Against the backdrop of a weakening global economy and volatility in international financial markets, countries of the Europe and Central Asia region (ECA) are transitioning to a new normal.
Oil-exporting countries in eastern ECA face the difficult adjustment to low commodity prices. That adjustment unavoidably comes with sharp real deprecations, job losses in construction and domestic services, falling asset prices (especially real estate and equity prices), increased fragility in partly dollarized financial sectors, and declining household incomes.
Very similar adjustments are taking place in surrounding countries with strong links to oil exporters through remittances and trade flows. Because of terms-of-trade losses and sharp declines in real remittances, most of the affected countries have seen their purchasing power drop more than 10 percent this year, much more than suggested by GDP numbers.
The adjustment in eastern ECA also comes with new opportunities in tradable sectors. Diversification strategies can now be much more successful than during the oil-price boom. That implies job creation in sectors that produce tradable, non-oil products, and exports to new destinations. To seize these opportunities policy makers have to embrace the new normal by using flexible exchange rates, absorbing negative side-effects, and facilitating investments in new sectors with competitive job opportunities.
In western ECA, the fragile recovery continues, despite significant headwinds in the global economy. In the European Union and the Western Balkans the new normal poses the question how to achieve a recovery of investments without the tailwinds of a global credit boom. Especially for Southern European countries, access to finance will not be as easy as before 2008.
Risks in western ECA are more balanced than in the east. While risks in the east are predominantly on the downside, west ECA countries are less affected by ongoing volatility in global financial markets. There are idiosyncratic risks in the west associated with large migrations of refugees escaping the Syrian war and the implementation of Greece’s reform program, as well as other lingering geopolitical issues.
On the under hand, there are promising opportunities, created by a weaker euro and lower oil prices, that could stimulate investment more than anticipated in the baseline forecast that is presented in this report.
The challenge for policy makers and financial markets is how to create an environment that is conducive to a stronger rebound in private investments. Faster and more effective insolvency procedures, strengthened financial sectors, and higher absorption of E.U. structural funds could contribute to such a rebound.
This Economic Update consists of two parts: (i) Economic Outlook, comprising two chapters, and (ii) Country Pages. In Part I, the first chapter describes the outlook for GDP growth, and then goes beyond GDP in a couple of important areas. It shows that terms-of-trade losses for oil exporters this year are much larger than changes in GDP.
Furthermore, the discussion suggests a way to calculate real values of remittances. For remittances-receiving countries the changes in real remittances also outweigh changes in GDP. Finally, the chapter shows that at the height of the Greek crisis, households in Greece suffered larger losses in income than suggested by GDP numbers.
The second chapter is more analytical. It establishes the link between oil prices and real exchange rates, both theoretically and empirically. It also presents model simulations that describe the consequences of oil prices on sectoral patterns and income distribution. Understanding these pervasive impacts is crucial for the design of policy responses.