bne -

Both the European Bank for Reconstruction and Development and International Monetary Fund warned January 24 that the sovereign debt crisis in the Eurozone will take its toll on economic growth in Emerging Europe and the Commonwealth of Independent States this year.

Cutting its economic growth forecasts for 2012, the EBRD warned that contagion through the Western European banks in particular puts the economies of Eastern, Central and Southeast Europe, as well as the Caucasus, at risk of further slowdown.

The bank's Regional Economic Prospects report forecasts a baseline case in which growth across its 29-country region will slow significantly to an average 3.1% in 2012, from the 4.8% expected for 2011. It also revises the forecast for growth in Central Europe and the Baltics down to 1.4% from the 1.7% it predicted in October, whilst the expectation in Southeast Europe dropped 0.6% to 1%. The forecast for Eastern Europe and the Caucasus dropped to 2.6% from 3.2% in the autumn, whilst Turkey and Russia are kept unchanged at 2.5% and 4.2%, respectively.

However, this baseline case is based on no further deterioration in the Eurozone crisis. Therefore, the report refers to "substantial risks" to the scenario, with the effects of the Eurozone crisis to be channelled through the Western European banks that dominate so many of the markets to the east. With that in mind, the report backs up recent calls for a coordinated response from all parties to limit the impact of the eurozone crisis on the regions the EBRD covers. "The deep integration of [Emerging Europe's] banking sector with Eurozone-based banks, particularly if compounded by the re-emergence of uncoordinated national policies with negative cross-border spillovers," is a significant risk to the region's economic growth, says the EDRD report.

Whilst the baseline growth scenario assumes that deleveraging by international banks will be managed in a collective response - ie. the "Vienna 2.0" initiative that the EBRD has led efforts establish in recent weeks - there is no agreement yet from the responsible governments, banks and agencies that this will emerge.

The report frets that the effects of deleveraging are already being seen across the entire region. "Worryingly... Western bank deleveraging appears to be under way since the autumn," it says, adding that "[e]very country in Central Europe, the Baltic economies and all Balkan countries except Bulgaria had net bank-related cross- border outflows," suggesting, it says, that transmission of the Eurozone crisis to the region via bank subsidiaries may have already begun in the fall of 2011.

Erik Berglof, the EBRD's chief economist, said: "It is absolutely essential that we build a coordinated response to Western bank restructuring that fully takes into account the impact on eastern Europe. Any failure to do so would mean a significant set-back for the emerging economies."

The report also notes a divergence amongst the 29 countries it covers, pointing out that those closer to the epicentre of the crisis are likely to suffer significantly from the slowdown in the Eurozone, whilst the effects lessen as the ripples fade further out. Therefore, worries over recession in Hungary and Slovneia are set against "respectable growth" in Russia and other CIS countries that are less integrated with Europe. Elevated commodity prices will also help, the report adds.

IMF update

In an update to its World Economic Outlook also released on January 24, the IMF said that the Eurozone would fall into a mild recession in 2012 after the sovereign debt crisis entered a "perilous new phase" toward the end of last year, affecting other parts of the world including emerging markets, especially CEE.

The IMF now forecasts advanced economies to expand by just 1.2% in 2012 - a downward revision of 0.75 percentage points relative to the forecast last September - picking up to just 1.9% the following year. The global growth outlook for this year is 3.3%. "Given the depth of the 2009 recession, these growth rates are too sluggish to make a major dent in very high unemployment," the IMF said.

The IMF said growth in the Eurozone in 2012 was now forecast at -0.5%, a decrease of 1.6% relative to the IMF's September projection. In particular, it predicts negative growth of 2.2% in Italy and 1.7% in Spain. "The epicentre of the danger is Europe, but the rest of the world is increasingly affected," said Olivier Blanchard, the IMF's Economic Counsellor.

The adverse spill-over effects from the Eurozone crisis are expected to be the largest for CEE, given the region's strong trade and financial linkages with the Eurozone economies. It now expects CEE to grow just 1.1% (vs the 5.5% in 2011) and 2.4% in 2013. The CIS should grow 3.7% in 2011 and 3.8% in 2013, with Russia growing 3.3% and 3.5%.

The report said in 2012-13, growth in emerging and developing economies is expected to average 5.75% - a significant slowdown from the 6.75% growth registered in 2010-11, and about 0.5 percentage point lower than projected in the September report. This reflects the deterioration in the external environment, as well as the slowdown in domestic demand in key emerging economies. Despite a substantial downward revision of 0.75 percentage point, developing Asia is still projected to grow most rapidly at 7.5% on average in 2012-13.

Financial sector risks rise

The IMF also worries that global financial stability has moved deeply into the danger zone as sovereign bond spreads in the Eurozone have widened, and the European Central Bank has been forced to play an increasingly vital role in sustaining the Eurozone financial system. "Despite the efforts of European policymakers to contain the Eurozone debt crisis and related banking problems, a comprehensive and decisive policy response is still needed," the IMF said.

"European policymakers need to promptly put in place a comprehensive package that restores confidence, and need to implement the policy measures agreed at the October and December euro zone summits," said Jose Vinals, head of the Monetary and Capital Markets Department.