Countries in Europe and its broader neighborhood cannot base long-term growth on their low-wage comparative advantage. Instead, they must lay the foundations of future-oriented growth models, including by improving governance, investing in infrastructure, and promoting environmental sustainability.

LONDON – More than ten years after the global financial crisis, the world economy is finally enjoying a broad-based recovery. Europe and its broader neighborhood 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.

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

The explanation is straightforward. Previously, Europe and its broader neighborhood 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 labor 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.

Countries in Europe and its broader neighborhood – 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-oriented 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 €2.2 trillion ($2.6 trillion). 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 channeled toward 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% of its road network into dual carriageways over the course of about ten 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 potential donors – such successes.

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 ERBD 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 toward a green economy. To ensure that the neediest households do not suffer, the removal of subsidies can be offset by targeted assistance, as has been done recently in Belarus, Egypt, and Ukraine.

A new growth model for Europe’s neighborhood 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 toward 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 neighborhood, progress would benefit not just the economy – including by promoting investment and innovation – but also the environment and society as a whole. That is an investment worth making.

The writer is Chief Economist at the European Bank for Reconstruction and Development.

Copyright: Project Syndicate