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By Dr. Ivailo Izvorski, Chief Economist, Europe and Central Asia Region, World Bank
Capital investment in most middle-income countries of Europe and Central Asia (ECA) is lower than in peer economies around the world. More sluggish business dynamism since the 2008 Global Financial Crisis (GFC), amid slower progress in advancing structural reforms and a more challenging global environment, has been the main reason. However, another factor has been the still moderate depth and breadth of the countries’ financial systems, despite substantial improvements in the efficiency of both lenders and borrowers during the transition from a planned to a market economy. This leaves firms and entrepreneurs unable to raise adequate capital for long-term and riskier investments. Diminished inflows of foreign direct investment (FDI) amid a more risk-averse global investor base have also contributed to this trend.
This leaves firms and entrepreneurs unable to raise adequate capital for long-term and riskier investments.
In terms of gross fixed capital formation as a share of gross domestic product (GDP), in only 5 of the region’s 23 countries is fixed investment higher than 25 percent of GDP, the threshold that the World Bank Group’s 2008 Growth Report identified as necessary for sustained growth acceleration (Figure 1). In three of these countries, the higher investment rates reflect efforts by governments and state-owned enterprises, rather than the private sector. On average, fixed capital investment in ECA countries amounts to 22 percent of GDP, compared with approximately 26 percent in East Asia and the Pacific (EAP). Inadequate investment makes it difficult for firms to upgrade their technologies and infuse foreign expertise and capital, ultimately slowing productivity growth and innovation.
So, how are firms’ investments financed? Similar to most countries in the European Union (EU), overwhelmingly by bank borrowing and retained earnings (own resources).
The depth of ECA credit markets has improved over the last several decades, but they are still catching up with their European counterparts.
The depth of ECA credit markets has improved over the last several decades, but they are still catching up with their European counterparts. For a region where firms are substantially dependent on bank credit for growth, moderate financial depth translates into modest growth potential. The overall availability of credit to the private sector from domestic banks has not changed much since 2019, averaging approximately 41 percent of GDP, which is slightly over half of the EU average (Figure 2). The challenge is especially pronounced in terms of long-term credit, with less than half of the firms across ECA reporting access to long-term credit (Figure 3). When evaluated on the global credit-access distribution, most ECA countries fall below the median, with many ranking near the bottom.
The differences in the extent of financial intermediation among countries are substantial. At one end, credit to the private sector amounts to about 12 percent of GDP in Tajikistan and at the other, to nearly 70 percent in Russia. Countries with some of the highest levels of income per capita in the region have low levels of credit availability. For example, Romania has the third-highest GDP per capita in the region and a sound financial system, yet it ranks in the bottom third of the ECA countries in terms of credit to the private sector. (For example, for more than a quarter of Romanian firms, access to credit has been a major constraint, with more than a fifth having their loan applications rejected—almost three times higher than the ECA average.)
Limited access to long-term bank credit leads firms to rely on their own funds and short-term financing. This limits their ability to engage in substantial projects that require long-term commitments of stable resources.
As countries’ incomes increase and firms’ operations become more sophisticated, bank resources are typically supplemented by financing from capital markets. This has been the path traveled by many countries in EAP and Latin America and the Caribbean (LAC). By accessing debt or equity, enterprises can benefit from a more diversified and deeper investor base, often with longer maturities and lower costs. The countries of Europe and Central Asia lag both EAP and LAC in terms of the role their capital markets play in financing firms’ growth. For example, cumulative capital raised in ECA during 2010-22 amounted to approximately 11 percent of GDP, compared to 21 percent in Latin America and the Caribbean and almost 26 percent in East Asia and the Pacific. The total equity-market capitalization of the countries in ECA is approximately $750 billion, with more than half of that accounted for by Poland. This is only modestly higher than the equity-market capitalization of Brazil, a country with half the population of ECA.
Opportunities for enterprises in Europe and Central Asia to access venture capital have been rising rapidly, even from a low base. Around the world, venture capital (VC) finances riskier investments in start-up companies or young and dynamic firms that are trying to scale up their operations. Commercial banks are not the answer to the challenges these entrepreneurs face when creating innovative and risky ventures. As of 2019, venture-capital investments were made in only half of the 23 ECA countries. Their cumulative per capita value, on average, was less than 3 percent of the values in each of Estonia and Sweden, the top two countries in the EU (Figure 4). After the COVID-19 pandemic, however, venture capital appears to have increased substantially. Among the countries of the Southern Caucasus and Central Asia, for example, where investments were negligible before 2019, inflows totaled approximately $110 million in 2023.
In line with these developments, there are 13 unicorns—privately held firms valued at more than $1 billion—in Europe and Central Asia, out of a total of more than 1,539 globally. While the US dominates this list, with more than half of the total, Estonia has 10 unicorns. There is a need for countries in Europe and Central Asia to make it easier for venture capital to enter in larger amounts to finance firms’ growth and innovation.
The path for the countries of Europe and Central Asia is clear
For the middle-income countries of ECA to reach the high-income level, a business environment that provides substantial economic freedom to entrepreneurs, rewards merit, bolsters the quality of education, and supports predictability and ongoing integration with global markets is needed. But this progress crucially depends on firms having adequate, stable and diversified financing. Access to finance for enterprises is crucial for economic growth and needs to be a priority for policymakers.
— Acknowledgement —
The author, Chief Economist for the Europe and Central Asia Region at the World Bank, gratefully acknowledges the valuable research assistance of Sergiy Kasyanenko.
ABOUT THE AUTHOR
Dr. Ivailo V. Izvorski is the Chief Economist of the Europe and Central Asia Region of the World Bank. Over nearly 30 years, he has worked in technical and managerial positions on the countries of Sub-Saharan Africa, East Asia and the Pacific, and Europe and Central Asia at the World Bank, the Institute of International Finance, and the International Monetary Fund. Before his current position, Ivailo was the Manager of the World Bank Global Debt, Macro, and Growth Unit and, before that, the manager of the macroeconomists for Europe and Central Asia. Ivailo holds MA and PhD degrees in economics from Yale University.