Recent developments

In 2007 Europe and Central Asia¹ achieved a remarkable 6.8 percent GDP advance, down moderately from 7.3 percent in 2006, against a background of global financial turmoil, rapid changes in commodity prices, and incipient slowing of demand in the Euro Area.
Growth was supported by robust domestic demand, whose contribution to regional growth peaked at 10.7 points in 2007.

Private consumption and fixed capital formation grew by 8 percent and 15.8 percent, respectively, during 2007.
At the same time, net exports asserted increasing drag on the region’s growth, from minus 0.6 points of growth in 2002 to almost minus 4 points by 2007, reflecting buoyant import demand that fostered a larger regional current account shortfall—and increasing dependence on foreign financing.

Both central and eastern European (CEE) and Commonwealth of Independent States (CIS) countries sustained double-digit growth in investment and imports, while private consumption growth exceeded 8 percent (see table below).

GDP growth for the CEE economies, at 6.1 percent during 2007, remained sturdy, but the group’s current account deficit spiked to a new high of 7.8 percent of GDP.
CIS countries, many of which are commodity exporters taking advantage of surging prices, recorded their second-strongest growth in a decade at 8.6 percent, to which domestic demand contributed 16.4 percentage points.

Commodity revenues have allowed strong expansionary fiscal policies in CIS countries, pushing wage and credit growth up.
Across the region, the growth situation has been diverse: while five countries enjoyed double-digit GDP advances, Hungary achieved a meager 1.3 percent gain (see figure on page 3 of this regional outlook).

Moreover, quarterly data show diverging trends: for some countries growth continued, some showed a gradual easing, and others Kazakhstan and the Baltic states) saw a sudden falloff in the final quarter of 2007.

Hungary has shown no sign of economic recovery since its fiscal austerity measures depressed domestic demand.
It appears more fragile than it did earlier, given its worrisome levels of public and external debt (about 70 percent and 90 percent of GDP, respectively) in the current unfavorable external environment.

Meanwhile, growth of three other Central European countries (the Czech Republic, Poland, and the Slovak Republic) accelerated into 2007.
The Slovak Republic’s 10.4 percent performance was especially notable.

The Baltic States are cooling: the end of real estate booms in all countries has turned the direction of concern from overheating to “hard landing.”
The abrupt slowing of growth in Latvia, from 10.9 percent year over year in the third quarter of 2007 to 3.6 percent during the first quarter of 2008, shows that the risk is significantly biased toward the downside.

Other economies tending toward overheating—Bulgaria and Romania—seem to have performed well during 2007, but they have become more vulnerable given difficulties in financing large current account deficits in an anxious global financial environment.
After experiencing a volatile exchange rate in mid-2006, Turkey tightened its monetary policy, which dampened domestic demand.

Growth dropped by more than 2 points and depressed import demand.
Still-strong export and investment growth supported 4.6 percent GDP gains in 2007.

Among CIS countries, the Russian Federation grew by a strong 8.1 percent during 2007; it retained that momentum into the first quarter of 2008, thanks in part to higher-than-expected oil prices, registering an 8 percent GDP advance year over year.
Russia’s budget surplus stood at 5.4 percent of GDP during 2007 and increased to 6.6 percent during the first quarter of 2008.

The country’s current account surplus rose to $37 billion in the quarter, up from $23 billion a year earlier.

Net FDI inflows to Russia reached $52 billion in 2007.
At the same time, the strength of domestic demand, rapid increases in liquidity, and hikes in food and fuel costs have seen inflation ramp up to 12.8 percent year over year in the first quarter—the highest rate in several years.

But Russia’s oil production advanced only 2.3 percent in volume terms during 2007, compared with average growth of 9 percent earlier this decade; natural gas production declined 0.5 percent during the year.
The current stagnancy in energy output may be attributable to an uncertain investment environment for foreign direct investment in energy, as well as high tax burdens on the sector: the overall tax burden on natural gas is 46 percent and is as much as 62 percent on crude petroleum.

A notable vulnerability facing the region is deteriorating current account deficits in many countries  (see figure on  page 3 of this regional outlook).
With the exception of CIS hydrocarbon exporters, almost all economies showed deterioration in current account balances during 2007.

The deficit has reached more than 10 percent of GDP in the Baltics, Bulgaria, Romania, Georgia, the Kyrgyz Republic, and Moldova, underscoring existing worries about unsustainable growth in several economies.
Substantial inflow of remittances to the smaller countries of the CIS, however (which in 2006 accounted for 18.3 percent of GDP in Armenia, 6.4 percent in Georgia, 27.4 percent in the Kyrgyz Republic, and 36.2 percent in Moldova), have helped to finance demand for imported goods.

Net FDI flows to the region established a record in 2007 but are expected to decline in 2008 due to the global credit crunch, covering a smaller portion of current account deficits.
Moreover, an increasing reliance on foreign bank borrowing suggests that should external finance dry up on the back of a sharp deterioration in international markets, households and businesses would be unable to roll over debts created by the current credit boom and would be forced to consolidate, with an ensuing—potentially substantial—drag on economic activity.

Contagion from high-income countries’ financial and real-side troubles to the region would be passed through the trade link and external financing, so the impact on the countries of Europe and Central Asia will differ depending on the country’s trading pattern and its reliance on external finance.
The region’s export growth is expected to be negatively affected particularly by an easing of import demand in the European Union in 2008.

This effect is likely to be more pronounced in the CEE (where a large portion of exports is shipped to the Euro Area) than in the CIS (where export destinations within the group, such as Russia, and emerging markets, such as China, remain resilient and commodity prices are projected to remain at elevated levels).

International investor perceptions of the apparent increase in risk in several countries in the region have been reflected in widening spreads on credit default swaps and government bonds for these countries.
Sovereign Emerging Markets Bond Index (EMBI) spreads widened across all countries since the start of the financial turmoil, peaked in March, and then declined slightly, but with much differentiation among them (see figure on page 3 of this regional outlook).

Between mid-2007 and the end of April 2008, spreads increased for Russia (63 basis points, or bp), Bulgaria (93bp), Hungary (95bp), Turkey (110bp), Ukraine (169bp), and Kazakhstan (270bp), in contrast with Poland (42bp), which has recently displayed stronger fundamentals and less reliance on external financing.