OeNB Report 2024/5: Economic Trends in CESEE (2024)

1 Economic trends inCESEE EU member states

Inflation is getting back on track amid a protracted economicrecovery

1 Regional overview

Russia’s invasion of Ukraine remains the single most important eventfor general economic developments in the EU member states of Central,Eastern and Southeastern Europe (CESEE). The Russian attack on Ukrainetriggered high uncertainty and sent inflation through the roof to reachlevels last seen in the 1990s. The starting conditions for 2023 weretherefore extremely challenging. Yet, the CESEE EU members have dealtwith these challenges rather successfully and engineered a soft landing.Inflation has come down substantially and sustainably, without exertingan overtly excessive burden on economic growth and the labor market. Yeteconomic growth remained muted and was a far cry from the dynamism seenin earlier years and from what one would expect based on CESEE’s growthpotential. 1 ^, 2 ^, 3

Chart 1

Inventory cycle is weighing on growth

Output growth was dragged down strongly by a depletion of stocks.These stocks had been built up over the pandemic, when supply chainswere clogged, companies hoarded vital inputs and occasionally found itdifficult to sell certain finished (or semifinished) products oninternational markets. Souring sentiment, uncertainty, weakeninginternational demand and rising energy bills after the start of the warin Ukraine were responded to by gradually reducing existing inventories.This weighed on production, especially in industry, and possibly helpedto push the sector into recession. Surveys suggest that the industrialsector had largely gotten rid of its excessive stocks by early 2024.This, however, does not necessarily imply that the inventory cycle hasalready started to turn, as retail trade is still reporting overly fullwarehouses.

Exports suffer from weak international demand and adversedevelopments of price competitiveness

The weakness of industry in CESEE EU is also a reflection of thecountries’ strong integration in international supply networks and thegeographic structure of their trade partners. Export volumes have beencontracting since spring 2023, with especially strong reductions in thethird quarter of 2023. On the one hand, this was related to weak worldtrade in general and to the meager economic performance of Germany – acountry central to CESEE’s growth model – in particular.

On the other hand, the price competitiveness of the CESEE EU memberstates has also considerably worsened since the beginning of theinflation wave. On the back of positive inflation differentials betweenthe CESEE countries and important trading partner countries (especiallythe euro area), real effective exchange rates trended up strongly. Inearly 2024, the Czech koruna and the Polish zloty, for example, tradedsome 20% above their real effective value of early 2021. Developments inmanufacturing unit labor costs (ULC) were also deeply unfavorable.Declining labor productivity (amid contracting manufacturing output)coupled with strongly rising labor costs pushed up ULC growth over thewhole of 2023. These dynamics were stronger than in the euro area andpushed up ULC-deflated effective exchange rates throughout most theregion.

Imports have declined even more

The overall growth contribution of the external sector, however,remained positive, as depressed domestic demand weighed down importgrowth to levels even lower than export growth.

Private consumption is gradually recovering, but remainsrather weak overall

Besides stock changes, especially private consumption dragged downdomestic demand. At an average growth rate of only 0.8% in the secondhalf of 2023, consumer spending expanded only very moderately and, inany case, significantly more slowly than the long-term average. On apositive note, however, in the first half of 2023, consumer spending hadstill contracted. The recovery in the second half of 2023 was based onseveral factors: (1) rising purchasing power, as wages expanded swiftlyand inflation came down noticeably, (2) improving consumer sentiment,with especially notable improvements in labor market and inflationexpectations and (3) a very resilient labor market, considering theeconomic slowdown. To provide a few numbers: Average real wage growthturned positive and reached more than 6% annually in the fourth quarterof 2023. This was a level largely comparable to the readings of thepre-pandemic period. The average unemployment rate in February 2024stood at 4.3%. This was lower than before the outbreak of the war inUkraine and in line with the all-time low reported in late 2019. Abroader measure of the labor market slack – i.e. the share of personswith an unmet need for employment in the extended labor force – evenbeat its end-2019 record-low reading. Labor market resilience is alsounderlined by employment rates often close to or at historical highs(and in most cases also notably above employment rates in the euro area)and by ongoing labor market shortages that refuse to moderate despitethe economic slack and strong wage demands.

Investment stands out as the most important driver of growthin domestic demand

Investments performed far better than consumption and contributedstrongly to GDP growth in the CESEE EU member states. Their positivecontribution even increased in the course of 2023. This momentum wasfueled by public investments in infrastructure, energy and defense andwas supported by regular inflows of EU money from two overlappingmultiannual financial frameworks as well as from payouts from theRecovery and Resilience Facility. The fourth quarter of 2023 witnessedthe largest disbursem*nt of funds from the facility yet, amounting to atotal of nearly EUR 8 billion for CESEE.

A breakdown of capital formation by asset type showed ongoing healthyinvestment in machinery and equipment (including weapon systems) and arecovery of construction investment. Within construction, it was otherbuildings and structures that drove the uptick, while investment indwellings contracted in most countries of the region. The EuropeanCommission’s business and consumer survey shows that – despite tighterfinancing conditions and a more difficult situation in terms of demand –planned investment spending in the manufacturing sector is still rathersolid and, in most cases, higher than in the five years preceding theCOVID-19 pandemic. This strength, however, reflects efforts towardrationalization at the expense of replacement and extensions.

High-frequency activity and sentiment indicators point to afurther tentative recovery

Readily available high-frequency activity indicators support thepicture of an ongoing, though somewhat tentative recovery. Industrialproduction and retail sales’ growth remained weak in a longer-termperspective but have slowly and continuously improved over the pastmonths. In February 2024, industry kept stuck in recession, but retailsales again expanded moderately for the first time in over a year. Asfar as construction is concerned, a noticeable kink in production growthwas observed in early 2024, reducing the impetus of construction for thebroader economy.

Chart 2

Sentiment indicators have also improved since the summer of 2023. InMarch 2024, the economic sentiment indicator of the European Commissioneven bet its long-term average. It was buoyed in particular bybrightening consumer and services sentiment. Sentiment among consumersbenefited from disinflation and respondents’ more favorable evaluationof the current and future general economic environment and theirpersonal financial situation. Sentiment in the services sector,brightened on account of better than expected demand conditions. Also,industrial sentiment trended up moderately based on improving productionexpectations. Readings of the purchasing managers’ index (PMI), however,remain well below the 50-points threshold that would indicate aneconomic expansion. This weakness partly also reflects structuralfactors, including the post-pandemic shift in consumption back towardservices and a general uncertainty amid intensified fragmentation andcurrent geopolitical turbulences.

Chart 3

The inflation wave seems to have finally broken

The average inflation rate in CESEE fell to 3.7% in March 2024 – thelowest level recorded since July 2021 – compared with almost 17% at thebeginning of 2023. The observed downward movement was stronglyinfluenced by lower price pressures from energy and food. In the firstthree months of 2024, energy prices even contributed negatively toinflation, which had not been the case for three years. European energymarkets stabilized after the disruptions of 2022 amid a redirection ofenergy demand away from Russian energy carriers, an expansion ofrenewable energies and a mild winter that left large parts of gasstorages untouched. Food price inflation benefited from a good harvestin 2023, from Ukraine’s ability to export more grain thanks to a navalcorridor in the Black Sea and land exports via Romania as well as fromcheaper input prices (fuel, energy, fertilizer). Base effects were alsoat play in both areas.

The disinflationary process, however, was much broader based andencompassed large parts of the consumption basket. In March 2024, some80% of all items within the HICP recorded falling inflation rates. Thesedownward trends were based on (1) weaker cyclical demand pressures andinflation expectations supporting the restrictive monetary policystance, (2) declining producer and commodity prices that were slowlyfeeding through the price chain, (3) a general reduction in upstreamprice pressures and the fading of external supply shocks 4 aswell as (4) generally more benign import price developments.

Chart 4

Prices for services remain elevated

Nevertheless, core inflation remained above headline inflationthroughout the observation period and stood at 4.9% in February 2024.This was related to comparatively high price rises in services, a sectorin which pricing is heavily dependent on wage trends. The share ofinflation that was accounted for by services rose from a fifth at thebeginning of 2023 to more than half in March 2024. A decomposition ofquarterly national accounts data shows that – while profits contributedless or in some cases negatively – the contribution of labor costs tothe annual change in the gross value added deflator remained substantialand roughly unchanged over the second half of 2023.

Inflation targets are being met again in manycountries

At the country level, all countries saw a strong decline in pricegrowth. In several cases, inflation was converging to respective targetsin early 2024. In Hungary, inflation stood at 3.6% in March 2024 (CPI),which was already within the range around the country’s inflation target(3% ± 1percentage point). In Czechia, inflation came in at 2% (CPI) inMarch 2024 and therefore reached its target (2% ± 1 percentage point).In Poland, inflation even undercut its target (2.5% ± 1 percentagepoint) with 2% in March 2024 (CPI). Among the inflation-targetingcountries with independent monetary policy, only Romania failed to bringinflation close to its target (2.5% ± 1 percentage point) as CPIinflation stood at 6.6% in March 2024. Among the CESEE euro areamembers, price growth proved rather sticky in the first three months of2024 in Croatia (4.9% in March) and Slovenia (3.4% in March) butconverged toward the target in Slovakia (2.4% in March). Inflation wason a clear downward trend in Bulgaria and reached 3.1% in March2024.

Looking forward, central banks do not necessarily see a continuationof the swift, and in many ways unexpected, strong disinflationary trend.While the cyclical momentum of the economy will likely remain muted overthe short term, base effects will reverse over the course of 2024 andimported inflation could rise again, either because of exchange rateswings or because of a resurgence of supply chain problems. Moreover,tight labor markets could push up wage demands and consumption, pinningdown core inflation at higher levels. Some questions also remain withregards to the continuation of government interventions in food and/orenergy prices that are still in place in several countries.

Monetary easing progresses at a reduced pace

These considerations informed monetary policy decisions in theinflation-targeting countries in the review period, so that Poland andRomania did not cut their rates (any further). The Hungarian centralbank set further steps and lowered its policy rate in six installmentsfrom 13% in October 2023 to 8.25% in April 2024, as disinflation hasbeen stronger than expected and external and domestic demand pressureshave remained persistently low. Magyar Nemzeti Bank (MNB), however,slowed the pace of easing in March, as risk premiums on Hungarian assetshave risen. A relaxation was also implemented in Czechia, where the keyinterest rate was reduced from 7% in October 2023 to 5.75% in April2024. In its latest statement, the Czech central remarked that itconsiders it necessary to persist with tight monetary policy and tocontinue to approach further rate cuts with caution.

Chart 5

Generally healthy banking sectors have not yet acceleratedlending

The fall in inflation and the associated stepwise reductions inpolicy rates did not provide a boost to credit markets yet. In fact,credit dynamics remained rather lackluster throughout most of theregion, with companies in many instances being even more hesitant thanhouseholds to take on new credit. Surveys for the second half of 2023reveal that credit supply conditions remained tight across the board andthat credit demand was robust only for short-term operations (e.g. forworking capital, debt restructuring and consumer credit), while credittake-up for longer-term operations (e.g. fixed investment and housing)was weaker. This possibly reflected ongoing uncertainty in the bankingsector despite ample corporate and retail funding, high capitalizationand a largely positive development of asset quality. Throughout 2023,private sector deposits exceeded private sector claims by a large marginin all countries but Slovakia; tier 1 capital ratios frequently remainedat levels of about or above 20% and nonperforming loans (NPLs) trendedfurther down. By the end of 2023, nonperforming loan ratios reachedtheir lowest level since the great financial crisis in many countries(e.g. in Czechia, Bulgaria, Romania, Croatia and Slovenia). Moreover,the share of so-called “stage 2” loans, for which banks are less certainof credit quality, also declined in some countries compared to a yearearlier (e.g. in Czechia, Hungary, Romania and Slovakia).

Chart 6

Banking sector profits at a record high

Banking sector profitability also developed very favorably. A strongrise in lending rates coupled with a weaker transmission of monetarypolicy signals to deposit rates sent bank’s net interest margins up, andimproving asset quality allowed for some release of provisioning.Against this background, the average return on assets in the CESEEregion increased to 1.6% at the end of 2023, a figure last observed 15years ago.

Chart 7

External accounts swing into surplus

In 2023, the combined current and capital account balance in theCESEE EU member states turned into surplus for the first time since thepandemic disrupted global trade. For the regional aggregate, the surplusreached 0.6% of GDP in 2023, up from –3.9% of GDP a year earlier. Thisremarkable improvement was driven predominantly by the trade balance,which was propelled by (1) positive terms-of-trade effects on the backof lower prices for energy imports, (2) a generally lower energyconsumption and (3) a certain decline in nonenergy imports amidst theeconomic downturn. Among the other components of the external accountsno major changes were reported for the second half of 2023 (andthroughout full-year 2023), with large negative contributions fromprimary income (mainly repatriated FDI earnings amid generally soundcorporate profits) and notably positive contributions from the capitalaccount (mainly from inflows of EU funds).

Chart 8

At the country level, the picture was very much comparable: combinedcurrent and capital account balances moved close to or remained insurplus. The major exception from this pattern was Romania, where thetrade balance not only did not improve, but the overall current accountbalance remained deep in the red.

At same time, capital kept on flowing into Romania. FDI inflowscovered around a third of the deficit and the country was among thelargest recipients of portfolio (government debt) investments in CESEE.The financial account for the broader CESEE region showed FDI inflows of1.6% of GDP in 2023 (down from 3.2% of GDP in 2022), portfolio inflowsof 1.2% of GDP in 2023 (up from an outflow of 0.4% of GDP in 2022) andoutflows of other investments of 0.8% of GDP in 2023 (down from aninflow of 1.6% of GDP in 2022). Those capital flows partly reflected thechanges in the international interest rate environment. The narrowinginterest rate differential between CESEE countries and the euro areamade cross-border financing via intercompany loans (recorded under FDI),loans and trade credits (both recorded under other investments) lessattractive. At the same time, healthy investor appetite and risingbudgetary financing needs boosted debt portfolio liabilities.

Chart 9

Public finances often moved farther away from the Maastrichttargets

General government budget deficits mostly increased in the CESEEregion. Though revenues kept flowing in – they were up by 0.6 percentagepoints of GDP on average, owing mostly to higher capital revenues –,expenditure was on an upward path too (+1.2 percentage points of GDP).Interest expenditure grew noticeably as higher rates were slowly feedingthrough into the debt stock. But spending in the region also increasedon the back of higher social benefits and subsidies, reflecting measuresto control inflation, the electoral cycle and, to some extent, theworking of automatic stabilizers. A clear increase was also recorded ingovernments’ gross fixed capital formation. This uptick was not onlysupported by EU co-financing requirements, but military spendingincreased as well. According to NATO data, outlays for defense increasedby close to EUR 20 billion in 2023, of which Poland contributed roughlythree-quarters.

Chart 10

At the time of writing, Romania was the only CESEE country subject toan excessive deficit procedure. Through the lens of the Maastrichtcriteria, 2023 brought the following developments: All countries butCroatia, Bulgaria and Slovenia reported a public deficit of above 3% ofGDP in 2023. Deficits even increased to above 5% of GDP in Poland and toeven above 6% of GDP in Romania and Hungary. The debt criterion was lessof a problem, as (1) CESEE countries have historically recorded ratherlow debt levels compared to their Western European peers, also in termsof the 60% of GDP threshold and as (2) inflation and associated highnominal GDP growth reduced debt levels. In the region, only Hungary,Slovenia and Croatia reported government debt above 60% of GDP. However,in the latter two countries, debt levels fell most strongly year onyear. For the region on average, the debt stock declined from 54% of GDPin 2022 to 53.4% of GDP in 2024.

2Croatia: top of the EU league in economic growth and inflation

In 2023, economic developments in Croatia were somewhat exceptionalin a cross-country comparison. Croatia recorded one of the highest GDPgrowth rates in the EU in 2023, but also one of the highest HICPinflation rates as of March 2024. Regarding house price developments,Croatia reported the third-highest annual growth rate among EU countriesin 2023. The comparatively weaker transmission of monetary policy likelyplayed a role in these developments.

Croatian GDP grew by 2.8% year on year in 2023, after growthaccelerated to 3.6% in the second half of the year. On the output side,the largest contributions to annual growth came from taxes, followed bycontributions from the sectors of wholesale and retail trade, financialactivities and professional, scientific and technical activities. Onlythe industrial sector made a negative contribution to annual growth. Onthe expenditure side, household consumption and net exports made thelargest positive contributions. Gross fixed capital formation also madea positive, albeit smaller contribution. Its growth accelerated in thesecond half of the year. Only changes in inventories contributednegatively to the annual growth rate.

Regarding private consumption, growth picked up in the second half ofthe year and was supported by a resilient labor market. The unemploymentrate was 6.4% in December 2023, mildly higher than in mid-2023, butlower than at end-2022. The employment rate continued to increase to newhighs, reaching 66.5% at end-2023. While annual HICP inflation remainedrelatively high in Croatia (4.9% year on year in March), wage growthoutpaced inflation. Gross wages increased by roughly 6% in real terms in2023. Wage developments are certainly one factor to watch when it comesto the inflationary process. The Croatian central bank’s latestprojections predict HICP inflation at 3.5% for 2024 and 2.4% in2025.

Private consumption was also supported by continued strong lending tohouseholds with growth around 8% year on year. Growth of general-purposecash loans accelerated markedly. During the second half of 2023, lendingdynamics slowed further in the corporate segment, likely due to highfinancing costs. The banking sector continued to profit from higherinterest rates. Its return on assets reached 1.8%, the highest level inmore than 20 years. The sharp increase was mostly due to interestincome. The NPL ratio declined mildly to 2.6% at end-2023. The Tier 1capital ratio stood at an elevated level of 23%. The decline by 1.2percentage points compared to end-2022 was largely due to dividendpayments in the first half of the year.

The fiscal deficit remained under control and was 0.7% of GDP in2023. Government debt stood at 63% of GDP, more than 5 percentage pointslower than a year ago. In 2023, all three major rating agencies updatedthe outlook for Croatia’s sovereign rating to “positive.”

The current account recorded a surplus of 1.1% of GDP in 2023. Thedeficit of the goods balance was lower than in 2022, while the servicesbalance surplus remained broadly unchanged. The latter was supported byanother strong tourist season. The capital account surplus was 2.9% ofGDP. Croatia remained among the leading countries in terms of theabsorption of Recovery and Resilience funds. By mid-April the EuropeanCommission had disbursed four payments amounting to EUR 3.7 billion(1.1% of GDP, 63% of total allocated grants). The absorption offinancial means from the Cohesion Fund is, however, progressing veryslowly relative to other EU countries.

2024 is another politically important year for Croatia, due toparliamentary, EU and presidential elections. Parliamentary electionswere held on April 17, 2024. The electoral campaign was short andintensified after President Milanović announced his ambitions to becomeprime minister for the largest opposition party. In the end, the rulingCroatian Democratic Union (HDZ) lost some seats compared to theelections in 2020 but remained the strongest party. Still, the resultsof upcoming coalition talks are highly uncertain.

3Slovakia: navigating tight labor markets and fiscal urgency

In the second half of 2023, the Slovak economy showed mixed signalsof recovery and ongoing challenges. It continued to expand at a similar,rather moderate pace as in the first six months of the year. In thewhole of 2023, real GDP thus grew by 1.1%. While this was a noticeableslowdown of the growth pace compared to 2022, a worse outcome wasavoided thanks to a strong fiscal stimulus 5 .More specifically, amid negative real wage growth in the first threequarters of 2023 and depleted pandemic-era savings, the government’sincrease in social spending and measures to counteract the impact ofelevated energy prices helped mitigate the decline in households’ realdisposable income. Consequently, while these measures contained thecontraction of private consumption, they boosted government spending,particularly in the second half of the year. Gross fixed capitalformation was the brightest spot among domestic demand components in2023. Especially the final quarter saw a massive increase in investmentactivity as a result of the last opportunity to exploit EU funds fromthe previous programming period. The central and particularly localgovernments invested primarily in infrastructure projects andtransportation. Yet firms too, facing shortages of (skilled) labor,increased their investment in machinery and equipment, i.e. automation.Amid weak (foreign and domestic) demand and relaxed supply chainfrictions, changes in inventories put a massive drag on growth (–5.6percentage points in 2023). In contrast, net exports made a key growthcontribution in 2023. This was despite an annual contraction of exportswhich suffered from subdued foreign demand. Lately, this trend has alsoreached the automotive industry, the crucial workhorse of the Slovakeconomy and its exports. However, weak domestic demand led to an evenstronger decline in imports.

To a certain extent, the labor market keeps defying thenot-so-exuberant growth performance of the Slovak economy. Labor supplyhas been continuously widening, facilitated by a rising number ofemployed foreigners and an increasing participation rate. The latter isdue, among other things, to previously inactive segments of the laborforce, such as older individuals and those who previously believed theycould not find work, now re-entering the labor market. Nonetheless,despite the influx of this labor, the tension in the labor market andshortage of skilled labor remain high. As a result, the unemploymentrate has reached new historical lows, continuing its downward trend,which has persisted since early 2013 with one significant breatherduring the pandemic. After two years of contracting real wages,households purchasing power started expanding again toward end-2023 asnominal wage growth outpaced inflation. Annual growth in wages wasparticularly pronounced in the public sector owing to one-offbonuses.

Since its peak in February 2023 at levels unseen since mid-2000,inflation has been continuously heading downward. Aided by a baseeffect, the drop in inflation accelerated with the turn of the year. Asa result, with the most recent reading of 2.7% in March 2024, inflationin Slovakia is approaching the ECB’s price stability target fast. Theeasing of headline inflation has been driven by most categories, inparticular food, energy and other commodities. Yet, given weak consumerdemand and high interest rates, core inflation has mimicked the steepdownward path of headline inflation.

The general government deficit increased significantly to 4.9% of GDPin 2023 after 2% of GDP a year earlier. The rise was driven particularlyby temporary energy support measures such as energy price caps, apermanent increase in social spending as well as higher expendituresowed to inflation indexation. The fact that the fiscal outcome ended upbetter than budgeted (–6.4% of GDP) should not mask Slovakia’s urgentneed to bring public finances back on a sustainable path. The governmentdebt stood at 56% of GDP by end-2023. However, Slovakia’s independentfiscal watchdog, the Council for Budget Responsibility (RRZ), keepsissuing serious warnings, including the message that in the absence ofconsolidation measures, public debt could exceed the Maastrichtcriterion of 60% of GDP already next year. While the government stressesthat consolidation will not come at the expense of the achieved socialstandard, a significant consolidation plan is due to be presented (toforeign investors) by mid-year.

4 Slovenia: softlanding but fiscal risks remain

In 2023, Slovenia’s GDP grew by 1.6% year on year (down from 2.5% in2022), experiencing some acceleration from the first to the second halfof the year. Gross fixed capital formation remained the most vigorousdemand component and the biggest contributor to the overall GDP growthrate in the second half of the year. Construction activity in particularwas very buoyant, supported by public sector investments including thosefinanced with EU funds and those in connection with reconstruction worksafter the devastating floods in early August 2023. By contrast, thecontraction of investments in machinery and nontransport equipmentdeepened in the second half of 2023. This was in line with the continueddecline in industrial capacity utilization, worsening export order booklevels, tight monetary conditions, accelerating decline in corporatecredit and global economic uncertainties. Also, private consumptiongrowth weakened during the second half of 2023, although signs of someimprovement appeared in the final quarter. Poor consumer confidence andweak household credit growth (in particular for house purchase) seem tohave suppressed consumption, despite the acceleration of real averagewage growth to nearly 5%. At the same time, government consumptionaccelerated, likely supported by expenditures for post-floodreconstruction. Year-on-year export growth weakened sharply and turnednegative in the second half of 2023. Although imports contracted evenmore, their (further) deterioration compared to the first half of 2023was smaller than that of exports, resulting in a notable decline in the(positive) contribution of net real exports to the overall GDP growthrate.

The general government budget deficit amounted to 2.5% of GDP in2023, down from 3.0% in 2022. The decline was caused by the budgets oflocal governments and the social security fund reaching a small surplus,while the deficit of the central government increased modestly, mainlydue to substantial public investments, higher labor costs, the weakeningof economic activity and government measures to mitigate the impact ofhigh inflation and severe floods. For 2024, the government is targetinga general government budget deficit of 3.8% of GDP. However, since the2023 deficit turned out lower than the planned 4.5% of GDP, the fiscalcouncil has warned against the implementation of discretionary measuresin the course of 2024 that could have a lasting negative impact on thefiscal position. According to the council, renewed demands for publicsector wage increases represent a further risk for fiscalsustainability, if not accompanied by a systematic public sector wagereform and an increase in public sector efficiency.

Gradual disinflation continued during the reference period and HICPinflation fell to 3.4% year on year in March 2024. Disinflation wasprimarily driven by energy and unprocessed food prices. Both baseeffects and the decline in global commodity prices toward the end of2023 and in early 2024 played a role. At the same time, core inflationdecelerated substantially as well, mainly on account of processed foodand nonenergy industrial goods prices. Despite moderation, servicesprice inflation has been notably higher than the overall inflation ratesince the last quarter of 2023, which may be related to the comparablystronger growth in unit labor costs in major segments of the servicessectors during 2023.

Slovenia’s combined current and capital account turned around in 2023and registered a surplus of 4.2% of GDP. The improvement came mostlyfrom the goods balance, which benefited from favorable terms-of-tradedevelopments and weak domestic demand and registered a minor surplus.Despite the appreciation of the ULC-based real effective exchange rate,Slovenia’s market share in total EU-27 imports continued to increase in2023. The services balance showed a big surplus, comparable to 2022, andalso the primary and secondary income balance and the capital accountposted a smaller combined deficit than in 2022.

Owing to the improvement in net interest income, banking sectorprofitability improved notably in 2023, with return on assets doublingto 2.1%. This helped bolster the capital base, leading to an increase inthe capital adequacy ratio (tier 1) to 16.9% by the third quarter of2023. Despite the economic turbulences of the past few years (COVID-19and energy crisis) the share of nonperforming exposures remained athistoric lows.

5Bulgaria: sticky inflation and political instability may postpone euroadoption

Real GDP growth slowed to 1.5% in the third quarter and acceleratedto 1.8% in the fourth quarter of 2023. While private consumption sloweddown to 3.2% in the fourth quarter of 2023 and public consumptionstagnated, gross fixed capital formation recovered significantly fromnegative growth rates in the first half of 2023. As a result, domesticdemand contributed –1.1 percentage points to growth in the third and+0.5 percentage points in the fourth quarter of 2023, thereby recoveringfrom the strong contraction in the first half of 2023. Exports continuedto decline in the second half of the year, but as imports declined evenmore, net exports of goods and services delivered a large positivecontribution to economic growth in the second half of the year.

Monetary tightening in the euro area has been transmitted relativelyslowly to interest rates in Bulgaria. Hence, credit demand remainedstrong and supported domestic demand. In the last quarter of 2023, loansto nonfinancial corporations grew by 9.9% and loans to households by15.9%. The latter financed the ongoing housing boom and new carpurchases. House price growth at 10.1% in the final quarter of 2023continued to outpace consumer prices.

Looking ahead, gross fixed capital formation will partly depend onthe implementation of projects under the Recovery and ResilienceFacility. The submission of related plans was subject to further delaysand they were only tentatively approved by the European Commission atthe end of 2023.

Moreover, weak external demand will continue to weigh on growth in2024. Industrial production continued to decline in the early months of2024, and manufacturing sentiment remains below average. Meanwhile,declining inflation, rising real gross wages, relatively lowunemployment and labor shortages have strengthened household purchasingpower. Recent improvements in consumer sentiment point to strongerprivate consumption in 2024. Yet, youth unemployment increasedsubstantially to 16.2% in February 2024. Recent economic forecasts 6 predict moderate growth of theBulgarian economy in 2024, in the range of 1.9% to 2.7%. Economicactivity could improve in 2025 if the external environment turns morefavorable, when real GDP growth is expected to reach 2.5% to 2.9%.

Headline inflation decelerated gradually from 6.4% in September 2023to 3.1% in March 2024. Disinflation was driven by all main components,except rather sticky services prices. Food and services inflationremained the largest contributors to headline inflation, accounting fora combined share of 75% in March. Month-on-month rates of change suggestthat significant price pressures remain in the pipeline for food andservices. Further, the decline in energy prices came to a halt inFebruary.

Moreover, labor cost pressures may prove to be sticky, as laborshortages persist in the dynamic industrial and services sectors of theeconomy. Rising compensation per employee and only modest gains inproductivity growth per employee pushed up unit labor costs for theeconomy by 9.7% in the final quarter of 2023.

Looking ahead, indicators of selling price expectations suggest thata majority of entrepreneurs in the construction, services and retailtrade sectors still expect to increase their selling prices thisyear.

According to the latest inflation forecasts 7 ,headline inflation is expected to decline to range from 3.4% to 4.0% in2024 and from 2.7% to 3.1% in 2025. Core inflation is projected todecelerate more moderately, driven by second-round effects from inputprices and a gradual moderation in wages. Upward risks are associated tostronger consumer demand, rising unit labor costs amid labor shortagesand geopolitical events.

The current account was largely balanced in 2023 (–0.3% of GDP). Thetrade deficit fell to 3.9% of GDP. The decline in real exports of goodswas almost entirely due to repairs at the Kozloduy nuclear power plantand at one of the largest metallurgical plants, as well as due to theban on exports of refined products from Russian crude oil. The surplusin the services balance widened to 7.1% of GDP due to ICT- andtourism-related services. The number of foreign visits has returned topre-pandemic levels. The net inflow of foreign direct investmentincreased to 3.3% of GDP in 2023, comprising mostly reinvested earningsin the banking sector.

Fiscal policy supported the recovery from the pandemic butcontributed to the inflation surge. The IMF concluded in its Article IVstatement from March 2024 that this year’s fiscal policy in Bulgarianeeds to strike a balance between supporting disinflation and notjeopardizing the recovery. 8 Reducing inflation isimportant for Bulgaria, as its accession to the euro area, which isplanned for 2025, could fail due to the inflation criterion. However,meeting the inflation criterion is only a matter of time. On the otherhand, ongoing political instability in the country is likely to pose agreater hurdle. The scheduled change of prime minister did not takeplace at the end of March; instead, there will now be the sixth snapelection in four years – it will take place at the same time as theEuropean elections on June 9, 2024.

6 Czechia:contracting economy and easing inflation

After real annual GDP growth had turned negative in the secondquarter of 2023, the economy continued contracting in the second half ofthe year. Despite a moderate turnaround in the final quarter, the Czecheconomy experienced an overall contraction of 0.3% for the year 2023.Consequently, real output of the Czech economy at the end of 2023 wasstill below the pre-pandemic level in 2019. While domestic demandexerted a massive drag on the economy, net exports counteracted. Owingto households’ declining purchasing power and higher savings, privateconsumption continued to contract significantly. By the fourth quarterof 2023, it had been shrinking for seven consecutive quarters in realterms. On a positive note, the declining pace of contraction suggests agradual return of consumer confidence, mainly on the back of rising realdisposable income as inflation fades. Public consumption remained astalwart driver of the economy in the second half of 2023, indicating,inter alia, higher expenses in health care and education following thearrival of Ukrainian war refugees. Gross fixed capital formation provedincreasingly robust throughout 2023, reflecting possibly a strengtheninginvestment environment supported by flows from EU funds from theprevious programming period. Net exports made the single mostsignificant positive contribution to growth as subdued foreign demandwas offset by an even weaker domestic appetite for imports. In greaterdetail, the decline in exports of goods and services came to a halt inthe second half of 2023 while imports observed a pronounced contractionfor most of 2023. Despite firms maintaining high inventory levels due tofears of a potential return of supply chain disturbances, changes ininventories put a strong drag on economic growth indicating a reductionin firms’ stockpiling activities.

Czechia’s current account witnessed a remarkable turnaround, swingingfrom its largest deficit in 2022 (6.1% of GDP) in over a quarter-centuryto a modest surplus in 2023 (0.4% of GDP). While the services balancestayed stable, the reversal in the current account balance was propelledprimarily by a notable goods balance rebound, predominantly ascribableto a steep decline in the import bill. The latter was driven by acombination of factors, including reduced energy import prices, lowerenergy consumption as well as a general decline in nonenergy importsamid the economic downturn. While the primary income kept navigating indeeply negative territory, the deficit shrank noticeably on the back ofa lower, though fluctuating, outflow of dividends. Consequently, thereduction in the negative primary income balance also contributed to theimprovement in the current account.

Despite the economic malaise and mounting signs of easing – interalia a marked slowdown in nominal wage growth since the second quarterof 2023 – the labor market in Czechia stays tight. Hence, a slightincrease in 2023 notwithstanding, the unemployment rate remains amongthe lowest in the EU. At the same time, employment rose somewhat in thesecond half of 2023.

Annual consumer price inflation has kept continuously falling sinceits peak in January 2023 (except for October 2023). A base effect madethe disinflation pace accelerate sharply at the beginning of 2024 sothat the HICP inflation rate dropped to 2.2% in March. Headlineinflation thus plunged into the central bank’s tolerance band (2% ± 1pp) 9 for the first time since July 2021while core inflation plummeted in parallel. The composition ofdisinflation was broad-based amid lower costs of imports and fadeddomestic inflationary pressures. Particularly food, energy andadministered prices provided significant contributions to the inflationdecline. In response to falling inflation, the CNB began to ease itsmonetary policy in December 2023. It has reduced its key policy rate inthree stages since, from 7% – where it had stayed since August 2022 – tothe current 5.75%.

The general government deficit in 2023 came in nearly CZK 72 billionlower than in 2022 and also somewhat lower than had been budgeted. Dueto subdued economic growth, the deficit as a share of GDP slightlysurpassed the envisaged 3.6% of GDP. The fiscal impulse was slightlyexpansionary. The better than planned balance (in absolute terms) wasowed to the fact that revenue growth outpaced the one in expenditures byabout 7%. This is ascribable to, inter alia, high corporate income taxcollections bolstered by taxation of firms’ windfall profits, dividendsfrom the state-owned energy company CEZ as well as inflows from EU funds(especially from the Recovery and Resilience Facility). Gross publicdebt decreased slightly in 2023. On the back of a fiscal consolidationpackage, the deficit should narrow to just above 2% of GDP in 2024. Onthe flipside, the fiscal austerity measures will have a significantnegative impact on economic growth.

7Hungary: first signs of recovery after small GDP contraction

Although economic growth was much less negative during the secondhalf of 2023 than during the first half, GDP contracted by 0.9% year onyear in 2023 as a whole. Similarly, to the first half-year, gross fixedcapital formation was the biggest drag on growth. Constructioninvestments, especially dwellings, continued to contract heavily (albeitless than during the first six months of the year). The growth rate ofinvestments in machinery and equipment also turned negative during thesecond half of 2023. The worsening export situation, comparatively lowcapacity utilization and worsening economic confidence in most sectorsof the economy (despite some improvement toward the end of the year)seem to have depressed investment activity. This was also reflected inthe continued weakness of lending to corporates. The decline inhousehold consumption moderated in the second half of 2023, in line withthe improvement in real wage developments on the back of sharply fallinginflation. Also consumer confidence improved. Export growth continued todeteriorate in the second half of 2023, mainly due to weakening exportsto the euro area. Since weak domestic demand caused a sharp drop inimports, the contribution of net real exports remained large.

The budget deficit of the general government reached 6.7% of GDP in2023. Hence, the deficit was higher than in 2022 (6.2% of GDP) and alsoexceeded the most recent government forecasts. The substantialovershooting of the target was mainly attributable to weaker thanexpected indirect tax revenues as a result of contracting domesticconsumption, higher than planned pension expenditure (in line with legalobligations to compensate for inflation) and high interest expenditure.For 2024, the government in early March 2024 raised its deficit targetfrom 2.9% of GDP to 4.5% of GDP. The deficit is planned to fall to 3.7%of GDP in 2025 and to 2.9% of GDP in 2026.

Since its peak in January 2023 at 26.2%, HICP inflation has graduallydeclined to reach 3.6% in March 2024. The slowdown was primarily drivenby energy and unprocessed food prices, including base effects and thedecrease in global commodity prices during the last quarter of 2023 andearly 2024. Core inflation decreased as well, though to a smallerextent, and amounted to 4.5% in March 2024. Within core inflation, pricepressures are still most visible in the services segment, which is inline with comparatively strong growth in unit labor costs in variousservices industries. The decline in core inflation has been supported byweak private consumption, tight and only cautiously easing monetaryconditions and government measures to promote competition in the retailsector (e.g. price monitoring system, mandatory discounts).

In response to falling inflation, MNB continued to ease policy duringthe reference period by regular monthly cuts of 75–100basis points inthe base rate (which had again become the main policy rate in September2023). However, various factors continued to impede monetarytransmission (e.g. caps on deposit and loan interest rates), “voluntary”lowering of the interest premium (over the interbank rate) to zero onnew corporate loans concluded between February1 and April 30, 2024, fora period of six months. The mandatory caps on large deposits and on SMEloans were discontinued at end-March 2024. At the same time, MNB hasincreasingly complained about being exposed to permanent pressure forbigger rate cuts and also criticized other suggestions for an artificialeasing of monetary conditions (e.g. a government proposal to replace theinterbank rate by the – substantially lower – T-bill yield as thereference rate for corporate loans).

Weak domestic demand and moderating global energy prices, causing afavorable terms-of-trade effect, have also led to a marked improvementin the country’s external balance. The combined current and capitalaccount registered a small surplus in 2023, following a sizable deficitin 2022. This was helped by a sharp improvement in the goods (andservices) balance, while the combined balance of primary and secondaryincome and the capital account deteriorated. The EU Commission’sdecisions in mid-December 2023 and early March 2024 to unfreeze aboutEUR13billion in cohesion funds has also been supportive for thecountry’s external financing position, while the rest of total availableEU funds (around EUR32billion in grants and loans) remain frozen untilHungary fulfills the necessary conditions. Moreover, in mid-March 2024,the European Parliament decided to sue the Commission for theunfreezing.

8Poland: zloty appreciation helped inflation return to target while keyrate remained unchanged

In 2023, annual GDP almost stagnated at 0.2% year on year. Annualgrowth rates turned positive in the second half, reaching 1.5% in thefourth quarter. The quarter-on-quarter pattern showed strong 1.1% growthin the third quarter but zero growth in the second and fourth quarter.This unstable GDP growth resulted from even more volatile privateconsumption, with another quarter-on-quarter contraction in the fourthquarter that translated into quasi-stagnation year on year. In contrast,gross fixed capital formation grew strongly throughout the year bothquarter on quarter and year on year. Both real exports and even more soreal imports contracted sharply in the second and third quarter andrecovered in the fourth one in quarter-on-quarter terms. In the case ofreal imports, the recovery was not sufficiently strong to renderpositive year-on-year growth in the fourth quarter. The growth driverstoward year-end were fixed investment, expanding real exports andcontracting real imports, while inventory change rendered a sizablenegative contribution to growth.

The stagnation of private consumption in the fourth quarter likelystill reflected the decline of both real wage sum and real grossretirement pensions in preceding quarters. Yet, on the back ofdisinflation, these real income indicators substantially increased intandem with consumer confidence, boding well for a sustained recovery.Fixed investment continued to rely on both corporate and publicinvestment, with the former benefiting from the broadening ofprofitability in the enterprise sector and the latter from EU funds,while residential investment continued to shrink. The lower number ofdwellings under construction mirrored the nominal decline of housingloans.

Corresponding to the sizable positive contribution of net exports toannual growth, the surplus of the goods and services balance increasedstrongly from a year earlier to more than 6% of GDP in 2023. Thecombined current and capital account surplus rose to almost 2% of GDP.Net FDI inflows declined but continued to be substantial at about 2% ofGDP.

Both in the full-year 2023 and in the final quarter, nominal ULC ofmanufacturing gross value added were far higher than a year earlier, aslabor cost increases outpaced the productivity rise that resulted mainlyfrom the shrinking of labor input measured in hours worked. The ULCincrease exceeded the euro area ULC rise substantially in full-year2023. Also, the zloty’s nominal value in euro was higher than a yearearlier from the second to the fourth quarter; in real (ULC-deflated)terms the zloty was stronger by roughly 10% in each quarter of 2023.After further monthly nominal appreciation in early 2024, the zlotysettled at 4.31 zloty for one euro at end-March.

According to HICP (and national CPI) definition, annual headlineinflation declined from 12.5% (13.1%) in the second quarter to 6.3%(6.4%) in the fourth and stood at 2.7% (2.0%) in March 2024, while coreinflation came down from 12.5% (11.6%) in the second quarter to 4.2%(4.6%) in March. Within the core HICP, nonenergy industrial goodsinflation stood at 1.7% in March, while the annual change of themanufacturing producer price index continued to be negative. TheMonetary Policy Council (MPC), pursuing a CPI inflation target of 2.5% ±1 percentage point, has maintained its main policy rate at 5.75% sinceearly October 2023. In early April, the MPC decided to keep interestrates unchanged, pointing at substantial uncertainty related to fiscaland regulatory policies and to the pace of recovery, coupled with demandpressure stimulated by wage growth over the medium term.

The general government deficit rose to 5.1% of GDP in 2023 but isprojected by the European Commission to decline to 4.6% of GDP in 2024,helped by declining budgetary costs related to high energy prices and bythe recovery-driven rise of revenues. The expenditure-to-GDP ratio willremain high due to defense spending and higher spending for publicsalaries, pensions and families with children. General government debtis expected to rise to about 54% of GDP at end-2024, from 49.6% of GDPat end-2023.

9Romania: mounting fiscal challenges and slow disinflation

Year-on-year GDP growth in Romania remained positive in the secondhalf of 2023 bringing the full-year figure to 2.1%. Domestic demandcontinued to drive economic activity, whereas exports declined in thesecond half of the year amid weak external demand.

Gross fixed capital formation confirmed its role as the key growthdriver. It was supported by EU-funded investment in publicinfrastructure as well as investment in machinery and equipment.Domestic credit to corporates grew by about 10% year on year in thesecond half of 2023 and despite a slight deceleration in nominal terms,growth became positive in real (CPI-adjusted) terms. EU fund flows underthe multiannual financial framework 2014–2020 were still substantial in2023. Under the Recovery and Resilience Facility, the EU disbursed thesecond payment amounting to about EUR 2.8 billion to Romania atend-September 2023. The request for the third payment was submitted byRomania at end-2023. However, in mid-March, European Commissionofficials explained that the disbursem*nt is delayed due to thegovernment’s failure to fulfill necessary conditions (e.g. fiscal andstate-owned-enterprises reforms) and reduce the budget deficit in linewith its commitments.

After a slowdown in the third quarter, private consumption growthstrengthened in the final quarter of 2023. Real wage growth furtheraccelerated to 9.2% at end-2023, supported by two minimum wage hikes in2023. However, the unemployment rate ticked up somewhat in the finalquarter. At the same time, consumer lending gained some momentum.

While real wage growth backed private consumption, productivitydevelopments were weak. In the manufacturing sector, unit labor costsincreased markedly, while the Romanian leu remained broadly unchangedvis-à-vis the euro. The current account deficit remained high in 2023but declined somewhat compared to 2022 thanks to a reduction in thetrade deficit. The combined current and capital account deficit(including EU fund inflows) improved to 4.9% of GDP, 44% of which werefinanced by net FDI inflows. Debt-creating portfolio and otherinvestment inflows caused the external debt ratio to rise in 2023. Atthe same time, gross official reserves increased noticeably.

Consumer price inflation declined further to 6.6% in December 2023.Food prices contributed to a large extent to this development due tosupply factors and policy measures (the broadening of the list of basicfood products subject to the mark-up cap). In the first two months of2024, headline inflation was again above 7% – mainly due to electricityprices, higher oil prices as well as an increase in excise duties onfuels and tobacco products – but came back to 6.7% in March. Coreinflation fell from 8.5% in December 2023 to 8.1% in March 2024. Afterhaving hiked its key policy rate to 7% in January 2023, the NationalBank of Romania (NBR) has left it unchanged since. The NBR currentlyprojects inflation to fall to 4.7% at end-2024 and to 3.5% at end-2025.Hence, the central bank assumes that inflation will come down to theupper bound of the inflation target variation band of 2.5% ± 1percentage point only toward the end of its forecast horizon.

Comparatively robust growth in recent years has to be seen againstthe background of loose fiscal policy. For 2023, the general governmentbudget deficit target was missed by a wide margin. It amounted to 5.7%of GDP in cash terms compared to the 4.4% of GDP target. In ESA terms,the 2023 budget deficit stood at 6.6% of GDP. Romania has been subjectto an excessive deficit procedure since 2020. According to a councilrecommendation adopted in June 2021, Romania should have reached adeficit of 4.4% of GDP in 2023 and should bring it down further to 2.9%of GDP in 2024. The Romanian fiscal budgetary strategy published atend-2023 shows that the deficit is scheduled to go down gradually to4.9% of GDP in 2024 and fall below 3% of GDP only in 2027. It is worthnoting that European Commission officials recently warned that thebudget deficit could reach 7% of GDP or more this year. Moreover, theIMF expects that the newly enacted pension reform will create largeadditional fiscal costs of about 1.5% of GDP in the coming years (thoughreducing spending in the long run).

2 Economic trends inEU candidate countries

1Western Balkans: no time for rest as new challenges lie ahead

Economic growth rebounded cautiously in the second half of2023

After a marked slowdown in economic activity observed in the WesternBalkan (WB) countries in 2022, real GDP growth continued to deceleratein 2023 on the back of elevated inflation, tightened financingconditions and weak external demand. While economic performance wassubdued particularly in the first six months of the year, signs of agradual rebound emerged during the latter half of 2023, especially inthe region’s largest economy, i.e. Serbia, where the GDP growth ratemore than tripled between the first and the second half of the year(table 9). GDP-weighted real economic growth in the region thus averaged2.5% in 2023, ranging from 1% in North Macedonia to 6% in Montenegro.Despite the overall rather lackluster economic activity, there is also a“glass-half-full” interpretation of the economic trends recorded in2023: Since economic growth in all WB countries exceeded that of the EU(0.4%) real convergence resumed after a setback in 2022. However, theclouded macroeconomic environment in the EU, which accounts for 35% to80% of exports for the small and mostly open Western Balkan economies,has weakened foreign demand, thus hindering more robust growth. 10 ^, 11 ^, 12

Table 9

Robust domestic demand but uneven net exports

On the expenditure side, economic growth in the Western Balkans in2023 was largely driven by domestic demand, although the performance ofdifferent components varied across the region, with each countrynavigating its unique challenges and growth catalysts. Against thebackdrop of buoyant nominal wage growth and easing inflation, privateconsumption played a critical role in fueling most of the economies inthe Western Balkans. Nonetheless, its contribution to economic growthdeclined in most instances compared to 2022. Household consumption wasthe main driver of GDP growth, particularly in Kosovo and Montenegro. InKosovo, consumer spending was buoyed by wage increases, robust creditgrowth and strong remittance inflows. In Montenegro, it benefitedsignificantly from a surge in tourism and the influx of affluentmigrants, among other factors. As crises-related fiscal measures weregradually phased out, public consumption showed mixed results across theregion. Particularly Albania and to a lesser extent Bosnia andHerzegovina saw relatively vigorous increases in public spending. Theseincreases provided a relatively significant contribution to economicgrowth and – in case of Albania – compensated weakening privateconsumption. In North Macedonia, government consumption contracted formost of the year in real year-on-year terms but recorded a rather strongincrease in the fourth quarter, driven, inter alia, by a notable rise inpublic sector wages.

Gross fixed capital formation was another key determinant of economicactivity in the WB countries, albeit with a very uneven performanceacross the region. Albania witnessed vigorous investment activities,particularly in the construction sector, and tourism-relateddevelopments, driven by strong foreign direct investment inflows. InKosovo, fixed investment recovered in 2023 and, in Serbia andMontenegro, it continued to expand. North Macedonia experienced awhopping decline in capital formation 13 ,reflecting primarily a strong negative contribution of stock changes in2023, which contrasted with the accelerated buildup of gas and oilreserves during the energy crisis in 2022. Destocking (or slowerstockpiling) on the back of the easing energy crisis and fading supplychain frictions brought about (strong) negative contributions toeconomic growth by stock changes also in other countries, such asAlbania and Serbia.

The performance of net exports, too, varied significantly across theregion despite common factors in external trade dynamics: Importsdeclined in several instances in the wake of lower energy imports whileexports of goods were hampered by weak external demand. However, weakermerchandise exports were counteracted by a continued robust increase inservices exports. Turning to developments in individual countries,import volumes in North Macedonia plunged sharply due to reducedelectricity imports and the sizable destocking described before.Consequently, despite a slight decline in exports, net exports ended upcontributing a substantial 5.4 percentage points to GDP growth.Similarly, in Serbia, lower imports of energy and raw materials combinedwith exports benefiting from new production capacities brought about asignificantly positive contribution of net exports to economic growth.Albania, too, saw a strong contribution of net exports on account of alarge expansion of exports of (tourism) services. While record touristarrivals boosted exports also in Montenegro, comparably strong increasesin imports as well as slumping merchandise exports toward year-enddampened the overall contribution of net exports. In Kosovo and Bosniaand Herzegovina, net exports somewhat dampened GDP growth as increasesin imports outpaced export growth.

Chart 11

External imbalances narrowed

As a result of the developments of exports and imports outlinedabove, the combined current and capital account deficits as a percentageof GDP shrank across the board. At end-2023, the balances thus rangedbetween a deficit of –11.4% in Montenegro and a slight surplus of 0.7%in North Macedonia. North Macedonia also recorded the largestimprovement in the external accounts compared to 2022 (6.7 percentagepoints), exclusively driven by the goods trade balance on account ofsignificantly lower gas and oil imports.

Goods trade deficits declined notably but remained significant acrossthe region, ranging between –9.5% of GDP in Serbia and a whopping –47.6%of GDP in Montenegro. These figures point toward the need to improve thegoods exports base. The improvements in services trade balances arosefrom robust tourism revenues, an essential driver of exports in mosteconomies, and increasingly also ICT exports. As a result, surpluses inthe services trade balance ranged between more than 4% of GDP in Serbiaand nearly 25% of GDP in Montenegro.

Remittances and FDI inflows remained robust in the region and werecrucial sources of financing. In many countries, they remainedconcentrated in the tourism and real estate sectors. FDI inflowsoutstripped or – in the case of Kosovo – almost fully covered thefinancing needs from the combined current and capital accounts.Nonetheless, FDI inflows as a percentage of GDP declined in mostcountries. In Montenegro, however, FDI inflows saw a dramatic plunge by7 percentage points compared to 2022. As a consequence, the externalfinancing gap was mirrored in a sizable decline of central bank reservesfrom more than 32% of GDP at end-2022 to 19.5% 14 ayear later. This is the second-lowest reserve level in the region afterKosovo, where central bank reserves amounted to less than 12% of GDP 15 . In the remaining countries,reserves hovered slightly above or – in case of Albania – somewhat shortof 30% of national GDP.

Chart 12

Trends on the demand side were largely echoed on the supply side. Lowforeign demand, especially in the EU, poses one of the key challenges inthe current economic environment as it brought about lower new ordersand production needs. This was reflected in subdued industrialproduction. After moderate yet positive growth in 2022, industrialproduction in the region as a whole saw a slight contraction in 2023despite some acceleration in Serbia. The shrinkage was particularlypronounced in Albania and Bosnia and Herzegovina. Possibly, the feebleindustrial production is linked to the strong destocking trend as firmstended to serve the frail demand from existing inventories first. Incontrast, services, especially tourism and increasingly ICT, wereimportant determinants of economic growth on the supply side.

Continued labor market paradox: cyclical tightening shadowedby persistently high youth unemployment

Trends in the labor market continued to present a mixed picture,encompassing cyclical improvements on the one hand and sustainedstructural challenges on the other. Although official labor marketstatistics may not fully capture the reality due to high levels ofinformality and limitations in data availability, indicators suggestthat the labor market tightened further in 2023. Overall, employmentkept rising in the region even though its growth slowed down somewhat onthe back of weakened economic performance. Labor force participationalso improved in several instances. Similarly, unemployment continued todecline in most countries, thus extending the solid long-lastingdownward trend that had only temporarily been interrupted during thepandemic (table 10). At the end of 2023, the unemployment rate variedfrom just under 10% in Serbia to slightly over 13% in Bosnia andHerzegovina, Montenegro, and North Macedonia.

Nonetheless, although cyclical improvements continued and key labormarket indicators in the Western Balkans hovered around historicalhighs, they still significantly lagged behind their counterparts in theEU. Hence, the still comparably high unemployment levels and low formalemployment as well as labor force participation suggest not onlypersistent structural weaknesses but, in some cases, also a persistentlylarge informal sector. Particularly in Albania the latter amounts toabout a third of total employment.

Moreover, labor markets in the region suffer from structuralmismatches between labor demand and supply, particularly among youngpeople, with youth unemployment rates ranging from over 20% in Albaniato more than 35% in Montenegro. Despite the still comparably high(structural) unemployment rates, there is abundant anecdotal evidence offirms facing labor shortages, especially in sectors such as constructionand services. While these bottlenecks are exacerbated by adversedemographic trends and emigration, inflows of workers, e.g. from variousAsian countries, offer a degree of alleviation. In this regard, Kosovois a particularly vivid case in point at the moment. Surveys suggestthat following the visa liberalization with the EU in January 2024,there are quite a few in the general population that have strongintentions to leave the country. While these intentions may not be(fully) realized, and immigration of workers, for example fromBangladesh, may partially counteract this trend, there is a risk thatlabor market bottlenecks could worsen. The ongoing tightening of thelabor market has been mirrored in vigorous, double-digit growth ofnominal wages in the Western Balkan economies in general and in thebooming sectors in particular (table10). As nominal wage increases havegenerally outpaced falling inflation rates real wage growth may posesome upside risk to the disinflation process.

Table 10

Some improvement of fiscal indicators boosted in part bystrong nominal GDP growth

Overall, fiscal developments in the WB region did not see anydramatic developments in 2023. The fiscal balances across the regionshowed relatively limited variation. The revenue side generallybenefited from the moderate economic rebound. In addition, somecountry-specific idiosyncrasies and nuances also helped, such as robustincome tax revenues in Albania, improved tax compliance andformalization in Kosovo or higher than expected indirect taxes andwindfall revenues in Montenegro. In these three countries the fiscaloutcome was also aided by a substantial underexecution of capitalexpenditures on the expenditure side (relative to plans envisioned inthe budget). As a result, fiscal deficits decreased to 2.2% of GDP inAlbania, 0.3% of GDP in Kosovo and most significantly in Montenegro,i.e. by 3 percentage points to 2.3% of GDP. Especially in a country withno autonomous monetary policy like Montenegro a prudent fiscal stance isa key element to (regaining) price stability. Serbia too saw its generalgovernment deficit improve further, despite some one-off expenditures onagriculture, pensions and wages. Similarly, Bosnia and Herzegovinaachieved a slight fiscal surplus, notwithstanding increased socialspending in the Republika Srpska. Conversely, in North Macedonia, thealready comparably high budget deficit in 2022 widened further lastyear, as savings from lower electricity subsidies were partiallyreallocated to increase public sector wages.

Consequently, compared to 2022, public debt-to-GDP ratios decreasedin all economies of the region but North Macedonia. In addition to theimproved fiscal balances, the debt ratios also benefited from highnominal GDP growth. Montenegro witnessed the largest drop in the debtburden, i.e. by more than 8.5 percentage points. Within just two yearsthe general government debt-to-GDP ratio declined by 20 percentagepoints. Nonetheless, the debt level in Montenegro remains the secondlargest in the region and together with Albania still ranges above 60%of GDP.

On the other side of the spectrum, we see Kosovo and Bosnia andHercegovina with relatively contained debt levels. In North Macedonia,even though public debt remained broadly unchanged, at 51% its financingis highly reliant on external borrowing which may pose some challengesand risks. Overall, in some cases fiscal vulnerabilities persist,primarily with respect to the high domestic and external refinancingneeds and exposure to interest and exchange rate risks. Against thisbackdrop, restoring fiscal buffers in the vulnerable countries remains apriority, particularly to provide leeway for coping with futureshocks.

Table 11

Various risks to disinflation

After consumer price inflation had climbed sharply to historicalhighs in 2022, it eased dramatically in 2023 in all WB countries, exceptSerbia, where the disinflation process set in with some delay. Annualheadline inflation in 2023 averaged between 4.8% in Albania and 12.5% inSerbia, and it continued to decelerate in the early months of 2024. InMarch 2024, consumer price inflation ranged between 1.9% in Bosnia andHerzegovina and 5.5% in Montenegro. In Serbia, annual inflation stood at5%. The National Bank of Serbia (NBS) projects inflation to enter itstarget band (3±1.5%) by mid-2024 and to continue to decline toward thetarget midpoint by late 2024. In Albania, on the other hand, which isthe other inflation-targeting country in the region, inflation alreadystood below the target at 2.6% as of February.

Apart from the base effect, the slowdown in inflation has been drivenpredominantly by weakening global cost-push factors, especially easingfood and energy prices. This reflects the fact that these two categoriesaccount for a substantial weight in the consumer basket in the WBregion, significantly larger than in the euro area. More specifically,food and energy weigh 40% to 50% in the consumption baskets of the WBcountries compared to 30% in the euro area. Especially the share of foodin the basket is about twice as large as in the euro area. InMontenegro, the disinflation process seems to have stalled or evenreversed recently due to rather stubbornly elevated services inflationon the back of vigorous tourism and consumption. Reasons for the delayeddisinflation in Serbia are manifold, including, inter alia, dynamic wagegrowth, tight labor markets, price-setting power in retail as well asthe fact that the NBS has maintained a broadly stable exchange ratedespite appreciating pressures on the dinar (chart 15). In contrast, theAlbanian lek sharply accelerated its appreciation trend and in 2023alone gained some 11% in value vis-à-vis the euro which certainly helpedbring inflation back to the target of the Bank of Albania (BoA). On theflip side, strong appreciation pressures from buoyant financial inflowsdue to tourism, remittances and FDI have forced the BoA to intensify itsinterventions. Moreover, the hastened strengthening of the lek raisesdoubts about alignment with economic fundamentals and the potential riskof a sudden reversal.

In parallel to headline inflation core inflation too has declined tosingle digit values (though it should be noted that it is subject tovarying country-specific definitions). However, in a majority of the WBcountries, core inflation is higher than headline inflation, suggestingsome second-round effects of the past cost-push factors that have beenpassed through. Specifically, the higher inertia of core inflationreflects strong wage growth, to which particularly the morelabor-intensive services sector is more susceptible.

Chart 13

Inflation is expected to gradually decrease to and then plateau at alevel of around 2% over the medium-term horizon in Kosovo and Bosnia andHerzegovina. It will hover around the target in Albania and, accordingto expectations, from mid-2024 also in Serbia. In Montenegro, inflationis projected to remain stickier at 4% to 5% for some time to come, notleast in light of domestic wage pressures. The latter pose some risk ofa renewed acceleration of inflation, also in North Macedonia.Nonetheless, all central banks in the region are urged to closelymonitor risks arising from persistent geopolitical tensions, potentialsecond-round effects, and in some cases, only hesitantly declining coreinflation. They should remain vigilant particularly regarding thoseinflation expectations that are not yet fully anchored at levelsconsistent with price stability objectives and to risks related to tightlabor markets.

In the three WB countries with autonomous monetary policies,continued tightening of the monetary stance has helped to put inflationon a downward trajectory. After lifting its key policy rate in February,the BoA hiked it one more time, i.e. by 25 basis points to 3.25% inNovember 2023. After ten previous upward steps between March 2022 andMarch 2023, the National Bank of the Republic of North Macedoniacontinued to raise its policy rates four more times (15–25 basis pointseach) between May and September 2023, bringing it to 6.3%.

Chart 14

The NBS too, after raising its policy rate 13 months in a row beforeApril 2023, added two more hikes of 25 basis points each in June andJuly 2023. However, it has to be borne in mind that in Serbia, theeffective rate in the market is the one-week weighted average repo rate,which has hovered around 100 basis points below the policy rate. The IMFand the ECB have called upon the NBS to narrow the gap.

Unlike in several Central and Eastern European countries, policyrates in the WB have stayed at their respective peaks of the currenttightening cycle so far, and central bank representatives have beencautious in signaling when monetary policy easing will start. Hence,looking ahead, it has been stressed that future monetary policydecisions will depend on the movement of key inflation factors at homeand abroad and on the pace of disinflation.

Chart 15

In addition to the interest rate hikes, some of the aforementionedcentral banks have also increased their reserve requirements, absorbedexcess liquidity and/or employed macroprudential measures to support themonetary tightening and improve efficiency of the transmissionmechanism. Moreover, facing partially strong foreign currency (FX)inflows and appreciation pressures, the BoA, the NBS and the NationalBank of the Republic of North Macedonia intervened in the FX market tostabilize their respective currencies. In the case of Serbia and NorthMacedonia this happened in the context of, respectively, a de factostabilized and a pegged exchange rate regime. These interventions haveled to a continued, significant accumulation of international reservesat record levels.

In the three countries without autonomous monetary policy – Bosniaand Herzegovina, Kosovo and Montenegro – the limited tools available,such as minimum reserve requirements and macroprudential measures, havebeen barely actively employed in the current (dis)inflationary period.Following the recommendation by the IMF to align the remuneration rateon banks’ excess reserves with the ECB deposit rate the Central Bank ofBosnia and Herzegovina (CBBH) only marginally increased the remunerationrate in July 2023. In this context, it has to be stressed again thatprudent fiscal policy plays a key role in attaining and maintainingprice stability in countries without an autonomous monetary policy.

Financial sector proves resilient, yet a watchful eye onasset quality is warranted

The financial sector in the WB countries, largely dominated byforeign-owned banks, has navigated the series of shocks that occurredover the recent years relatively well and remains resilient. In nominalterms, bank lending to the nonbank private sector kept on expanding inall countries but Serbia. However, compared to 2022, nominal creditgrowth slowed down in 2023 in all countries, except Bosnia andHerzegovina. In Serbia, diminishing credit growth has been owed totighter monetary policy, stricter credit standards and in some instancesmacroprudential measures on the supply side. At the same time, demandcooled down in the wake of the economic slowdown. In real terms, creditexpansion in 2023 was positive in countries with a more advanceddisinflation process, namely Albania, Bosnia and Herzegovina and Kosovo,while it was negative in the remainder of the region. Hence, real creditgrowth 2023 ranged from almost –13% in Serbia to a vigorous expansion of8% in Kosovo. In most countries, growth in loans to households,especially mortgages, outpaced that of lending to corporates, as thelatter was particularly affected by weaker domestic economic activityand foreign demand. In Serbia, in particular, corporate lending – evenin nominal terms – contracted for most of 2023. In contrast, lending tofirms rebounded in Bosnia and Herzegovina and also held up quitestrongly in Albania due to real estate loans to corporates.

As for the currency decomposition, the share of foreign currencyloans in total loans remained broadly stable except for Albania, whereit declined significantly. This was brought about by deeply contractingFX lending and – at the same time – by a strong acceleration in growthof lek-denominated loans. Such a trend is ascribable to the sharpnarrowing of the interest rate differential between lek- andeuro-denominated loans, which turned even negative in case of businessloans. As a result, the long-lasting trend of falling attractiveness offoreign currency loans in Albania resumed after some interruption during2021 and 2022 sparked by higher inflation and Russia’s invasion intoUkraine. The share of FX loans in 2023 declined to 44% and was thusroughly 10 percentage points lower than in 2016 and almost 30 percentagepoints below the levels seen in 2007. With two-thirds of loansdenominated in foreign currencies, Serbia remains by far the countrywith the highest share of FX loans. The authorities continued to promotedinarization by developing local bond markets and stimulatingdinar-denominated deposits and loans via various measures. As a result,the dinarization trend resumed on the deposit side in late 2022, afterpreviously halting due to depreciation fears ignited by the war inUkraine and elevated inflation. The share of deposits in dinar thusreached a record high by end-2023. In contrast, the dinarization on theloans side has made less progress. The share of dinar-denominated loans,especially corporate loans, went down on account of maturing loansgranted under government guarantee schemes and an increase of FX-indexed(particularly investment) loans. Similarly, the National Bank of theRepublic of North Macedonia too put in place several measures to boostdenarisation, including raising reserve requirements on FX depositsrelative to denar deposits. While these measures helped stop or reversethe increasing share of FX-denominated deposits, loan euroizationremains a persistent trend. Overall, despite significant advances,currency substitution in some WB countries remains high, posing a tailrisk to financial stability and constraining monetary policytransmission. For the time being, however, trust in domestic currenciesremains rather stable as data from the OeNB Eurosurvey suggest.

In general, banking sectors in the region remain liquid and wellcapitalized (table 12) while their profitability keeps on improving,driven by net interest income, higher fees and commissions as well as afurther decline in noninterest costs. Despite the challenging globalgeopolitical environment, rather subdued growth and a series of crisesover the last years, asset quality has not deteriorated so far. On thecontrary, the share of nonperforming loans (NPL) in total loanscontinued to decrease in most countries or remained broadly stable in2023, ranging between 2% in Kosovo and 5% in Montenegro (table 12).However, despite these comparably low levels, in some instances, thebenign trend of the NPL ratio is owed mainly to continued high nominalcredit growth in the denominator, which somewhat disguises thedevelopment of the NPL stock in the numerator. In particular, in Albaniaand Serbia the NPL stock increased. Moreover, the fact that stage 2loans – a potential leading indicator of future asset quality changes –increased in North Macedonia and Serbia, calls for continued vigilance,especially in light of the credit, exchange and interest rate risks.While provisioning is mostly appropriate in the region, the most recentNPL monitor by the Vienna Initiative 16 sees a potentiallyrisky combination of a relatively high NPL ratio and low NPL coverage inAlbania, Serbia and particularly Montenegro.

In addition to the fragile geopolitical situation and challengingmacroeconomic environment, the microeconomic perspective still warrantssome caution as well. According to the most recent wave of the OeNB EuroSurvey, a range of 11% of interviewed household borrowers in Bosnia andHerzegovina to 21% in North Macedonia report that they will be unlikelyor very unlikely to repay their debt over the next 12 months. Whilethese are non-negligible shares, they are significantly lower than whatwas reported in 2022. Also, the perspective of the banks provides a morerelaxed picture than a year ago, although still somewhat mixed.According to the EIB Bank Lending Survey conducted in September 2023 17 , banks expected an improvement incredit quality (i.e. decrease in nonperforming loans) over the next sixmonths in Albania and Kosovo and a broadly unchanged situation in NorthMacedonia. In contrast, a deterioration in credit quality driven by thecorporate segment was expected in Bosnia and Herzegovina, and in boththe corporate and the retail segment in Serbia.

Table 12

European Commission is striving for renewed enlargementmomentum

After decades of enlargement efforts with too little (tangible)progress, enlargement fatigue is noticeable among the negotiatingpartners, and the credibility of the enlargement process isdwindling.

Partly due to this development, trust in the EU has declined in theWB countries, as shown by the OeNB Euro Survey 18 results. In Albania, more than 70% of all respondents had trust in theEU from 2010–2014 according to the survey, but the share dropped tobelow 25% in 2022 (no data available for 2023). Positive sentimenttoward the EU was highest in Bosnia and Herzegovina in 2021 (56% of therespondents had trust in the EU) and in North Macedonia in 2020 (58%).With shares of 52% (Bosnia and Herzegovina) and 44% (North Macedonia),survey results confirm somewhat diminishing trust in the EU amonghouseholds in 2023. In Serbia, trust in the EU was always low across allsurvey waves since 2009. In 2016, the highest level of trust wasreached: Almost 33% of the respondents said they had trust in the EU.The share, however, dropped to 24% in 2022 but recovered slightly toaround 26% in 2023.

Obviously, the EU enlargement process needs renewed momentum and morecredibility and predictability. This need is reinforced particularly bythe rising importance of other influential players for the WesternBalkans (predominantly China, Russia but also the USA) and bygeopolitical shifts induced by Russia’s aggressive invasion of*ckraine.

New impetus for the enlargement process was provided by theEnlargement Package 19 , which was adopted in November2023. The European Commission recommended opening accession negotiationswith Moldova as well as with Ukraine and granting candidate status toGeorgia. Moreover, the European Commission also recommended openingaccession negotiations with Bosnia and Herzegovina once the necessarydegree of compliance with the membership criteria has been achieved. InMarch 2024, the Council decided to open formal accession talks withBosnia and Herzegovina.

The Enlargement Package 2023 was complemented by the new Growth Planfor the Western Balkans, which is based on four pillars, namelyaccelerating integration with the EU’s single market 20 ,implementing a common regional market, boosting fundamental reforms andeventually providing financial support depending on the implementationof reforms. Financial resources allocated to the New Growth Plan amountup to EUR 6 billion with up to EUR 2 billion in grants and up to EUR 4billion in long-term loans over the 2024–2027 Multiannual FinancialFramework period. Each WB country should prepare a Reform Agenda oninvestment priorities and reforms based on the Economic ReformProgrammes. Ultimately, the allocation of funds will depend on progressmade by the country. By the end of April 2024, all WB countries hadsubmitted their respective Reform Agendas to the European Commission.These are now being reviewed by the European Commission.

2Georgia: economy benefits from the Russian invasion in Ukraine

Following the Russian invasion in Ukraine, Georgia formally appliedfor EU membership in March 2022. Subsequently, in December 2023, Georgiawas granted candidate status by the European Council. As such, we haveincluded it in our regular monitoring. While the invasion of Ukrainecaused a significant upswing in the Georgian economy, shiftinggeoeconomic patterns imply a high uncertainty going forward.

Real GDP growth in Georgia was slightly stronger than expected, at7.5% in 2023, following double-digit growth rates in 2021 and 2022. Lastyear’s growth is primarily attributed to tourism, trade, construction,financial services and investment. While remittances moderated duringthe second half of 2023, they still contributed significantly to GDPgrowth in the last two years. The National Bank of Georgia (NBG) raisedconcerns about the risk of output consistently exceeding its potentialdue to the combination of high growth rates of previous years andheightened credit activity. However, it should be noted that creditgrowth was largely driven by increased business loans. The resultingincrease in investment led to a higher output capacity, while minimizingrisk of sustained excess demand. Looking ahead, GDP growth is projectedto slow down to 5.7% in 2024 and converge toward its potential of 5% inthe medium term. The fiscal deficit remained low at 2.4% of GDP,supported by strong economic activity and revenue growth. Public debtremained under the 40% threshold and is expected to stay close to thatmargin in the medium term.

The current account deficit reached a historic low of 4.3% in 2023,which was partly driven by increased remittances and strong tourism. TheRussian invasion triggered large volumes of capital inflows, whichpersisted throughout 2022 and the first half of 2023, but moderated inthe second half. The balance of goods and services amounted to –8.6% ofGDP. Total exports increased by 8.2% and total imports increased by8.6%. Georgia’s most important export countries in 2023 were Azerbaijan(14.2% of goods exports), Armenia (12.9%) and Kazakhstan (11.5%).Leading export commodities include cars (34.9%), copper ores andconcentrates (8%) and wine (4.3%). Georgia’s most important importpartners are Türkiye (16.6% of goods imports), United States (12.6%) andRussia (11.3%), with the predominant import goods being cars (20.5%),petroleum products (7.6%) and packaged medicaments (3.5%). In recentyears, Georgia has established itself as a regional hub of importing andreselling used cars. From 2022 to 2023, imports and exports of carsincreased by 84.5% and 134.8%, respectively.

The labor market in Georgia is characterized by high structuralunemployment, shortage of skilled labor, high self-employment (around30%) and a high share of agricultural workers (around 40%). After theCOVID-19 shock, which led to unemployment reaching over 22% in the thirdquarter of 2021, Georgia’s labor market has recovered well, withunemployment declining to below pre-pandemic levels of 15.3% in the lastquarter of 2023. However, despite sizable unemployment, the labor marketremains tight, causing real wage growth to hit over 15% in 2023. Laborforce participation trended downward after 2015, reaching its low at48.3% in the first quarter of 2021, but has since increased to 54.3% inthe final quarter of 2023.

After inflation levels of above 10% in 2021 and 2022, the downwardtrajectory of headline inflation persisted throughout 2023, reaching0.4% in the last quarter and averaging 2.5% annually. The strong declineis primarily attributed to lower international commodity prices and anappreciation of the Georgian lari (GEL), while domestic price pressuresremain strong. After a period of high inflationary risk, low observedinflation caused the NBG to lower the policy rate by a cumulative 275basis points from May 2023 to 8.25% in March 2024. According to the NBG,inflation will remain below its target of 3% at the beginning of thisyear and it is predicted to stabilize close to the desired rate by theend of the year. The average inflation forecast for 2024 is 2.4%.Following a controversial ruling last summer, the government increasedits political influence on the NBG via changes to the organic law of thecentral bank. These changes raised concerns of limited central bankindependence among international institutions.

Overall, the banking sector in Georgia is highly concentrated andwell capitalized, as the tier 1 capital ratio increased from 17.1% in2022 to 19.7% in 2023. Indicators for liquidity and profitabilityremained sound throughout 2023. Return on assets increased from 3.8% inthe fourth quarter of 2022 to 4.1% in fourth quarter of 2023.Dollarization of loans decreased from 56.1% in 2022 to 47% in 2023,while dollarization from deposits decreased from 45% to 44.5%.Macroprudential policies to gradually reduce foreign currency lendingare in place, yet financial dollarization remains high.

The IMF sees upcoming challenges for Georgia to include astrengthening of the independence of the central bank, furthermacroprudential measures to mitigate risk of banking sectorconcentration and dollarization and improving the quality of educationacross the country.

3Moldova: sluggish recovery after war-induced recession

The Republic of Moldova (hereinafter: Moldova) received EU candidatestatus in June 2022, and the EU bodies formally opened accessionnegotiations in December 2023. As such, we have included Moldova in ourregular monitoring. 21

Amid EU accession plans and the challenges the war in Ukraine poseson neighboring Moldova, GDP growth was still muted in 2023. After asharp drop in 2022, GDP dropped further in the first half of 2023 andstarted to moderately increase only in the second half, also due to agood harvest season. Real GDP remained below 2021 levels at end-2023.Despite wages growing by over 16% in 2023, real wage growth and privateconsumption are low. Investment is still suppressed. The current accountbalance is clearly in the negative realm, with a net lending position ofmore than 11% of GDP in the fourth quarter of 2023.

Thus, while external demand again positively contributed to GDP in2023, domestic demand still did not recover and had a clear negativecontribution. In general, the Moldovan economy relies heavily on tradewith its neighbors and the EU. About 60% of all exports went to the EUin 2022, another 15% were exported to (potential) EU candidatecountries. Main export goods are agricultural and mineral products, foodand beverages as well as machinery. Following a trade agreement in 2016,which envisions full trade liberalization within ten years and alreadyincluded free trade for most goods, last year, trade liberalization foragricultural exports to the EU was granted until summer 2024. Prior toRussia’s invasion of Ukraine, Moldova almost completely depended onRussia for importing gas, which is also essential in electricityproduction. Financial support from European institutions helped reducethese dependencies in the last two years.

Unemployment stayed low during the last two years. However,employment rates are low as well, especially among women, and between20% and 30% of people are working in informal employment. Reforms, likefor example a civil service salary reform, are planned to make work inthese sectors more attractive. The tourism sector employs more than 10%of the labor force but, by the end of 2023, overnight stays had notcaught up with pre-pandemic levels yet.

After a yearly inflation rate of more than 30% in the second half of2022, it has been on a steady decline since then, reaching 3.9% in March2024. This is in the range of the 5% targeted by the central bank. Thekey policy rate was gradually reduced from over 21% in summer 2022 to3.75% in March 2024. Core inflation has exceeded headline inflationsince the third quarter of 2023. The exchange rate between the Moldovanleu and euro has remained relatively stable over the last years, showinga slight appreciation of the leu in 2023. This supported the strongupward trend in foreign exchange reserves, already seen over the lastfive years. In March 2024, reserves were over USD 5.3 billion, whichcorresponds to more than seven import months. Capital buffers in thebanking system are very high, e.g. the capital-to-risk-weighted assetsratio stood at about 30% in the final quarter of 2023. With still highpolicy rates in 2023, loan growth stayed weak while NPLs remainedrelatively high.

The government deficit stood at over 5% of GDP in 2023, comparable tothe deficit in 2020, and substantially higher than the average in theprevious decade. The government supported vulnerable households in therecession and, over the last two winters, by subsidizing high energyprices for example. Financial support especially from the EU and theEuropean Bank for Reconstruction and Development (EBRD) providedsignificant support to the budget in 2023 and helped alleviate thenegative spillover effects of the war. Energy dependency remains a highrisk, since Moldova’s electricity supply still crucially depends onproduction in Transnistria and hence Russian gas.

External funding will remain important for Moldova for mastering thechallenges imposed by the Russian war of aggression in neighboringUkraine but also for the ongoing reforms necessary for EU accession. Twomajor areas of reform remain the control of corruption and theindependence of institutions. Still, good reform progress towardaccession was made in the last two years, for example in some areas ofthe judicial framework and in financial services.

4Türkiye: lira depreciation, high inflation and low reserves raiseexpectations of further rate hikes

Published annual GDP growth amounted to 4.5% in 2023, down from 5.5%in 2022. While private consumption grew at double-digit rates, publicconsumption registered growth of about 5%. Gross fixed capital formationshowed an acceleration of growth to almost 9%, from 1.3% in 2022. Bycontrast, real exports contracted by almost 3%, after growth of 10% in2022. However, real imports grew by almost 12%, even more strongly thanin 2022, implying a large negative contribution of net exports. Part ofthe high import growth rate resulted from the increase of nonmonetarygold imports. The sum of growth contributions of all published demandcomponents, which includes the negative contribution of net exports,continues to exceed the published rate of GDP growth by far, suggestinga large negative contribution of inventory change, which, however, wasless pronounced than in 2022.

Public consumption and hence domestic demand growth was far morepronounced in the first half of 2023, reflecting both earthquake-relatedreconstruction and presidential elections. Moreover, seasonally andworking day-adjusted data show quarter-on-quarter contraction of bothfixed investment and real imports in the fourth quarter of 2023, incontrast to the annual average figures above.

The current account balance showed a deficit of 4.2% of GDP in 2023,which was 1.2 percentage points smaller than in 2022, reflecting theimprovement in the goods and services balance. Excluding almostunchanged net imports of nonmonetary gold, the current account deficitamounted to 1.8% of GDP. Net FDI inflows shrank to only 0.4% of GDP and,above all, net other investment inflows financed the remainingdeficit.

Official foreign currency (FX) reserves stood at 2.8 import months atend-2023, almost unchanged on a year earlier, but declined to 2.2 importmonths by end-February 2024. At the same time, the central bank’soff-balance net short positions due within one year amounted to 90% ofofficial FX reserves, with about half from FX swaps with domesticbanks.

Both annual HICP headline and core inflation remained at a very highlevel, accelerating from August 2023 to March 2024 to reach 68.6% and70.9%, respectively, with services inflation rising from 80% to 96.2%.In parallel, the lira depreciated in euro terms, by about 39% year onyear, amounting to euro appreciation in lira terms by about 65%, whichwas comparable to the size of inflation. The Turkish central bank (TCMB)doubled the key rate from 25% at end-August to 50% at end-March, whichstill implies a large negative real interest rate.

Banks continue to run a negative net FX position on balance, whichthey close by entering swaps with the central bank by initial FX sale.In parallel, nonfinancial corporations run a negative overall net FXposition on balance, with about one-quarter due to overall net domesticFX liabilities (mostly vis-à-vis banks), while the bulk is due toexternal liabilities. This overall net FX position continued to becomeless negative during 2023. At the same time, nonfinancial corporationsrun a positive short-term net FX position on balance, almost entirelyreflecting the net domestic FX position (mostly vis-à-vis banks).

The general government fiscal deficit rose strongly to 5.5% of GDP in2023 from 2.1% in 2022 mainly due to earthquake-related support andreconstruction and partly due to presidential election-related spending.IMF staff forecasts that it will remain close to that level in 2024.General government debt remains below 35% of GDP.

5Ukraine: economy recovers but remains under war-related pressures

Ukraine’s economy recovered by 5.3% in 2023 following a GDPcontraction of 28.8% in 2022. Remarkably, the recovery clearly exceededearlier projections by the IMF and the National Bank of Ukraine (NBU). Astrong harvest, a comparably stable situation in the energy sector aswell as the establishment of export routes enabled better than expectedgrowth. In general, loose fiscal policy supported domestic demand.Investments were underpinned by: defense spending and reconstruction,consumer demand through social programs and military allowances, amongother factors. Private sector wage growth also backed privateconsumption, while the private sector in turn contributed to soaringinvestment growth. Ukraine’s success in creating its self-managed BlackSea corridor after Russia refused to prolong the Black Sea GrainInitiative facilitated the export of grain and other goods. As a result,export contraction slowed down in the final quarter. Obviously, theeconomy must continue to deal with an immense burden emanating fromRussia’s aggression. In March 2024, Russia again intensified attacks onUkraine’s energy infrastructure causing blackouts in some regions. Laborsupply constraints due to migration and mobilization have been dampeninggrowth. After a new legal package on more wide-ranging mobilization wassigned by the president in early April, this effect will likely increasein the course of this year.

Ukraine’s budget deficit is very large, reflecting persistently highexpenditure needs for defense and social programs and revenue losses dueto the economic impact of the war as well as import tax losses fromborder blockades. The deficit (excluding external grants from revenues)rose to 26.3% of GDP in 2023 from about 25% in 2022 according to IMFestimates. For 2024, the budget deficit is expected to go down to 20% ofGDP. To boost tax revenues, the authorities inter alia introduced aone-time 50% tax on bank profits on extraordinary earnings of the year2023. On the external funding side, the European Council’s agreement onthe EUR 50 billion Ukraine Facility at the beginning of February was animportant step that allows the EU to provide financial support over theperiod 2024–2027. In April, the USA finally adopted a further militaryand financial support package worth around EUR 57 billion (includingaround EUR 7.5 billion in financial support). In addition to acting as avital source for budget funding, external financial support has enabledUkraine to avoid a balance-of-payments crisis and to build up itsinternational reserve buffers. In 2023, the deficit in the trade andservices balance rose to more than 20% of GDP given war-relatedconstraints on exports and high import demand. Positive income balances(with the secondary income balance including grants from abroad)compensated a large part of the trade deficit. In sum, the currentaccount deficit stood at about 5% of GDP in 2023 following a surplus ofsimilar size a year earlier. As external funding also arrived in theform of loans on a large scale, international reserves recorded asubstantial increase in 2023. Yet, external funding delays caused adecline in international reserves in the first two months of 2024. InMarch, Ukraine finally received ample inflows in the form of bridgefinancing under the EU facility (EUR 4.5 billion), a further IMF tranche(EUR 0.8 billion) and bilateral support – in sum about EUR 8.3 billion.As a result, international reserves climbed to EUR 40.5 billion covering5.8 months of future imports at end-March 2024. When approving thelatest disbursem*nt, the IMF noted that Ukraine continued to performstrongly in fulfilling the conditionality under the IMF Extended FundFacility.

The international reserves buffer has given the NBU room for maneuverto balance the FX market. Through FX market interventions, maintaininghigh real interest rates and adjusting FX controls, the NBU has steeredthe transition to a managed flexibility of the exchange rate. Since theend of the peg to the USD in early October 2023, the hryvnia hasmoderately depreciated against the USD (by about 7%). Keeping the FXmarket under control together with some other factors (good harvest,lower global energy prices, moratorium on raising some utility tariffs)supported a further considerable disinflation. Monetary financing of thebudget deficit stopped at end-2022. Consumer price inflation dropped to4.3% in February 2024 from 12.8% in mid-2023 and thus reached the NBU’starget range of 5% ±1 percentage point. Against this background, the NBUlowered its key policy rate stepwise to 14.5% in March 2024 (compared to25% in mid-2023). In March 2024, inflation amounted to 3.5%.

The NBU’s banking sector resilience assessment was completed atend-2023 and revealed capital shortfalls in five banks that have alreadybeen mostly addressed according to the IMF. A more detailed andindependent asset quality review will follow as soon as conditionsallow. Meanwhile, bank lending showed signs of stabilization thanks togovernment-backed subsidized lending initiatives. At the same time,deposits grew markedly.

3 Economic trends in Russia

1Russia: war spending boom is driving economic expansion and fuelinginflation; sharp key rate adjustment

The growth of the Russian economy accelerated in the second half of2023, facilitated by substantially rising budgetary outlays, stronglyrecovering consumer spending and growing capital expenditure that causedthe economy to grow above its potential. Hence, the recovery rested onbooming war-driven armaments production, rising incomes in thepopulation and dynamic lending. Brisk domestic demand reflected privateconsumption growing by 6.5% (in real terms) in 2023 as a whole,government consumption expanding by 7% and fixed investment growthaccelerating to 8.8%. Inventories accumulated at an even higher rate.While national accounts data for foreign trade are not yet available,net exports doubtlessly shrank in 2023. Overall GDP increased by 3.6% in2023. Production-wise, manufacturing led the way, growing by 7.5%. 22 ^, 23

The economy has clearly been showing signs of overheating, which hasprompted the Bank of Russia (CBR) to act decisively in recent months.The jobless rate (ILO definition) declined to only 2.7% in January 2024(a new post-Soviet record low), indicating a very tight labor market,saddled with persisting shortages of skilled staff. Real wages reachedrecord levels, which was one of the driving forces behind the upswing ofprivate consumption; the average real wage of the periodJanuary–November 2023 was 7.6% higher than a year ago. Moreover, in thefourth quarter of 2023, for the first time in a decade did realdisposable income of the population exceed its previous record level of2014 by 4%.

Soaring wages, swelling consumer demand, the expansionary fiscalstance, the substantial decline of the ruble (explained below), as wellas continuously high inflation expectations pushed up CPI inflation(year on year) from 4.3% in July 2023 to 7.7% in February 2024, beforeit slightly eased again to 7.5% in March 2024. The monetary authorityreacted energetically – if a few months later than it should have, asthe CBR itself conceded – with a series of consecutive key rateadjustments in July (+100 basis points to 8.5%), August (+350 basispoints to 12%), September (+100 basis points to 13%), late October (+200basis points to 15%) and mid-December 2023 (+100 basis points to 16%).As a result, this rate (the one-week auction repo rate) reached a levelmore than twice as high as half a year before. At its policy meetings inmid-February and mid-March 2024, the CBR left the key rateunchanged.

The shrinkage of oil-related budget revenues in the first half of2023 was reined in in the second half of the year due to the recovery ofthe Urals oil price after the G7 oil price cap of US 60 per barrel forRussian oil had lost some of its effectiveness. Still the average Uralsprice in 2023 came to USD 63, which was 17% lower than a year ago.Overall, the shrinkage of oil-related revenues was more than offset bythe increase of non-oil revenues, with the largest chunk, VAT andcorporate profit tax proceeds, boosted by Russia’s economic recovery.Driven by war-related spending, total budget expenditure in 2023somewhat surpassed planned levels, but the annual federal deficitremained within the government’s 2%-of-GDP target and reached 1.9% ofGDP. The shortfall was mostly funded by drawing down liquid assets ofthe National Wealth Fund (NWF) and from domestic borrowing. Overall, theNWF declined from USD 147 billion at end-February 2023 to USD 133billion twelve months later; NWF liquid assets had shrunk from USD86billion (4.3% of GDP) to USD56billion (2.8% of GDP).

Substantially lower energy export proceeds combined with higherimports cut Russia’s current account surplus by no less than 79% in 2023compared to the previous year, bringing it down to USD 50.2 billion(2.5% of GDP). This deterioration, combined with capital outflows,triggered the ruble’s slide by almost one-third against the US dollarand the euro in the first ten months of 2023. The incipient impact ofthe above key rate hikes, combined with the re-tightening of foreignexchange controls for a number of large exporting firms in mid-October(re-introduction of surrender requirement for export proceeds), causedthe ruble to stabilize and slightly rebound again until February 2024(+4% to +5%). Russia’s gross international reserves (of which aboutUSD300 billion had been frozen by Western jurisdictions in February2022) grew by USD 21 billion in the six months to end-March 2024,reaching USD589 billion at this point.

As referred to above, dynamic lending has been one of the factorsdriving Russia’s economic recovery. Corporate credit growth came to 11%in February 2024 (year on year, in real terms and exchangerate-adjusted), while loans to households increased by 18%. Among thelatter, (subsidized) mortgage loans continued to grow most swiftly.After a weak patch in 2022, banks’ profitability recoveredsubstantially. The sector’s net profit came to USD39billion in 2023.Yet the sharp key rate adjustment is starting to exert a cooling effecton real corporate lending (which had still grown at a rate of 16% inJune 2023), while retail lending is somewhat less affected, given thatmore than a third of household debtors benefit from some form of statesubsidy. That said, the rate hike is rendering these subsidy programsmore costly for the government to finance. Fueled by the rate hike,retail deposit growth recovered to 14% in February 2024 (year on year,in real terms and exchange rate-adjusted), while corporate deposits grewmuch more modestly (+4%). Given the relative stabilization of thesector, regulatory forbearance is gradually being phased out.