Analysis-Extreme weather adds to fiscal strains in central Europe

Analysis-Extreme weather adds to fiscal strains in central Europe

By Jan Lopatka, Karol Badohal and Gergely Szakacs

Just a week ago, before deadly floods swept through central Europe, the Czech Republic looked on track to become the first country in the region since COVID-19 to pull its budget deficit firmly below the 3% of GDP cap set by European Union rules.

Now that small victory for public finances hangs in the balance as the Czech Republic and Poland, which have borne the brunt of the deluge, count the cost of the worst floods to hit the region in at least two decades.

Based on estimates from local officials, the damage to infrastructure could reach a combined $10 billion in these two countries alone. Poland's finance minister said the $5.6 billion allotted from EU funds would cover some, but not all of the costs to recover from the floods.

Economic losses linked to extreme weather are adding to strains on state finances in a region still squeezed by the aftermath of the COVID-19 pandemic and the inflation surge following Russia's 2022 invasion of neighbouring Ukraine.

Since the pandemic when EU member states set aside the bloc's stipulation that they keep annual deficits to 3% of gross domestic product, budget shortfalls in the region ballooned to as much as 9% of GDP in Romania and 7% in Poland and Hungary.

Inflation and elections in Poland, Hungary and Romania – with the inevitable promises of largesse - further hampered deficit cuts.

Higher military investment, inflation-linked spending on pensions and increased debt servicing costs are also stretching budgets.

On Thursday, the Czech finance ministry said it would allocate 30 billion crowns ($1.3 billion), or 0.4% of GDP, for flood damage in a 2024 budget amendment, 25% above an initial estimate by ING economist David Havrlant early this week.

This could push the Czech deficit close to the 3% set under EU rules, up from an original 2.5% target, with next year's deficit now also projected above earlier plans.

Steffen Dyck, Senior Vice President at Moody's Ratings, said that although the region appeared better prepared than in the past to manage flooding, it was having to deal with incidents and their economic impact more regularly.

"There might still be an impact on government spending, depending on the ultimate damage, and some countries, like the Czech Republic and Poland, have already announced immediate emergency fiscal support," Dyck said.

The unexpected pressure on Czech finances highlights the scale of the challenge facing the rest of the EU's eastern member countries still grappling with larger deficits ranging from nearly 7% in Romania to more than 5% in Poland and Hungary.

LONG-TERM VIEW

A Reuters analysis of draft budgets and government announcements on fiscal plans shows Poland and Hungary could take most of this decade to reduce shortfalls to below 3% while Romania may not achieve this until the 2030s.

For Poland, the region's largest economy, Moody's predicts general government debt could rise to 60% of GDP by 2027 due to increased borrowing, which will lift debt-related expenditure.

Moody's expects the Polish budget deficit to exceed 5% of GDP in 2025, followed by "very gradual consolidation" towards a 3% shortfall over the next four to five years.

Saddled with the cost of flood repairs, Poland will now push for some more EU leeway in shoring up its state finances.

Fitch Ratings said spending pressures in Poland were "greater than anticipated" after Warsaw unveiled its 2025 budget draft, though a solid revenue base provided support.

The floods hit a region already reeling from a weak German economy, the destination for 20-30% of central European exports, with possible long-term ramifications for state finances.

"CEE growth prospects could suffer if Germany's economic weakness proves structural and protracted," Karen Vartapetov, Director and Lead Analyst for CEE and CIS Sovereign Ratings at S&P Global said.

"Weaker medium-term growth in turn could pressure CEE public finances at a time when government funding costs remain high."

Debt servicing costs surged to 4.7% of GDP in Hungary and 2% in Poland and Romania last year, with only the Czech Republic's 1.3% of GDP interest bill running below the EU average -- but still nearly twice the 0.7% level seen before COVID-19.

Romania has yet to unveil a 2025 budget, with Bucharest considering a seven-year timeframe to rein in its deficit from the EU's highest levels, which some economists say could reach up to 8% of GDP this year due to a costly pension reform.

Hungary, whose budget deficit has averaged nearly 7% of GDP since the pandemic, has pledged to lower it to 4.5% of GDP this year, though Moody's expects it to be a full percentage point higher even after recent attempts to curb the gap.