Nov. 2 (Bloomberg) -- The global financial crisis, which pushed some emerging European economies to the brink of collapse, revealed risky imbalances two decades after communism fell, the European Bank for Reconstruction and Development said.

The nations that joined the European Union, along with the southern Balkans, were driven into recession by the worldwide credit squeeze and lost investment. Commodity-rich nations including Russia and Kazakhstan, were punished for failing to diversify away from energy reliance, the EBRD said in its annual Transition Report.

There is the “necessity to diversify the economies, to not so much be reliant on the exports of oil and gas and a few metals,” said EBRD President Thomas Mirow in an interview in London today. There is also the need to “avoid just being dependent on very few production lines, which in a difficult situation has a very, very strong impact on the overall economy.”

The 30 emerging European and central Asian nations in which the EBRD invests are struggling to escape the deepest recession since they adopted free-market policies. The bank, which helped limit the impact of the financial crisis by persuading western European banks to stay in the region, has said the recovery from the region’s worst recession since the early 1990s will be “patchy” and “fragile.”

Financial Integration

Eastern Europe was the worst affected of all emerging markets by the worldwide financial turmoil because the level of financial integration they have reached with major economies has aggravated the impact, EBRD chief economist Erik Berglof said today at a London conference on the 20th anniversary of the collapse of communism.

“The crisis has been a deep crisis, a sudden crisis and had a dramatic impact,” he said. In some parts of eastern Europe “We expect a slow patch recovery.”

The effort to raise living standards to Western levels encouraged a credit boom, excess borrowing and a shift towards indebtedness in foreign currencies, Berglof said.

The International Monetary Fund needed to step in and finance rescue programs in Hungary, Latvia and Romania as the countries faced defaults and they struggled to refinance maturing debt and loans, many denominated in foreign currencies. The IMF has provided about $65 billion of loans to eastern Europe, which required more than $100 billion in bailout money.

High Debt Levels

“Excessive debt levels did play a role and we need to look at it in terms of our response in developing policies,” Berglof said. “We need to enhance financial integration but manage credit growth.”

As the recession deepened and unemployment soared, non- performing loans increased across the region as borrowers found it harder to make repayments. Declining currencies also pushed up the costs of loans taken out in euros or Swiss francs before the crisis to benefit from lower interest rates.

Berglof warned the countries should learn from the crisis and build regulatory safeguards to prevent a similar crisis from occurring in the future.

“The crisis has shown the need for urgent steps to help reduce dependency on foreign-exchange lending and to manage more effectively the demand for credit,” the EBRD’s report said. It added that “attempting to reverse financial integration would be the wrong conclusion to draw from the crisis. The presence of foreign banks and the resultant depth of financial systems played a crucial stabilizing role.”

‘Elusive’ Diversification

Resource-rich countries, such as Russia, Kazakhstan, Azerbaijan and Turkmenistan find conducting economic policy difficult as revenue and foreign-currency inflows fluctuate along with the global markets for commodities, the EBRD said. The lack of alternative sources of income presents a threat to their economies.

“The long-term goal of economic diversification remains elusive,” the report said. “Dependence on wealth from such resources and the very lack of diversification itself stands in the way of development of the sort of institutional framework that would support the creation of a more diverse industrial base.”

The crisis also meant a setback for efforts to further overhaul eastern European economies that would enable them to better compete with other emerging markets. Euro-aspirants are forced to delay the changeover as the recession cut tax receipts, spending increased on bank bailouts and unemployment benefits and currencies have become more volatile.

Euro Adoption

Estonia, which seeks to start using the euro in 2011, is struggling to stay within the EU deficit threshold this year to qualify. Poland’s ballooning deficit and rising state debt forced the country to abandon plans for adoption in 2012.

Berglof said that the rush to euro adoption, especially in the Baltic states of Estonia, Lithuania and Latvia, which have the EU’s worst recession, helped exacerbate the effect of the crisis because expectations of entering the euro boosted foreign currency-denominated loans.

Countries that have delayed euro-entry decisions, such as the Czech Republic, have “fared better. Setting dates is the wrong thing,” he said.

Berglof also said that the transition has been disrupted, but not stopped.

“It is clear that it has slowed down, but I don’t see any reversals,” he said. “The public solutions now in vogue do not represent, not in our region, do not represent a backlash.”

The region’s economies will grow about 2.5 percent next year after contracting an average 6.3 percent this year, the EBRD said last month.

The recovery will be curtailed by continued tight lending conditions by western lenders.

Currency Pegs

Bulgaria, Latvia and Lithuania, which have fixed exchange rates, will contract further as they cut wages, prices and government spending. Albania, Poland, Slovakia and Slovenia will grow faster next year than their neighbors due to relatively unharmed banking systems, the EBRD said.

Recovery prospects in Russia and Kazakhstan depend on the ability of the authorities to clean up their financial industries, the EBRD said.

The EBRD has focused on 12 “systemically important” western parent banks, such as UniCredit SpA and Societe Generale SA, as well as some large local lenders, including Latvia’s Parex Banka AS and Hungary’s OTP Bank Nyrt. to prevent a banking crisis. It is now planning to strengthen companies through loans and shareholdings, EBRD President Thomas Mirow said in an Oct. 6 interview.

The development bank is seeking a 10 billion-euro ($14.7 billion) capital increase from shareholders to meet the increased financing needs of banks and businesses.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

Last Updated: November 2, 2009 06:35 EST