Melanie Averall, Kim Forkes, and Katrin Robeck of Moody's Economy.com -

Growing but still poor

Growth in established Western economies is slowing. A recession scenario in the US is increasingly likely. Growth in the Eurozone is expected to slow by four-tenths of a percentage point next year. Emerging markets are growing more important as contributors to global growth. One region attracting increased interest from investors is the western Balkans.

Croatia, Serbia, and Bosnia and Herzegovina have moved beyond regional war and are increasingly getting their economies into shape. Growth over the past few years has been rapid; however, there is still a long way to go. Croatia is the wealthiest of these nations, but its per capita GDP was still a mere 18% of the OECD average in 2006. Bosnia came in second, with a per capita GDP at 6% of the OECD average, followed by Serbia at 4%.

Real GDP growth rates have outpaced the EU25 average in recent times. The western Balkan economies grew between 5% and 7% last year, with activity accelerating in the first half of 2007. Sources of growth have been widespread, with exports a key driver, particularly for Croatia where they account for roughly half of GDP. This reflects increasing access to markets in the EU. Private consumption is also slowly rising, whilst government spending remains large and burdensome in all three countries.

Deficits and unemployment

Although export growth is strong, and trade is a key economic driver, each of these countries is burdened by large and growing current-account deficits. Foreign debts, raised via imports for manufacturing and final consumption, must be paid back in foreign currencies. In these western Balkan nations, where currencies do not freely float, monetary policy is a tricky balance between economic stability, growth, and inflation. For example, Bosnia's currency board restricts appreciation against the euro, so rapid economic growth produces inflation – 7.4% in 2006, twice the rate of 2005. Price growth was nearly 12% in Serbia last year, though this was down compared with 2005. Maintaining price stability is critical for foreign investors and domestic consumers alike.

Investment is essential for driving forward income conversion. As a share of GDP, only Serbia's investment growth was below the 21% EU25 average. In Croatia this was as high as 30%. Nevertheless, unemployment in the western Balkans remains high. The European Commission estimates the unemployment rate in Bosnia exceeded 30%, with Serbia's above 20% in 2006. Croatia's unemployment rate, in contrast, is close to Germany's 11%, which is clearly linked to its higher per capita GDP.

Yet macroeconomic conditions, including employment, are probably better than the data suggest. The region likely hosts large informal economies, and the gathering of good economic statistics is not yet a perfected art in these economies. Including the grey economy should improve the overall picture, as well as attracting investors, boosting government tax revenues and making monetary policy decisions less complicated. Yet whilst macro fundamentals are getting into shape on paper and on the ground, other important developments are required at the structural, political, and legal levels.

Business environment matters

Further development will hinge on political and institutional stability, and the evidence suggests the Balkans still have a long way to go in this regard. The Transparency International corruption perception index suggests that political and economic crime is still a large problem compared with the EU standard. Croatia has the highest standards among the western Balkans, but corruption remains a key stumbling block. The country's current EU accession talks should, however, provide a strong impetus for further reforms, and the recent election result suggests a commitment to completing entry.

The prospect of EU accession is also providing incentives for reform in Bosnia. The closing of the Office of the High Representative – an ad hoc international organisation established to mediate among Bosnia's ethnic groups after the war in 1995 – highlights the move toward closer integration with the EU. Once the office closes, full responsibility for their own national affairs was to be moved to Bosnia, and the EU was to step up integration efforts. Political stalemate has, however, delayed the process. Bosnia's leaders have been unable to agree on a number of basic reforms. If the country's constitution does not evolve to appease all sides, rapid progress toward EU membership remains unlikely.

Political gridlock hurts

In Serbia, the main risk to the realisation of the country's growth potential is still the unresolved issue about the status of Kosovo. After several inconclusive rounds of talks, Serbia and Kosovo are nowhere near a solution. Kosovo's Albanians will not accept anything but full independence, while Serbia is only willing to grant provincial autonomy. After several inconclusive rounds of talks, a solution is still not in sight. The deadline for the current round with the 'Kosovo Troika' – comprising Russia, the US and the EU – is December 10, when the group will report back to UN Secretary-General Ban Ki-moon. The current deadlock suggests the talks are unlikely to produce a compromise.

The unresolved disagreements among ethnic groups divert attention and effort away from necessary economic reforms and toward EU integration. In a worst-case scenario, growing tension might deter foreign direct investment, slowing job creation, knowledge transfer and the development of national infrastructure.

EU accession promised

Thus far, Croatia is the only western Balkan candidate country to start accession talks. In December 2005, the former Yugoslav Republic of Macedonia was granted the status of a candidate country, though a succession dialogue has yet to begin. All the other western Balkan countries of Albania, Bosnia and Herzegovina, Montenegro, and Serbia (including Kosovo) are potential candidate countries. The European Commission says it is committed to eventual EU membership for these countries, provided they fulfill the accession criteria. Yet the Commission is determined to see that each country meets rigorous standards to ensure its smooth absorption into the Union.

In terms of political stability and the establishment of democratic institutions, the situation has clearly improved across much of the region. Yet serious worries remain. According to EU Enlargement Commissioner Olli Rehn, recent elections were "conducted in a peaceful and orderly manner and largely in accordance with international standards." But the deadlock over the long-term status of Kosovo is proving a particularly disruptive force in the region. Regarding the economic criteria, most of the Balkans is transitioning well from their old centrally-planned systems toward market economies. Containing inflation and beginning structural reforms have been particularly important achievements in recent years. Nonetheless, current account deficits, unemployment and poverty remain notable problems. Many sectors remain underdeveloped, and foreign investment flows, while rising in the Balkans, still lag behind those in other formerly socialist economies of Central and Eastern Europe.

Despite the undeniable progress made across the Balkans, the criteria for EU accession are ultimately subjective. This is particularly true of the third criteria: acceptance of the EU law known as the acquis communautaire. Comprising thousands of pages of rules and regulations, this law is negotiated piece by piece with each new candidate for EU membership, and thus the standards for each nation may vary from its neighbours. For the newer and less developed EU candidates, such as those in the western Balkans, the process can become a never-ending struggle. This not only complicates the politics of EU accession; it also can diminish the incentive value of Union membership for nations struggling to establish political and economic institutions. There may be little reason to pursue a goal so vaguely defined.

Moreover, many of the rules in the acquis communautaire were designed to apply to fully developed Western European market economies; they not only are expensive to implement but may be inadvisable or inappropriate for transitioning or developing nations. For instance, some of the 35 chapters cover financial services that may not yet even exist in places such as the western Balkans. The EU would do better to move such issues down its to-do list, and make the achievement of fundamental political and economic stability its priority for the region.

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