Unleashing the power of the private sector in Europe and Central Asia

Economic development in Europe and Central Asia (ECA) has been the story of the transition from plan to market, the advance of broad and deep structural reforms, and the emergence of private initiative as the main driver of growth. In less than three decades, a dozen ECA countries joined the European Union (EU). ¹ The successful transition of these countries to EU-integrated market economies with robust institutions and production structures illustrates just how far reforms have taken some countries in the region, including to high-income status. But the ambitious structural reform agenda of the 1990s has slowed in many middle-income countries in ECA, and their transition to market is still ongoing.

Weaker productivity growth in ECA over the past decade has slowed income convergence with advanced economies (figure 1). While there was a broad-based slowdown in productivity across emerging markets and developing economies after the global financial crisis, and in most advanced economies since the 1970s, the decline was steepest in ECA. Fundamental drivers of productivity growth, including progress in advancing institutional and market reforms, and technology adoption and innovation, which are all key for enabling private sector led growth, have weakened in ECA. Many countries in the region have made limited progress in establishing more effective corporate and market institutions in recent years.

Figure 1: Slowing GDP per capita convergence to the United States in ECA

^{Source: World Bank.
Note: The figure shows min-max ranges and averages for ECA, with real GDP at average 2010–19 prices and market exchange rates. Data for 2023 are estimates. ECA = Europe and Central Asia; GDP = gross domestic product.}

Against the background of slowing growth and convergence, the Spring 2024 ECA Economic Update focuses on the role of business dynamism and innovation in boosting prosperity and productivity in the region. Stronger economic growth depends crucially on a vibrant and innovative private sector. The ECA Economic Update examines trends in business dynamism and innovation in ECA and compares them with those in advanced economies in Europe and peer economies in the East Asia and Pacific region, where income and productivity growth have been broadly stronger in the past decade.

The region has plenty of room for improving business dynamism and innovation. Firms in ECA are less productive (figure 2) and less innovative than those in the advanced economies in Europe. Firm entry and exit rates are lower and firms do not grow much over time, pointing to a less competitive and dynamic business environment in which firms tend to innovate less, absorb less knowledge, and often become less productive over time.

Figure 2: Firm productivity in ECA lags advanced economies in Europe

^{Source: Calculations based on data from the latest World Bank Enterprise Surveys (for most countries, 2019).  
Note: The figure plots the distribution of log(labor productivity) across firms, using scaled survey weights, so that each country has equal weight. For the list of countries, see table 2A.1, in annex 2A in the Spring 2024 ECA Economic Update. ECA = Europe and Central Asia.}

Boosting business dynamism in ECA will require addressing several challenges, including upgrading the competition environment (figure 3), reducing state involvement in the economy, dramatically boosting the quality of education, and strengthening the availability of finance. Although meeting these challenges will look different in different countries, addressing them is an essential condition for stronger economic growth and overcoming the middle-income trap. Further, deepening integration into global markets will be crucial to help to accelerate both the adoption of new technologies and firms overcoming the limits to potential firm growth due to the small size of many economies in the region. Adverse demographics are also a challenge in the countries in the western part of the region, where tightening labor supply due to declining populations is exacerbated by high emigration rates of young and skilled workers.

Figure 3: Most countries in ECA saw little change in the competitive environment between 2006 and 2022

^{Source: Bertelsmann Stiftung Transformation Index (2022).
Note: The initial year for Kosovo is 2010, and for Montenegro it is 2008. BTI = Bertelsmann Transformation Index; ECA = Europe and Central Asia; EAP = East Asia and Pacific.
a. The BTI market-based competition measure captures the extent to which the fundamentals of market-based competition have been developed, with a maximum score (10) indicating that “market competition is consistently defined and implemented both macroeconomically and microeconomically. There are state-guaranteed rules for market competition with equal opportunities for all market participants. The informal sector is very small.” The minimum score (1) indicates that “market competition is present only in small segments of the economy and its institutional framework is rudimentary. Rules for market participants are unreliable and frequently set arbitrarily. The informal sector is large.”}

^{1 In 2004, nine ECA countries joined the EU: Cyprus, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia. Bulgaria and Romania joined in 2007, and Croatia followed in 2013.}