EBRD Sees Continued Obstacles to Eastern Europe Recovery

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By Paul Hannon

LONDON--Economic growth will continue to pick up in countries with close links to the euro zone as the currency area starts to emerge from its long-running crisis, but will be hindered by capital outflows and a reduction in lending by foreign banks, the European Bank for Reconstruction and Development said Tuesday.

Releasing its latest report on the outlook for the 34 economies in which it invests, the development bank cut its growth forecast for Turkey, citing the impact of "elevated political uncertainty" on borrowing costs, and repeated its warning that some countries in central and southeastern Europe face the threat of deflation.

In the years following the financial crisis, and the bond markets crisis that followed, exports to the euro zone from many countries in Eastern Europe slowed, while western European banks withdrew funds from their subsidiaries, reducing the availability of credit to businesses and households.

The EBRD said that with the euro zone's economy set to grow again this year after two years of contraction, exports from some countries in Eastern Europe are set to rise. The development bank said it expects the average growth rate of eight economies in central Europe and the Baltic States to pick up to 2.2% this year from 1.1% in 2013, a more rapid acceleration than the 1.9% it had expected when it previously released forecasts in November.

However, the growth prospects of its countries of operation will continue to be hindered by developments in the euro zone and the U.S., the EBRD said.

For the first time since 2011, there was a net outflow of capital from the 34 countries in the third quarter of last year as investors prepared for a gradual reduction in and then withdrawal of the stimulus being provided by the U.S. Federal Reserve.

"These outflows are likely to persist, as monetary conditions in the United States are expected to be gradually tightened," the EBRD.

The development bank said the European Central Bank's upcoming Asset Quality Review and stress tests may lead to an acceleration of the withdrawal of funding provided by western European banks to their eastern subsidiaries.

"Cross-border bank deleveraging pressures may intensify further if the eurozone-wide stress tests reveal significant recapitalization needs of major banking groups," the EBRD said.

The high rates of growth recorded by many Eastern European countries in the years prior to the financial crisis were facilitated by large inflows for foreign investment and bank lending.

The development bank said that while some progress has been made in recent years, most countries in the region still lack the financial markets and institutions that can provide an alternative source of investment to foreign capital.

"Given low domestic savings rates and underdeveloped local capital..., the recent reduction in foreign funding is unlikely to be swiftly offset by funding from local sources," the EBRD said. "This constrains potential investment growth and hinders long-term growth prospects."

However, the EBRD said despite those external impediments, the key to lifting long-term growth rates lies with the countries in which it operates, where needed reforms have stalled and in some cases been reversed since the middle of the last decade.

"For a sustained recovery to take hold, the region needs to reignite structural reforms and deal with the persistent legacy of the crisis," the EBRD said.

While leaving many of its forecasts for individual countries unchanged compared with November, the EBRD lowered its 2014 growth projection for Turkey to 3.3% from 3.6%, and said even that may prove optimistic.

"A further weakening or a reversal of capital flows would bring additional challenge for the Turkish economy," it said. "Another downward risk to the outlook stems from a continuation of political uncertainty at the high levels seen recently."

The EBRD was established in 1991 to help countries in Eastern Europe and the former Soviet Union make the transition from centrally planned to market economies, and has since expanded its range to include Mongolia, Turkey, Jordan, Morocco, Tunisia and Egypt.

-Write to Paul Hannon at paul.hannon@dowjones.com


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