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Restrictions May Apply: Shrinking EU Funds and the Impact for CEE Sovereign Ratings
   
For the past decade, Central and Eastern Europe (CEE), more specifically the so-called Visegrad countries (Czech Republic, Hungary, Poland, and Slovakia), have benefited from the steady inflow of EU structural and investment funds. This largesse (in the form of grants, not debt) from west to east also helped the region weather the global financial crisis fairly well, facilitating far smoother external adjustments than would have otherwise been the case.

But with Brexit negotiations underway, louder talk of a two-speed Europe, and growing friction between increasingly nationalist CEE governments and their European partners, S&P Global Ratings believes that over the next EU budgetary cycle, structural and investment funds may not only shrink, but also come with strings attached.

As a result, (potential) economic growth may weaken in the medium term, delaying further income convergence and in turn upside for the ratings, particularly should regional governments prefer not to meet any new conditionality attached to EU grants.

Overview
EU structural and investment funds have supported economic growth across CEE over the past decade, built infrastructure, and lifted living standards.

With the U.K. likely dropping out as the second-largest net contributor after Brexit, funds available in the new multiannual framework starting in 2021 will almost certainly be smaller.

Growing political tensions between some CEE countries and their European partners over democratic norms and about coping with the refugee crisis may lead to future fund disbursements being linked to compliance with European standards, including the rule of law.

Growing security challenges and continued refugee inflows from the Middle East and Africa may also lead to a shift in focus of funds disbursement, while existing programs like the Investment Plan for Europe may be expanded.

EU Funds Have Helped Build CEE Economies
EU funds have been one of the key pillars supporting economies across CEE, most notably the Visegrad-4 since they joined the EU in 2004. In the last programming period (2007-2013) over 220,000 jobs were created and almost 2,800 kilometers of new roads were built in CEE thanks to the steady stream of EU money from Brussels.

During the height of the global financial and eurozone sovereign debt crisis, these EU funds were important contributors to relatively quick economic recoveries as they were used to finance government investments to spur growth. Over 2007-2013, between 34% (Czech Republic) and 57% (Hungary) of government investments were financed with EU cohesion policy funding, according to data from the European Commission.

In the current programming period between 2014 and 2020, CEE countries have been awarded EU funds of roughly 19% of 2016 nominal GDP or on average 2.7% of GDP annually. Especially Poland (20.3%) and Hungary (22.3%) benefit greatly from financial support from Brussels.

While not all EU structural and cohesion funds target infrastructure projects in a broader sense, two out of the six available funds predominantly finance investment in network infrastructure in transport and energy. These two funds, namely the Cohesion Fund and European Regional Development Fund, account for almost 72% of available funds to CEE countries. Shifting the focus of the funds away from infrastructure projects to other areas of importance for the EU could hurt CEE economies.

Reasons Why the Pie Could Shrink
S&P Global Ratings believes there are three main reasons why the amount of available EU funds will shrink. What's more, the way they are disbursed and their purpose may change as well.

Brexit will almost certainly lead to a smaller EU budget in the forthcoming multiannual financial framework. As the second-largest net contributor most likely, pending the negotiations, leaves the EU in March 2019, it remains quite uncertain whether other large net contributors, such as Germany, France, and the Netherlands, will be willing to plug the gap created by the U.K.'s departure.Since 2000, all three countries have net contributed around 0.4% of GDP annually to the EU budget. To keep the EU budget at a roughly similar size, these countries would have to increase their net contributions by on average 0.2% of GDP. While budgetary situations are sound in Germany and the Netherlands, France's deficit still hovers at around 3% of GDP, giving the country little leeway for additional spending. Moreover, Paris and Berlin have already signaled their unwillingness to shoulder the entire financial Brexit burden on the EU.

New strings attached to EU funds might reduce available funds to CEE countries. Political tensions between the European Commission and some countries in the east are growing on multiple fronts. First, the unwillingness of some CEE countries to share responsibility by accepting refugees under a mandatory quota system agreed in 2015 has caused discontent in other European capitals and led the European Commission to launch infringement proceedings against Czech Republic, Poland, and Hungary and openly criticize the Baltic states. Moreover, the European Commission launched an investigation into Poland's changes to the Constitutional Tribunal under the EU rule of law framework and has recently stepped up its rhetoric against the country following controversial legislative proposals that could have undermined the independence of the judiciary. Hungary's parliament recently passed legislation affecting especially foreign-funded nongovernment organizations, including the Central European University. This move has sparked protests from the European Commission and an investigation from the Venice Commission, an advisory body of the Council of Europe. Given the multitude of these larger and a number of smaller conflicts, for instance over Polish deforestation plans in an EU-protected forest, calls have been growing louder by some member states to attach conditionality, such as compliance with the European rule of law framework, to fund disbursement.

Potential changes to EU fund allocation criteria will likely change the existing geography of funding. Givenincreasing domestic and external security challenges, the focus of EU funds may be, in part, shifting away from infrastructure funding--that primarily benefited CEE. Instead, more funds may be made available for helping to secure Europe's external borders which would provide more of a benefit to countries in the south, such as Greece, Italy, or Spain. Moreover, the way available funds are disbursed could also change by strengthening existing investment frameworks, such as the Investment Plan for Europe (the so-called Juncker Plan) by making funds available to everyone rather than having country-specific allotments.

So Much for Income Convergence?
Losing EU structural and investment funds could be a serious blow to continued income convergence in CEE. After a strong push in 2015 to use the last chance to absorb available EU funds from the 2007-2013 programming period, when EU funds contributed up to 1% of GDP growth, all CEE economies experienced a significant slowdown in economic growth in 2016 as public investment, and in turn private investment, slumped due to lower fund absorption.

We expect an acceleration of growth across CEE this year as EU fund absorption increases. Moreover, this should also support growth in the medium term. However, as the new programming period begins in 2021, a key growth engine, that is, EU-sponsored public-sector investments, could either be missing or become more costly as governments may lose the EU cofinancing of public-sector investments.

A Potential Constraint for the Ratings
On average, per capita income in CEE amounted to less than 50% of EU-28 income in 2015. This was only a 5 percentage point increase for the region as a whole since the outbreak of the global financial crisis, despite the significant support from the EU budget. Historically, EU transfers have aimed at boosting productivity and income levels in the east. If transfers are scaled back, this would appear to be another reason to no longer expect the sort of convergence that was taken for granted before the crisis. Also, lower EU funds might result in longer-term spending pressures on general budgets coming from significant infrastructure needs, potentially leading to weaker fiscal balances and ultimately higher government borrowings and debt.

While we expect CEE will outgrow the EU-28 as whole over the coming four years (an average annual 2.9% versus 2.3% for the EU-28), we also forecast average growth in the region will slow to an annual 2.7% in 2020 from about 3% in 2017.

However, to significantly boost income convergence, materially stronger growth vis--vis the rest of Europe's would be required. Looking ahead, however, a number of factors will likely put a lid on potential growth in the region. While productivity growth across the region has slowed, demographics are expected to start weighing on growth in the next few years as well. With the expected decrease in available EU funding and a potential shift away from infrastructure-focused funds, capital stocks may also not grow as quickly, moderating overall potential growth for the region. The larger risk may be the resurgence of Eurosceptic nationalism in Eastern European, which could lead to a decline in transfers, and in some cases substantially, resulting in a middle-income trap for most of CEE - an outcome that, alongside rising institutional risks - is likely to limit upside for the ratings. Only a rating committee may determine a rating action and this report does not constitute a rating action.