(Adds comments on euro adoption)
By Sebastian Tong
LONDON, Nov 2 (Reuters) - Flaws in East Europe's model of growth have been exposed by the financial crisis, and commodity-reliant countries like Russia must expand their industrial base to make them more resilient, the European Bank for Reconstruction and Development (EBRD) said on Monday. The development bank, one of the biggest investors in a push to transform the region since the collapse of communism two decades ago, also said in its annual report that risks arising from financial integration must be better managed.
It said countries had been over-reliant on foreign banks and inflows to drive growth in the boom years, leaving them highly vulnerable during the global credit crunch.
"The EBRD economists concede that financial integration has brought disadvantages, by encouraging credit booms, over-borrowing and a trend toward foreign currency borrowing," the bank said in the report.
But while this has deepened the region's recession, the EBRD said financial integration with the West remains a source of growth and should not be reversed.
"This means addressing the bias toward foreign currency lending through macroeconomic policies, regulation, and the creation of legal frameworks and market infrastructures supporting local currency finance," the EBRD said.
EBRD Chief Economist Erik Berglof said the delay in euro adoption faced by central and eastern European economies arising from the crisis could prove to be beneficial in the medium term.
"(This) will allow the authorities and other important market players to step in and build local currency capital markets critical to address (the problem of) foreign-currency exposure," he said.
The EBRD has been criticised by some of its 60-odd country shareholders for failing to warn eastern Europe and Central Asia about the dangers of overexposure to foreign borrowing before the credit crisis deepened last year.
The region has been among the hardest hit worldwide, with growth and budgets slashed and several countries forced to turn to the IMF, World Bank and European Union for emergency funds.
DEPENDENT
Commodity-rich countries among the 29 economies in which the EBRD operates also came in for criticism along with the bank for failing to reduce their over-dependence on income generated by their natural resources.
Policy management in Azerbaijan, Kazakhstan, Russia and Turkmenistan is further complicated by foreign currency inflows that fluctuate according to commodity prices, the EBRD said.
"In the long term ... these countries tend to grow more slowly than their resource-poor peers because they have higher macroeconomic volatility," it added.
This over-reliance in turn hampers the development of an institutional framework vital for a more diverse industrial base.
"Institution-building in resource-rich countries is likely to be difficult and protracted, but by no means hopeless," it said.
Earlier this month, the EBRD raised its 2010 economic forecast for the region to 2.5 percent instead of the 1.5 percent previously forecast.
The bank said it expects few new reforms by the region's economies though there has been no major rollback as seen during the 1998 Russian financial crisis.
"The lack of an anti-reform backlash reflects more mature economic institutions and political systems compared with 1998, better integration into regional and global institutions, and a more successful crisis response which has prevented high inflation and banking system collapses," it said.
"However, a major round of new reforms also appears unlikely," it added. (Reporting by Sebastian Tong; editing by Stephen Nisbet)