booming economies, dangerous politics

Economies in Transition Eastern Europe and the former Soviet Union Regional overview, June 2007
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Eastern Europe: booming economies, dangerous politics

A deep disjuncture between well-performing economies and disturbing political trends has opened up in much of the eastern Europe, according to the Economist Intelligence Unit's latest Economies in Transition Report (June 2007). Real GDP growth in the 28 transition countries of eastern Europe and the former Soviet Union reached a record 7.1% in 2006, and very strong activity has carried on into the first half of 2007. Foreign direct investment (FDI) inflows into the region reached a record total of US$108bn in 2006, up by 40% on the US$77bn received in 2005.

By contrast, the politics of the region exhibit a number of worrying trends, including signs of a deep political malaise in east central Europe, very poor political relations between Russia and the West, the consolidation of authoritarian trends in some countries of the CIS, an unsettled domestic political scene in key countries such as Ukraine and a looming crisis over the future of Serbia's breakaway province of Kosovo.

For the moment, economies have generally not been affected but according to Laza Kekic, the Economist Intelligence Unit's Director for Eastern Europe, "The divergence between economic and political trends cannot persist indefinitely. There is an appreciable risk that bad politics will eventually overwhelm the good economics."

The divergent political and economic trends characterise three areas in particular: developments in the new EU member states of central Europe; Russian-Western relations; and the situation in previously war-torn but now recovering south-east Europe.

Central Europe
Most of central Europe's economies have continued to boom following the attainment of EU membership in 2004. At the same time riots in Hungary in 2006, in conjunction with worrying political developments in a number of other countries, have highlighted a political malaise in the region. Although there appears to be no imminent threat to political stability, governments across the region are weak and populist tendencies have strengthened.

The removal of the previous unifying goal of EU accession has exposed the underlying fragility of the region's politics. Although democratic forms of government are in place, the substance of democracy—including a political culture based on trust and healthy levels of political participation—is often absent. According to the Economist Intelligence Unit's Index of Democracy, only two states from the region—Slovenia and the Czech Republic—qualify as consolidated full democracies.

Survey results show disappointing levels of support for the core values associated with the transition, and there is a strong nostalgia for pre-transition days. The roots of the new order appear to be shallow. There is also a deep divide in most countries between the winners and losers of the transition. This has given rise to populist politicians who combine "right-wing" attitudes towards social issues with "left-wing" ideas about economics (demands for tax increases, tighter labour regulations, and re-nationalisation of privatised property).

There is a danger that the poor political situation will begin to affect economic performance. The momentum for reform has slackened. In many countries there are important policies that need to be implemented—preparing economies for euro adoption, reforming the health, pension and tax systems—to lay the basis for sustainable growth. In a worst-case scenario, a vicious circle could develop. Faced by an economic downturn, the region's political systems—still unsupported by a strong democratic culture and traditions—could come under further strain.

Russia and the West
Russian-Western relations have hit their lowest point since the end of the cold war. There is a bewildering array of issues that divide Russia and the US and EU. Some of these are deep-rooted and are not amenable to an easy resolution. In addition to US missile defence plans, among the most contentious issues are NATO enlargement; energy policy; geopolitical competition in the former Soviet area; Russian internal political trends; and different concepts of the international order. If not a cold war, then a chilly stand-off is in the offing.

Yet, rising political tensions come at a time when Western trade with Russia and FDI into and out of Russia are booming. Economist Intelligence Unit surveys show that Western companies doing business in Russia are very bullish about the country. However, the deterioration in East-West political relations is not just "background noise" from which business can remain insulated. Political tensions could disturb in an unfavourable way the balance of Russia's current dualistic policy framework—a mix of statism in some sectors and liberalism in others. They could feed an increase in FDI protectionism in both Russia and the West. And if there is to be a new arms race, Russia will be making sharp increases in defence spending, thereby diverting resources from much-needed investment in health, education and infrastructure.

South-east Europe
The Balkan economies have continued to recover strongly. FDI flows have been at record levels in most countries. Rising employment and wages, and strong inflows of migrants' remittances, have underpinned buoyant consumption growth. South-eastern Europe is also poised for regional trade integration with the expansion of the Central European Free-Trade Agreement (CEFTA).

Yet one of the main sources of potential instability in the wider region surrounds the future of Kosovo. The US and most EU countries are firmly in favour of independence; Russia is firmly opposed. Irrespective of the final outcome, the situation threatens wider stability; it has the potential to affect a host of other disputes across the region; it will represent a major test for the EU; and it could also exacerbate greatly the already troubled relations between Russia and the West. Furthermore a potential crisis over Kosovo is looming at a time when the credibility of EU expansion (the main stabilising force for the region) has been gravely weakened.

The report also discusses the region's short-term macroeconomic outlook; the evolution of business environments; south-east European economic integration; euro entry prospects; recent FDI trends and forecasts; and long-term growth prospects.