Slow Road to Recovery

Abstract

The South East Europe (SEE6) region exited from recession in the first half of 2013, supported by a nascent recovery in the Euro area. Industry – especially manufacturing exports and energy – drove the recovery. The region experienced a welcome surge in exports in 2013, particularly car exports from Serbia. Favorable weather conditions supported a strong contribution of agricultural output to economic growth and helped weaken inflationary pressures. However, domestic demand remained depressed in most of the region, reflecting high unemployment, sluggish growth of household incomes and credit, and a difficult investment climate. Only in Kosovo and FYR Macedonia did public investment contribute to some strengthening of domestic demand. Beyond these short-term factors, a slowdown in productivity growth and rising unit labor costs adversely affected economic growth, lowering competitiveness and demand for labor.

Unemployment in the region, at about 24 percent on average, began to decline in the first half of 2013 from its peak crisis levels. While employment grew in Albania, FYR Macedonia and Montenegro, it remained depressed in Serbia and Bosnia and Herzegovina. But even where employment has recovered meaningfully since 2010, the gains were not broad-based and mostly concentrated in services. [All SEE6 region-wide average aggregates are simple averages unless specifically noted otherwise.]

Near term economic growth will be too weak to support substantial gains in employment. As export performance strengthened and imports declined, current account balances narrowed. The gradual recovery in the Euro Area helped the combined (weighted average) goods exports of SEE6 to grow by close to 13 percent (year-on-year), making a strong positive contribution to overall economic growth. Export growth picked up everywhere, propelled by new foreign direct investment (FDI)-based export capacity. However, the sustainability of this high export growth is uncertain in view of the region’s narrow export base and competitiveness issues. Weak domestic demand depressed imports in all countries but Serbia, where their rise was led by raw materials and parts used in export-oriented industries. FDI remained sluggish in SEE6, rising only by 0.7 percent of gross domestic product (GDP), but its share of financing of the current account increased. Remittances continued to be resilient overall, but the Greek crisis began to take its toll, especially on Albania.

Foreign banks’ deleveraging from SEE6, rising non-performing loans (NPLs) and weak credit growth underpinned the need for vigorous reforms to reduce vulnerabilities in the financial sector. European banks continued to deleverage and reduced their exposure to the SEE6 region. With the aim of improving their resilience and supervisory capacity, the SEE6 countries made some progress in implementing banking reforms over the past year. Banks remained well-capitalized with actual capital-adequacy ratios above the regulators’ requirements in all six countries. Liquidity was high at 25-35 percent of total assets. However, NPLs reached worrisome levels at above 20 percent of total loans in Albania and Serbia and about 18 percent in Montenegro. Their rise stemmed from the sluggish state of the economy, weak insolvency regimes and widespread payment indiscipline in the private sector, exacerbated by public sector arrears to businesses in some of the SEE6 countries. In this environment, despite ample liquidity and cuts in policy rates, banks remained reluctant to extend new loans. As a result, credit growth slowed in most SEE6 countries.

Fiscal deficits remained high and public debt increased in 2013. The SEE6 average fiscal deficit is expected to remain at elevated levels at 4.2 percent of GDP in 2013 (compared to 4.1 percent of GDP in 2012). Structural rigidities in public expenditures, the weak tax base, and depressed fiscal revenues contributed to this outcome. Despite some fiscal consolidation efforts, the SEE6 governments did not address key rigidities such as the high public sector wage bill (averaging over 9 percent of GDP) and the poorly targeted social transfers (at 12.5 percent of GDP on average). As a result, the pace of the fiscal adjustment remained insufficient to reverse the adverse debt dynamics in some countries. Average public debt increased in SEE6 and is expected to reach 45 percent of GDP by end- 2013, from 42 percent a year earlier. Public debt remained at above 60 percent of GDP in Albania, Montenegro, and Serbia.

Growth Outlook and Risks: With depressed domestic demand, uncertain export prospects, and significant external risks, the SEE6 short-term outlook remains frail (Table 1). After the bounce-back of the regional economy in the first half of 2013 and taking into account the latest high-frequency data, economic growth for the year is expected be around 1.8 percent. Net exports will continue to drive growth in SEE6 in the short term. However, given the limited export base of the SEE6 economies and the uncertain new FDI-driven export capacity, sustained export-led recovery is by no means assured. Much depends on a lasting recovery of external demand. In contrast, unfavorable labor market conditions, a poor investment climate, and difficult credit conditions that depress consumption and investment will keep a lid on the overall economic activity. Therefore, weighted real GDP of the SEE6 region is now expected to grow 1.8 percent in 2014, about one percentage point less than the earlier, mid-2013 estimate. The slowdown is driven by the Serbian economy, which is now expected to expand by only 1 percent in 2014 (compared to a 2 percent mid-2013 estimate) because of the planned fiscal consolidation and a declining private consumption. In contrast to Serbia, economic growth in the other five SEE countries is expected to firm up in 2014 and exceed the pace of economic expansion of 2013.

Risks to the SEE6 near-term outlook are on the downside. Main external risks relate to the pace of the increase in global interest rates and sovereign borrowing costs arising from a possible tapering of quantitative easing in the U.S.; the Euro Area recovery; and deleveraging and the potential exit of parent banks from the SEE6 countries. Internal risks relate to “reform fatigue” that may delay policy implementation, and daunting fiscal and debt challenges in several countries. Also, slow resolution of NPLs, arrears accumulation in some countries, and depressed credit growth could further dampen prospects for growth.

Beyond this difficult short-term horizon, how can SEE6 raise their longer-term growth prospects? While maintaining macroeconomic stability remains a top policy priority, structural reforms will have to be pursued with vigor. The nascent export-led growth of 2013 is a positive development, but sustaining it will be a challenge. In addition to the need to improve their fiscal positions, reduce public debts, and strengthen banking systems, SEE6 face significant structural challenges in improving productivity and competitiveness, including in the areas of the investment climate, the labor market, and the public sector.

Keywords: South East Europe, Western Balkans, macroeconomic policy, economic outlook, fiscal policy, business environment

JEL Classification: O52, O57, P52, E6