Macroeconomic overview

Growth performance in south-eastern Europe (SEE) has been mixed, despite an improving external environment. On balance, the region has showed considerable resilience in the face of country-specific negative shocks, such as the severe floods seen in Bosnia and Herzegovina and Serbia in mid-2014. Cyprus is continuing to perform well under its bailout programme (which has been in place since April 2013) with contractions in output slowing significantly in 2014.

After six years of deep recession, Greece (a recipient member country of the EBRD since 2015) recorded marginally positive annual growth (of 0.8 per cent) in 2014. In 2015, however, uncertainty about the new government’s reform programme and its relations with international creditors dented investor and consumer confidence, leading to a steady outflow of deposits from the banking system. Matters came to a head in late June and early July when the government closed the country’s banks and imposed strict limits on cash withdrawals from ATMs, as well as wide-ranging capital controls. Greece also temporarily went into arrears on its payments to the International Monetary Fund (IMF). The situation eased in the second half of July when the EU agreed to a €7.2 billion bridging loan to Greece through the European Financial Stabilisation Mechanism, allowing Greece to clear its arrears with the IMF and make a scheduled bond payment to the ECB. The banks reopened on 20 July but the limits on withdrawals and capital controls remained in place.

The annual growth rate in Turkey fell to 2.9 per cent in 2014. The economy has continued to fall short of its growth potential in 2015, despite benefiting from the decline in oil prices, as expectations of monetary tightening in the United States, rising geopolitical tensions in the region, the perceived volatility of domestic politics in the wake of the parliamentary elections in June and weak investor sentiment have increased the country’s risk premium, while its export performance has been relatively modest. Turkey’s persistent current account deficit narrowed somewhat in 2014, helped by declines in commodity prices, but remained large at 5.7 per cent of GDP.

The recovery in the SEMED region has gained momentum. Growth in Egypt, the region’s largest economy, has strengthened, driven by increases in private consumption and investment. Economic activity has benefited from policy reforms, a more stable political environment and – thanks to financing from the Gulf Cooperation Council – an accommodative fiscal policy. Elsewhere in the region the pace of recovery has been slower. Meanwhile, the region has continued to suffer from extremist attacks.

While the economic outlook has, on balance, strengthened somewhat in the CEB, SEE and SEMED regions, it has become substantially weaker in Russia, Central Asia and eastern Europe and the Caucasus (EEC). Russia’s output contracted in the first half of 2015, with declines in oil prices exacerbating structural problems in the economy and compounding the effect of economic sanctions imposed by the European Union, the United States and several other countries. Indeed, real wages and retail sales fell at a rate of almost 10 per cent in the first few months of 2015.

Declines in remittances and export demand from Russia, coupled with country-specific structural bottlenecks, led to a significant weakening of growth in the EEC region and Central Asia in late 2014 and the first half of 2015. Economic activity in Ukraine suffered further in the first half of 2015, reflecting a lack of investor and consumer confidence, the tightening of fiscal and monetary policies as part of the country’s macroeconomic adjustment and reform programme, ongoing discussions on external debt restructuring, increases in energy tariffs, bank failures and far-reaching changes in the banking sector.

The remainder of the macroeconomic overview looks in greater detail at the changes in the external environment and their impact on the economies of the region.

Most of the EBRD’s countries of operations have benefited directly from the decline in oil prices through reduced bills for energy imports and improvements in their terms of trade (that is to say, the average price of their exports in terms of the average price of their imports; see Chart M.1). The economies that have benefited most from declines in the price of hydrocarbons through reduced import bills include Cyprus, Greece, Jordan, the Kyrgyz Republic, Morocco and Turkey. In the CEB region energy import bills are estimated to have fallen by an average of around 2 per cent of GDP.

Countries in the SEMED region are also benefiting from fiscal savings as a result of reduced spending on explicit or implicit domestic energy subsidies. It is estimated that a 50 per cent decline in oil prices is associated with fiscal savings of between 1 and 3 per cent of GDP across the region. Moreover, lower oil prices provide a favourable environment for further reforms of subsidies – an important element of improving the sustainability of public finances in these countries in the medium term.

At the same time, while gains from reductions in oil prices are generally spread across numerous countries, the losses are concentrated in major exporters of oil and gas (Azerbaijan, Kazakhstan, Russia and Turkmenistan). The decline in oil prices has significantly weakened the economic outlook in these countries. In Russia, for example, declines in oil prices have compounded the effect of weak investor confidence in light of the economic sanctions imposed since March 2014, as well as structural problems in the economy.

While Azerbaijan and Kazakhstan are even more dependent on hydrocarbon exports than Russia (in terms of their contribution to total exports, government revenues and total value added), these economies have been able to accumulate substantial savings in special oil funds, creating the policy space necessary to deploy large-scale fiscal stimulus and thereby cushion the impact of reduced exports and fiscal revenues. In Russia, by contrast, the scope for fiscal loosening is limited by the relatively low level of fiscal reserves in the country’s stabilisation funds.

The recession in Russia has resulted in major negative spillover effects for many oil-importing economies in the EEC region and Central Asia which are heavily dependent on Russia for exports, investment and remittances (see the index measuring economic dependence on Russia and the accompanying discussion in the Transition Report 2014). In these countries the indirect effects of declining oil prices (through their impact on Russia) may more than offset any direct gains from improvements in their terms of trade.

In response, stock markets in the eurozone rallied and yields on sovereign bonds declined (temporarily turning negative in some cases) before recovering somewhat. The euro then depreciated further against the US dollar in June and July 2015 as the Greek crisis intensified.

Monetary conditions in eurozone countries and countries with close economic ties to the eurozone have softened following the implementation of quantitative easing. Cyprus, Estonia, Latvia, Lithuania, the Slovak Republic and Slovenia are all directly eligible for asset purchases under the programme (Lithuania being the latest transition country to join the eurozone, having done so on 1 January 2015). Greece may also become eligible as agreement has been reached with the European Commission, the ECB, the IMF and the European Stability Mechanism regarding a new bailout programme. Interest rates in many other countries in central Europe and the SEE region have declined, mirroring interest rates in the eurozone. Stock markets in these countries have also seen significant gains. For instance, equities in Hungary and Poland outperformed both the S&P benchmark and global emerging market benchmarks in the months that followed the announcement of quantitative easing.

In addition, most currencies in the CEB and SEE regions (as well as that of Turkey) have weakened against the US dollar, mirroring the euro (see Chart M.2). Weaker currencies (on a trade-weighted basis) and more accommodative monetary conditions should boost competitiveness in these economies. While many new EU member states have gained in competitiveness relative to the EU-15 economies since 2010 in terms of exchange rate-adjusted unit labour costs, a number of them (notably Bulgaria and the Baltic states) have been losing competitiveness (see Chart M.3).

At the same time, depreciating currencies can increase the cost of servicing debt denominated in US dollars. Turkey, in particular, may be affected by the rising burden of US dollar-denominated debt, while the depreciation of the euro – the currency of Turkey’s key trading partners – is limiting the competitiveness gains derived from the weaker lira.

As discussed in the Transition Report 2014, monetary tightening in the United States tends to reduce capital inflows in emerging markets (at least temporarily) and increase the volatility of such inflows. This reflects a perceived deterioration in the balance between the risks and rewards of investing in emerging markets when returns on investment in core advanced markets rise.

Flow data for mutual funds suggest that funds’ inflows and outflows are indeed strongly correlated across emerging markets in Asia, Latin America and Europe as they tend to be driven to a very significant extent by the global attitude to risk and monetary conditions in the United States.1 Furthermore, the volatility of monthly inflows in emerging markets (calculated as the average standard deviation of monthly flows to various countries, expressed as a percentage of GDP, over a five-month period) spiked when the forthcoming tapering of quantitative easing was first announced in June 2013 (see Chart M.4).

The actual tapering (that is to say, the reduction of the monthly purchases of assets by the Federal Reserve) did not start until January 2014 and it was well anticipated and largely priced in by the markets. Nevertheless, the volatility of flows to emerging markets spiked again (albeit less dramatically) when the Federal Reserve actually began tapering.

This episode suggests that capital flows to emerging markets are likely to become significantly more volatile once interest rates begin to rise, with reduced net inflows in emerging markets initially. Countries that rely heavily on capital flows other than foreign direct investment (FDI) for the financing of their current accounts (such as Turkey) will be particularly vulnerable if US interest rates rise more strongly than expected. A sell-off in China’s stock markets in August 2015 led to a sharp increase in volatility in the global financial markets. As a result, capital outflows from emerging markets appear to have intensified.

The sanctions imposed on Russia by the United States and the EU remain in place, as do the Russian counter-sanctions (bans on selected food imports from sanctioning countries). These sanctions, combined with uncertainty about their possible escalation in the future, have limited the ability of banks and firms to access international debt markets, contributed to an increase in net private capital outflows and negatively affected business confidence. If sanctions remain in place for a prolonged period of time, they may negatively affect innovation and technological modernisation in Russia, with a negative impact on productivity in the long term.

Geopolitical tensions are also affecting Turkey and the SEMED region, with the global and regional terrorist threat posed by Islamic State increasing in both Iraq (Turkey’s second largest export partner) and Syria. The weaker export environment and deteriorating market sentiment that have resulted from these tensions have all but offset the benefits of declining oil prices for Turkey’s economy. Pressure on the value of the country’s currency and equities has been compounded by the inconclusive results of the parliamentary elections in June and the military intervention against Kurdish and Islamic State positions in July 2015. Political tensions also remain high in Libya and terrorist attacks have hit the tourist industries of a number of countries in the region.

The SEMED countries that have been worst affected by this regional and domestic instability are Jordan and Tunisia. In Jordan, conflict in neighbouring Iraq and Syria has disrupted exports, including those to Turkey and Lebanon. Furthermore, Syrian refugees now account for nearly one-fifth of Jordan’s population. This massive influx of refugees has strained public services, government finances and labour markets. In Tunisia, on the other hand, the recent worsening of the domestic security environment is expected to weigh heavily on tourism and investment.

In contrast, inflation in Russia rose to around 15 per cent year-on-year in July 2015. This largely reflected a combination of the pass-through of import prices following the depreciation of the rouble and the impact of the ban on selected food imports that was imposed in 2014 on countries that placed economic sanctions on Russia. Currency depreciations also resulted in significant increases in inflation in the Kyrgyz Republic, Tajikistan and Ukraine. Meanwhile, inflation in Turkey is well above the central bank’s target for the fourth consecutive year as the depreciation of the lira has pushed up the prices of imported goods, offsetting the disinflationary impact of lower oil prices.

The decline in remittances from Russia to Central Asia and the EEC region has been particularly sharp. By early 2015 remittances were declining at rates similar to those observed in 2009 at the height of the crisis – by around 40 per cent year-on-year in US dollar terms (see Chart M.8). The impact of declining remittances has been particularly strong in Armenia, Moldova, the Kyrgyz Republic and Tajikistan, where remittances totalled between 20 and 50 per cent of GDP before the crisis (see also Box 2.4).

The decline in remittances reflects a combination of a weaker rouble and the return of a significant number of migrants to their home countries. Although data on actual migration flows are very patchy, hundreds of thousands of migrant workers are reported to have returned to Tajikistan, Uzbekistan and other countries in Central Asia and the EEC region.

Remittances have continued to rise in SEMED countries, where a significant percentage of remittances come from Gulf Cooperation Council countries and the United States.

Corporate bond issuance in the region has increased strongly since the 2008-09 crisis but from a very low base (see Chart M.10). As a result, overall volumes of outstanding bonds in the CEB and SEE regions, which total around 2 per cent of GDP, represent only a small fraction of the total stock of corporate bank credit. Consequently, the growth of bond financing has been unable to offset the negative or very weak loan growth seen in these economies. Furthermore, corporate bond issuance came to a halt in early 2015, reflecting weak capital flows to emerging markets more generally.

The recovery of credit remains constrained by high non-performing loan (NPL) ratios. Indeed, Chart M.11 shows that the growth of real bank credit has, on average, been substantially weaker in countries with persistently high NPL ratios. The analysis in Chapter 1 of this report shows that this relationship also holds over longer periods of time and in larger samples of countries. NPLs limit the willingness and ability of banks to lend to corporate and household clients. On the other hand, a lack of credit growth makes it more difficult for companies to refinance their debt or secure bridge financing in the event of temporary liquidity problems, thereby exacerbating NPL problems in an economy.

As a result of decisive action by regulators, NPL ratios have recently declined significantly in both Kazakhstan (following the very high levels observed in 2008-14) and Romania. In contrast, as Ukraine’s recession has deepened, its NPL ratio has risen rapidly, approaching 30 per cent. NPL ratios are estimated to be well in excess of 40 per cent in Cyprus and Greece, and close to 20 per cent in several other SEE countries, with even higher ratios in the case of corporate loans. The NPL ratio has also risen in Tunisia, where NPLs account for around 16 per cent of total loans, concentrated in state-owned banks. In addition, significant delays in passing laws to recapitalise and restructure public-sector banks and create an asset management company to absorb toxic assets are restricting the flow of fresh credit to businesses and holding back growth.