Southeast Europe leads in reform of region's transition economies

By bne IntelliNews November 23, 2007

Dominic Swire in Prague -

Reform of the transitional economies of Central and Eastern Europe continues at breakneck speed, with the countries in Southeast Europe moving fastest, the European Bank of Reconstruction and Development (EBRD) said in a recent report that covers the 29 economies into which it invests.

Competitive wage levels along with an improving economic and institutional framework are the main drivers behind economic growth in the region, according to the report entitled "People in Transition 2007." Investor sentiment has also been buoyed by the increased prospects of a number of Southeast European countries joining the EU. However, there are still concerns about rapidly increasing inflation, the global credit crunch and large external imbalances that could threaten macro-economic and exchange-rate stability.

The EBRD forecasts the economies into which it invests will grow 6.1% next year, a slowdown from 7% this year - though that was the fastest rate of growth since the collapse of communism began in 1989.

The development bank said the rise in borrowing costs on international markets stemming from the sub-prime mortgage mess in the US could have the serendipitous effect of cooling some of the region's more overheated economies, such as in Bulgaria and Romania. However, a sharp rise in costs or a prolonged inability to borrow at all could have more drastic consequences for these countries running large current-account deficits.

The report singles out proximity to the EU as one of the main economic drivers for countries in the Western Balkans. Montenegro has signed a Stabilisation and Association Agreement with the bloc, the first step along the road to eventual membership. Croatia is already a long way down that road and looks likely to become the EU's next new member. The EU has also had significant influence in the reform of the legal framework and enforcement of competition policy in Macedonia, along with major reform in the telecommunications sector in Albania.

Shared optimism

Such optimism is shared in a recent report by UniCredit Group that says GDP growth in the region is unlikely to slow anytime soon and predicts a surge in the mortgage sector of 24% per year over the next two years.

Some of the best performers include Bosnia and Serbia, both of which are expected to maintain GDP growth of above 6% over the next two years. Romania, Bulgaria and Croatia are not far behind with a predicted 5-6% over the same period, according to UniCredit's estimates.

The report says the main force behind this strong performance is a rising level of consumption from an increasingly wealthy population which is striving to catch up with the lifestyle of their Western neighbours. "Consumption is marked by fast income growth and improved access to the credit market. This is also supported by a wealth effect arising from fast growth of house prices," says Debora Revoltella, chief economist for CEE at UniCredit.

The growth is spurred by relatively low levels of durable goods ownership with only 30% of people in Southeast Europe owning a computer and just 40% owning a car, compared with EU averages of over 50%.

Filip Tesar, a research fellow at the Czech Institute of International Relations concurs. "The acquisition of status symbols such as houses, cars or clothing is still one of the important incentives for Southeastern Europeans," he says, noting that the building industry is also one of the main contributors to the high GDP growth in the region.

The growing middle class and booming housing market is reflected in the expansion of the Swedish furniture group IKEA. Often seen as a barometer of prosperity, IKEA is already in Romania and Turkey and has plans to enter the markets of Croatia and Slovenia within the next four years.

The expansion plans are unsurprising in light of the results from the firm's first store in Romania, which posted sales of €40m in its first six months, over 70% higher than expectations. The company is now looking to significantly raise its profile in the country by opening one store per year over the next six years.

However, Tesar warns not to get carried away with such figures. "The key sign of progress will be growth of competitive production in the Balkan countries, not the growth of imports," he says.

On the contrary, Tesar warns that increasing imports can actually be damaging to the region. In the case of Kosovo, he argues, it's a potential Catch-22 situation. "The main source of government revenues [in Kosovo] is import duties. Thus every attempt to restructure the economy means the government must cut off this main revenue source, but without this money it can not restructure," Tesar says.

Another major risk linked to the region is the large external imbalances many countries are running up. This is particularly worrying for Bosnia and Bulgaria, which are expected to run up deficits of up to 18% this year. Nevertheless, analysts are crossing their fingers that the reason behind these worrying statistics is the need to build up production capacity during the convergence process, which will hopefully transform into improved exports over time.

"Even at the peak of the US sub-prime mortgage crisis the stability of the exchange rates in SEE was never put into question by the market apart from an overdue correction of the Romanian leu from excessively strong levels," says Michael Palzer, head of communications at Raiffeisen Bank. "We see the high current-account deficits as a sign for the ongoing restructuring of the economies similar to the experience of the Central European countries in the late 1990s, early 2000s."

Investors in the region will be hoping he is right. Time will tell whether Southeast Europe is a bet worth putting your house on.

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