Policy tightening at home and abroad weighs on short-term growth prospects, but should help Emerging Europe in the longer term

By: Franziska Ohnsorge Senior Economist

Authors: Franziska  Ohnsorge, Piroska M Nagy, Peter Sanfey

We’ve just published our latest update on Emerging Europe and Central Asia’s economic outlook which indicates that the recovery in the transition economies is progressing with important exceptions, and highlights the key factors behind this diverse picture.In many countries economic activity was strong in the first half of the year, but the outlook is dimmer, due to the short-term negative demand impact of fiscal austerity  packages and/or global exiting from crisis-related macro policy loosening: (i) in advanced EU countries (main export markets for emerging Europe), (ii) in transition countries themselves  (dampening domestic demand); and (ii) globally, as the rest of the world exits from crisis-related expansionary macro economic policies, weakening global demand for natural ressources and commodities.  Balance sheet pressures on banks active in the region also weigh on credit growth. Significant uncertainty remains both on the downside and upside; however, the balance of risks has shifted to the downside since May.

As a result, the growth forecast for the EBRD’s region of operations has been revised downward by 0.2 percentage points since the last EBRD forecasts in May to 3.5 per cent in 2010, and by 0.1 percentage point to 3.9 percent in 2011:

• The downward revision is most pronounced in both years for South-Eastern Europe where the recession appears to be lingering.
• In Central-Eastern Europe, stronger than projected recent growth, while lifting 2010 growth, is expected to fade in 2011. Some Central European countries have recently witnessed stronger than expected growth, which may spill into 2011; at the same time policy uncertainty can also affect investor confidence in cases such as Hungary.
• Central Asia is expected to grow somewhat more than previously projected on the back of good prospects for commodity exports.

A recovery appears to be underway in the second quarter of 2010, although with notable exceptions. On the back of a global recovery in trade, growth in industrial production and exports increased in most countries in the second quarter. In the largest emerging market countries of the region (Russia, Turkey and, since the presidential election, Ukraine), a return of capital inflows has also contributed to growth. Strong commodity prices, despite some market volatility, have benefited commodity exporters (Russia, Kazakhstan, Armenia and Mongolia).

In contrast, output growth continues to be near zero or negative in most countries of south-eastern Europe, and neighbouring Croatia and Slovenia. Here, recovering exports were offset by weak domestic demand, and financial systems suffered some pressure from the turmoil in Southern European sovereign debt markets. In several countries, net capital inflows remain subdued and credit to the private sector contracted or stagnated. In addition, flood damage reduced GDP in some countries. Another exception to regional recovery is the Kyrgyz Republic where political turmoil has disrupted economic activity.

Inflation pressures continued to subside across the region. In those countries where inflation has picked up since end-2009, the increase was caused by hikes in administered energy prices (FYR Macedonia, Kazakhstan, Moldova and Slovenia), VAT and excise tax rises (Bosnia and Herzegovina, Bulgaria and Estonia), or sharp depreciations (Georgia).

 

 

 

 

 

 

The outlook for the remainder of 2010 and for 2011 is generally weaker than recent economic activity suggests. Central and Eastern European countries depend heavily on trade and financial links with the EU. Given the weakening outlook for the Eurozone – as fiscal austerity programmes are implemented and financial markets are likely to remain volatile – the external environment may be less benign than previously projected. Credit growth is expected to remain weak as long as banks’ balance sheets remain under pressure, regulatory uncertainty lingers, and the cost of capital are elevated. In addition, country-specific developments will constrain growth. Several countries have announced additional fiscal tightening measures (e.g., Lithuania, Romania and Serbia). Resource-rich countries in the Caucasus and Central Asia will be affected by a slowdown in commodity prices resulting from shrinking demand from Asia.

Downside risks, mostly due to the external environment, have intensified. The “fan chart” below, which is estimated for EU member states in the transition region plus Croatia, illustrates how the risks have become increasingly tilted to the downside. Fiscal consolidation in Europe and monetary tightening in China may still trigger a sharper slowdown in global growth than currently projected. In this downside scenario, trading partner growth could turn negative in the second half of 2010 and remain negative in 2011. This could be compounded by further deleveraging in the financial sector if capital and liquidity remain scarce and risk aversion rises. Financial market volatility could rise significantly. In addition, if market nervousness over fiscal sustainability intensifies, several countries may require austerity packages to convince markets of the sustainability of public finances. While expenditure-based fiscal consolidation may benefit competitiveness in the medium-term, it would dampen growth in the short-term.

At the same time, prospects for fiscal sustainability are better than in many advanced economies and may result in upside risks. Compared with advanced economies and other emerging markets, public debt-to-GDP ratios in the region are generally low. Many countries are implementing significant fiscal consolidation programmes which, if focussed on expenditure cuts that typically produce more lasting improvements in fiscal balances than revenue increases, should improve fiscal sustainability as well as competitiveness. In addition, medium-term growth prospects are typically stronger than in advanced countries which are planning to implement austerity programmes. As a result, capital flows in search of yield may be attracted to debt markets in the EBRD’s region of operations, helping to push growth in the whole region possibly above 4 per cent this year and closer to 5 per cent next year.

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