2. Global headwinds weigh on the recovery

Following a strong rebound in 2021, growth, although still robust, was on a decelerating path in the first half of 2022. In Q1 of 2022, the Western Balkan economies remained resilient overall, supported by sizable policy actions at the EU, euro area, and national levels. First-quarter growth was particularly strong in tourism-based economies and in Serbia. However, growth decelerated in Q2, as countries had to deal with the direct consequences of the war and is projected to continue decelerating in the second half of the year reflecting higher base levels of growth in Q3 and Q4 2021 and the stronger global headwinds.

Rising prices, monetary policy tightening, and supply-side constraints have created headwinds to a stronger recovery. With average inflation surpassing 13 percent in the Western Balkan region in July 2022, consumers and firms have been faced with rising costs and reduced purchasing power. As a response, central banks in the region have stepped up efforts to control inflation and tame inflationary expectations by raising policy rates. In the current environment, however, these important actions, taken at a time when the recovery is losing strength, and when the economies are facing supply-side constraints including labor shortages, have contributed to the significant headwinds. Overall, growth in the region is expected to reach 3.4 percent in 2022, 0.6 pp above the average growth expected in the EU (Figure 2.1).

Private consumption and investment were the key drivers of growth in the first half 2022. Both business and consumer confidence remained strong, and despite increasing energy and food prices, consumption contributed significantly to growth in the first half of the year (Figure 2.2). Rising wages and remittances, together with increasing private credit, have supported private consumption. Investment was particularly strong in Bosnia and Herzegovina where it has been mostly driven by infrastructure works and private investment, as well as North Macedonia and Serbia but mostly due to the rise in inventories. In contrast, in Kosovo, a slowdown in private investment amid higher construction input prices and a low capital execution rate in the public sector is expected to lead to a negative contribution of investment to growth for 2022.

With investment playing a key role in economic growth, the recovery seems structurally different from past experience and bodes well for the region despite the global headwinds. Compared to the years after the 2008-09 global financial crisis, between 2012 and 2019, when low investment contributed on average 1 percentage point (pp) to GDP growth, the contribution of investment to growth has been significantly higher in 2021 and 2022, at 3.7 and 2.1 pp, respectively (Figure 2.2). While total investment is playing a stronger role in this post-COVID-19 recovery, the composition of investment is slow to change as most businesses seem to still be behind on the digital and green investment agenda (Box 2.1). In all Western Balkan countries, the higher costs of energy and materials are expected to weigh on private investment going forward, leading to a potential delay in the execution of planned investment, and overall muted contributions of investment to growth.

Box 2.1. what are firms struggling with in the western balkans region?

Several challenges constrain business growth, reflected in low productivity growth in the region. Challenges include access to finance, anti-competitive practices of competitors, lack of or expensive technology, and lack of skills (Figure 2.3). While access to finance has always been reported as a significant challenge in the region, the other growth constraints have become particularly acute in the recovery phase, with shortages of key inputs such as technology and skills becoming more severe, and still high regulatory barriers to entry and conduct, and weak competition policies unaddressed.

Contrary to isolationist trends, economic integration emerges as a way ahead. The quality of regional cooperation is deemed important or very important by the majority of businesses within the region, with the majority of businesses confirming the benefits received from the regional free trade agreement (the 2006 Central European Free Trade Agreement). Businesses in the Western Balkans also continue to believe in the benefits of EU accession, even though they have become less optimistic regarding timelines, implementation, and competitiveness vis-à-vis other EU countries.

Overall confidence remains well below pre-pandemic levels, with old and new challenges ahead. Despite the significant jump in 2021, overall confidence remains below the prepandemic level in four of the six Western Balkan countries, while for Albania and Kosovo, general confidence has returned to previous highs. However, firms report that economic development, unemployment, corruption, and emigration remain the top concerns in the region. In addition, new challenges lie ahead. With the green transition likely to pick up

(Box 2.1 continued) speed in the next few years, most businesses would need to step up their efforts to adjust their operations toward more environmentally friendly operations and investments. As of now, however, the majority have taken no or only minor steps (Figure 2.4).

Figure 2.3. Anti-competitive practices of competitors and access to technology are reported as major growth constraints for businesses in the recovery.

Source: The 2022 Balkan Business Barometer survey was conducted during mid-February to mid-March 2022 in Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia. The Business Opinion survey presented 177 questions to 1203 business owners, managers, or executives. More info is available at: Balkan Barometer | Welcome (rcc.int). Note: Major constraints faced when trying to scale up, as reported by businesses.

Albania, Kosovo, Montenegro, and Serbia, stand out for their export growth. Exports in Kosovo, particularly for manufactured goods, increased by 29.4 percent y-o-y through July. Diaspora-driven service exports also increased significantly, and travel data suggest that positive momentum continued during the summer season in tourism-led economies, like Albania and Montenegro. In Montenegro, growth of exports outpaced that of imports, supported not only by further tourism recovery but also by higher metal and electricity prices.

On the production side, services have been the engine of the recovery. Both industry and construction have struggled in the region, owing in part to rising energy and materials costs; the exception have been construction in Albania and industry in Serbia, which remained important for growth. The contribution of agriculture to the region’s economies was modest or negative, due to the rise of input prices and unfavorable climate conditions. All economic sectors were strongly affected by labor market tightening. This applies especially to tourism, but also to other sectors, such as information and communication technology and agriculture. In Albania, a new wave of emigration among Albania’s youth is one of the main causes of labor shortages.