UPDATE 1-Growth to rise in Europe's transition economies-EBRD

By Daniel Bases

LONDON, Nov 13 (Reuters) - Eastern Europe and the former Soviet Union will see growth increase in 2006 driven mainly by domestic demand, but risks of rising inflation and slipping foreign direct investment pose challenges, the EBRD said on Monday.

The European Bank for Reconstruction and Development, the development bank for the region, said growth in the 29 transition countries it tracks would grow, on average, 6.2 percent in 2006 versus 5.7 percent in 2005.

That falls short of the record 6.7 percent GDP growth rate of 2004. This latest transition report sees economic growth of about 6 percent in 2007.

The EBRD was established in 1991 to aid the transition of Communist bloc countries to capitalism.

"The growth is increasing very fast. It is stronger in the eastern part of the region, the former Soviet Union, than in central eastern Europe. Also growth is very strong in south-east Europe, driven primarily by consumption, but also by high fuel and raw material prices," EBRD chief economist Erik Berglof told Reuters in an interview.

Increasingly, the EBRD said, transition is being driven by markets rather than by governments.

Robust growth has been driven mostly by domestic demand, which in turn has been supurred by growth in credit and rising wages, the EBRD said.

"Strong demand and high energy prices are, however, contributing to inflationary pressures throughout the transition region," the report said.

"Moreover domestic savings are insufficient to cover investment, resulting in large and presistent current account deficits at a time when foreign direct investment is projected to decline slightly from levels recorded in 2004-2005."

Foreign direct investment is expected to fall to 5.5 percent of GDP for the region in 2006 from 5.9 percent in 2005.

Berglof said progress on institutional reforms has been uneven, with great strides made in finance and telecommunications, while public administration lagged.

"It is a mixed picture, in some sectors reform is going faster, in the financial sector in particular. In some other parts which are important as well, reforms are not going as fast. The reform of the public administration, that area of competition policy, is not moving as fast and is a cause for some concernm," Berglof said.

((To view the projected growth rates for individual countries, please click on [ID:nL13925836]))

FINANCE AND PRIVATE EQUITY

The region's financial sector is growing apace. A boom in household borrowing and increasing participation by foriegn banking institutions, but still lagging legal and regulatory reforms, is a recipe for future financial instability.

While welcomed for their stability and expertise, foreign banks cannot take the place of grass roots institutional reforms, the EBRD said.

((For more in-depth report on the region's financial sector, click on [ID:nL13934377]))

The growth of private equity investing within the region is a key development needed for growth an innovation, but investment from local insurers and pension funds and friendlier regulations are needed for it to reach full potential.

Private equity funds attracted a record $1.6 billion last year, a quarter of what firms in central and eastern Europe and former Soviet republics raised on international stock markets.

((For more in-depth report on the growth of private equity in the region, click on [ID:nL12821917])).

REGIONAL DIFFERENTIATION

While the pace of reform continues, there are disparities between the EBRD's three main regions of operation.

Central eastern Europe and the Baltic states (CEB) as well as former Soviet Republics of the Commonwealth of Independent States (CIS) are expected to see FDI flows drop.

These two regions have seen the pace of reform slow. For CEB, reforms have larely been put on hold due to weakening public support in many countries for further painful restructurings.

For energy rich countries of the CIS, reforms were undertaken but the pace slowed as oil and commodity prices rose, indicating revenues are restraining the urgency for reform.

Early transition countries from south-eastern Europe (SEE), primarily in the Balkans, plus Russia, are projected to have an increase in FDI.

In Russia's case it is expected to more than double.

"We should remember FDI in Russia had been very limited in the past," said Berglof.

Reforms in SEE, however experienced an increase as it moves toward EU integration. EU accession is still a potent motivator for this region, one that would be hard to replace if there is 'fatigue' among existing EU members for expansion.

GDP growth in SEE is expected to rise to 5.9 percent in 2006 from 4.7 percent in 2005. Growth for the CIS and Mongolia is projected to reach 6.9 percent versus 6.6 percent in 2005.

CEB regional growth is expected to rise to 5.3 percent from 4.7 percent in 2005, reflecting largely a recovery in Poland.

((Reporting by Daniel Bases; Editing by Ian Jones; Telephone: +44 207 542 2464; e-mail: daniel.bases@reuters.com; Reuters Messaging: daniel.bases.reuters.com@reuters.net))

Keywords: ECONOMY EBRD GROWTH