Below is given chapter of GEP 2008 related to Europe and Central Asia. The report said GDP in Europe and Central Asia is expected to grow by 6.7 % in 2007, and then slow to 6.1 % in 2008 and 5.7 % in 2009. Inflation has risen in several countries, tied to sustained strong domestic demand and rising food and fuel prices (made worse by drought in Bulgaria and Romania). Signs of overheating are evident in Bulgaria and the Baltic states. In Turkey, an easing of monetary policy is expected to strengthen domestic demand, leading to a pickup in growth, and a continued large current account deficit.

Europe and Central Asia

Recent developments

GDP growth in the Europe and Central Asia region eased slightly, from 6.9 percent in 2006 to 6.7 percent in 2007, reflecting a modest softening of both external and domestic demand (table A3). With a stable population in the region, this means that per capita production continued to increase at remarkable rates of more than 6 percent. High productivity gains have been made possible by technology diffusion, double-digit growth in investment supported by rapid credit expansion through lending by domestic and foreign banks, high energy prices for hydrocarbon exporters, and large remittance inflows from workers overseas.

These same factors have boosted private consumption and consistently raised import growth 3 or more percentage points above the already robust expansion of exports. These developments, which have helped to rapidly increase standards of living, are not without shadow costs. Capital inflows have created challenges for macroeconomic management; inflation remains high relative to that in the Euro Area, making it more difficult for several countries to maintain effective exchange rate pegs; and current account deficits in many oilimporting countries have become unsustainably high.

At the subregional level, growth in Central and Eastern Europe (CEE) moderated to a still robust 6.0 percent in 2007 from 6.5 percent in 2006 (figure A4), buoyed by rapid growth in credit and in real wages, strong capital inflows, and high remittance inflows. The falloff in growth in CEE is attributable in large measure to a slowdown in Hungary, where a program of fiscal consolidation pushed growth down 3.2 percentage points to 2.2 percent in 2007. The decline in growth in CEE also stems from continued moderation in Turkish GDP, which slowed by 1 percentage point to 5.1 percent in 2007 from an unsustainable 8.9 percent pace posted in 2004.

In contrast with CEE, growth in the Commonwealth of Independent States (CIS) accelerated sharply from 7.8 percent in 2006 to 8.2 percent in 2007 (figure A4). A strong increase in public consumption and investment, combined with a slightly improved contribution from net exports, formed the foundation for this pickup in growth. Revenue gains for the oil-exporting economies, notably Azerbaijan, Kazakhstan, and the Russian Federation, continue at robust rates, given increasing oil prices, and are providing ongoing support to demand growth through fiscal linkage. A construction boom in residential, commercial, and civil engineering (infrastructure) projects is contributing to a rise in the non-oil sectors.

Among the smaller CIS economies, high worker remittance inflows, FDI, and vibrant demand from regional oil exporters (notably Russia) and from Asia (especially China) are underpinning growth. Gross worker remittances represented a substantial share of GDP for several of the region’s countries in 2006, ranging from the equivalent of 4 percent of GDP to as much as 38 percent: Albania (15 percent), Armenia (19 percent), Azerbaijan (4 percent), Georgia (7 percent), the Kyrgyz Republic (12 percent), Moldova (38 percent), and Tajikistan (20 percent). Remittances are anticipated to maintain this strong level in 2007.

Europe and Central Asia’s regional current account position shifted to a modest deficit equivalent to 1.3 percent of GDP in 2007 after posting a surplus of 0.6 percent in 2006 (figure A5) and an average surplus of nearly 1 percent of GDP over 2000–05. Strong domestic demand is driving import volume growth of 12.8 percent, well in excess of exports at 9.2 percent. Sizable current account deficits among countries in CEE have been financed to a large extent by FDI, although for the Baltic states, foreign borrowing by banks has come to represent a substantial share of external finance, leading to higher external debt-to-GDP ratios. In the case of Latvia, that ratio reached 112 percent in 2006 and is projected to remain above 100 percent during 2007–09.

Moreover, short-term debt as a share of total external debt is high in a number of countries, reaching more than 40 percent in Latvia, Lithuania, and the Slovak Republic. These indicators point to potential future problems with currency and maturity mismatches.

In the CIS, worker remittances have helped finance significant external deficits in a number of smaller countries. In Kazakhstan and the Kyrgyz Republic, external debt as a share of gross national income stood at 83 and 86 percent, respectively, in 2005, and in the case of Kazakhstan, this share has increased by 12 percentage points since 2001.

Indeed, the rise in the international indebtedness of Kazakh banks has recently focused attention on the country, given the turbulence in international financial markets. In the Kyrgyz Republic, debt burdens remain at high levels, but they have been reduced sharply since 2000—by more than 50 percentage points as a share of gross national income—largely because of debt rescheduling by the Paris Club in 2002 and an improvement in debt management strategy.

Fiscal positions in the region generally deteriorated in 2007, with the largest shifts posted in the CIS. The most notable decline has been in Tajikistan, where the fiscal balance shifted from a surplus of 1.6 percent of GDP in 2006 to a deficit of 10.3 percent. This reflects, in part, an effort to offset weakening exports to sustain domestic consumption and investment. Marked deteriorations in fiscal positions of 2 percentage points or more during 2007 have been recorded in Belarus (2.0 points), Bosnia and Herzegovina (3.4 points), Kazakhstan (3.0 points), Russia (2.2 points), and Turkey (3.4 points). In contrast, notable consolidation has been achieved in Hungary, where the austerity program reduced the deficit from 9.2 percent of GDP in 2006 to 6.4 percent. Firming government revenues underpinned by stronger than expected GDP growth helped manage a reduction of Poland’s deficit from 3.9 percent of GDP in 2006 to 3.0 percent in 2007. In Azerbaijan, increasing oil revenues and new productive capacity have led to a considerable rise in the fiscal surplus, which is equivalent to 5.0 percent of GDP, up from 0.1 percent in 2006. Monetary policy across the region has become more restrictive to counter rising inflationary pressures. Price increases are stemming from sustained high domestic demand growth and rising fuel and grain prices, the latter aggravated locally by drought conditions in Bulgaria and Romania and globally by the surge in the use of cereals for biofuels.

Moldova posted the largest escalation in prices. In Hungary and Latvia, prices were up 3 percentage points; inflation in Hungary is being driven by increases in indirect taxes and administered prices and in Latvia by rapid credit expansion tied to vibrant capital inflows. In Azerbaijan, inflation is expected to rise to 16 percent in 2007, double the rate of 2006; in Ukraine and Uzbekistan inflation is expected to average 17.5 and 17.0 percent, respectively.

In several countries, however, inflationary pressure has eased. In Romania, consumer prices fell from 6.6 percent during 2006 to 4.6 percent in 2007, thanks to currency appreciation and a delay in regulated price adjustments. The Slovak Republic is also projected to see an easing of inflation of some 2 percentage points. Tighter domestic conditions and exchange rate appreciation helped moderate inflationary pressures in Croatia, Kazakhstan, and Turkey during the year. Nonetheless, inflation pressures are expected to rekindle, in part reflecting higher food prices and energy costs, which are affecting a wide spectrum of countries. The impact of market turbulence tied to the U.S. subprime mortgage market has been fairly limited in the region, and initial downside adjustments in currency and asset prices have largely been recouped. Bond spreads increased, but not as much as in other markets. Nevertheless, concerns about potential spillovers remain
for a number of countries in the region, particularly those that have experienced rapid credit growth and private sector borrowing from abroad, the proportions of which may be underestimated. Signs of overheating are clearly evident in Bulgaria and the Baltic states, where already worrisome external positions have deteriorated even further during 2007. Given that foreign inflows are financing much of the credit expansion in these economies, increased market volatility points to heightened concerns in relation to currency mismatches, sudden stops, and contagion. A potential exchange rate risk is present in a number of countries where loans denominated in foreign currencies make up a large share of total loans by domestic banks. In the Baltic states, Hungary, Kazakhstan, Romania, and Ukraine, this ratio was 40 percent or more in 2006, and in the case of Latvia, the share increased by more than 15 percentage points since 2001 to nearly 80 percent in 2006.

Medium-term outlook

From GDP gains of 6.7 percent in 2007, growth is projected to continue easing, falling off to 6.1 percent in 2008 and to 5.7 percent in 2009. The slowdown in 2008 is expected to be widespread across countries in the region, given heightened risk aversion and volatility on international financial markets, which could spill over to the region both directly and also indirectly through a faltering of external demand. Slower growth in the OECD countries, especially in Germany and the Euro Area, may dampen export growth for CEE during the year. Difficulties among European financial institutions would also have repercussions throughout Europe and Central Asia.

Domestic demand growth is anticipated to moderate from recent highs, with the contribution to growth from both private consumption and investment projected to fall by 0.2 percentage points during 2008. The contribution of trade to growth—reflecting weakened external demand, and despite a degree of softening import growth—is expected to become still more negative in 2008. Three notable exceptions to the projected growth slowdown in 2008 are Albania, Hungary, and Turkey. In Albania, continued strong domestic demand is expected to help firm up growth. A key component of that demand is increased public investment to mitigate the power shortages that have created a bottleneck to growth. In Hungary and Turkey, improvements in domestic conditions should permit additional easing of monetary policy, bolstering demand sufficiently to bring about a pickup in GDP growth. By 2009, external demand is projected to strengthen in concert with GDP growth in the OECD, leading to an improvement in contributions to growth from net exports, equivalent to 1.9 percentage points in 2009 (following a drop by 2.3 percentage points in 2008).

A further falloff in domestic demand growth; particularly the investment in the CIS countries, is projected to offset this improvement somewhat, resulting in modest deceleration in regional growth to 5.7 percent in 2009. In large measure, the projected slowdown in the CIS is driven by the near completion of major hydrocarbon investment projects that led to the expansion of production and export capacity in recent years. Despite a rise in external demand and continued moderation in domestic demand, the regional current account is anticipated to continue to deteriorate through 2009, largely because of declines in the terms of trade for hydrocarbon-exporting countries as oil prices begin to soften. Inflationary pressures are likely to ease over the medium term, with median GDP inflation coming down from 6.9 percent in 2007 to 6.4 percent in 2008 and 5.5 percent in 2009. This decline is tied to generally tighter credit conditions in both international and domestic markets. However, this somewhat sanguine picture masks an expected rise in inflation pressures in Belarus and Georgia and slower progress toward stabilization of consumer price inflation among oil exporters (as well as in Moldova and Ukraine) because of strong demand pressures. Among the new EU member countries, only the Slovak Republic is anticipated to join the Euro Area in the coming years following Slovenia’s entry in 2007.

Risks

Downside risks to regional growth are tied to potential overheating and a sudden unwinding of large external imbalances. The presence of large foreign banks in several countries in the region, and the fact that many of these countries share common creditors and investors, appears to expose them to higher contagion risk in the event of a nondiscriminatory pullout, similar to what occurred in East Asia in 1997. In particular, large current account deficits (equivalent to about 12 percent or more as a share of GDP) in Bulgaria, Georgia, Latvia, Lithuania, and Romania remain a concern. Risks to growth are also associated with the slowing of reform momentum in the new EU member states and other countries in CEE. In the CIS, slow progress with economic reforms and only gradual diversification from commodity market dependence remain a concern, pointing to slower medium-term growth prospects. And a more protracted workout of the housing situation in the United States and associated financial distortions there and in other OECD markets present a substantial downside risk.

Higher than anticipated oil prices also present risk for energy-importing countries in the form of higher import bills and increased inflationary pressures. With respect to the latter, while countries with free-floating currency regimes in CEE have direct policy levers to manage inflationary pressures, those with currencies pegged to the euro, such as the Baltic states and Bulgaria, have more limited options. Higher than projected grain prices could also lead to increased inflationary pressures, particularly among the low-income countries, where food expenditures represent a large share of consumption.

Despite gains in a number of Millennium Development Goal indicators, some countries in the region, particularly in Central Asia and the Caucasus, have shown regressing trends and slower progress toward achieving the goals. The Caucasus have met the goals related to carbon emissions and primary education, but concerns remain about the nonincome poverty indicators, such as malnutrition, access to tertiary education, HIV/AIDS, the environment, and soil and water management.