South East Europe Regular Economic Report No. 3: From Double-Dip Recession to Accelerated Reform

After two years of fragile recovery from the global recession, as a group the six South East European countries (SEE6) – Albania, Bosnia and Herzegovina (BIH), Kosovo, FYR Macedonia, Montenegro, and Serbia – are experiencing a double-dip recession in 2012. Deteriorating external conditions, the impact of the severe winter on economic activity, and a continuing rise in unemployment early in the year took a toll on consumption, investments, and exports. The risks noted in the June report have materialized. Credit recovery and fiscal consolidation are under threat. Nonperforming loans (NPLs) – thought to be stabilizing only a few months ago – are again on the rise. As a result, both within and outside the region the environment has become much more difficult to navigate, and the policy trade-offs necessary to stabilize economies and reignite growth are tougher. After growing by about 2 percent annually in 2010-11, the combined real GDP of SEE6 will shrink -0.6 percent in 2012, with real output in Serbia declining by as much as 2 percent. Also, it is now clear that even in the best of circumstances, the road to sustained recovery will be arduous: growth in 2013 is now expected to average 1.6 percent and the risks may be formidable. Among the clouds on the horizon for 2013 are the global impact of the U.S. “fiscal cliff,” the uncertain recovery of the Eurozone, and high commodity prices – risks to which all the SEE6 countries are highly vulnerable. Also worrisome for its households is the risk of a new food price shock, which could exacerbate poverty and put pressure on the middle class. In this fragile environment, Serbia, Albania, and Montenegro in particular will need to persevere in reducing fiscal deficits and bringing down debt, even as they must continue to improve the investment climate and reform labor markets and the public sector. In all SEE6 countries, public sector arrears pose special challenges to fiscal management and the private sector, and there are unfinished, structural reforms agendas. After two years of deep crisis, a sluggish recovery, rising unemployment and poverty, and a continuing recession – even with the best efforts on fiscal consolidation and structural reforms, which must continue – there is a danger that SEE6 countries are caught in a vicious circle that reinforces the cycle of long-term austerity, low if not negative growth, high debt, and even higher risks of social upheaval. To prevent this outcome, this report argues, SEE6 governments need to redouble their efforts to accelerate fiscal and structural reforms. These countries have largely exhausted their fiscal space and reduced public investment (except Kosovo, an outlier) to a fraction of what is needed to maintain public capital stock in critical infrastructure. Private investment is suppressed by the lack of productive, complementary public investments, slow credit recovery, and depressed domestic demand. External demand is minimal, and exports are not only too few, they are prevented from becoming an immediate, new engine of growth by infrastructure, finance, and other deficiencies. What is needed first and foremost, this report argues, is more intensive policy reform to reduce public debt and accelerate structural reforms, especially in public sector governance, the investment climate, and labor markets. Given their vulnerabilities, the SEE6 countries could also better prepare for new food price shocks. If such accelerated reforms materialize, external support – well-coordinated and targeting the region as a whole, not just individual countries – from the EU and global international financial institutions (IFIs) could help ease the transition to a more sustained growth in medium term. In November 2012, the European Investment Bank, the European Bank for Reconstruction and Development, and the World Bank announced €30 billion in financing for Central and South East European countries over the next two years. In SEE6 countries, this timely initiative would likely be delivered via the Western Balkans Investment Framework (WBIF) and other IFI resources. IPA resources will also be important, especially in supporting institutional reform and rural development. By focusing on major infrastructure of regional significance (rail, highways, energy, and gas) and on jobs and small and medium enterprises, the efficiency of investments, growth, and employment could be substantially heightened. However, additional financing for growth and jobs could prove effective only if accompanied by intensified fiscal and structural reforms, especially in the areas of investment climate, labor markets, and governance.