A new growth model for Europe’s neighbourhood

The developing economies of Europe previously outperformed emerging economies elsewhere, but the impact of the Recession stalled their growth. A shift towards a future-orientated growth model is required to arrest this decline

Author: Sergei Guriev
April 4, 2018

More than 10 years after the global financial crisis, the world economy is finally enjoying a broad-based recovery. Europe and its broader neighbourhood are no exception: economic growth in almost every country in Central and Eastern Europe, Central Asia, the Middle East and North Africa, as well as in Russia and Turkey, has accelerated in the last year, and is projected to remain robust. Yet new challenges loom. If not addressed, these regions’
prospects will dim.

A changing outlook
As the European Bank for Reconstruction and Development’s (EBRD) new Transition Report shows, before the Great Recession, the countries of Europe and its broader neighbourhood were outperforming comparable emerging economies elsewhere. In recent years, however, the tables have turned – and the gap is growing.

Firms with a higher share of green revenues have higher stock market valuations, even if their current return on equity is lower than that of their non-green peers

The explanation is straightforward. Previously, Europe and its broader neighbourhood enjoyed high total factor productivity (TFP) growth. By eliminating many of the inefficiencies inherited from their socialist or otherwise dirigiste pasts, these countries were putting their capital and labour to increasingly good use.

Yet, by 2009, the low-hanging fruit had been picked, and investment in fixed capital had fallen below the levels in emerging economies elsewhere. Faced with the large amounts of non-performing loans inherited from the crisis, countries shifted their attention to deleveraging, leaving investment and TFP growth to stall.

Essential integration and investment
Countries in Europe and its broader neighbourhood – even those whose economies are less developed – cannot base long-term growth on a low-wage comparative advantage. Instead, they must lay the foundations of future-orientated growth models, underpinned by stronger human capital and innovation.

This demands, first and foremost, deeper integration into the global economy. Nowadays, access to larger markets is vital to generating incentives for innovation and productivity growth. European Union countries obviously benefit from the single market. For emerging Europe and the countries of the Middle East and North Africa (MENA), however, taking advantage of economies of scale will require reduced trade barriers and better connectivity.

In concrete terms, this means that emerging Europe and the MENA region need to invest more in infrastructure. And, in fact, according to the Transition Report’s estimates, these regions’ infrastructure investment requirements amount to about €2.2trn ($2.6trn). To meet this need, fiscally constrained countries will have to mobilise private resources, via private-public partnerships.

Developed-country actors often worry that infrastructure investments in emerging economies may result in ‘roads to nowhere’, with money being channelled towards remote regions where nobody lives or from which existing residents are eager to leave, using those shiny new roads. But this does not have to be the case.

Turkey is a case in point. In 2002, the country launched a major effort to turn 25 percent of its road network into dual carriageways over the course of about 10 years. The EBRD’s Transition Report’s analysis shows that this investment has had a major impact on domestic trade and created jobs in the country’s previously underdeveloped eastern regions. As countries attempt to attract financing for their own infrastructure projects, they should learn from, and highlight for the benefit of potential donors, such successes.

The value of being green
Designing effective strategies for long-term infrastructure investment requires attention to another key area: the environment. Countries must anticipate the regulatory changes that will arise, as they attempt, say, to meet their commitments under the Paris climate agreement.

This approach is in line with the market consensus. Using the FTSE Russell Low Carbon Economy database, the EBRD found that while greener firms remain less profitable than their less sustainable counterparts – they are, after all, largely younger and smaller – they are growing faster.

Perhaps more important, we found that firms with a higher share of green revenues have higher stock market valuations (price-to-earnings ratios), even if their current return on equity is lower than that of their non-green peers. This suggests that investors expect stronger growth in greener market segments, or at least attach more value to supporting greener firms.

In places where fossil fuels are adequately priced, firms themselves also recognise the benefits of greener, more energy-efficient technologies. Unfortunately, many countries still have in place substantial energy subsidies, which must be phased out to propel the shift towards a green economy. To ensure that the most in-need households do not suffer, the removal of subsidies can be offset by targeted assistance, as has been done recently in Belarus, Egypt and Ukraine.

Adjusting the model
A new growth model for Europe’s neighbourhood must also involve a rebalancing of the financial system. Given the Great Recession’s legacy of non-performing loans, financing for new investment is more likely to come from equity than from debt. Fortunately, equity investors are also oriented towards the long term, and are increasingly willing to buy greener assets.

Yet greater reliance on equity finance will require better state and corporate governance, underpinned by the rule of law. Achieving that will be no easy feat.

But EBRD research implies that, at least in the European neighbourhood, progress would benefit not just the economy – by promoting investment and innovation – but also the environment and society as a whole. That is an investment worth making.

© Project Syndicate 2018