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Some 15 years after the fall of the Berlin Wall, many of the former communist countries from central Europe to Central Asia have made commendable progress in their transition to a market economy and pluralist democracy, says the EBRD’s latest transition report.

Despite progress, however, the report warns that even in the most successful transition countries, the scope for further progress has not been exhausted.

Political leaders in the region must renew their commitment to structural reforms and sound macroeconomic policies, both of which are drivers of sustainable growth.

For the fourth straight year the economies of this region are outpacing the world economy, with growth forecast to rise to 6.1% in 2004 from 5.6% in 2003. Growth is expected to be highest in the Commonwealth of Independent States (CIS), at 7.4%, compared with 5% in south-eastern Europe (SEE) and 4.9% in central Europe and the Baltic states (CEB). In Russia, the region’s largest economy, growth is expected to slow slightly, to 6.9% from 7.3% a year ago. For 2005, the bank forecasts an overall growth rate of 5.5% for the region.

In many countries across the region, sharp increases in local bank lending are boosting consumption and investment. In all but a handful of countries years of strong growth and modest inflation have contributed to higher living standards. If sustained, such a dynamic growth performance holds out the prospect of eventual convergence with the more advanced industrial economies.

Willem Buiter, chief economist at the EBRD, cautions, however, that macroeconomic vulnerabilities remain for most countries. In the larger countries of central Europe and the Baltic States, persistent and unsustainable fiscal imbalances remain a concern. Reining in spending and curtailing subsidies to non-viable ailing industries is a particularly challenging task when unemployment is already high.

This is also true for the SEE countries, where the combination of high unemployment and high (but declining) poverty rates has left political leaders with little room for manoeuvre. Foreign direct investment has recovered substantially in the past year, but many countries in the Western Balkans still rely heavily on donor support, which may not be as readily available in the future, and on remittances from abroad. In the CIS, growth continues to rely heavily on high but volatile prices for energy, metals and various agricultural commodities. Sustainable diversification into other sectors remains a challenge for all countries that export natural resources.

While growth has been maintained across most of the region, progress in reforms has been mixed. The current EU candidate countries – Bulgaria, Croatia and Romania – made the most progress in market reform. All three made significant gains in banking sector reforms and infrastructure, while Bulgaria and Romania undertook large-scale privatisations. Following years of rapid progress needed to complete the EU accession process, many of the CEB countries experienced a slowdown in the pace of reform. The CIS countries, which continue to lag behind the others, made only modest progress. The standout was the Kyrgyz Republic, which made progress in large-scale privatisation and infrastructure. The risk that some CIS countries may become locked into a trap of weak governance, low productivity and high vulnerability to internal or external shocks is still very real.

A renewed commitment to reform, especially to building market-supporting institutions and improving the business climate, is needed to maintain growth and promote diversification. Evidence in the report suggests that, even after controlling for other factors (such as oil prices, external demand and the catching-up process), sustained structural reforms will stimulate growth in the longer term. Higher growth can in turn spur further reforms, potentially leading to a “virtuous circle ”

One area requiring much more attention is infrastructure – the subject of this year’s special section of the report. One chapter focuses on regulatory challenges and another on private-sector participation in infrastructure services.

The report presents evidence from a survey of regulators in the telecommunications, electricity and railways sectors on regulatory effectiveness. The results show that experience in establishing modern regulatory regimes for utilities has been mixed. Many of the advanced countries in the region have succeeded in establishing independent and accountable authorities. Others have struggled to put credible arrangements in place.

This is due in part to the weak institutional environment in many transition countries, and to the ability of vested interests to seize control of or hinder the reform agenda.

Regulators face enormous challenges. They must devise and implement a tariff system that promotes efficiency and environmental sustainability in production and consumption, guarantees universal access to essential services, and encourages investment and modernisation. They need to promote, where possible, competition and to ensure that all operators have access to infrastructure networks on equal terms. Despite limited data, surveys of industrial consumers of infrastructure services suggest that effective regulation helps improve service delivery.

The report also looks at the development and extent of private-sector participation (PSP) in telecommunications, energy, water and transport services across the region. The telecommunications sector has attracted most private-sector interest, followed by urban transport and, to a lesser extent, the power sector. Private involvement in water, roads and railways infrastructure has lagged behind. PSP has been most evident in CEB and the EU candidate countries of SEE. The bulk of investment has come from western – mostly European – utilities. However, utilities from within the transition region and small local investors are becoming increasingly important.

Governments have promoted PSP for a number of reasons – to enhance the effectiveness of risk mitigation and risk sharing in infrastructure investment, to improve the performance of utilities and to reduce (or at times to hide in off-budget and off-balance sheet special purpose vehicles) the pressure on fiscal resources. Conclusive analysis of the consequences of PSP in the region is still limited by the lack of data. Nevertheless, it is clear that PSP has helped to commercialise services and, in some cases, to improve access to finance.

In future, local investors are likely to play an increasing role in PSP. There is also likely to be a move away from outright asset sales to concessions and management contracts, which harness the expertise of the private sector but limit its financial exposure.

Outside the telecommunications sector, regulatory weaknesses have resulted in tariffs that have made it difficult to earn a rate of return on equity that adequately reflects the equity risk being taken by the private investors. This mirrors what is happening in other emerging markets.