands, and tried to nationalize part of the pension system. Even the region’s largest player, Poland, might have picked up on the Hungarian vibe. In 2014, the government of Polish Prime Minister Donald Tusk radically changed the second-pillar pension system, while the newly elected conservative president, Andrzej Duda, promised during the electoral campaign to raise taxes on banks and said that he considers foreign ownership of banks to be detrimental to the country’s economy.

AUSTERITY BITES

One clear positive is that the mistrust of politicians subsequently turned into a drive against corruption.

In the early 2000s, Romania, like many of its neighbors, saw strong economic growth fueled by easy credit and heavy foreign investment. When the global financial crisis hit, the Romanian people braced for a sharp slowdown—notably painful for the manufacturing sector and agriculture—that eventually turned into an outright crash. But Romania has chosen a more traditional response. Liberal and tough-minded, austerity measures in Romania were among the most severe in Europe: salaries of public sector employees were cut by 25 percent; numerous social welfare benefits were slashed by 15 percent; and the value-added tax increased from 19 percent to almost 25 percent. The new labor code, adopted in 2011, made it easier for employers to hire and fire employees and to use flexible forms of employment contracts. And the country speeded the privatization of crucial companies.

The austerity measures were mostly prescribed by the IMF, the EU, and the World Bank, which opened three credit lines of a total of more than 20 billion euros. Indeed, throughout the years, Bucharest has turned out to be an eager follower of the IMF’s aggressive fiscal austerity program. And the program did indeed result in a stabilization of the country’s finances and an economic boom, at least when it comes to the macroeconomic numbers. However, the cure—especially the combination of expenditure cuts and tax increases—brought public frustration, too. It resulted in an erosion of the public’s confidence in politicians and culminated in a wave of protests in 2012, leading to the resignation of the center-right government headed by Prime Minister Emil Boc, the main promoter of austerity. One clear positive is that the mistrust of politicians subsequently turned into a drive against corruption. As a result, numerous members of the political elite have been arrested.

TROUBLE AHEAD

Hungary’s and Romania’s different ways of dealing with the crisis, one traditional and the other unorthodox, both bore some fruit: they primarily succeeded in maintaining financial discipline and reducing the level of budget deficit below three percent. In neither case, however, is the recovery—contrary to Hungarian and Romanian politicians’ claims—a full vindication of the reforms. As far as the slow growth is concerned, both economies have benefited much more from a general cyclical upturn in the eurozone, especially from the stability in Germany, their top trade and investment partner (this country covers 25 percent of the export for Hungary and 17 percent for Romania). The strong injection of EU funds—Hungary rejected the EU credit line, but it still received money from the EU budget—has been a further fillip.

Despite economic growth, the governments of Romania and Hungary should not rest easy.

In turn, the main danger the two states face is turmoil in the EU. Although some significant reforms were introduced after 2008, the countries are still reliant on foreign capital, foreign technical patents, and cheap labor. EU funds—available until 2020—have been invested mostly in infrastructure or have been distributed among local oligarchs. Health care, education, and science are still underfunded. Technical capacity is poor, and the bureaucracy inhibits entrepreneurship. And both countries’ top talent is leaving to work abroad. 

Although the reforms in Hungary and Romania created statistical growth, they did not solve the countries’ structural economic problems. Even worse, they did not improve people’s daily lives. The dissonance between impressive upticks in economic indexes and the stagnant standard of living is shocking. According to Eurostat, over 30 percent of Hungarians are at risk of poverty and social exclusion, and some local sources—such as the TARKI Research Institute—suspect that more than 40 percent of people are already living below the poverty line. Meanwhile, entrepreneurs can more easily make a profit thanks to a flat income tax of 16 percent, but their earnings are subject to a 27 percent value-added tax, which is the highest rate in the EU. Romanians face similar circumstances: the country has the EU’s second-highest rate of risk poverty, affecting almost 42 percent of the population, according to Eurostat. Things are especially bad for Roma, one of the most significant ethnic minorities in both countries.

In short, despite economic growth, the governments of Romania and Hungary should not rest easy. The region is, or will soon be, facing a middle-income trap—when a country attains a certain income level, it becomes stuck there, at least if it stops looking for other sources of growth, stops reforming labor market conditions, and stops investing in high-tech industry and education or in improving enforcement of the legislation. That trap could be harder to face than the postcrisis slowdown and requires much smarter efforts, no matter whether it is approached in a traditional or unorthodox manner.