Economies in Transition

Country Forecast
Economies in transition
Eastern Europe and the former Soviet Union
Regional overview
September 2006
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Economies in transition: Regional overview 1
Country Forecast September 2006 www.eiu.com © The Economist IntelligenceUnit Limited 2006
Contents
2 Fact sheet
3 Summary
3 Financial sector development and growth
3 Political outlook
3 Economic forecast
3 Business environment rankings
4 The subregions
5 Financial sector development and economic growth in transition
economies
5 Introduction
5 Patterns of growth
6 Sources of growth
9 Financial sectors in transition
12 Empirical results
17 Conclusions
20 Political outlook
24 Further EU enlargement
27 Economic forecast
29 Short-term outlook
35 Inflation
36 External sector
38 Foreign direct investment
43 EMU membership
49 The long-term outlook
53 Business environment rankings
55 Articles from previous issues
58 Data summary
61 Guide to the business rankings model
62 List of indicators in the business rankings model

2 Economies in transition: Regional overview
Fact sheet
Annual data 2005 Historical averages (%) 2001-05
Population (m) 405.7a Population growth -0.2a
GDP (US$ bn; market exchange rates) 1,868 Real GDP growth 4.9
GDP (US$ bn; PPP) 3,788 Inflation (av) 8.3
GDP per head (US$; market exchange rates) 4,600 Current account balance (US$ bn) 15.6
GDP per head (US$; PPP) 9,760 FDI inflows/GDP 3.6
a Economist Intelligence Unit estimate.
Background: Political developments since 1989 have been dominated by the break-up of the former communist federations
and the move to multiparty parliamentary democracy. The economic transition of the east-central European countries
(Poland, Hungary, Slovenia, the Czech Republic and Slovakia) has generally proceeded more smoothly than elsewhere in
the region. The effects of war in former Yugoslavia and a slower pace of reform have determined developments in south-
eastern Europe. Political democratisation has proceeded slowly and unevenly in many former Soviet republics.
Political structure: Democratic traditions are weak in most countries in the region. The exceptions, nearly all of them in
central Europe, now have systems that approach west European practice. The communist period lasted much longer in the
former Soviet Union, and political developments in most parts of the region have been characterised by a drift
towards authoritarianism. The end of the cold war has led to open or latent disputes over boundaries and the position of
ethnic minorities.
Policy issues: The speed and extent of reform and of institutional change varies widely across the region. Countries with
proximity to Western markets and stable political outlooks have proceeded faster and more successfully with stabilisation,
liberalisation and privatisation. In parts of the Commonwealth of Independent States (CIS), the number of reform reversals
has increased since 1996. Although the post-1989 collapse in output ended by 2000, the average level of real GDP in the
region is still only around 95% of its 1989 level. The difficult tasks of financial sector reform and institution-building
represent the second stage of reforms. Institutional weaknesses, such as the weak rule of law and widespread corruption,
continue to plague much of the region.
Taxation: Most countries have carried out sweeping fiscal reforms, including the introduction of value-added tax (VAT) and
the overhaul of corporate and personal income-tax systems. Inadequate tax collection by central governments remains a
problem in many CIS and Balkan states.
Foreign trade: The collapse of the Council for Mutual Economic Assistance (CMEA, or Comecon) and the break-up of the
Soviet Union disrupted trade and output patterns. Some countries have been successful in reorienting their trade to the
West. Attempts to promote trade and integration within the CIS have so far been largely unsuccessful. Total merchandise
trade in the region in 2005 amounted to an estimated US$1.35trn. Because of the continuing large surplus in Russia, the
region's total current-account surplus in 2005 was an estimated US$43bn.
Exports (2005) US$ bn Imports (2005) US$ bn
East-central Europe 286.0 East-central Europe 292.6
Balkans 58.9 Balkans 97.3
Baltics 24.9 Baltics 32.6
CIS 345.9 CIS 216.6
Eastern Europe excl former Soviet Union 344.9 Eastern Europe excl former Soviet Union 389.9
Eastern Europe incl former Soviet Union 715.7 Eastern Europe incl former Soviet Union 639.1

Summary
Few empirical studies have looked specifically at the contribution of financial
sector development to transition economies' growth, although developed
financial markets have been generally assumed to be crucial to supporting
growth performance. An empirical exercise that relates GDP growth to a range
of variables finds some support for the proposition that financial sector
development—in particular the role of foreign-owned banks—had a significant
positive impact on transition economies' growth during the past decade.
The results of elections held in eastern Europe this year do not indicate any clear
shifts in regional trends or direction. Bulgaria and Romania are set to join the EU
on January 1st 2007 (at most there could have been a one-year delay until
January 2008), but this will be under the strictest conditions ever applied to new
members. Acrimonious negotiations on the final status of Kosovo appear to be
grinding towards an impasse and possible crisis. It is difficult to predict the
effects on developments in the wider region—not only in restive and resentful
Serbia, but also in Bosnia and Hercegovina (BiH), Macedonia and possibly
further afield. This is occurring when the EU's most effective instrument for
influencing developments in the region—the offer of EU membership—has been
seriously weakened by the anti-enlargement mood sweeping western Europe.
The short- and medium-term economic outlook for the transition region appears
good, despite the political uncertainty affecting many countries, with growth
averaging well above 5% per year in the forecast period of 2006-10. However,
there are risks to the baseline outlook, ranging from slow reform in much of the
Commonwealth of Independent States (CIS) to threats to the global outlook.
Risks are also associated with large external imbalances in some countries and
commodity dependence in the CIS. Across the region, rapid credit growth is a
sign of financial sector development, but it also raises concerns about financial
stability. Inflows of foreign direct investment (FDI) into eastern Europe reached a
record total of US$74.9bn in 2005. In 2006 FDI inflows are expected to increase
further to about US$79bn, before tailing off gradually in 2007-10 as major
privatisation programmes are completed. Despite its ambivalence towards FDI
in some sectors, Russia has emerged as the main FDI destination in the region.
East European business environments are expected to continue to improve over
the medium term. The intra-regional gap between the leading reformers and the
later-reforming countries will narrow.
Key indicators
Eastern Europea and CISb 2005 2006 2007 2008 2009 2010
Real GDP growthc (%) 5.6 6.4 5.7 5.2 4.8 4.6
Consumer price inflation (av; %) 9.0 7.1 7.0 6.1 5.5 5.2
Current-account balance (% of GDP) 2.5 2.8 1.9 0.9 -0.1 -1.2
a The Balkan states of Bulgaria, Croatia, Romania and Serbia and the eight new EU members in
east-central Europe and the Baltic states. b Russia, Kazakhstan, Ukraine and Azerbaijan.
c Weighted averages for the 16 countries.
Editors: Laza Kekic (editor); Stuart Hensel (consulting editor) Editorial closing date: September 15th 2006
All queries: Tel: (44.20) 7576 8000 E-mail: london@eiu.com Next report: Full schedule on www.eiu.com/schedule
Business environment
rankings
Economic forecast
Political outlook
Financial sector development
and growth

The subregions
The region comprises 28 countries as a result of the break-up of the Soviet, Yugoslav and Czechoslovak federations. Montenegro
became the region's latest and smallest independent state following an independence referendum on May 21st 2006. Based on
geographical and associated political criteria, four main subregions can be identified.
East-central Europe: Czech Republicab, Hungaryab, Polandab, Slovakiaab, Sloveniaab; Balkans: Albania, Bosnia and
Hercegovina, Bulgariaa, Croatiac, Macedonia, Montenegro, Romaniaa, Serbiaa; Baltics: Estoniaab, Latviaab, Lithuaniaab;
Commonwealth of Independent States (CIS): Russiaa, Ukrainea, Belarus, Moldova, Armenia, Azerbaijana, Georgia,
Kazakhstana, Kyrgyz Republic, Tajikistan, Turkmenistan, Uzbekistan
The articles and the Fact sheet refer to trends throughout the region. The medium-term economic forecast summary relates only
to east-central Europe, the Baltic states, four Balkan countries (Bulgaria, Croatia, Romania and Serbia), and four CIS countries
(Azerbaijan, Russia, Kazakhstan and Ukraine)
a Covered by individual Country Forecasts. b EU member state.
Basic data, 2005
Population
(m)
GDP per
heada
GDP per
headb
Real GDP
indexc
Growth
(av; %)d
Inflation
(av; %)d Exportse Importse
Current
accounte
East-central Europe 65.8 14,990 9,390 144.7 3.5 4.3 286.0 292.6 -19.2
Czech Republic 10.2 18,690 12,150 168.1 3.6 2.2 78.3 76.5 -2.5
Hungary 10.0 16,930 10,920 128.8 4.2 5.9 61.8 63.8 -8.0
Poland 38.2 12,940 7,940 148.6 3.0 2.7 95.8 98.5 -4.3
Slovakia 5.4 15,900 8,720 123.2 4.6 5.8 32.0 34.5 -4.1
Slovenia 2.0 23,160 17,200 135.3 3.4 5.5 18.0 19.3 -0.4
Balkans 53.0 7,960 4,020 90.0 5.2 8.5 58.9 97.3 -19.1
Albania 3.1 5,440 2,620 136.1 5.6 3.1 0.7 2.5 -0.6
Bosnia and
Hercegovina 3.9 6,130 2,560 76.9 5.0 1.8 2.6 7.5 -2.1
Bulgaria 7.7 9,150 3,480 97.2 4.9 5.3 11.7 17.1 -3.1
Croatia 4.6 12,190 8,620 97.9 4.7 2.7 9.0 18.3 -2.5
Macedonia 2.0 7,070 2,760 87.9 1.4 1.9 2.0 3.1 -0.1
Montenegro 0.6 6,710 3,290 67.1 0.0 10.8 0.5 1.2 -0.2
Romania 21.6 8,740 4,490 104.9 5.7 18.3 27.7 37.3 -8.4
Serbia 9.5 6,490f 3,230f 51.1f 5.5f 27.0f 4.6f 10.2f -2.1f
Baltics 7.1 14,280 7,710 106.9 7.8 2.7 24.9 32.6 -5.2
Estonia 1.3 16,310 9,740 126.1 7.6 3.5 7.8 9.6 -1.4
Latvia 2.3 12,920 6,860 106.9 8.1 4.0 5.3 8.3 -2.0
Lithuania 3.4 14,390 7,480 100.1 7.6 0.9 11.8 14.7 -1.8
CIS 279.8 8,230 3,510 84.0 6.8 11.0 345.9 216.6 86.3
Russia 143.4 11,010 5,320 84.0 6.1 14.8 243.6 125.3 83.6
Ukraine 46.7 6,930 1,770 58.0 7.7 8.0 35.0 36.2 2.5
Belarus 9.8 7,910 3,030 112.5 7.5 30.9 16.1 16.6 0.5
Moldova 4.0 2,540g 860g 45.5g 6.9g 10.1g 1.1g 2.3g -0.3g
Armenia 3.0 4,830 1,620 97.6 12.2 2.4 1.0 1.6 -0.2
Azerbaijan 8.4 5,210 1,490 77.5 13.5 4.5 7.6 4.3 0.2
Georgia 4.5 3,650 1,430 43.3 7.3 5.8 1.5 2.7 -0.8
Kazakhstan 15.2 8,300 3,660 103.8 10.3 7.1 28.3 18.0 -0.5
Kyrgyz Republic 5.1 2,000 480 85.2 3.7 4.1 0.7 1.1 -0.2
Tajikistan 6.8 1,270 330 54.7 9.4 15.7 1.1 1.4 0.0
Turkmenistan 6.5 6,290 980 129.1 12.0 8.5 4.9 3.6 0.3
Uzbekistan 26.3 1,990 480 109.8 4.6 14.2 4.9 3.5 1.3
Transition
economies total 405.7 9,760 4,600 95.6 4.9 8.3 715.7 639.1 42.8
a US$ at purchasing power parity. b US$ at market exchange rates. c 1989=100. d 2000-04. e US$ bn. f Data exclude Kosovo. g Data exclude the
Transdniestr region.

Financial sector development and economic growth
in transition economies
By Helios Padilla Mayer, Consultant to the European Investment Bank
This article investigates the role of financial sector development in explaining
economic growth during the transition. In recent years a large literature has
been built up that investigates the sources and patterns of growth during the
transition. Studies initially focused on the causes of the sharp decline in output
in the initial years of the transition, and later on the main driving forces of
recovery. Empirical investigations have assessed the impact on growth of initial
conditions at the start of transition, macroeconomic policies, privatisation and
other reforms, external conditions and other factors. Few studies have looked
specifically at the contribution of financial sector development to growth.
A growth accounting exercise to decompose the proximate sources of growth in
transition economies in 1990-94, 1995-99 and 2000-03 finds that growth in
physical capital and total factor productivity explain almost all of the growth
since the nadir of the transition recession in the mid-1990s.
It is hypothesised that effective and developed financial markets are crucial to
supporting the growth performance of transition economies, and that financial
sector development has played a significant role in facilitating increased
investment and physical capital growth, and the efficiency improvements
captured by the total factor productivity variable.
In the final part of the article, a cross-country empirical exercise that relates GDP
growth to a range of variables, including indicators of financial sector develop-
ment, examines the proposition of whether financial sector development has
had a significant positive impact on transition economies' growth.
We can distinguish between three phases of growth in the transition: 1990-94,
1995-99 and the period from 2000 (in the empirical analysis, data availability
dictates that we focus only on 2000-03 for this subperiod). During the first
phase of transition (1990-94) most economies experienced very steep declines
in GDP. In 1994 real output in the transition region as a whole was more than
one-third lower than its 1989 level. The rate of contraction varied from 12% in
east-central Europe (the Polish transition recession was the most short-lived,
only up to 1992) to 40% in the Commonwealth of Independent States (CIS).
Real GDP began to recover, in some cases strongly, in the second phase
(1995-99)—especially in the leading reformers of east-central Europe and the
Baltic states, despite the impact of the 1998 Russian financial crisis. In 1996 east-
central Europe recovered its 1989 level of output, although other subregions
remained well below their 1989 level.
Since 2000 recovery growth has spread to the entire region, including the
previously weakly performing Balkan and CIS economies. GDP growth has been
supported by buoyant private-sector activity and rapid growth in exports. High
rates of GDP growth since 2000 have occurred in many countries, despite the
Patterns of growth
Introduction

global economic slowdown in the early part of the decade. The strong oil-led
recovery in Russia has also had an important positive impact on many other CIS
states. By 2005 average output in the region was, however, still 4% below its 1989
level; Balkan real GDP was 10% below its 1989 level, and CIS output 16% below.
40
60
80
100
120
140
160
1989 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05
East-central Europe Balkans Baltics CIS
Real GDP trends
(1989=100)
Source: Economist Intelligence Unit.
We employ a standard growth accounting approach, based on the neoclassical
production function, to identify the main sources of growth during the various
transition subperiods. The level of output, Y, depends on the level of inputs—
physical capital, K, human capital, H, and labour, L—and the level of
technology, A.
The growth of output can be decomposed into the weighted growth of factor
inputs and a residual that reflects technological progress or total factor
productivity growth. Thus GY = a*GK + b*GH + c*GL + GA, where GY is growth
of real GDP, GK growth of the capital stock, GH growth in human capital and
GL growth of labour input. GA stands for the growth in total factor productivity.
Under certain assumptions, the shares of physical capital, labour and human
capital in income can be used to represent the weights a, b and c.
The variables for 1990-2003 for 26 transition economies (all except Bosnia and
Hercegovina—BiH—for which data were unavailable) were measured in the
following way. Output is represented by real GDP expressed in constant 1995
national prices. Since there are few official estimates of the physical capital stock
we use real investment growth rates as a proxy for growth rates of the physical
capital stock. Whole-economy employment levels are used to measure labour
input.1 An index based on the educational attainment of the workforce is used to
measure human capital. The index is constructed by expressing the educational
attainment (primary, secondary and tertiary levels of education) of the labour
force in each country as deviations from the sample mean.
1 Caution is called for when using employment data as a measure of labour input. The
more accurate measure would be hours worked, not a head-count. This is important since
both the business cycle and trend factors involve variations in average working hours.
Without a measure ofhours worked, the variation will be captured in the estimates oftotal
factor productivity growth. However, since data on hours worked are not available for all
countries, there is no alternative to usingnumbers ofemployed to measure labour input.
Sources of growth
Measurement

Table 1
Factor income shares, 1990-2003
Physical capital Labour Human capital
1990-94 1995-99 2000-03 1990-94 1995-99 2000-03 1990-94 1995-99 2000-03
East-central Europe 0.30 0.35 0.39 0.43 0.26 0.27 0.27 0.39 0.34
Balkans 0.26 0.27 0.32 0.41 0.11 0.42 0.33 0.62 0.26
Baltics 0.41 0.41 0.41 0.43 0.43 0.43 0.16 0.16 0.16
CIS 0.24 0.27 0.31 0.46 0.10 0.19 0.30 0.63 0.50
Source: Author's calculations.
In the absence of reliable or readily available data on factor income shares, many
growth accounting exercises simply assume values for the factor income shares/
weights (a, b and c) and also assume that these are the same across countries.
One way of estimating factor shares is to use the underlying production
function, and regress output on the factor inputs. We rely on this method only
in part. Dobrinsky (2001) presented data on capital income shares for the
transition economies. This was calculated on the basis of the share of the gross
operating surplus in gross output. We use Dobrinsky's approach to estimate the
capital income share for 1990-2003. This is combined with using panel
regressions that relate factor inputs to output in order to obtain estimates of
income shares for labour and human capital.
The results of our growth accounting exercise are presented in Table 2. In all
transition economies the contribution of human capital to economic growth in
all subperiods appears to have been negligible. Human capital growth rates
have been generally low during the transition. They have varied from an
annual average rate of 5% in the CIS countries, 3% in the east-central European
countries, and near to zero in the Baltic and Balkan countries. However, these
results may not be surprising, given the erosion of human capital endowments
from the initially relatively high levels inherited from the communist era (at
least in terms of educational attainment). In addition, many transition countries
have had a significant increase in tertiary education enrolment only in recent
years, and many of these additional students have not yet entered the labour
force. Therefore, it is expected that human capital will begin to have a more
significant impact on economic growth in the future.
The contribution of employment growth to economic growth has also been low,
and was negative in all country groups in 1990-94, and after that did not even
approach 1 percentage point. Under the communist regime, both participation
and employment rates were high. The initial output shock at the onset of transi-
tion was accompanied by a drastic adjustment and reflected in sharp declines in
participation and employment rates. State-owned enterprises in all transition
economies experienced large falls in employment and/or real wages in the early
1990s. In east-central Europe, the initial fall in industrial employment ranged
between 10% (in the Czech Republic and Poland) to over 20% (in Hungary).
In the early transition period investment was falling and physical capital contri-
buted negatively to economic growth. In 1995-99 physical capital made a strong
contribution to recovery in the leading reformers of east-central Europe and the
Baltics. From 2000 investment started to make a positive contribution to growth
in other subregions, which became more attractive for investment after the end
Contribution of human capital was
negligible

of the Balkan wars and owing to growing interest in oil and natural resources in
some CIS economies. Therefore, the growth in physical capital started to make a
significant contribution to economic growth in these subregions as well.
The contribution of total factor productivity to GDP growth is calculated as the
difference between real GDP growth and the weighted growth of factor inputs.
The contribution of total factor productivity to economic growth was negative
in 1990-94. It tended to increase throughout the period and became positive
and highly significant in all subregions, except the Balkans, in 2000-03. In east-
central Europe almost the entire annual average real GDP growth rate of 3% in
2000-03 can be explained by growth in total factor productivity. This probably
reflects the fact that this subregion was the most advanced in reform and thus
the region in which growth was most likely to be driven by improvements in
the efficiency of use of factor inputs.
Table 2
Sources of growth, 1990-2003
(percentage points of growth)
Real GDP growth Physical capital Labour force
1990-94 1995-99 2000-03 1990-94 1995-99 2000-03 1990-94 1995-99 2000-03
East-central Europe -2.32 3.67 2.98 -0.30 3.11 0.14 -1.34 0.05 -0.19
Czech Republic -2.62 0.85 2.41 -0.47 -0.31 2.04 -1.10 -0.49 0.03
Hungary -3.31 3.72 3.47 -0.03 4.66 -1.50 -3.09 0.23 0.02
Poland 1.03 5.42 2.05 -1.17 5.24 -2.40 -0.84 0.32 -0.31
Slovenia -4.99 4.10 4.13 -0.81 2.00 0.83 -0.95 0.13 -1.06
Slovakia -1.72 4.27 2.84 0.97 3.97 1.71 -0.72 0.07 0.35
Balkans -5.65 0.92 3.99 -0.21 0.69 3.44 -2.15 0.18 0.40
Baltics -11.93 4.74 6.97 -7.44 5.60 6.09 -0.96 -0.29 -0.89
Estonia -9.48 4.97 6.26 -6.69 2.27 4.99 -1.68 -0.81 -0.33
Latvia -12.88 5.00 7.30 -14.42 8.40 7.51 -1.12 -0.81 -0.07
Lithuania -13.44 4.25 7.36 -1.20 6.14 5.77 -0.08 0.76 -2.25
CIS -14.16 2.13 8.63 -4.89 0.46 4.68 -1.21 -0.24 0.13
Russia -10.28 -0.38 5.70 -6.18 -5.22 2.78 -1.31 -0.04 0.08
Ukraine -14.01 -3.87 7.92 -6.41 -1.38 3.35 -1.36 -0.21 -0.03
Human capital TFP
1990-94 1995-99 2000-03 1990-94 1995-99 2000-03
East-central Europe 0.02 0.41 0.21 -0.70 0.10 2.83
Czech Republic 0.28 0.15 0.18 -1.32 1.51 0.17
Hungary -0.03 0.70 0.80 -0.16 -1.88 4.14
Poland -0.03 0.70 0.80 3.07 -0.85 3.97
Slovenia -0.15 -0.07 -0.71 -3.07 2.04 5.07
Slovakia 0.03 0.56 -0.01 -2.00 -0.33 0.79
Balkans -0.07 0.53 -0.18 -3.11 -0.20 0.33
Baltics 0.00 0.03 0.01 -3.54 -0.60 1.76
Estonia 0.07 -0.04 -0.09 -1.18 3.55 1.69
Latvia -0.05 0.10 0.15 2.71 -2.68 -0.29
Lithuania -0.01 0.03 -0.04 -12.15 -2.67 3.88
CIS 0.15 0.24 0.06 -8.47 1.52 3.86
Russia 0.09 -0.62 -0.13 -2.88 5.51 2.97
Ukraine 0.09 0.71 -0.06 -6.32 -2.99 4.66
Source: Author's calculations.
Although a useful starting-point for at least identifying the proximate sources of
growth, the growth accounting framework cannot provide an explanation of
Total factor productivity increases begin
to drive growth

the underlying causes or drivers of growth (what explains factor accumulation
and total factor productivity growth). This is the case even if we abstract from
some of the measurement and methodological difficulties of growth accounting
exercises, which are especially acute in the context of the transition.
We hypothesise that financial sector development is likely to have played a
significant role in facilitating increased investment and physical capital growth,
and the efficiency improvements captured by the total factor productivity
variable. Before turning to our empirical exercise to test the hypothesis, we
briefly review in the next section the main aspects of financial sector
development of the transition economies.
The relationship between financial sector development and economic growth
has been the subject of much debate. A body of empirical work supports the
proposition that financial development contributes significantly to growth,
especially long-term growth—for example King and Levine (1993) and Levine
(1998). There is also some evidence to suggest that the link is stronger for
emerging markets—that is, less financially developed countries such as the
economies in transition. The channels of impact of financial sector
development on growth are varied and range from the mobilisation of savings
for investment to helping direct capital to its most profitable uses and thereby
boosting efficiency of the use of resources.
The creation of financial sectors compatible with a market economy was one of
the most difficult challenges for most transition economies—many of which
started practically from scratch in this respect. After the fall of the communist
regimes, transition economies needed capital to restructure the real economy. In
particular, state-owned enterprises had to modernise in order to compete in
international markets. Transition economies also needed the creation of new
enterprises that could provide basic consumer goods and services, but
entrepreneurs lacked access to start-up capital.
Most transition economies followed the same broad paradigm for the
transformation of their banking sector from the communist mono-bank system.
The standard model of financial reform involved the establishment of a two-
tier banking system, the abolition of restrictions on the internal convertibility of
money, liberalisation of interest rates, restructuring and privatisation of state
banks and their enterprise borrowers, and the entry of new private banks. At
the same time, the state had to take on the important new roles of providing
effective prudential regulation and supervision of banks.
There has been remarkable process in financial sector reform, although this pro-
gress has been uneven across regions, countries and market segments (Buiter and
Taci, 2003). There have been significant achievements in the privatisation and
restructuring of state banks in most transition economies; there has been exit by
failing institutions and entry and development of new domestic and foreign
banks; and the legal, supervisory and regulatory framework has improved,
supporting enhanced competition in the provision of banking services.
The pace and sequencing of reforms differed significantly across the transition
economies. In east-central Europe and the Baltic states, the state liberalised early
Financial sectors in transition
Remarkable progress in financial
reforms

the market for banking services and developed its capacity for effective
prudential supervision and regulation in step with the growing role of private
banks in the system. Elsewhere, the banking sector remained a source of directed
subsidised lending to politically well-connected, financially troubled enterprises.
Transition economies chose very different strategies for the method and speed
of privatisation of state-owned enterprises, including banks. Until 1993 or 1994
state banks still dominated the banking sector even in the advanced reforming
countries. In this period state-owned banks controlled more than 70% of
banking in Hungary, Poland and Slovakia, with the share of state banks lower
only in the Czech Republic and Estonia.
Table 3
The financial sector and transition
Asset share of state-
owned banks (%)
Asset share of foreign-
owned banks (%)
EBRD index of
banking reform
EBRD index of
non-bank financial
sector reform
1999 2004 1999 2004 1999 2005 1999 2005
East-central Europe 33.4 8.6 35.6 71.3 3.3 3.7 2.9 3.4
Czech Republic 41.2 2.9 38.4 84.9 3.3 4.0 3.0 3.7
Hungary 7.8 6.6 61.5 83.5 4.0 4.0 3.3 4.0
Poland 24.9 19.4 49.3 71.4 3.3 3.7 3.3 3.7
Slovakia 50.7 1.3 24.1 96.7 2.7 3.7 2.3 2.7
Slovenia 42.2 12.6 4.9 20.1 3.3 3.3 2.7 2.7
Balkans 55.6 13.5 23.0 63.5 2.3 3.1 1.7 2.1
Albania 81.1 51.9 18.9 47.1 2.0 2.7 1.7 1.7
Bosnia and Hercegovina 75.9 4.0 3.8 80.9 2.3 2.7 1.0 1.7
Bulgaria 50.5 2.3 42.8 81.6 2.7 3.7 2.0 2.3
Croatia 39.8 3.3 40.3 91.2 3.0 4.0 2.3 2.7
Macedonia 2.5 1.9 11.5 47.3 2.7 2.7 1.7 2.0
Romania 50.3 7.5 43.6 58.5 2.7 3.0 2.0 2.0
Serbia and Montenegro 89.0 23.4 0.4 37.7 1.0 2.7 1.0 2.0
Baltics 17.5 1.3 67.0 79.1 3.2 3.8 2.7 3.1
Estonia 7.9 0.0 89.8 98.0 3.7 4.0 3.0 3.3
Latvia 2.6 4.0 74.0 48.6 3.0 3.7 2.3 3.0
Lithuania 41.9 0.0 37.1 90.8 3.0 3.7 2.7 3.0
CIS 35.3 30.5 18.6 23.5 1.8 2.3 1.7 1.9
Russia n/a n/a 10.6 7.4 1.7 2.3 1.7 2.7
Ukraine 12.5 8.0 10.5 12.1 2.0 2.7 2.0 2.3
Belarus 66.6 70.2 2.9 20.0 1.0 1.7 2.0 2.0
Moldova 7.9 17.6 34.4 33.6 2.3 2.7 2.0 2.0
Armenia 3.5 0.0 44.3 56.7 2.3 2.7 2.0 2.0
Azerbaijan 82.5 56.1 4.4 5.8 2.0 2.3 1.7 1.7
Georgia 0.0 0.0 16.1 58.1 2.3 2.7 1.0 1.7
Kazakhstan 19.9 3.7 n/a 5.5 2.3 3.0 2.0 2.3
Kyrgyz Republic 25.8 4.1 16.5 70.1 2.0 2.3 2.0 2.0
Tajikistan 6.9 12.2 60.9 6.2 1.0 2.0 1.0 1.0
Turkmenistan 96.9 96.1 1.6 1.6 1.0 1.0 1.0 1.0
Uzbekistan 65.8 67.6 2.0 4.4 1.7 1.7 2.0 2.0
Transition economies 38.3 18.3 28.6 48.9 2.4 2.9 2.0 2.3
Memorandum item
New EU members 27.4 5.9 47.4 74.3 3.3 3.8 2.8 3.3
Note. The values of the EBRD indices range from 1 (no reform) to 4.3 (developed-country standards).
Source: EBRD, Transition Report, 2005.
Different privatisation strategies

Privatisation of the banking sector in the transition countries gained speed in
the mid-1990s. Over a period of a few years a drastic shift in ownership took
place. Whereas Hungary early on went for a quick sale of its banks to foreign
direct investors, Poland combined public offerings with management buyouts
and some placements with foreign strategic investors. The mass voucher
privatisation strategy of the Czech Republic and the resulting complex cross-
ownership structure of banks and enterprises led to persistent bank bailouts by
the government. The state retained a significant ownership in banks, and only
later opted for their sale to foreign strategic investors. By 1999 on average only
about one-third of banking assets remained in state hands in east-central
Europe and the CIS, and less than 20% in the Baltic states.
Large-scale privatisation was delayed in the Balkan countries. However,
Bulgaria, Croatia and Romania have made significant progress in privatisation
in recent years and the main remaining state-owned banks are in the process of
being privatised. Serbia and Macedonia have also made major progress with
bank sales to strategic investors. In some CIS countries, the government still
exerts a high degree of control over the banking sector (the exceptions are
Russia, Armenia, Kazakhstan and Tajikistan). Furthermore, the method of
privatisation has limited the gains from the ownership transformation. The
mass voucher privatisation in some CIS countries and the rapid creation of a
large number of small banks established by non-financial enterprises created
the twin problems of connected lending and excessive sectoral concentration of
bank loans.
Ongoing banking sector privatisation throughout most of the transition region
meant that by 2004 less than 20% of the region's banking assets were still in state
hands. In the new EU member states only about 6% of assets were still under
state ownership. In all, the extent of the transformation of ownership structures
in the banking sector in such a short space of time has been extraordinary.
In countries with underdeveloped financial systems such as the transition
economies, the role of foreign banks is likely to be particularly important. There
has been extensive penetration by foreign banks, which are modernising the
sector, improving efficiency and deepening financial intermediation.
Political as well as economic considerations explain the different country
experiences across the region regarding the scope and efficiency-enhancing
implications of foreign entry in the banking sector. By the beginning of this
decade foreigners had gained control of most of the assets of the banking sector
in east-central Europe (except for Slovenia) and the Baltic states. Hungary was
the first country to open its banking sector to foreign participation, but others
soon followed. The Czech Republic resisted foreign ownership of its larger
banks until the failure of several of those banks between 1996 and 1998
prompted the sale of all large banks to foreign strategic investors. Foreign entry
in the Balkan countries was initially slow, but has picked up markedly in recent
years (see Shinkman, 2004). In the CIS, the entry of foreign banks has been
restricted, with liberalisation a recent phenomenon.
Overall, however, foreign penetration of banking sectors gathered pace in most
countries after 2000, and by 2004 about 80% of bank assets in the Baltic states,
The role of foreign banks

70% in east-central Europe and 64% in the Balkans were in foreign hands. The
share has continued to increase since then. Only in the CIS is the average share
of foreign-owned bank assets still relatively low.
Despite the far-reaching change and financial sector reform over the past
decade, the banking sector still lags behind best practice as regards the scale and
scope of the provision of financial services. This is true even of most advanced
reformers in the region. The level of bank intermediation between domestic
savers and potential investors in the domestic real economy remains low. The
degree of development of non-banking financial institutions is less than that of
the banking system, as evidenced by the European Bank for Reconstruction and
Development (EBRD) indicators in Table 3. Despite considerable financial sector
reform, most transition economies thus display a lower degree of financial
deepening than market economies at similar levels of economic development.
Consumer credit has led the way in bank activity, and, despite continuing
problems of access to loans, enterprises in the region are also benefiting from
improved borrowing conditions and new products. The banks of the region
are likely to play an increasingly active role in the coming years. The ultimate
goal of strengthening and deepening the banking sectors of the region is, of
course, to spur faster economic growth.
There is an extensive empirical literature on growth in the transition—for
example, Fisher et al. (1997); Berg et al. (1999); Havrylyshyn et al. (1999 and
2000); Campos and Coricelli (2002); Falcetti et al. (2005). Most of these studies
use cross-section regressions, looking at average growth across the transition
countries in a given period. Some studies have used panel regressions, in which
cross-section and time-series observations are combined.
Most empirical studies have confirmed that standard growth model
assumptions perform poorly in explaining growth patterns during the unique
and turbulent period of the transition. Instead ad hoc approaches have
attempted to assess the impact on growth of initial conditions at the start of
transition, macroeconomic policies, privatisation and other reforms, external
conditions and other factors.
Few studies have looked specifically at the contribution of financial sector
development to growth. A rare exception is a study by Andriesz, Asteriou and
Pilbeam (2003), which examined Polish experience from 1990 to 2002 and
showed that financial liberalisation had a positive impact on economic growth.
They measured financial liberalisation with the EBRD indices of banking
reform, reform of non-banking financial institutions, as well as other indicators
of the development of banking sector (the number of banks, the share of
privately owned banks, and loan-deposit rate spreads).
In our empirical investigation of the impact of financial sector development on
transition economies' growth we also need to take account of other factors, or
control variables, that are likely to have influenced growth over the whole
period or in certain subperiods.
Control variables
Empirical results

Among the main ones considered are:
• Y, output per worker at the start of a period, to capture the convergence
hypothesis (that poor countries will grow more quickly than rich ones, other
things being equal);
• ID, a measure of initial conditions in 1990; and
• REF, a measure of overall market reforms in the first phase of transition,
1990-94.
Despite a common legacy of planning, transition economies started out under
different circumstances. There were significant differences in terms of initial
level of development, macroeconomic distortions, integration into the trading
system of the communist countries, and the extent of prior reforms. Prior
studies have shown that this had a strong impact on performance, especially in
the initial years of the transition. Our composite measure of initial conditions is
similar to the ones constructed by de Melo et al. (1997), EBRD (1997) and Falcetti
et al. (2005). It is based on six indicators of market distortions in 1990 taken
from de Melo et al.:2
• the share in GDP in 1990 of trade with countries in the Council for Mutual
Economic Assistance (CMEA, or Comecon) trading bloc;
• an estimate of "repressed inflation" in 1987-90;
• the black-market exchange-rate premium;
• a measure of the degree of "over-industrialisation";
• the number of years spent under communism; and
• a dummy variable taking the value of 1 if the transition country had a
capitalist economy for a neighbour prior to 1990, and 0 otherwise.
The extent of economic reform in 1990-94 (REF) is measured on the basis of the
EBRD's ratings for progress in various types of reforms. The various dimensions
of reform are rated for each year and each transition country on a scale of 1 to
4.3 (the standard achieved in developed countries). The indicators can be
divided into three subsets: enterprise reforms; liberalisation; and financial
institutions. Enterprise reform covers small- and large-scale privatisation and
enterprise restructuring. Liberalisation covers price liberalisation, trade and
foreign-exchange system liberalisation and competition policy. Financial sector
reform is measured by progress in banking reform and interest rate
liberalisation, and the development of securities markets and non-financial
institutions (as reported for 1999 and 2005 in Table 3). To avoid a clear overlap
with our measures of financial sector development, we omit the EBRD's
financial sector reform subset and calculate REF as the simple average of the
values of the six indicators in the enterprise reform and liberalisation subsets.
2 Other studies have used up to a dozen indicators to construct a composite index of
initial conditions.

Financial sector development is measured by three indicators:
LLY is the ratio of liquid liabilities to GDP, where liquid liabilities consist of
currency held outside the banking system plus demand-bearing liabilities of
banks and non-bank financial intermediaries. This indicator measures the
extent of financial intermediation.
BANK represents the role of commercial banks in the overall financial sector. It
is the ratio of commercial bank domestic assets to the sum of commercial bank
and central bank domestic assets.
FOREIGN is the share of foreign banks' assets in total bank assets.
Data were also gathered on a fourth indicator, PRIV, the ratio of claims on the
non-financial private sector to GDP. However, this indicator tended to be
insignificant or even to appear with the wrong sign in almost all the empirical
tests, probably because of a high degree of collinearity between this indicator
and other financial sector indicators.
Other control variables used in the empirical estimates include our estimates of
the growth of human and physical capital and employment growth in the
given subperiods. As with PRIV, the results were generally insignificant and are
not reproduced here.
The data in Table 4 show that in all periods the ratio of liquid liabilities to GDP
increased, but has generally still remained low, especially in the CIS countries.
Liquidity ratios have been clearly affected by different inflation rates in
transition economies. In many CIS economies throughout much of the period
liquidity ratios remained low as a result of an extensive reliance on the use of
non-monetary surrogates and barter arrangements.
Table 4
Liquidity (LLY) ratios, 1990-2003
(%)
1990-94 1995-99 2000-03
East-central Europe 37.6 44.8 51.7
Czech Republic 58.5 63.4 68.8
Hungary 39.6 39.4 41.2
Poland 21.5 29.0 39.6
Slovakia 53.2 57.8 62.2
Slovenia 15.2 34.5 46.8
Balkansa 28.6 25.4 37.2
Baltics 17.6 21.6 29.3
Estonia 14.1 24.0 35.5
Latvia 23.2 23.8 28.8
Lithuania 15.7 17.1 23.6
CISb 5.1 8.7 12.5
Russia 4.1 13.9 13.3
Ukraine 2.6 11.6 22.6
a Excluding Serbia and Montenegro. b Excluding Uzbekistan and Turkmenistan.
Source: IMF, International Financial Statistics.

Financial systems in transition economies have been dominated by banks. In
part this was the result of the insufficient scope and effectiveness of legal
contract enforcement, and weakly defined property rights. As the data in
Table 5 demonstrate, banking sector assets in transition countries account for a
very high proportion of overall financial assets.
Table 5
Banking sector assets/total financial assets (BANK), 1990-2003
(%)
1990-94 1995-99 2000-03
Hungary 99.9 99.9 99.9
Poland 68.1 69.2 69.2
Slovakia 84.8 82.7 82.0
Slovenia 86.6 85.2 83.0
Balkansa 92.7 91.3 90.4
Baltic s 85.61 84.78 84.32
Estonia 82.23 81.32 80.37
Latvia 81.43 79.25 77.89
Lithuania 93.16 93.77 94.68
CISb 93.4 92.9 92.4
Russia 88.9 88.0 89.5
Ukraine 95.7 95.2 92.7
a Excluding Serbia and Montenegro. b Excluding Uzbekistan and Turkmenistan.
Source: Bankscope.
As argued above, the entry of foreign banks was crucial for transition countries'
financial sector development. Table 6 gives the average ratios of foreign banks'
assets to total bank assets for the three subperiods in our empirical exercise.
Table 6
Foreign banks' assets/total bank assets (FOREIGN), 1990-2003
(%)
1993-94a 1995-99 2000-03
Hungary 33.5 49.0 76.0
Poland 5.0 16.2 68.9
Slovakia 5.0 12.2 70.4
Slovenia 1.0 3.0 16.4
Balkans 0.7 11.6 52.0
Baltics 1.0 41.6 71.0
Estonia 1.0 57.0 90.4
Latvia 1.0 53.8 79.1
Lithuania 1.0 14.0 43.7
CISb 0.0 6.1 25.1
Russia 0.0 8.0 23.8
Ukraine 0.0 5.0 12.3
a Owing to lack of data, first-period average covers 1993 and 1994 only. b Excluding Turkmenistan.
Source: Bankscope.

0
10
20
30
40
50
60
70
80
90
100
Czech
Republic
Hungary
Poland
Slovakia
Slovenia
Estonia
Latvia
Lithuania
Russia
Ukraine
1993-94
1995-99
2000-03
Foreign banks
(ratio of foreign banks' assets to total bank assets)
Source: Bankscope.
The estimated impact of financial development indicators on economic growth
are reported in Table 7. In the first transition period (column 1), a measure of
initial conditions (ID) seems to be the most important explanatory variable for
economic growth. Financial development indicators explain economic growth
only to a very limited extent. The coefficient on LLY is positive and statistically
significant at the 10% level. The BANK variable is actually estimated to have
had a statistically negative impact on growth. This result may not be all that
surprising, since in the stages of transition the banking sector was dominated by
underdeveloped or unreformed domestic banks.
In the second period, 1995-99 (column 2), the measure of foreign banks'
presence, FOREIGN, is included and has—as might have been expected—a
positive and highly significant impact on economic growth. Foreign banks
brought in new capital and skills. They encouraged competition and
innovation, strengthened corporate governance and management, and rendered
the sector more efficient by introducing new skills, products and technology.
Table 7
Growth and financial sector development
1990-94 1995-99 2000-03
ln Y -0.026 -0.014 -0.014
(-0.149) (-2.282)* (-2.159)*
ID90 -0.01
(-3.38)**
REF1990-94 0.002 0.007
(2.449)** (1.749)
LLY 0.002 0.002 0.002
(-2.249)* (-2.05)* (-2.053)*
BANK -0.004 -0.091 0.086
(-2.527)** (-2.998)** (3.505)**
FOREIGN 0.072** 0.066*
(5.514) (1.921)
R2 adj 0.396 0.576 0.558
Note. t statistics in parentheses; * and ** denote 10% and 5% statistical significance, respectively.
The dependent variable in each subperiod is the annual average growth rate of real GDP per worker.
The results

In the estimated equations LLY, BANK and FOREIGN stand for the annual
average growth rates of the ratios in the years of the given subperiod.
For 1995-99, LLY is estimated to have had a positive but only marginally
significant impact, providing further evidence for the proposition that increases
in liquidity supported economic growth. However, the BANK variable
continues to be estimated with a significant negative coefficient, as for 1990-94.
Since foreign banks did not yet represent a significant share in the total banking
system, the overall banking sector remained inefficient. However, FOREIGN is
estimated to have had a strong positive impact on growth in this subperiod.
For the 2000-03 period, LLY again has a marginally positive impact. The
banking sector is by now dominated by foreign banks and this means that
BANK is estimated to have a very strong impact on growth. The coefficient for
FOREIGN is also estimated with a positive sign, although (unlike for 1995-99) it
is only weakly significant, which is unsurprising, given the strong collinearity
for this period between BANK and FOREIGN.
Among the control variables, in addition to the role of the initial conditions
variable in explaining growth in 1990-94, output per worker at the start of a
period had a significant negative impact, in line with the convergence
hypothesis, in 1995-99 and 2000-03. The indicator of lagged market reforms in
1990-94 (REF) had a significant positive impact in 1995-99, which became much
weaker, and statistically insignificant, for 2000-03.
Our results, however, need to be treated with caution. Given the manifold
measurement and methodological difficulties that plague empirical
investigations of the determinants of growth, especially for transition
economies, our results can only be seen as suggestive and not conclusive. As in
many regression analyses, there is uncertainty as to the primary direction of
causation—whether it is from financial development to growth, or whether
financial deepening merely tends to accompany or follow growth. It is also
possible that variables that might also have been important influences on
growth have been omitted from the estimations, or that some of the financial
sector indicators are actually proxies for other factors that affected growth.
Nevertheless, there are some strong and plausible a priori arguments that
suggest that financial development has been crucial for transition economies'
growth. This is especially the case with respect to the role of foreign banks, and
this thus increases confidence in our empirical results.
Overall, our results suggest a positive growth impact of certain financial sector
development indicators—especially of foreign bank penetration—on transition
economies' growth since the mid-1990s.
Our growth accounting analysis showed that the main sources of growth for
the transition economies since the mid-1990s have been growth in physical
capital and total factor productivity growth. The contributions of total factor
productivity to economic growth were negative in the early stage of the
transition period, but then turned positive and increased thereafter in almost all
subregions. Our empirical analysis also confirmed previous findings that initial
conditions and economic reforms were in certain subperiods important
Conclusions
Caution is called for

determinants of transition countries' growth, as was the initial level of income
per worker.
There was also evidence that financial sector development had a positive
impact on growth. In the early stage of transition period, only an increased
liquidity had a positive effect on growth. In the second period, foreign banks
are identified as being important, since their efficiency and ability to use new
skills, products and technology in transition economies contribute strongly to
economic growth. The learning-by-doing process, spillover effects and the fact
that foreign banks acquired a majority of domestic banks appear to have
enabled banking systems to generate a strong contribution to economic growth
over the past decade.
Andriesz, Ewa; Asteriou, Dimitrios and Pilbeam, Keith (2003): The Linkage
between Financial Liberalization and Economic Development: Empirical Evidence
from Poland, Discussion Paper Series, City University Department of Economics,
London.
Berg, Andrew; Borenzstein, Eduardo; Sahay, Ratna and Zettelmeyer, Jeromin
(1999): The Evolution of Output in Transition Economies: Explaining the Differences,
IMF Working Paper no. 73.
Berglof, Erik and Bolton, Patrick (2001): The Great Divide and Beyond: Financial
Architecture in Transition, The William Davidson Institute at the University of
Michigan, Working Paper no. 414.
Buiter, Willem and Taci, Anita (2003): "Capital Account Liberalization and
Financial Sector Development in Transition Countries" in Bakker, Age F P and
Chapple, Bryan (eds), Capital Liberalization in Transition Countries: Lessons from
the Past and for the Future, Edward Elgar, Cheltenham.
Campos, Nauro F and Coricelli, Fabrizio (2002): "Growth in Transition: What We
Know, What We Don’t and What We Should", Journal of Economic Literature,
vol. 40, no. 3.
Coricelli, Fabrizio (1999): Financial Market Development and Financial
Liberalization in Economies in Transition, Mimeo, University of Sienna.
De Melo, Martha; Denizer, Cevdet; Gelb, Alan and Tenev, Stoyan (1997):
Circumstance and Choice: The Role of Initial Conditions Policies in Transition
Economies, World Bank Policy Research Working Paper no. 1866.
Dobrinsky, Rumen (2001): Convergence in Per-Capita Income Levels, Productivity
Dynamics and Real Exchange Rates in the Candidate Countries On the Way to the
EU Accession, International Institute for Applied System Analysis, Laxenberg,
Austria.
European Bank for Reconstruction and Development (EBRD): Transition Reports,
various years.
Falcetti, Elisabetta; Lysenko, Tatiana and Sanfey, Peter (2005): Reforms and
Growth in Transition: Re-examining the Evidence, EBRD Working Paper no. 90.
References

Fischer, Stanley; Sahay, Ratna and Vegh, Carlos: "From Transition to Market:
Evidence and Growth Prospects" in Zecchini, Salvatore (ed.), Lessons from the
Economic Transition: Central and Eastern Europe in the 1990s, Kluwer Publishers,
Dordrecht.
Giannetti, Mariassunta and Ongena, Steven (2005): Financial Integration and
Entrepreneurial Activity: Evidence from Foreign Bank Entry in Emerging Markets,
European Central Bank Working Paper Series.
Havrylyshyn, Oleh and van Rooden, Ron (2000): Institutions Matter in
Transition, but So Do Policies, IMF Working Paper no. 70.
Havrylyshyn, Oleh; Wolf, Thomas; Berengaut, Julian; Castello-Branco, Marta;
van Rooden, Ron and Mecer-Blackman, Valerie (1999): Growth Experience in
Transition Countries: 1990-98, IMF Occasional Paper no. 184.
King, Robert G and Levine, Ross (1993): "Finance, Entrepreneurship, and Growth:
Theory and Evidence", Journal of Monetary Economics, vol. 32.
Levine, Ross (1998): "The Legal Environment, Banks and Long-Run Economic
Growth", Journal of Money, Credit and Banking, vol. 30.
Shinkman, Matthew (2004), "The Banking Sector in the Countries of Former
Yugoslavia", Economies in Transition: Eastern Europe and the former Soviet
Union—Regional Overview, June 2004, Economist Intelligence Unit.

Political outlook
Election watch
Presidential Parliamentarya
East-central Europe
Czech Republic 2008b 2010
Hungary 2010b 2010
Poland Oct 2010 Sep 2009
Slovakia 2009 2010
Slovenia Nov 2006 2008
Balkans
Albania 2007b 2009
Bulgaria Oct 2006 2009
Bosnia and Hercegovina Oct 2006 Oct 2006
Croatia 2010 2007
Macedonia 2009 2010
Montenegro 2007 2010
Romania 2008 2008
Serbia 2009 2007
Baltics
Estonia 2006b 2007
Latvia 2007b Oct 2006
Lithuania 2009 2008
CIS
Russia Mar 2008 Dec 2007
Ukraine 2009 2011
Belarus 2011 2008
Moldova 2009b 2009
Armenia 2008 2007
Azerbaijan 2008 2010
Georgia 2009 2008
Kazakhstan 2012 2008
Kyrgyz Republic 2010 2010
Tajikistan 2006 2010
Turkmenistan 2008-10 2009
Uzbekistan Dec 2007 2009
a For lower houses unless otherwise indicated. b President chosen by parliament. In Estonia chosen
by a combination of parliament and local councils.
There have been a number of elections in the region in 2006. Parliamentary
elections were held in Ukraine in March; in Hungary in late April; in the Czech
Republic and Slovakia in June; in Macedonia in July; and in Montenegro in
September. There are still more to follow this year, with voters going to the polls
in October in Latvia to elect a new parliament. Bosnia and Hercegovina (BiH)
will hold both parliamentary and presidential elections in October. Belarus
held a presidential election in March, and Bulgaria will hold one in October.
The results of recent elections do not indicate any clear shifts in regional trends
or direction. It appeared that the victory by conservatives and populists in
Poland's parliamentary and presidential elections in 2005 might set the tone for
the rest of central Europe in 2006. In particular, it looked fairly likely that
Hungary would embrace the right-wing Fidesz-Hungarian Civic Union (Fidesz),
led by Viktor Orban. However, the ruling Hungarian Socialist Party (MSZP) won

the election in April, with a somewhat increased majority. This was the first
time that an incumbent had won in Hungary since the transition began.
However, the idea that this might be the beginning of a possible new regional
trend of incumbents winning elections was not confirmed in either the Czech
election—in which the ruling Czech Social Democratic Party (CSSD) lost power,
at least temporarily—or Slovakia, where the reformist coalition government of
Mikulas Dzurinda lost the election on June 17th. The same happened in
Macedonia, where the opposition Internal Macedonian Revolutionary
Organisation-Democratic Party of Macedonian National Unity (VMRO-DPMNE)
defeated the incumbent Social Democratic Alliance of Macedonia (SDSM) in
the parliamentary election on July 5th.
Thus the Hungarian result appears to have been an exception to the long-
standing trend in the region of incumbents almost invariably losing elections.
The Hungarian result may have had much to do with the inept strategy of the
right-wing opposition. Specific circumstances related to the recent successful
pro-independence drive in May affected developments in Montenegro, where
the incumbent government held comfortably on to power in recent elections.
The ruling Democratic Party of Socialists (DPS) and its coalition partner, the
Social Democratic Party (SDP), won a majority in the election held on
September 10th.
In some respects, the region appears now to be going backwards politically.
Reform momentum throughout much of the region, especially in the new EU
member states, is petering out. Poland's government is seen as eccentric—
preoccupied with cultural and national issues—and incompetent; Slovakia's as
populist and anti-reformist; Hungary's as spendthrift and ineffectual. The Czech
Republic has been unable to find a workable government following its
parliamentary election in June. Estonia, Latvia and Slovenia all have cautious or
fragile coalitions, preoccupied with sharing the fruits of power rather than with
pursuing further reform. In Slovakia and Poland the coalitions have an added
ingredient: extremist populist parties of left and right. Lithuania has a weak
minority government. Hungary's government looks weak and there are doubts
over whether it can cope with serious macroeconomic problems.
Robert Fico's leftist Smer-SD (Direction-Social Democracy) came to power in
July in Slovakia, in coalition with the far-right Slovak National Party (SNS) and
the People's Party-Movement for a Democratic Slovakia (LS-HZDS) of
authoritarian former prime minister Vladimir Meciar. The populist Mr Fico's
choice of coalition partners caused dismay among foreign investors and EU
states, not least because it threatened to undo many of the reform gains made
since 1998 under Mr Dzurinda, who had served two terms as prime minister.
The new government's programme includes a promise to halt strategic
privatisations; partly reverse tax, healthcare and pension reforms; increase taxes
for high-earners; and to boost welfare spending.
The Czech election in June was a tie. The most obvious coalition government,
of the conservative Civic Democratic Party (ODS), the Christian Democratic
Union-Czechoslovak People's Party (KDU-CSL) and the Green Party, had 100
seats, with the same number going to the CSSD, led by the outgoing prime
Political backsliding

minister, Jiri Paroubek, and the Communist Party of Bohemia and Moravia
(KSCM). The conservative ODS (which won a plurality of votes in the election)
is in power only until a confidence vote on October 4th, which it will almost
certainly lose. The party's leader, Mirek Topolanek, will continue as caretaker
prime minister, at least until local and Senate elections later that month.
Months of political uncertainty loom.
In Hungary, the main opposition party, Fidesz, has already launched a
campaign to transform the October municipal elections into a sort of
referendum on the fiscal austerity package adopted in July. Potential major
losses for the centre-left governing parties (coupled with loss of the Budapest
mayoralty) would intensify internal pressure both between the governing
coalition parties (the MSZP and its junior partner, the liberal Alliance of Free
Democrats) and within the senior ruling MSZP.
So far the region's well-performing economies (with the exception of Hungary)
appear to have been remarkably immune to the trend of political uncertainty
and weakness. A similar pattern can also be observed in parts of the
Commonwealth of Independent States (CIS), where good economic
performance has accompanied even worse political trends or similar political
uncertainty (for example, Ukraine's economy has been recovering strongly
despite the months-long political impasse that followed that country's
parliamentary election in March 2006). However, it cannot be assumed that this
disconnect between the economic and political developments in the region can
persist indefinitely. In many countries there are important decisions and policy
initiatives that need to be taken—such as preparing economies for euro
membership, reforming the health, pension and tax systems, and other reforms
to lay the basis for sustainable growth.
The situation in Kosovo—the breakaway Serbian province that has been run by
the UN since 1999—continues to cast a shadow over the entire region. The
security situation remains fragile, and acrimonious negotiations on the final
status of the province appear to be grinding towards an impasse and a possible
crisis. It is difficult to predict the effects on developments in the wider region—
not only in restive and resentful Serbia, but also in BiH, Macedonia and possibly
further afield. Furthermore, all this is occurring when the EU's most effective
instrument for influencing developments in the region and increasing the
chances of stability—the offer of EU membership—has been seriously eroded
and weakened by the anti-enlargement mood sweeping western Europe.
The internationally mediated talks on the status of Kosovo between the Serbian
authorities and representatives of Kosovo's ethnic Albanian majority have been
under way in Vienna since February. Little progress has been made on any of
the issues discussed so far—economic relations, minority rights, the extent of
self-government for the Serb minority in the province and its links with
Belgrade. The key issue of Kosovo's final status has not even been discussed yet.
The UN's chief negotiator, Martti Ahtisaari, is under pressure from the Western
powers to produce a solution to the intractable problem by the end of the year.
A consensus of sorts appears to have been reached among the five Western
members of the "Contact Group" (the UK, the US, France, Italy and Germany—
Risk in the Balkans

the remaining member is Russia) over the long-standing UK/US position of
independence for Kosovo as the preferred solution. Russia stands apart from the
rest of the Contact Group—although it remains unclear how Russia will behave
at the end of the present process. Russia has warned that the solution for
Kosovo had to be based on general principles and that it would have universal
implications, including for frozen conflicts in the former Soviet Union.
Some see Serbia's assent for independence as the key to a lasting and stable
settlement, but no Serbian government will sign an agreement that grants
Kosovo independence. Many appear to have genuinely believed that it would
be possible to entice Serbia into giving its assent to "conditional independence",
and that Serbia might be tempted by the compensation of "accelerated Euro-
Atlantic integration" (at least until French and Dutch voters put a dampener on
further EU enlargement in 2005 by rejecting the EU's constitutional treaty).
Furthermore, the decision by the EU in early May to suspend talks with Serbia
and Montenegro on a stabilisation and association agreement (SAA) owing to
the failure of Serbia to capture Ratko Mladic and extradite him to the Inter-
national Criminal Tribunal for former Yugoslavia (ICTY) in The Hague has
further complicated matters and reduced the scope for EU influence on Belgrade.
A recommendation by the West for an independent Kosovo would not be easy
to push through. It would require a new UN Security Council resolution, and
Russia might well oppose this. Today's assertive Russia is not the Russia of the
1990s that backed most Western decisions on the Balkans. Indeed, in a recent
interview with Western journalists, Russia's president, Vladimir Putin, for the
first time stated explicitly that Russia would use its veto in the UN Security
Council to prevent a solution for Kosovo that "was not acceptable to us". He
repeated warnings from earlier this year that independence for Kosovo could
not be treated as a sui generis case and that it would set a precedent for other
troubled regions, including breakaway territories in the former Soviet Union
such as Abkhazia and South Ossetia.
All this might mean a fudged solution, and at the very least delay considerably
the implementation of any envisaged Kosovo independence. The UN might be
bypassed altogether. However, this would mean a messy process of bilateral
recognitions of Kosovo and would mean that Kosovo could not become a
UN member.
Even if all these obstacles are overcome, the absence of Serbian agreement
poses risks. On the one hand, Serbian rejection may not have any practical
consequences, especially in the short to medium term. The Serbian position
would become a classical revisionist one of waiting until international
circumstances changed. Although the issue could be a harmful distraction in
Serbian political life for years, Serbia's claim over Kosovo might assume the
same character—with little practical significance—as, for example, the
constitutional commitment of the Republic of Ireland to the island's unification.
However, there could also be more immediate destabilising consequences, and
the present equanimity with which the risks for Serbia and the fallout for the
region are sometimes viewed may not prove justified.
A messy denouement

The EU is still struggling to recover its sense of direction following the rejection
of the EU's constitutional treaty by French and Dutch voters in mid-2005. The
agreement reached by EU heads of state and government in December 2005 on
the EU's budget for 2007-13 removed an important irritant between key
member states, but it has not restored a renewed sense of purpose. The EU is
no closer to resolving the deep disagreements among its existing member states
about the future structure and reach of the EU.
The current political climate in the EU clearly poses problems for future
enlargements. A major cause of opposition to the EU's constitutional treaty was
the perceived negative economic impact of the 2004 enlargement—namely
through competition for jobs and investment. Public opposition to further
enlargement has increased in many EU member states, along with concerns
about the ability of the EU's institutions to cope with additional members.
According to the most recent Eurobarometer poll, in the 15 "old" EU members,
only 41% of the public are now in favour of further enlargement. The French
constitution had already been amended earlier in 2005 to require referendums
to ratify any enlargement following the accession of Bulgaria, Romania and
Croatia. For many of the states still clamouring to join, there is now a risk that
political hostility to enlargement in the EU15 will close off their membership
prospects for the foreseeable future.
Bulgaria and Romania are set to join the EU on January 1st 2007 (at most there
could have been a one-year delay until January 2008), but this will be under
the strictest conditions ever applied to new members. Bulgaria, in particular,
will come under tough EU scrutiny and faces possible legal and financial
sanctions unless it demonstrates progress in tackling organised crime and high-
level corruption.
The European Commission, which is due to issue a report on the two countries'
readiness at the end of September, appears to have rejected the idea of
postponing Bulgaria or Romania's entry until 2008 on the grounds that it would
discourage reformers. However, the two countries, especially Bulgaria, are likely
to be subject to "safeguard measures"—sanctions that can be activated after a
country joins the EU. The EU has the power to suspend regional aid payments
worth billions of euro to either Bulgaria or Romania if they are shown to be
subject to persistent fraud. If Bulgaria fails to tackle crime and corruption, it
could be excluded from EU legal co-operation and its courts' judgements would
not be recognised by the EU.
In Bulgaria's case, the Commission wants the establishment of a system for
assessing farmers' claims for aid; results in investigating and prosecuting
organised crime networks; implementation of anti-corruption laws; the
enforcement of anti-money-laundering provisions; and improved financial
controls of structural and cohesion funds. The demands on Romania are
considerably less onerous and involve the setting up of an agency for dealing
with direct payments to farmers; establishing a system for assessing farmers'
claims for aid; and providing "real time" information on value-added tax (VAT)
refunds in order to fight fraud.
Further EU enlargement
Slipping support for further
enlargement
Bulgarian and Romanian EU
membership

Official concern in Brussels about Bulgaria's and Romania's preparations is
likely to heighten the mood of "enlargement fatigue" in the EU. There are fears
in some member states that the accession of the two poor countries in south-
eastern Europe could lead to mass immigration and increased organised crime.
In 2005 the EU decided to open membership negotiations with Croatia, after a
ruling that Croatia was co-operating fully with the ICTY in The Hague.
Macedonia has received a positive (if qualified) European Commission avis
(opinion) on its application. After long delays, on June 12th Albania signed with
the EU an SAA—the EU's main pre-candidate status instrument. The EU also
commenced negotiations on SAAs with BiH and with Serbia and Montenegro—
talks with the latter were, as mentioned, suspended at the beginning of May
because of Serbia's failure to capture and deliver Mr Mladic to the Hague war-
crimes tribunal. Montenegro is hoping that independence will provide it with a
"fast track" towards EU membership, although that looks doubtful given the
unfavourable climate to further EU expansion and the EU's concerns about
corruption, organised crime and weak administrative capacity in Montenegro.
That the process is proceeding formally is, however, hardly a surprise. It could
scarcely have been otherwise, given the challenges faced by the EU in the
region, including the Kosovo issue; the West's efforts to make BiH a unitary
state; and the fragility of Macedonia. At such a time the EU was hardly going to
jettison its main (and arguably only effective) foreign policy tool of the prospect
of membership.
Croatia's path to the EU has been smoothed by the capture last year of Croatia's
main war-crimes indictee, Ante Gotovina. However, the growing anti-
enlargement mood in many EU countries—and the wish by some to signal to
other membership aspirants that the enforcement of admission criteria will be
tougher in the future than it has been in the past—also poses potential problems
for Croatia. Even if, as expected, Croatia succeeds in implementing all the
necessary reforms for membership, its chances of admission to the EU in the
near future are uncertain. Croatia is well aware that the failure of the EU
constitution has been interpreted by leading European political figures as a vote
against further expansion. Securing the approval of all 25 member states (or 27
after Bulgaria and Romania are admitted) may prove difficult. The Treaty of
Nice, which provides for only 27 members, would also have to be amended in
order to accommodate Croatia and any other new members.
For the rest of the Balkans, the backlash against enlargement looks even more
serious. The western Balkan countries were pretty much promised eventual
membership at the EU's Thessaloniki summit in 2003. The region has struggled
to come to terms with its post-war legacy, and views future EU membership as
a key to peace and economic development. Even more than in the case of
central Europe, the hope of EU membership seems to be the main driver of
political and economic reform in the region. The conclusions of the meeting of
EU foreign ministers in Salzburg in March will hardly have reassured the
countries of the western Balkans. The closing statement confirmed that "the
future of the western Balkans lies in the EU", but added the dampener that "the
EU also notes that its absorption capacity has to be taken into account".
The western Balkans
Croatia's prospects

Big questions thus remain about the future of the EU accession process, as well
as its effectiveness in transforming the candidate countries. The specific French
requirement for ratification by referendum of future enlargements contributes
to doubts about the credibility of the enlargement process. The EU could string
the potential candidates along so tortuous and demanding an accession path
that it could amount to de facto exclusion. The defeat of the EU constitution has
changed the rules of the game. For several years the carrot of potential EU entry
and the stick of potential exclusion served to influence the behaviour of
political actors in the region. As the realisation sinks in that EU expansion in
even the medium term is highly unlikely, the ability of EU policymakers to
influence Balkan states will wane.
Countries such as Ukraine and Moldova continue to view EU membership as a
long-term objective. In the current climate, it is highly unlikely that these
countries will soon be considered as candidates for membership. Nevertheless,
although these countries have never featured particularly highly on the EU's
agenda, the entry to office of a Western-oriented government in Ukraine in
early 2005 has put pressure on the EU to put more flesh on its fledgling
European Neighbourhood Policy (ENP), which is envisaged as an alternative
to membership.
The prospects for further enlargement of the EU will depend in part on how
successful Europe is in resuscitating its economy. As long as millions of
Europeans are unemployed, or fear for their jobs, they will be reluctant to
welcome new EU members and their workers. Enlargement prospects will also
depend on the direction in which the EU develops. For example, greater use of
"variable geometry"—the idea that not every member state needs to take part in
every EU policy area—would make enlargement more likely. Finally, if EU
applicants are prepared to accept long derogations or "safeguards" that would
postpone their full participation in some EU policies, further enlargement might
become more politically acceptable in western Europe.
EU economic recovery may hold the key
to further enlargement

Economic forecast
Global outlook
2005 2006 2007 2008 2009 2010
Real GDP growth (%)
US 3.2 3.3 2.2 2.9 3.0 3.0
Euro zone 12 1.3 2.3 1.8 2.0 2.1 2.0
World (market exchange rates) 3.5 3.9 3.2 3.2 3.2 3.2
World (PPP) 4.9 5.3 4.7 4.7 4.5 4.6
World trade growth (%)
Goods 7.8 9.3 7.6 7.7 7.9 7.9
Consumer price inflation (%; av)
US 3.4 3.8 3.3 2.8 2.7 2.7
Euro zone 12 2.1 2.3 2.2 1.9 1.8 1.8
Export price inflation (%; av)
Manufactures (US$) 2.5 2.7 7.6 2.3 1.2 1.4
Commodities (% change in US$ prices)
Oil (Brent; US$/b) 54.7 71.1 70.0 59.0 48.0 45.0
Non-oil commodities 4.1 24.5 -3.8 -6.5 -11.6 -4.8
Food, feedstuffs & beverages -0.5 8.9 -4.5 0.7 -6.7 0.9
Industrial raw materials 10.3 43.6 -3.2 -13.1 -16.8 -11.5
Interest rates (%)
US$ 3-month commercial paper rate (av) 3.5 5.2 5.3 5.6 5.7 5.7
€ 3-month interbank rate (av) 2.2 3.1 3.9 3.9 3.9 3.9
Exchange rates
US$:€ (av) 1.24 1.26 1.37 1.33 1.29 1.25
¥:€ (av) 137 143 137 127 120 115
¥:US$ (av) 118 108 97 95 93 90
World GDP growth has been strong in 2006 and is expected to reach 5.3% in
the year as a whole, compared with 4.9% in 2005 (measured using purchasing
power parity—PPP—weights). But a slowdown in parts of the developed world
will soon affect world growth. In 2007 world growth is expected to slow to
4.7%, which will still represent a robust performance. Economic expansion over
the forecast period as a whole (2006-10) will average about 4.7% per year, better
even than the strong performance of the previous five years. Measured using
GDP at market exchange rates, the world economy is forecast to expand by 3.9%
in 2006 and 3.2% in 2007, a pace that will be maintained in 2008-10. The very
rapid rate of expansion of China and India means that these two countries are
driving much of the global growth, although growth has been sturdy, if not
nearly as fast, in many other regions. World activity is also benefiting from the
fact that global liquidity remains high by historical standards, notwithstanding
ongoing monetary tightening by the major central banks.
Real GDP growth in the euro zone reached a rate of 2.4% year-on-year in the
second quarter of 2006, its highest level in four and a half years. Euro zone
growth in 2006 as a whole is projected at 2.3%. A slowdown in 2007 will be
largely attributable to a contraction in consumer demand in Germany related to
a rise in value-added tax (VAT). Almost all euro zone countries will experience
at least a slight slowdown in 2007, a result of a worsening external
environment and the strengthening of the euro against the US dollar. This is
The outlook for the euro zone

reflected in falling measures of business confidence. Consumers in these
economies look likely to pick up the slack, at least in the short to medium term.
West European growth has a strong impact on economic activity in the new EU
members and most of the Balkan economies, given the large share of their
exports directed to western Europe. For the east-central European countries,
merchandise exports to the EU15 are on average equal to one-third of GDP.
Exports to Germany alone account for about 20% of GDP in the Czech
Republic, Hungary and Slovakia. Most new EU members in eastern Europe are
thus highly sensitive to shifts in demand in the developed west European EU
states—although most new EU members have been successful in recent years in
compensating at least in part for slow euro zone growth by redirecting trade to
faster-growing regions.
An encouraging sign for the transition economies at present is the pick-up in
their main trade partner, Germany. Real GDP growth in Germany is expected to
accelerate from 0.9% in 2005 to 2.2% in 2006. After four years of consecutive
decline the Economist Intelligence Unit expects gross fixed investment to rise in
2006 on the back of a substantial increase in corporate profits. A slight
improvement in the labour market, a stabilisation of real wages (after earlier
falls) and an improvement in confidence have boosted consumer demand.
Advance purchases ahead of the VAT increase planned for 2007 are boosting
private consumption in 2006, but the VAT rise will have the opposite effect in
2007. The VAT increase will lead to slowdown in the German economy in 2007,
with growth projected at only 1.4%.
The strong euro will prevent EU exports from growing quickly, and higher euro
zone interest rates and continuing worries about unemployment will limit the
recovery in euro zone domestic demand. Real GDP growth from 2008 is
expected to average about 2% per year, equal to the trend rate. Another factor
that will prevent faster growth will be a high ratio of savings to disposable
income in the household sector. Consumers' propensity to spend may be
dampened by fears about their governments' ability to meet pension liabilities
and healthcare costs.
The outlook for many of the economies in the Commonwealth of Independent
States (CIS) continues to be tied to Russia, which is the main export destination
for most CIS members. Strong Russian import demand has made a major
contribution to the subregion's rapid growth in recent years.
Our baseline forecast is for strong growth in the world economy over the
forecast period, but there are a number of threats that could drag down global
economic performance. The most significant global economic risks in the short
term stem from the possibility that the US slowdown could be sharper than
expected and that the US slips into recession. The main threat to the global
outlook has for some time stemmed from the large US current-account and
fiscal deficits and the implications of these for the sustainability of the
US dollar's exchange rate. A significant slide in the US dollar, as opposed to a
gradual adjustment of US imbalances, would elicit a policy response that
would lead to a sharp increase in interest rates and a recession. Western Europe
and much of the rest of the world would be likely to be seriously affected.
Russia and the CIS outlook

Persistently high international oil prices have threatened to drag down economic
performance in oil-importing countries—although they are boosting the short-
term prospects of CIS energy exporters. We expect prices to average about
US$70/barrel (dated Brent Blend) in 2006 and 2007. The market remains
vulnerable to supply disruptions. Although the world has become more efficient
in its use of oil than in the past (the oil intensity of economic activity has fallen
by one-half over the past 20 years), high prices are inevitably placing a heavy
burden on oil consumers. Thus, if prices should rise further, or even if they are
sustained at the present high levels, the relative immunity of world growth to oil
prices may not last.
Other risks include the threat of trade protectionism in the wake of the failure
of the Doha round of trade liberalisation talks. Rising protectionist sentiment
can also be seen around the world in measures to restrict foreign investment in
so-called strategic sectors. There is also an array of geopolitical risks in the
Middle East and elsewhere that could have a negative impact on global
economic activity.
Growth in the transition countries has remained solid despite the impact of
high oil prices on oil importers, and of domestic political uncertainty and/or
reform slowdowns in many countries. The overall outlook for the region for
2006-07 remains good, with average growth in 2006 increasing to 6.6%,
compared with 5.8% in 2005. GDP growth is forecast to drop back to 5.7% in
2007 as a result of slowing Russian growth and a decline in euro zone demand.
Throughout east-central Europe growth accelerated in the first half of 2006, often
to record levels. Surging domestic demand has tended to be the main driver of
growth, although export growth has also held up well in most countries.
Polish real GDP growth continues to accelerate, the pattern since early 2005.
Second-quarter growth reached 5.5% year on year, compared with 5.2% in the
first quarter. Gross fixed capital formation surged by 11.4% in the first half of
2006, because of more intensive use of EU funding and the improving financial
condition of Polish corporates. Private consumption growth was 4.1% in the first
half of 2006, compared with 2.4% in the same period of 2005. Net exports
continue to provide a positive contribution to growth, although this was slightly
lower in the second quarter than in the first.
Real GDP growth
(%, year on year)
2005 2006
1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr
Czech Republic 5.4 5.8 5.8 6.9 7.1 6.2
Estonia 7.2 9.9 10.6 11.1 11.7 12.0
Hungary 3.2 4.5 4.5 4.3 4.6 3.8
Latvia 7.6 11.4 11.4 10.5 13.1 11.1
Lithuania 4.4 8.4 7.9 8.8 8.8 8.4
Poland 2.2 2.9 3.9 4.3 5.2 5.5
Romania 5.9 4.1 2.4 4.3 6.9 7.8
Slovakia 5.4 5.4 6.3 7.4 6.3 6.7
Slovenia 2.8 5.4 3.6 3.7 5.1 4.9
Sources: National statistics; Economist Intelligence Unit.
Surge in first-half growth
Short-term outlook

Hungary's pace of real GDP growth remains the slowest in central Europe. It
slowed to 3.8% year on year in the second quarter of 2006, from 4.6% in the
previous quarter (which was also the slowest rate in the subregion), on the back
of a sharp slowdown in domestic demand. Exports remain the main driver of
growth—they rose by 15.1% year on year in the second quarter, although this
was down on the 18.2% growth posted in the first quarter. Gross fixed capital
formation decreased by 3.6% in the second quarter, which was triggered by the
combined effect of much lower motorway construction costs and a 9.4% drop
in real estate investments. The first-half data do not incorporate the effects of
the government's austerity package, which was adopted by parliament in July.
Further deceleration in GDP growth in the second half of the year can be
expected, triggered by the negative impact on domestic demand. An increase in
the effective corporate tax rate will put downward pressure on investment, as
will a fiscally induced slowdown in motorway construction.
The Czech Republic's real GDP growth slowed to 6.2% year on year in the
second quarter, after hitting a record high of 7.1% in the first. Private consump-
tion growth remained robust in the first half, reaching almost 4% owing to tax
cuts that have boosted disposable incomes. Fixed investment growth has also
remained firm, at some 6% year on year in the first half of 2006. The net
contribution of foreign trade to real GDP growth is weakening somewhat, as
stronger domestic demand continues to pull in larger amounts of imports.
Growth in Slovakia accelerated to 6.7% year on year in the second quarter, from
6.3% in the first (although first-half growth was down on the rate of expansion
reached in the second half of 2005). Domestic demand continued to drive GDP
growth in the second quarter, although some slowdown was more than offset
by an improvement in the performance of the external sector. Private
consumption lost some momentum, rising by 5.9%, compared with a 6.6% gain
in January-March. Investment growth slowed more sharply, to 7%, following
16% growth in the first quarter. The external sector exerted a smaller drag on
GDP than in the first quarter, owing to a sharp slowdown in import growth (to
15.1% in the second quarter, from 20.8% in the first).
Slovenia's real GDP grew by 4.9% year on year in the second quarter of 2006,
slowing slightly from the 5.1% growth in the first quarter. The importance of
consumption for GDP growth increased for the fourth quarter in a row: it
contributed 4.5 percentage points to the 4.9% growth. After brisk growth at the
beginning of the year, exports and imports slowed in the second quarter:
exports expanded at an annual rate of 8.6%, down from 14.9% in the previous
quarter, and import growth slowed to 8%, from 13.5% in the first quarter.
Consequently, the external trade balance contributed very little to GDP growth.
Romania's real GDP growth surged to 7.8% in the second quarter, so that first-
half growth amounted to 7.4%, which exceeded most expectations. Economic
growth was led by growth in construction, industry and services. Construction
increased by 14.2% year on year in the second quarter, industrial production by
7.8% and services by 7.5%. Growth at this high level is likely to be unsustainable,
as it is being driven by consumption, fuelled by strong credit growth.
Hungarylags behind
Surging growth in Romania

Real GDP growth continues at a very robust pace in the Baltic states, at faster
than expected rates. Latvian and Estonian real GDP grew by about 12% year on
year in the first half of 2006; Lithuania's economy lagged slightly behind its
Baltic neighbours, with "only" 8.6% growth over the same period.
In the CIS average real GDP growth was 6.5% in the first half of 2006, an
acceleration over the 5% recorded in the first quarter. There was considerable
variation in performance—ranging from the remarkably high rate of oil-driven
expansion in Azerbaijan to the sluggish performance of the Kyrgyz Republic, in
which industrial output has dropped sharply. Domestic demand—as revealed
by generally strong growth in fixed investment and retail sales volumes—has
been the main driver of growth in most of the CIS. On the supply side,
construction and consumer-related services have been the main growth areas,
with industrial production growth lagging behind.
Indicators of economic activity, Jan-Jun 2006
(% change, year on year)
Real GDP Industrial output Fixed investment Retail sales volume
Russia 6.5 4.4 9.4 11.3
Ukraine 5.0 3.6 12.2 24.7
Belarus 10.1 12.6 36.9 16.6
Moldova 6.2a -6.4 13.0 7.0
Armenia 11.9 -1.0 31.8 12.1
Azerbaijan 36.3 41.1 7.9 12.1
Kazakhstan 9.3 5.1 25.2 13.5
Kyrgyz Republic 3.1 -6.8 18.4 15.7
Tajikistan 7.1 6.3 31.0 8.8
Uzbekistan 6.6 9.7 4.5a 11.6
CIS average 6.5 5.5 12.0 13.0
Note. Data are unavailable for Georgia and Turkmenistan.
a January-March.
Sources: CIS Interstate Statistical Committee; national statistics.
In Russia real GDP growth accelerated to 7.4% in the second quarter from 5.5%
in the first (when Russia's coldest winter in a generation dampened economic
activity). Year-on-year growth in the first half of the year amounted to 6.5%. The
pick-up has been led by construction, which posted year-on-year growth of
12.3% in the second quarter, up from just 1.6% in the first quarter. The trade
sector also maintained double-digit rates of growth. The Ukrainian economy
has recently shown signs of picking up sharply, with real GDP growth in
January-July accelerating to 5.5% year on year, up from 2.6% in 2005. Growth
has been driven by a combination of rising world prices for exports, such as
steel, and increased domestic demand.
Despite political uncertainty and stalling reforms, short-term economic
prospects for east-central Europe remain good. Annual average growth in
2006-07 in the subregion is forecast to reach 4.8%, compared with 4.3% in 2005.
Rising disposable incomes and large public investment projects funded by the
EU, as well as strong inflows of foreign direct investment (FDI), are boosting
domestic demand. Import demand in the euro zone has picked up and
exporters are also proving adept at penetrating new markets, particularly China.
Good short-term prospects

In Poland, sluggish domestic demand caused real GDP growth to slow from
5.4% in 2004 to 3.4% in 2005. However, growth is expected to pick up strongly
to 5.2% in 2006 and to slow only to 4.8% in 2007. Consumer spending is set to
continue to grow at a rapid pace in 2006-07, and investment is expected to
increase rapidly. The dampening effect of a stronger zloty on exports will be
outweighed by rising productivity and a gradual recovery in demand in
Poland's main west European markets.
Hungary's real GDP growth is forecast to slow to 3.9% in 2006, and to 2.9% in
2007 as a result of a substantial (and long overdue) fiscal tightening. Moreover,
the risks to Hungary's outlook are greater than in the case of its neighbours.
Hungary remains the economy most at risk in the region to turmoil in emerging
markets. Investors have been taking a closer look at the country's large current-
account and fiscal deficits, both of which are running at or above 8% of GDP.
Although the government has taken steps to restrain the expansion of the fiscal
deficit, there are serious doubts about the government's ability to meet ambi-
tious deficit-reduction targets. The authorities plan to reduce the fiscal deficit by
some 4 percentage points of GDP in 2007. However, the measures will be
difficult to implement in view of legal and administrative complexities. Since
the package relies mainly on raising taxes, and not reducing spending, it may
adversely affect potential growth, not just aggregate demand in the short term.
In the Czech Republic, real GDP growth is forecast to decelerate from 6.1% in
2005 to an annual average of 5.6% in 2006-07. Domestic demand will be the
primary driver of growth. Investment activity will be supported by large public
investment projects, as a result of increased use of EU structural funds and
inflows of FDI. Private consumption growth is likely to accelerate as a
consequence of cuts in income tax, an improving labour market and the
stimulatory effects of increased investment. The net contribution of foreign trade
to real GDP growth will remain positive, but will be weaker than in 2005, as
stronger domestic demand pulls in larger amounts of imports.
Slovakia will remain the fastest-growing economy in east-central Europe. The
primary drivers of growth in 2006-07 will be investment and exports. Despite a
projected slowdown compared with 2005, capital spending will remain strong
well into 2006, as the two new car-assembly plants owned by PSA Peugeot-
Citroën (France) and Kia Motors (a division of South Korea's Hyundai) become
operational. The government will also contribute to infrastructure spending,
using privatisation proceeds and EU funding. Exports are forecast to continue to
grow strongly, owing to a recovery in demand in the euro zone and rising
automotive production, the bulk of which is destined for foreign markets.
Personal consumption growth will decelerate slightly, owing to rising interest
rates and slower real wage growth. Real GDP growth is forecast to reach 6.2% in
2006, before moderating to 5.4% in 2007.
We expect a pick-up in average growth in the Balkan economies in 2006,
although weaker external demand and policies to curb escalating external
imbalances will lead to slower growth in 2007. Growth will slow in 2006 in
Albania, Serbia and Bulgaria—and is expected to remain the same as in 2005 in
Risks to Hungary
Automotive sector underpins Slovak
expansion

Macedonia—but it will accelerate by more than 2 percentage points in the
subregion's largest economy, Romania.
Macroeconomic indicators
(%; annual average)
GDP growth Inflation
2005 2006 2007 2005 2006 2007
East-central Europe 4.3 5.2 4.5 2.6 2.9 3.3
Czech Republic 6.1 6.2 5.0 1.9 2.7 3.3
Hungary 4.1 3.9 2.9 3.6 3.6 6.0
Poland 3.4 5.2 4.8 2.1 1.3 2.0
Slovakia 6.1 6.2 5.4 2.7 4.3 2.8
Slovenia 3.9 4.0 4.2 2.5 2.4 2.4
Balkans 4.7 5.7 5.0 5.5 5.9 4.4
Albania 5.5 5.0 6.0 2.4 2.8 2.5
Bosnia and Hercegovina 5.0 5.3 5.3 4.5 7.6 4.0
Bulgaria 5.5 5.0 4.5 5.0 7.4 4.3
Croatia 4.3 4.5 4.5 3.3 3.4 2.7
Macedonia 4.0 4.0 4.5 0.0 3.0 2.0
Montenegro 4.1 6.0 6.0 3.4 2.5 3.5
Romania 4.1 6.5 5.0 9.0 7.2 5.6
Serbia 6.3 6.0 5.5 16.1 13.6 10.7
Baltics 8.8 8.8 7.4 4.5 4.7 3.8
Estonia 9.8 9.5 8.2 4.1 4.3 3.2
Latvia 10.3 9.7 7.5 6.7 6.3 4.8
Lithuania 7.5 7.9 7.0 2.7 3.6 3.3
CIS 6.5 7.3 6.3 8.6 8.8 8.6
Russia 6.4 6.5 5.9 12.7 9.8 9.3
Ukraine 2.6 6.3 6.0 13.5 8.0 10.0
Belarus 9.2 8.8 6.0 10.3 7.7 12.6
Moldova 7.1 4.5 5.5 11.9 12.8 12.5
Armenia 14.0 9.0 8.0 0.6 8.7 2.8
Azerbaijan 26.4 33.0 17.5 9.6 7.7 7.7
Georgia 9.3 8.8 6.4 8.2 10.0 8.1
Kazakhstan 9.4 9.0 8.7 7.6 8.7 7.1
Kyrgyz Republic -0.6 2.0 4.0 4.3 6.4 7.0
Tajikistan 6.7 7.0 7.2 7.1 7.5 6.5
Turkmenistan 6.0 13.0 3.0 10.6 11.0 11.3
Uzbekistan 7.0 6.5 6.7 6.9 7.5 8.1
New EU members 4.7 5.6 4.8 3.3 3.6 3.5
Transition economies total 5.8 6.6 5.7 6.2 6.5 5.9
The short-term outlook in the Baltic states remains very promising. The average
growth rate in the subregion in 2006 is expected to match that of 2005 (8.8%).
Despite a deceleration in 2007 to a projected 7.4%, growth will remain
considerably more rapid than in east-central Europe. Domestic demand growth
has been strong, but solid performance by the region's highly competitive export
sectors has also driven growth. The Baltic states are benefiting greatly from
strong flows of FDI, and their exports are shifting up the value chain, allowing
Estonia, Latvia and Lithuania to hold their own against Asian competitors.
Economic performance in the CIS has been strong over the past few years,
despite slow structural reforms. Some of this is the result of a bounce-back from
the steep post-Soviet decline. Other factors are also at work, particularly in the
Baltic economies continue to surge

Economies in Transition

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