Why are the western Balkans lagging behind?

Transition in central and eastern Europe since the collapse of communism has hardly been a resounding success. Only a few countries in the region—typically those that started out at a high level—can claim to have living standards approaching those in the poorest parts of western Europe. However, even by regional standards, the countries of the western Balkans (largely the former Yugoslavia) have performed particularly badly. This performance can be attributed to a multitude of factors, although a narrow focus on the lack of reform ignores the deeper causes of these countries' problems. Greater distance from the mighty German industrial base; the prospect of a protracted spell in the waiting room for EU accession; and even institutional and cultural factors that pre-date communism are all important. Our forecasts indicate that there will be little change in economic performance in the next five years, increasing the gap not only with western Europe, but also with the better-performing former communist economies in central Europe and the Baltics.

A former World Bank economist, Branko Milanovic, recently reviewed the experience of 25 years of transition in central and eastern Europe (CEE). Based on the criteria of growth in income per head, trends in income inequality and progress in political democratisation, he concluded that only two countries can without serious reservations be rated to have been successful: Poland and Estonia (we would add the Czech Republic and Slovenia, although in both cases a significant head start should be taken into account). The expectations at the start of the transition period that most east European countries would converge economically with the rest of Europe, experience only modest increases in inequality and become consolidated democracies have not been fulfilled.

The performance of the western Balkan economies has been especially poor, including in comparison with the east European states that joined the EU in 2004 and 2007—the ten new member states. It should be noted that this is an undemanding comparison criterion, as the performance of the new member states, with the exception of the small number of countries mentioned above, has been in the main rather disappointing or modest. As the chart below shows, in purchasing power parity terms, only the Czech Republic and Slovenia have passed more than one "western" European country (Greece and Portugal) in terms of per capita wealth. The gap with the next level—Spain and Italy—remains significant.

Membership of the EU has clearly not proved to be a panacea—far from it. However, despite their economic problems and political regression in some cases (notably in Hungary), the ten new member states that joined in 2004-07 have on the whole been more successful than the western Balkans in consolidating economic reforms, integrating into the world economy, attracting foreign investment and reorienting trade to the West. By contrast, the economic transition of the western Balkans has stalled. The region's inability to integrate by trading more with western Europe in particular is emphasised by the extremely low share of merchandise trade exports in nominal GDP compared with the Baltics and central Europe (see chart below). Growth in the western Balkans is weak and fragile. The region suffers from low investment, average unemployment is at around one-quarter of the adult population and there are pockets of extreme poverty. Emigration from the region has shot up. The western Balkans thus face the risk of permanent marginalisation on the periphery of Europe.

In 2014 real GDP in the western Balkans was still almost 10% below its 1989 level, whereas it was almost 60% higher on average in the countries that joined the EU in 2004-07. GDP per head in the western Balkans was only 27% of the average level in the EU15 countries, and roughly half the average level in the 2004-07 EU joiners.

The western Balkans consist of Albania, Bosnia and Hercegovina (BiH), Kosovo (which is not recognised by all EU members), Macedonia, Montenegro and Serbia—all candidate or aspirant members of the EU. Croatia "escaped" the western Balkans when it joined the EU in mid-2013, but continues to suffer from many of the region's ailments. The eastern Balkan countries of Bulgaria and Romania also share some of the region's problems despite their membership of the EU since 2007.

The three phases of transition

The transition in the western Balkans has had three phases. The lost decade of the 1990s was characterised by wars, international sanctions, slow or non-existent economic and political reform, lost markets and sharp falls in output. Between 1989 and 1994 real GDP in the western Balkans contracted by almost 60%; by 2000 it was still more than 40% below its 1989 level. A second phase took place from 2000 and until the 2008 crisis. GDP began to recover, although the pace of growth was not much faster than for the 2004-07 EU joiners during this period. Furthermore, the improved performance in 2001-08 was based on an unsustainable pattern of increased consumption linked to fast credit growth, widening current-account deficits and increasing private debts.

Performance has been especially poor since the 2008 crisis, the period that constitutes the third phase. Output fell in 2009 and since then the region has essentially stagnated. The process of convergence with the rest of Europe has stalled.

The reasons for the western Balkans' poor performance include:

A preference for fixed exchange-rate regimes (formal and de facto), which has been a recipe for trouble.

Despite some progress in regulatory reforms, as measured by the World Bank's ease of doing business rankings, there are key areas where further improvement is needed—especially in dealing with construction permits, enforcing contracts and resolving insolvency.

Low public capital spending. The average ratio of public capital spending in GDP in the western Balkans fell to 5.4% in 2013; it was lowest in Serbia, at only 2.1%. Only in Kosovo has there been an increase in capital spending since 2008, and that is mainly accounted for by investment in a single motorway.

There has been little scope for fiscal stimulus. The average public debt/GDP ratio in the western Balkans increased by 18 percentage points in 2009-14 (in Croatia and Serbia the increase was around double that).

Foreign direct investment (FDI) is key to growth especially when domestic investment and savings are low. FDI in the western Balkans has been notably weak since a peak in 2006-07 of more than US$7bn inflows per year. Annual FDI inflows collapsed to less than US$4bn in 2012-14.

The IMF's diagnosis

According to a recent IMF report ("The Western Balkans: 15 Years of Economic Transition"), there are two main reasons for western Balkan underperformance: greater physical distance from Europe's core, which in particular affects the ability to integrate into German supply chains; and the loss of reform momentum. The latter is ascribed to reform fatigue and encroaching vested interests. One can add that the increasing certainty that there will be no further EU enlargement during at least the next five years has greatly weakened one key reform anchor or incentive. The external dependence of western Balkan economies on crisis-ridden or slowly growing Greece and Italy, rather than Germany (although some, notably Macedonia, have been able to fix this to a large extent), has been another negative aspect.

The IMF's methodology to identify reform priorities is based on an econometric investigation of the link between growth and reforms, and on the gap between the ten countries that joined the EU in 2004-07 and each western Balkan economy for each reform area. On this basis, the priority areas for reform in the western Balkans are said to be:

Improving the quality of governance,

Increasing the efficiency of goods markets,

Labour market reform,

Strengthening human capital,

Deepening financial systems.

There are two problems with the IMF's and other international organisations' focus on the lack of reform. First, improving the main area of weakness—poor institutions or governance—is a long-term "slow-burner" task, not easily amenable to policy actions. The second big issue is the question of why the western Balkan countries have been slower to reform and more vulnerable to the influence of vested interests. Of crucial importance are the region's weaker public administration and policymaking capabilities. In part, these can be traced back to pre-communist legacies, in particular the enduring impact of divergent Ottoman and Habsburg colonial experiences.

Another feature that is inimical to reform is that most countries in the western Balkans have characteristics that our research has found to be closely associated with vulnerability to social unrest and political upheaval. These include:

New and inexperienced states and bureaucracies;

A history of unrest;

Ethnic and border disputes;

High unemployment;

Non-consolidated democracies;

Very high levels of popular dissatisfaction with politicians;

Corruption;

Low levels of trust in political institutions.

Outlook remains subdued

Given the apparently entrenched nature of many of the factors holding back the western Balkans, there appears to be little chance of a fundamental change in fortunes for the region any time soon. None of the countries discussed will join the EU in the next five years, and even a ten-year time horizon looks unrealistic at this stage. Greater integration with the German industrial sector would require a broader ramping up of the export base in the western Balkans—something that is highly unlikely to be achieved even in the medium term. This applies equally to Croatia, even though it is now a member of the EU—in its case, late accession (compared with the 2004-07 joiners) appears to have provided little more of an advantage than not joining at all.

Meanwhile, some other former communist countries—notably the Visegrad states and the Baltics—look set to grow more quickly and (mostly) from a higher base over the next five years, increasing the relative weakness of the western Balkan economies even within the CEE region. As the chart above shows, we expect Estonia's GDP per capita (at 2005 prices expressed in US dollars) to increase to 66.8% of the German level by 2019, a 6.5-percentage-point increase on the (estimated) 2014 level. Poland's ratio will increase by 5.7 percentage points, to 60% of the German level, over the same period. The performance of the western Balkan countries, for which we forecast out five years, will be much less impressive, particularly in the case of Croatia. Meanwhile, in 2019 the ratios of GDP per capita for Serbia, Macedonia and BiH will be just 31.4%, 32% and 25.1%, respectively, of the German level. In the context of what will by then be three decades of transition, this will be viewed by many as nothing short of disastrous.