Countries in the region of Europe and Central Asia should evaluate their vulnerabilities and prepare contingencies to deal with both the immediate and longer-term effects of an economic downturn, the World Bank said in its January 2012 global economic prospects report.
 
"Most countries in the region have less fiscal space available for counter-cyclical policies to cope with a sharp deterioration in global conditions as compared with 2008/09," the World Bank said.
 
In such eventuality, where fiscal space exists, governments could use countercyclical policy to support growth, by increasing spending on social safety nets that would limit poverty impacts, and on infrastructure projects that would benefit growth, the Bank recommended.
 
Countries with limited fiscal space could increase the effectiveness of countercyclical fiscal policy, improving the targeting of social safety nets and prioritising infrastructure programs necessary for longer term growth.
 
In such situation, monetary policy could also become more accommodative provided that inflation expectations remain anchored, the World Bank said.
 
Countries where credit has increased rapidly in recent years should engage in stress testing of their domestic banking sectors, the report recommended.
 
"A much weaker external environment could result in sharply lower domestic growth and falling asset prices that could result in a rapid increase in the number of non-performing loans and domestic banking stress."
 
Countries with large external financing needs should pre-finance these needs to avoid abrupt and sharp cuts in government and private sector spending, the World Bank said.
 
With growth in high-income countries likely to remain subdued for an extended period, countries in the region may need to identify new drivers of growth and to address structural problems that negatively affect competitiveness.
 
"There are considerable downside risks to the region’s economic outlook," the World Bank said.  
 
It said that the primary risk facing the global economy is a deterioration of the situation in high-income Europe, which could result in a significantly weaker external environment for Europe and Central Asia’s main trading partners but also a significant exacerbation of negative confidence effects.
 
"Such deterioration would magnify a number of pre-existing vulnerabilities in the region, including those arising from direct trade and banking-sector exposures, as well as more indirect effects running through both financial and real channels, including possibly sharp reductions in global external financing conditions, lower commodity prices and weaker remittances."
 
The Bank said that the region has unusually strong banking-sector linkages with high-income Europe, both in terms of ownership links and dependencies for day-to-day financing.
 
Foreign claims of European banks are particularly large in Latvia, Romania, Bulgaria, Lithuania and Albania relative to the size of their economies.
 
"Should the crisis in Europe accelerate the deleveraging among parent banks or a tightening of credit conditions, transmission of these conditions to the financial markets in developing Europe and Central Asia would likely be swift and potentially very damaging."
 
Several countries in the region are also vulnerable to generalised risk aversion by both foreign and domestic investors, the World Bank said.
 
Should conditions deteriorate substantially, international capital flows could weaken much further and borrowing costs could rise sharply.
 
Countries with high levels of short-term debt or maturing long-term debt and those with large current account deficits are particularly vulnerable to such a tightening in financial conditions.
 
"Turkey is particularly vulnerable with its large current account deficit and large short-term debt vis-à-vis its reserves," the World Bank said.
 
"In a similar fashion, Belarus and Montenegro are also vulnerable to a freezing-up of global credit as well as Georgia, Bulgaria, and Romania with their heavy reliance on short-term debt."
 
Moldova is also at risk since it finances its large current account deficit with flows other than FDI, which tend to be volatile.
 
The European Union remains a key export market for countries in Eastern Europe and Central Asia, accounting for more than half the region’s exports, with Romania, Lithuania and Latvia particularly vulnerable to a sharp downturn in European demand, the Bank said.
 
A substantial faltering of global growth may disproportionately impact commodity exporters through a possible reduction in commodity prices.
 
Based on current export volumes, in an event of a sharp fall in oil prices the hardest hit economies in the region are likely to include Russia and Azerbaijan.
 
Remittances, which are a very important source of both foreign currency and domestic incomes for several countries in the region, may be severely affected since 40 per cent of remittances emanate from high-income Europe.
 
Also, remittances outflows from Russia are particularly important for the region, which would decline considerably if oil prices fall sharply. Such reduction in migrant remittances will pressure on current account positions in several countries that rely heavily on remittances, in particular in Tajikistan, Kyrgyz Republic, and Moldova, the World Bank said.