Domestic Consumption Drives Growth in Eastern Europe

Economic growth across countries from central Europe to central Asia is being driven increasingly by domestic consumption, especially as countries become more prosperous and people seek a higher standard of living, the EBRD says in its Transition Report 2006, issued today.

Region expected to grow at 6.2 per cent in 2006.

High energy and metal prices continued to help boost economies across commodity-rich countries, but higher wages, more access to credit and, in some countries, remittances from migrant workers helped fuel the 5.7 per cent growth for the region as a whole in 2005 (6.7 per cent in 2004). The region continues to be one of the fastest growing globally, and is projected to expand by 6.2 per cent in 2006.

The Commonwealth of Independent States (CIS) and Mongolia grew fastest at 6.6 per cent in 2005. This was down from 8 per cent in 2004 mainly due to a slowdown in Russia, but growth is projected to increase to 6.9 per cent in 2006, helped by a revival in Russia, and by high commodity prices. Azerbaijan has become one of the world's fastest growing economies with growth of over 26 per cent due to the expansion of its oil sector with the opening of the Baku-Tbilisi-Ceyhan pipeline this year. Countries such as Armenia, Georgia and Ukraine, which do not have significant energy resources, are seeing robust private consumption, rapid credit growth and strong remittance flows.

In Russia, growth is estimated to have reached 6.4 per cent in 2005 (7.1 per cent in 2004, projected 6.5 per cent in 2006). Foreign investment into Russia has grown, as has outward investment from Russia into other countries as Russian companies look for business opportunities abroad. A major challenge for Russia, as well as other commodity-rich countries, is to continue the diversification of their economies, and not become overly dependent on high commodity prices for growth.

In south-eastern Europe (SEE), a revival of some industries, such as the metals sector, expanding exports, and strong domestic demand, fuelled by credit growth, contributed to growth of 4.7 per cent in 2005, down from 6.9 per cent in 2004 mainly due to a slowdown in the region's largest economy, Romania. The strongest growth was seen in Serbia at 6.3 per cent, while several other countries grew at 5 per cent or more. Bulgaria and Romania, both of which will join the European Union in January 2007, are growing strongly again and the region as a whole is expected to grow by 5.9 per cent in 2006.

In central eastern Europe and the Baltic states (CEB), low interest rates and financial service innovations such as mortgage lending promoted strong domestic demand and export growth that saw the region grow by 4.7 per cent. Growth fell from 5.2 per cent in 2004, mainly due to a slow down in Poland. Projected growth of around 5.3 per cent in 2006 will be helped by a recovery in Poland. Unemployment across most countries remains high but is on a downward trend and labour shortages are arising in certain sectors, such as construction in the Baltic states and automotive in the Slovak Republic. Mortgage lending across the region increased particularly strongly, reflecting an increasingly well-developed and competitive financial sector.

Despite strong economic growth across the region, the report warns of impending risks and challenges. For example, households' increased access to finance is driving domestic demand that, combined with higher energy prices, is raising inflationary pressure across many countries. While many central banks have increased interest rates to manage inflation, the report says fiscal policy in CEB has generally been too loose to stem domestic demand effectively.

The reform process continues, but with differences within individual sub-regions. For example, SEE made most headway in the past year, driven in some countries by the prospects of EU accession. However, many governments in CEB have, since joining the EU in 2004, slowed on reform as public support for further restructuring has weakened. In the CIS, reforms in the past year have been concentrated in the wealthier countries of the region, especially Kazakhstan, Russia, and Ukraine, where institutional strengthening, such as improved legal and regulatory frameworks, over the past few years has underpinned a favourable market response.

Economies across the region are growing strongly, and are catching up with western Europe, said Erik Berglof, Chief Economist at the EBRD. But there is no room for complacency, especially as many OECD countries begin to increase interest rates that could diminish the appetite for investment in emerging markets, said Mr Berglof.

Finance in Transition

The striking transformation of the financial sector is the focus of this year's Transition Report, based on an in-depth survey of banks and financial institutions. Since the collapse of Communism, the sector has moved from a state-controlled system to one in which a wide number of financial institutions offer a diverse range of finance to large businesses, households, retail clients and small and medium-sized enterprises (SMEs.

Moreover, financial markets across the region have grown in size and complexity. In addition to banks, stock and bond markets and private equity are becoming important aspects of the region's financial systems. Private equity funds had a difficult start in the transition region, but the industry is now expanding rapidly with investment returns comparable to those in Western Europe. The expansion of private equity funds has had a positive effect on economic development in the region. As well as being an additional source of finance, equity funds have a direct impact on the performance of enterprises.

Financial sectors remain dominated by banks. Domestic banks are gradually reaching the standards of their western counterparts, having made significant advances in recent years in expanding their financial services to reach wider audiences. Institutional reforms have helped to reduce bank costs, particularly those associated with risk management and the evaluation of credit information.

Foreign-owned banks are very active in the region, particularly in central eastern Europe, and in many countries control over 80 per cent of the market. The entry of foreign banks has been positive for market development, and they have helped transform the sector by introducing skills, technologies and financial services, and by driving competitiveness. They are more cost effective than their domestic competitors. However, foreign bank dominance in some transition countries can be cause for concern. While the greater penetration of foreign banks in the region is a broadly positive development, one potential downside could be the risk of problems at a parent bank impacting a subsidiary, and vice versa.

Further development of the sector would bring significant returns in economic growth, especially in countries with the lowest levels of financial sector development. Lending is influenced by how banks perceive the legal environment and the level of protection it provides. For example, banks with a favourable view of the legal institutional framework are more inclined to lend to SMEs and households and to provide mortgages. Those countries that make the necessary legal reforms are benefiting most from financial sector development, which in turn promotes economic growth.