Will Emerging Europe Sovereigns Outshine Developed Europe in 2025?

• We see greater room for optimism in the growth and credit outlook for emerging Europe (EE) compared with the developed Europe (DE) market economies.

• While we expect sovereign credit quality in emerging Europe to improve on average, we favor an active approach to issuer selection based on individual fundamental analysis to identify upgrade/downgrade candidates.

• Navigating key risks remains important, with possible escalations in geopolitical tensions in Eastern Europe, the potential for tariffs under a second Trump administration, slower-than-expected fiscal consolidation, and rising authoritarian sentiment all idiosyncratically influencing the trajectory of each sovereign’s credit rating.

The double shock of the pandemic and the surge in energy prices following Russia’s invasion of Ukraine has had a significant impact on the European economy over the past five years. Although we see tentative signs of a cyclical recovery, questions have arisen over the European economy’s structural outlook given permanently higher energy costs, increasing competition from China, weakening demographics, and rising debt burdens. Nonetheless, we see greater room for optimism in the growth and sovereign credit outlook in emerging Europe compared with the developed Europe market economies.1

While emerging European countries experienced the same demand and supply shocks, we believe prospects remain more favorable than in developed Europe due to several key differentiators:

• Average investment shares to GDP2 in EE countries consistently outperformed developed Europe countries, even during the global financial crisis (GFC), the eurozone crisis, and the Covid-19 pandemic, and we expect this trend to continue.

• Net foreign direct investment (FDI) inflows have decoupled from developed Europe since 2017, driven in part by the Tax Cuts and Jobs Act (TCJA) under the first Trump administration, but also by a rising share of FDI flows from DE into EE, as well as from China.

• Institutional and governance improvements will continue, supported by EU accession and financing criteria acting as an anchor, as well as support from international financial institutions (IFIs) and multilateral development banks (MDBs).

• The average debt burden in EE economies is substantially lower than in DE. While fiscal balances have widened in response to shocks and the conflict in Ukraine, consolidation as part of EU requirements or International Monetary Fund (IMF) programs (e.g., in Serbia) will continue to anchor EE fiscal paths.

Higher Investment Rates Underpin Convergence With Developed Europe

Average gross fixed capital formation as % of GDP (weighted by GDP)

Source: Macrobond as of 19 September 2024

Since the start of the 2000s, EE economies have consistently outpaced developed Europe in investment shares to GDP. Excluding Poland, gross fixed capital formation as a percent of GDP has averaged 24.4% for emerging Europe, compared to an average of 20.9% for developed Europe over the past two decades.3 Prior to the GFC (in 2000-2007), the gap was even more pronounced, with a 4.5 percentage point difference in investment levels.3 Although this disparity narrowed after 2008 as business confidence declined, it remained significant, with EE maintaining a 2.6 percentage point lead.³

The higher share of investment to GDP in emerging Europe economies, and in emerging markets more generally, is explained by capital flows for economic modernization and expansion of productive capacity as these countries move up the value chain. Many EE economies have also benefited from nearshoring investment from DE economies, thanks to their relatively lower labor and manufacturing costs. Central and Eastern European economies have particularly benefited from this trend, given their proximity to Western Europe, membership of the EU, and possession of a skilled labor force. The competitive advantage is significant, particularly for the CE4 countries,4 which have average hourly wages at 44% of the mean EU-27 level, making them an attractive region for firms to relocate manufacturing.

FDI Decoupling Should Continue to Support Differences in Investment Rates

Average FDI as % of GDP (GDP weighted)

Source: Macrobond as of 19 September 2024.

In the 2000s, emerging Europe economies saw greater net FDI inflows as a share of GDP than DE economies. However, these inflows stalled and converged toward DE levels in the wake of the GFC and the eurozone crisis as investment declined, underpinned by weak business confidence. While FDI inflows gradually recovered from 2014 onward, flows decoupled in 2017, and the difference widened in favor of emerging Europe.3

Initially, the decoupling could be explained by the Trump administration’s Tax Cuts and Jobs Act, which substantially increased US global tax competitiveness. This hit FDI flows into DE economies harder because the TCJA allowed for US companies to repatriate previously untaxed overseas profits at a reduced rate. Additionally, developed European countries have relatively higher corporate tax rates than emerging European economies. In 2017, corporate taxes in DE economies were 10 percentage points higher on average than in EE countries. Subsequently, FDI pivoted from inflows into DE totalling 4.3% of GDP in 2017 to outflows of 2.1% of GDP the following year as competitive tax pressures grew, while EE economies’ FDI inflows fell but remained positive, dipping to 3.7% of GDP in 2018 from 5.1% in 2017. 3 Since then, average net FDI inflows into EE economies have increased to approximately 8% of GDP, whereas DE net flows have flatlined at 0.2% of GDP.3

Average Corporate Tax Rates Remain Higher in DE

GDP weighted

Source: The Tax Foundation as of 17 December 2024.

Additionally, EE economies have seen increasing FDI inflows from China, whereas flows into DE countries have been slowing since 2017, given weakening bilateral relations amid geopolitical concerns. According to the China Global Investment Tracker (American Enterprise Institute), investments from China into EE were higher than into DE for the first time in 2023, at $6.4 billion, versus $6 billion for DE.5 Hungary remains best placed to take advantage of FDI inflows from China due to its strong bilateral ties, having received an estimated €16 billion in total investments so far – with further major FDI projects with prominent Chinese battery makers planned over the next two years.5 Similarly, Serbia maintains close bilateral ties with China, having signed a strategic partnership agreement in 2016, and China is now Serbia’s second-largest trading partner by import share, at 12.1% in 2023.5

Investment Flows From China Into DE and EE Have Equalized

Source: China Global Investment Tracker (American Enterprise Institute) as of 3 July 2024.

Weighted GDP Growth Rates Continue to Diverge Post-Pandemic

Index of average real GDP by DE and EE (2000 = 100, by 2023 nominal GDP weights)

Source: Macrobond as of 27 January 2024

Given these factors, the weighted growth rate since 2000 has been higher on average in EE countries. In fact, while EE growth rates saw larger drops on average during the GFC, the eurozone crisis, and the pandemic, the recoveries that followed were significantly stronger, and this divergence has persisted. Given the structural difference in investment shares to GDP, we expect EE economies’ growth rates to continue to outpace those of DE economies in the medium term.

The post-pandemic outperformance can also be explained by the availability of additional funding, such as the EU’s Recovery and Resilience Facility, which has helped EE economies converge to average EU income levels. EE countries are the main beneficiaries of these funds, with Croatia, Romania, and Poland set to receive 13%, 9%, and 8% of their GDP, respectively, in funding.6 As of January 2025, 47% of the funds committed under the facility have been disbursed, with two years remaining – we expect the bulk of the remaining funds to be disbursed before the August 2026 deadline.6 The EU has also greenlighted a Reform and Growth Facility for the Western Balkans, which will provide €6 billion during the 2024-2027 period for six non-EU Balkan countries.6 As part of these facilities, funding is conditional on achieving fundamental reforms, largely focused on rule of law and improving institutional resilience, which should help to enhance structural growth and credit quality.

The EU Recovery and Resilience Facility Will Help Close the Income Gap

Loans and grant funding as % of GDP by country

Source: European Commission as of 27 December 2024

Since 2000, all EE economies have seen per capita income levels converge to the EU average. The average EE GDP per capita (in constant prices) as a percentage of the average EU GDP per capita has increased from 40% in 2000 to 63% in 2024.7 Lithuania, Romania, and Poland saw the greatest catchup over the period, with GDP per capita rising by 45, 37, and 35 percentage points of the EU average, respectively (see chart).7 Montenegro, Bosnia, and North Macedonia saw the lowest rises, converging by just 8 to 14 percentage points.7 However, given our expectation for structural improvements along with growth in EE economies that continues to outpace that of DE, average per capita income will continue to converge to average EU levels over the medium to long term, supporting credit quality and increasing economic resilience.

The Top and Bottom Three Risers in GDP Per Capita

Constant prices as % of EU-27 average

Source: Macrobond as of 28 October 2024

EE institutional and governance factors will likely keep improving

Most EE countries have made progress in their Worldwide Governance Indicators (WGI) over the past two decades and have subsequently moved up the percentile rankings.8 Higher WGI scores are supportive of credit strength, given their incorporation into credit rating agency sovereign methodologies. More fundamentally, stronger indicators point to countries that boast a stable, predictable operating environment with checks and balances on government and a more level playing field for business.

We expect that EU accession criteria, EU financing conditions, and other IFI funding conditions will remain an anchor for further institutional reforms in EE countries, which will support structural convergence of growth with DE economies over time. For example, Romania’s Recovery and Resilience Plan (RRP) requires the government to digitize public services and administration, including reporting on the effectiveness of state-owned enterprises (SOEs), which should reduce bureaucracy and enhance fiscal transparency.

Taking the average percentile ranking for the six factors that compose the WGIs, Serbia, Albania, and North Macedonia saw the greatest improvement among EE countries between 2002 and 2022. Of the 17 EE countries considered, 12 have seen increases in the percentile rankings in the average score of the six factors over the past two decades.8 The overall trend for the WGI factors points to rises in the average scores for EE countries, which we expect to continue as economic development advances.

Average EE Worldwide Governance Indicator Percentile Ranks Rose From 2002 to 2023

Source: World Bank as of 30 October 2024.

Debt is higher than in the 2000s, but the margin to developed Europe is healthy

Historically, EE economies have benefited from lower debt burdens on average than the DE countries. This can be explained by a variety of factors, including higher nominal growth rates, the transition from command-based economies, and less sophisticated capital markets. In 2000, average EE debt to GDP was 38%, compared with 60% in DE economies.9 Following the GFC, the eurozone crisis, and the pandemic, debt burdens in DE countries grew disproportionately, rising to 85% in 2023 compared to 51% for emerging Europe – or a difference of 34 percentage points in 2023 compared to 22 percentage points in 2000.9

The change in the spread can be explained by bailouts and stimulus measures in the advanced economies, in addition to lower nominal GDP growth rates. Due to larger initial debt burdens and persistently weak structural growth, DE economies are more sensitive to rising debt levels than their EE counterparts, particularly during periods of high interest rates. As a result, DE countries are likely to see steeper rises in debt-to-GDP ratios, necessitating more severe fiscal consolidation but at the cost of social trade-offs. However, EE countries face higher financing costs than their DE counterparts, outside of EU and IFI funding, and thus also require careful fiscal management.

In terms of fiscal policy, EE and DE economies have tracked similar trajectories following the financial crisis. Since 2000, EE fiscal balances excluding Poland have averaged 3.2% of GDP (3.4% including Poland), compared to 2.5% in DE economies.9 While deficits for both ballooned following the pandemic, we continue to expect consolidation over the medium term, supported by the EU’s fiscal rules and fiscal anchors for non-EU countries. For example, Serbia is opting for a Policy Coordination Instrument with the IMF to commit to budget deficits of no greater than 3% of GDP. 8 Similarly, EU accession candidates will effectively need to maintain budget deficits below 3% of GDP to comply with the EU’s fiscal rules.

Given this, we expect that emerging European economies should continue to maintain, on average, a healthy debt-to-GDP differential of 30 percentage points to developed Europe through the end of the decade. Short-term upward pressures on military spending will temporarily slow fiscal consolidation in Eastern European countries, given the ongoing conflict in Ukraine, but the IMF projects that average overall balances for emerging Europe (ex Poland) should reach 3.3% of GDP (4% including Poland) by the end of 2025, down from 3.7% in 2024.9 A resolution to the conflict in Ukraine would provide a boost for EE economies, driven by lower risk premia and less uncertainty.

Average Debt-to-GDP in DE Far Exceeds That for Emerging Europe

By 2023 nominal GDP weights

Source: Macrobond, IMF Fiscal Monitor as of 23 October 2024.

Average Fiscal Balances as % of GDP in DE and EE

By 2023 nominal GDP weights

Source: Macrobond, IMF Fiscal Monitor as of 23 October 2024.

Emerging Europe credit ratings have risen on average over the past 25 years

What do these trends mean for credit quality, and therefore ratings? Given our expectation that EE growth will continue to outpace DE, along with structural and governance improvements and manageable debt profiles, we believe overall credit quality in EE will continue to rise. Average EE credit ratings by GDP weighting have increased from BBB- in 2000 to close to A- in 2024 (or from BB+ to BBB+ when excluding Poland).10 DE credit ratings, on the other hand, have fallen on average, from AAA/AA+ to AA/AA- over the same period.10

Average EE Credit Ratings Rose While DE Fell Between 2000 and 2024

By 2023 nominal GDP weights

Source: Bloomberg as of 23 January 2025.

Looking forward, as of 23 January 2025, 29% of EE countries had a positive outlook from at least one of either Moody’s, S&P, or Fitch, slightly above the 25% rate for DE countries.10 However, this also follows recent sovereign upgrades for Albania, Croatia, Montenegro, and Serbia since the start of the second half of 2024. Meanwhile, 12% of EE countries have a negative outlook from at least one of the major credit rating agencies, compared with 25% of DE sovereigns.11 We therefore anticipate more upgrades for emerging Europe than developed Europe over the coming 12 to 18 months.

While we expect average credit quality in EE to increase, we favor an active approach to issuer selection based on individual fundamental analysis to identify upgrade/downgrade candidates. Navigating key risks remains important, with possible escalations in geopolitical tensions in Eastern Europe, the potential for tariffs under a second Trump administration, slower-than-expected fiscal consolidation, and rising authoritarian sentiment – all of which may idiosyncratically influence the trajectory of each sovereign’s credit rating.