Overlapping crises in the Western Balkans

Aluminium blocks are seen in Wagner Automotiv industry in Gradacac, Bosnia and Herzegovina February 8, 2022. REUTERS/Dado Ruvic/Illustration

The countries of the Western Balkans are facing a series of economic shocks all at the same time. The region’s economy was only just beginning to bounce back from the COVID-19-induced recession, but now also needs to grapple with the fallout of the war in Ukraine, a resurgence in inflation, and a pressing energy transition. Steering through these crises involves risks and will require careful choices.

All six of the Western Balkan economies—Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia—saw a strong economic recovery with 7.4 percent growth in 2021 as the region rebounded from the recession of 2020. In fact, the strength of the recovery exceeded forecasts due to a combination of pent-up consumer demand, relaxed travel restrictions despite high infection rates and low vaccination, and a rebound in investment and a surge in exports—all aided by continued fiscal support. A return to economic growth saw job creation, in turn helping to reduce poverty across the region.

Tax revenues also bounced back in 2021 with the growth recovery, reducing budget deficits and public debt. However, one year of growth is simply not enough time for any country to rebuild fiscal and debt buffers for the next shock if it is a large one. Public debt fell to 57 percent of GDP in 2021, about 4 percentage points lower than the 2020 peak, but still higher compared to the pre-COVID-19 50 percent of 2019. As a result, governments across the Western Balkans entered 2022 with limited room for maneuver.

Even before the outbreak of war between Russia and Ukraine, economic growth in the Western Balkans was already slowing toward pre-crisis rates, and similarly inflation was already rising as supply constraints and pent-up demand across the world pushed commodity prices higher. The war in Ukraine is exacerbating these two trends and pushing inflation sharply higher, as well. It is also denting business and consumer confidence, impacting trade and tourism, and causing severe disruptions in food and energy supply chains. This is especially the case in Serbia and Montenegro, which are the Western Balkan economies most exposed to trade with Russia and Ukraine.

Testing times ahead

The Western Balkans now face an especially uncertain outlook. In addition to the outbreak of war, COVID-19 has not gone away, and the energy disruption caused by the war in Ukraine has exposed vulnerabilities associated with the region’s still heavy reliance on fossil fuels. While we were expecting a continued strong rebound in 2022 as most epidemiological measures were lifted, and as pent-up demand drove consumption and investment growth, the war has disrupted this trajectory. In our current baseline scenario, we expect real output to grow at 3.1 percent in 2022—a downward revision by almost 1 percentage point—and below the historical growth rate. Moreover, further downgrades of growth and higher inflation forecasts are likely as the conflict stretches into summer 2022, sanctions intensify, and the EU’s growth slows further (Figure 1).

Not only is the region facing a growth slowdown, but rising food and energy prices mean that the poorest households that spend more than 60 percent of their budgets on food and energy are experiencing an especially high rate of inflation (Figure 2). They often lack the coping mechanisms to absorb a higher cost of living.

Policy trade-offs amid uncertainty

The economies of the Western Balkans weathered the COVID-19 shock comparatively well as they rebounded faster and stronger than expected, using fiscal policy to support vulnerable households and firms. However, resources have been depleted and a key challenge now is to respond to pressing needs today, while also keeping an eye on the reforms needed to support equitable, greener, and sustainable growth tomorrow. Governments will have to be frugal—carefully using their limited fiscal resources to protect the poorest households that spend a larger share of their income on food and energy. Policy measures to respond to current, pressing needs should be timebound so that governments can switch back to rebuilding buffers as pressures dissipate. Furthermore, in an environment of scarce resources, now is the time for governments to step up efforts to improve tax compliance, strengthen social assistance systems to protect the energy poor, and reallocate resources toward energy efficiency investments, as well as enable private investments into renewable energy.

Finally, governments should not lose sight of reforms neglected since 2020 that are vital for enhancing long-term potential growth. Structural reforms to improve human capital, support labor market participation (especially for women and youth), and strengthen competition would help boost potential growth that had been slowing even before the current crisis. Additionally, attracting greener and higher value-added foreign investment would require deeper efforts to streamline business regulations, and boost connectivity and digitalization.