The economic recovery that began in most parts of emerging Europe last year is continuing in 2011 but facing increased downside risks.

In its latest quarterly economic report on the region, the EBRD said growth in 2011 is likely to remain reasonably strong, showing average expansion of a little over 4 percent despite continued regional divergences.

The report continues to forecast average growth for the EBRD countries of operations of 4.2 percent for 2010, unchanged from projections made in October last year.

The stronger than expected recovery in core Europe, strengthening remittance flows from Russia, and a measured recovery in credit growth have supported growth across the region during 2010 although in several countries a high level of non-performing loans is continuing to be a drag on balance sheets. In a few countries, summer droughts slowed growth.

EBRD also sees growth of 4.2 percent for 2011, broadly in line with previous forecasts. However, the report adds “Downside risks have increased.”

On the positive side, the report notes that stronger-than-anticipated growth in the core eurozone, fiscal and monetary stimuli in the US, and rising commodity prices are likely to boost growth across the region in an increasingly private sector-led recovery. Fiscal consolidation will likely restrain growth in south-eastern Europe.

Risks to this outlook are increasingly tilted to the downside

However, the report adds that risks could emerge if loose monetary policies fuel persistently higher inflation in advanced countries, leading in turn to an earlier than anticipated monetary tightening by major central banks.

Financial sector turmoil surrounding eurozone sovereign and related bank debt markets may cause a stronger increase in global risk aversion than has been witnessed so far, it says.

In eastern Europe itself, domestic policies, such as moves to cut back on private pension funds or the introduction of significant bank taxes, could worsen investor sentiment and create potential for a quick reversal of recent net capital inflows. The report also notes that private sector borrowers remain vulnerable to any sharp currency depreciations.

“An even worse scenario could materialize if currency wars turn into trade wars in the form of import restrictions. Rising food prices and extreme-weather-related food security concerns can also lead to trade restrictions in the absence of global policy coordination,” the report says.

Looking at emerging Europe by region, the new EBRD report sees an increasingly divided growth path in Central Europe and the Baltics. Estonia, Poland and the Slovak Republic are expected to show growth of above three percent in 2011, based on the prospect of only slightly slower growth in Germany this year.

But moves to unwind the pre-crisis credit boom and fiscal retrenchment will continue to hold back growth in Latvia and Lithuania. Modest growth in Hungary last year is expected to accelerate only marginally in 2011.

The report says that the recovery in south eastern Europe continues to lag behind other transition economies with the exception of Turkey. In eastern Europe and the Caucasus, the Ukrainian economy has continued to recover from the 15 percent contraction seen in 2009. However, the regional drought in 2010 adversely affected agricultural production.

In the EBRD’s largest economy, Russia, growth momentum is expected to pick up again after slowing in the third quarter of 2010 when output was adversely affected by a heat wave, drought and forest fires, the EBRD report says.