East European governments must cut deficits and repair banking systems to spur economic growth after the financial crisis that pushed some countries close to default, the International Monetary Fund said.

“Policy makers in emerging Europe face the difficult challenge of dealing with the legacies of the crisis, while not hurting the recovery,” the Washington-based lender said today in its regional economic outlook. The tasks include “reducing fiscal deficits to secure sustainable debt” and “repairing banking systems while reviving credit.”

The former communist countries in Europe and central Asia are recovering from their deepest recessions since switching to free-market policies two decades ago. Cheap credit helped growth average 5 percent annually in the boom years. At the height of the credit crisis, the IMF provided about $65 billion of loans to the region, making it the largest recipient of bailouts.

The IMF provided loans to Hungary, Latvia, Ukraine, Romania and Serbia as the countries faced defaults and struggled to refinance debt, often denominated in foreign currencies. The region received more than $100 billion in total, including aid from the European Union and World Bank.

The fund expects the region’s economies to grow 3.8 percent in 2010 and 3.9 percent next year after gross domestic product shrank 6 percent in 2009 as capital inflows came to a halt.

‘Healthy’ Balances

The financial crisis unmasked the underlying fiscal problems in east Europe, the IMF said. While increasing tax receipts led to “healthy” budget balances during the boom years, expenditures were growing rapidly, according to the IMF.

Budget deficits across emerging Europe averaged 6 percent of GDP last year compared with zero in 2008, the IMF said. Average public debt levels swelled to 30 percent of GDP from 24 percent. The average deficit will narrow to 5.2 percent this year and 4.1 percent in 2011, with debt climbing to 30.8 and 32.1 percent, respectively, the IMF forecasts.

“With deficits still at very high levels, and a permanent loss in revenues resulting from the end of the demand boom, it is clear that substantial fiscal consolidation is needed over the next few years,” even if it hurts growth in the short term, according to the report.

Countries with “high fiscal vulnerabilities” must move swiftly to cut deficits and avoid being punished by financial markets, because investors are more focused on public finances after the euro region debt crisis, the IMF said. Deficit-cutting programs that rely on reducing spending rather than increasing revenue will be less harmful for growth, according to the fund.

‘Credible’ Policies

Fiscal policies can help revive credit growth while banks are repairing balance sheets impaired by the growth in delinquent loans, the IMF said.

“Credible macroeconomic policies would also make it possible to keep policy interest rates low, which would not only stimulate demand for credit, but would also encourage bank funding” and limit the reliance on foreign currency financing, the IMF said. “Creditless recoveries in GDP growth are generally slow and shallow.”

The region also needs investment in manufacturing to shift growth away from services and construction, which propelled economies in the boom years, according to the report. Companies must develop new markets for manufactured goods and services, which will require a shift in government policies, the IMF said.

Source: http://www.bloomberg.com/news/2010-10-20/east-europe-must-reduce-deficits-repair-banks-to-nurture-growth-imf-says.html