Central, Eastern and Southeastern Europe: Mind the Credit Gap

Three speeds of economic activity within the region, but generally weak investment

Reviving investment a challenge given firms are still overindebted

Policies need to support domestic demand, and to help resolve debt burden

Policies should aim to support the recovery and address excessive private sector debt, the report says. Some countries need urgent progress on the structural reform agenda to escape the debt trap and sub-par medium-term growth.

The region’s countries have been diverging down three paths. Baltic countries, Central and Eastern Europe (CEE), and Turkey are faring best, thanks to cheaper oil and a stronger euro area recovery. Southeastern Europe (SEE) is getting a smaller boost from these factors, due to lingering structural weaknesses and private sector debt. Commonwealth of Independent States (CIS) economies are expected to contract this year, with Russia affected by falling oil prices and sanctions and Ukraine in the midst of geopolitical tensions and macroeconomic adjustment.

A number of risk factors going both ways could come into play in the near future. There is a possibility of financial market volatility, for example as the US Fed begins to normalize its monetary policy. This could raise the cost of borrowing and reduce investment in the region. Any intensification of geopolitical tensions related to Ukraine or a prolonged period of turbulence in Greece could also weigh on the region’s prospects. On the upside, growth in the euro area could exceed expectations on the back of the ECB’s monetary policy and lower oil prices.

Sluggish investment, stubborn credit gap

Much of the CESEE region still lacks investment (Chart 1). In the second half of 2014, investment only made a positive contribution to growth in Central and Eastern Europe. Uncertainties about the strength of global and euro area recovery and geopolitical tensions are only partly to blame. The burden of debt in the private sector is another factor.

Since the global financial crisis, most countries in the region have significantly reduced investment and increased savings. However private debt-to-GDP ratios have declined only in a few countries. This reflects a combination of deep recessions, low inflation, and the impact of currency devaluations on debt burdens. CEE countries have seen less of a boom-and-bust cycle and hence, faced less of a deleveraging challenge than elsewhere in the region. While Baltic countries have made progress in reducing private...