Eastern Europe and the CIS are set to preserve their growth momentum in 2003 but risks are on the rise


UNECE releases its Economic Survey of Europe, 2003 No.1

"The considerable uncertainties surrounding the outlook for the global and west European economies, and not least the potential shock waves from a possible war in Iraq, cast a long shadow on the short-term outlook for eastern Europe and the CIS" stresses Mrs. Brigita Schmögnerová, Executive Secretary of the United Nations Economic Commission for Europe (UNECE) commenting on the latest issue of the Economic Survey for Europe just released by the UNECE. "At the same time, it must be acknowledged that the east European and CIS economies demonstrated surprising resilience to the global slowdown in 2001 and 2002, thanks to the strong growth of their domestic demand and, in several cases, their unexpectedly good export performance."

Despite some slowing down of activity in eastern Europe and the CIS in 2002, rates of economic growth in these regions remained generally higher than those in western Europe. Aggregate GDP in the CIS grew by 4.8 per cent in 2002 due to the still significant momentum from the previous year of rapid growth and a continuing boom in some of the Caucasian and central Asian countries (table 1.1.3). The growth of aggregate GDP in eastern Europe was lower (3.0 per cent) than in the CIS but was basically unchanged from the previous year. This fairly buoyant economic activity in eastern Europe and the CIS reflected in the first place a shift from external to domestic sources of growth: the enduring strength of domestic demand was one of the main factors that prevented a further weakening of output growth.

Such a pattern of growth, however, is a mixed blessing for the east European and CIS economies. On the one hand, the resilience of domestic demand is a sign of confidence in the future prospects of these economies on the part of both consumers and investors. This also reflects the considerable progress that some of these countries have made in their market reforms, as evidenced by the invitation to eight east European countries to join the European Union in 2004. But also in some of the CIS economies, several years of strong growth have contributed to rising incomes and levels of welfare of the population, which, in turn, have reinforced domestic support for economic activity.

On the other hand, reliance on domestic demand as the main engine of growth is unlikely to be sustainable since most of the region consists of small, open economies. With few exceptions, most east European and CIS economies are characterized by chronic and large current account deficits, accompanied in some cases by fiscal imbalances (the twin deficit problem); an excessive shift towards domestically-driven growth is clearly not an appropriate strategy for keeping these deficits in check.

Although changes in real net exports did not generally make a positive contribution to GDP growth in 2002, one of the surprising developments during the year was the strength of east European exports in the face of the persistent weakness of economic activity in western Europe: on average they grew faster than both western import demand and total world exports. Moreover, this was the second consecutive year of such relative strength, a consequence of which was an increase in the east European share of west European markets.

Several factors are likely to have contributed to this outcome. Since the start of economic transformation more than a decade ago, a number of east European economies have had massive inflows of FDI, a significant part of which have been undertaken by large, export-oriented multinational companies. These new and expanding capacities exploit the comparative advantages of these economies in low-cost labour (particularly, low-cost skilled labour) as well as their proximity to the major markets of western Europe. This fundamental competitive edge appears to have been one of the factors that allowed east European exporters to continue to gain export market share in some particular products despite the weakness of western demand.

In a period of global economic slowdown - as was the case in 2001 and 2002 - the importance of eastern Europe's comparative advantage may have been amplified by the global squeeze on profit margins, which has likely prompted multinationals to accelerate the relocation of part of their global production volumes to lower cost countries, including some east European economies. At the same time eastern Europe itself is under pressure from countries offering even more competitive conditions for labour cost-saving or located nearer to other major markets, as suggested by the recent relocation of some production lines from eastern Europe to destinations in south-east Asia.

Overall, the rising market shares of east European exporters are a medium-term development reflecting transition-related changes in the international division of labour. Due to the nature of their underlying comparative advantage and the existing differences in labour costs, the east European economies are likely to gain further market shares in west European and global markets in the short- to medium-run. In the longer run, however, comparative advantage is not static and as development and income levels in eastern Europe start to catch up with those in the industrialised countries, new sources of international competitiveness will have to be developed via the accumulation of physical and human capital.

Despite the generally unfavourable external environment, net capital flows into eastern Europe generally rose in 2002, largely due to changes in international investors' perception of relative risk in emerging markets. The upturn reflects changes in two main flows: larger volumes of FDI, and a surge in short-term capital flows which, in net terms, changed direction from 2001. At the same time, privatization, which has been a major attraction for FDI in eastern Europe in recent years and an important source of financing of current account deficits, is nearing its end in most of these countries. The elimination of this convenient source of financing implies the need for alternatives or for an adjustment in the external balances of some countries.

On balance, the downside risks, which have been escalating steadily since the final months of 2002 and the beginning of 2003, are probably not fully acknowledged in the official forecasts for the year (table 1.1.3), some of which were formulated last autumn in the context of preparing the 2003 budgets. The widening fiscal imbalances in some central European economies also pose a risk to their future growth. The countries acceding to the EU will need to make additional fiscal adjustment in order to comply with the EU's fiscal rules. The required fiscal tightening will inevitably restrain growth of domestic demand and hence overall economic growth in these countries.

Although some governments have recently lowered their forecasts, the official outlook for most countries in eastern Europe and the CIS remains fairly optimistic about growth prospects in 2003. These forecasts imply aggregate real GDP growth in eastern Europe of close to 4 per cent in 2003 and in the CIS by almost 4½ per cent. In Poland, after a sharp downturn in 2001 and a slow recovery in 2002, the budget for 2003 is based on the assumption that recovery will gain momentum in 2003 with GDP growing by 3.5 per cent; most independent analysts, however, envisage GDP growth in the range of 2 to 3 per cent. In the other central European countries (the Czech Republic, Hungary, Slovakia and Slovenia), GDP growth in 2003 is expected to remain relatively moderate, between 3 and 4 per cent. By contrast, strong growth (with GDP rising by some 5-5½ per cent) is expected to continue in 2003 in the three Baltic states, the fastest growing region of eastern Europe for the last three years. Moderate to strong growth (with GDP increasing in most cases by some 4 to 5 per cent) is forecast for the majority of the south-east European economies but the economic situation - as well as the risks to the outlook - differ considerably across countries.

Russia's budget for 2003 was based on a set of macroeconomic projections whereby, under different assumptions about the external environment (in the first place, the price of crude oil) the rate of GDP growth was expected to be in a range of between 3.5 and 4.4 per cent. The most recent forecasts by independent analysts are even more optimistic, suggesting GDP growth of between 4 and 5 per cent. However, recent developments do not point in the same direction. Thus, while world oil prices surged to a two-year high in the early months of 2003 (a development which will benefit both Russian exporters and the economy at large), the significant weakening of the dollar (in which oil is priced) against other major currencies is likely to be detrimental. While the policy of moderate real exchange rate appreciation has facilitated Russia's recent disinflation, it is also likely to have contributed to the slowdown in industrial output in the last quarter of 2002. These somewhat conflicting trends indicate the uncertainties that surround the short-term outlook for the Russian economy.

Ukraine's recovery also lost some momentum in 2002 and GDP growth is expected to remain moderate (at some 4 per cent) in 2003. Apart from the weakening demand for Ukrainian exports in both Russia and western markets, this reflects a continued tightening of monetary policy with the central bank focusing its efforts on achieving a fast rate of disinflation. Some moderation in GDP growth is also expected in Kazakhstan but, according to official forecasts, GDP should nevertheless grow by some 6 per cent in 2003, underpinned not only by the strength of the oil-related industries but also by a continuing recovery in other sectors of the economy. Moderate to high rates of GDP growth are expected elsewhere in the CIS in 2003, with official forecasts ranging between 4 and 7 per cent (table 1.1.3).

UNECE Economic Analysis Division

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Ref: ECE/GEN/03/P04