bne July 2011 - Beyond the Burger: Why are prices so high in emerging markets?

Inside this issue: Russia feels let down by Europe China's EU bridgehead crumbles Turkey's power to the people A long hot summer in Kyrgyzstan July 2011 www.businessneweurope.eu

Special Report: Ukraine on trial

BEYOND THE BURGER Why are prices so high in emerging markets?

bne July 2011 Editor-in-chief: Ben Aris (Moscow) editor@businessneweurope.eu

Contents

+7 9162903400

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Managing editor: Nicholas Watson (Prague) +42 0731582719 watson@businessneweurope.eu Eastern European editor: Tim Gosling (Moscow) +7 9031927966 gosling@businessneweurope.eu Eastern Europe: Graham Stack (Kyiv) stack@businessneweurope.eu

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Central Europe: Robert Smyth (Budapest) +36 19995200 rsmyth_hu@yahoo.com Jan Cienski (Warsaw) +48 604994850 jancienski@ft.pl Mike Collier (Riga) +37 129473192 editor@balticfeatures.com Matthew Day (Warsaw) +48 607291187 mattday@businessneweurope.eu Tom Nicholson (Bratislava) +42 1907732736 tom.nicholson@sme.sk Kester Eddy (Budapest) +36 308665550 kester.eddy@gmail.com Steven Roman (Tallinn) +372 56665911 steven@online.ee Southeast Europe: Justin Vela (Istanbul) +90 5393614470 justinvela@bne.eu David O'Byrne (Istanbul) +90 5359210950 davidob@ttnet.net.tr Bernard Kennedy (Ankara) +90 535 7485120 bkennedy@superonline.com Ian Bancroft (Belgrade) ian.bancroft@transconflict.com Bogdan Preda (Bucharest) +40 722580137 bpreda@gmail.com Nadia Damon (Sofia) +359 885 849884 nadiadamon@gmail.com Andrew MacDowall (Sofia) andrew.macdowall@googlemail.com

COVER STORY 6

The Insiders

8

Beyond the burger

14

23

Russia the best place to become billionaire

24

A new Russian sovereign wealth fund

Perspective CENTRAL EUROPE

16

17

18

EASTERN EUROPE

26

China's EU bridgehead crumbles in Poland

Russia feels let down by Europe

29

Poland hypes Euro 2012 economic kick

A Russia-China gas deal?

Don't hold your breath

31

Pressing the nuclear tender button

Belarus' share-trading moratorium lives on

32

Floating Home Credit

Eurasia: Bureau Chief: Clare Nuttall (Almaty) +7 7073011495 nuttall@businessneweurope.eu Molly Corso (Tbilisi) molly_corso@yahoo.com Oliver Belfitt-Nash (Ulaanbaatar) +97688113149 oliver@businessneweurope.eu

19

Lukashenko reverts to his old tricks

34

The Latvian economy: my part in its downfall

20

Russia's privatisation chief discusses the 3-year programme

36

Poland cautious over giving keys of Lotos to Russians

38

Fat and Hungary

International: Derek Brower (London) derekbrower@gmail.com

22

When to let go? The state's role in transition economies

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bne July 2011

Contents

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Feeling at home in Central and Eastern Europe starts right here.

61

SOUTHEAST EUROPE

15 million customers have selected us as their bank of choice.

Raiffeisen Bank International represents more than 20 years of experience in Central and Eastern Europe, covering 17 markets in the region with subsidiary banks, leasing companies and other financial service providers. International companies, local businesses of all sizes and private individuals rely on our network of around 3,000 branches.

Over 100 international banking awards validate the group‘s service quality. www.rbinternational.com

SPECIAL REPORT

49

A long hot summer in Kyrgyzstan

59

Trials and tribulations in Ukraine

51

On the block in Kyrgyzstan

61

52

Joint stock exchanges

Massive Ukrainian government moneylaundering surfaces

Mol's Balkan blues deepen

53

Hunting for treasure on the Mongolian steppe

63

Trial separation seen for Ukraine and IMF

Croatia displays its split personality

55

High food and energy prices threaten Tajik recovery

65

Donetskal share freeze hits Ukrainian market's credibility

57

Georgian libertarian champions frontier banks

66

Ukrainian companies head west

67

Reform in Ukraine - mixed progress

69

CLASSIFIED

70

UPCOMING EVENTS

40

It's the economy, Erdogan

42

Turkey's power to the people

43

Macedonia's ruling nationalists triumph

45 46

47

EURASIA

How the Eurozone crisis resembles "Yugoslav syndrome"

6

I The Insiders

bne July 2011

The natural flight of capital

There are two areas however – and here Russia differs from its peers – which affect capital flows.

Elena Kolchina of Renaissance Asset Managers Elena Kolchina

S

ince my first grown-up trip abroad, I have dreamed of buying a flat in Notting Hill. My dream has nothing to do with the famous film (apart from the fact that the film made my dream much more expensive). My desire for a flat in London has more to do with being a person born in an emerging market who wants to buy a home and keep money in a developed country for my children.

I first went to London as a student who wanted to learn English and was lucky enough to stay for a month in Notting Hill in a flat belonging to one of the founders of Troika Dialog, the first Russian investment bank. It was 1995, and the difference between life in Russia and the developed world was huge (especially if your first taste of the developed world was one of the prime London residential areas). I promised myself that one day I would have an address here too.

What seemed like a crazy idea then has become mundane today for many Russians, while the same flats in central London are becoming increasingly unaffordable for many English.

According to Peter Rollings, CEO of Marsh & Parsons, there is now fierce competition for residential space in many of London's best locations between foreign investors, which has sparked bidding wars for the very best properties.

Rollings says there was an average of 14.3 applicants per property in January and in some cases prices were pushed well beyond the original asking price. "Demand from international investors has been particularly bubbly in the last month, and is helping to drive activity in London's prime property market. Alongside strong demand from American and Chinese buyers, many foreign buyers have been withdrawing money from more uncertain economies and making long-term, more secure investments instead in the capital's bricks and mortar," says Rollings.

Capital to capital There has been a lot of discussion about the recent spike in capital flight from Russia recently. The latest figures indicate that in the first five months of 2011, the net capital outflow from Russia amounted to $35bn, which roughly matches the

bne July 2011

total capital outflow for all of 2010.

Capital outflow is a natural phenomenon for most emerging markets, as it's simply a prudent move designed to protect wealth accumulated rapidly in an unpredictable world. The fact that emerging market economies now drive global GDP provides an opportunity for many people in these markets to become rich. For example, according to bne, between 2004 and 2011 Russia produced one billionaire for every 1.87m people – you were more likely to become a billionaire in Russia than in any other country in the world in the last 10 years.

Capital flight has only intensified following the recent crisis, which is not surprising as crises always worry the newly rich that they might lose their wealth as fast as they got it. As a result, we are now witnessing a record number of IPOs from emerging market companies and private banking in London and Switzerland have enjoyed a massive inflow of money.

Although emerging markets have gone a long way in their transformation into developed markets, in many ways –including corporate governance and the quality of daily life – we are still far from the point when someone who grew up in an emerging market and made big bucks wants to keep their wealth at home. On the contrary, we are at a point when we want to realize that old dream and buy a home (or a business) in the developed world.

However, I don't think it's necessary to read too much into the current bout of capital flight from Russia. For example, I wouldn't name the often-cited poor investment climate as the main reason for money wanting to leave Russia. Indeed, foreign direct investment inflows to Russia continue to increase at a steady rate and this year may reach pre-crisis levels, which testifies to the opposite. Many global companies continue to operate successfully in Russia and many want to expand their presence here. For every foreign company that has problems in Russia and makes the headlines, there are hundreds that have none and are earning handsome profits. The recent acquisition of the leading Russian diary and juice producer WBD by PepsiCo for $3.8bn is a prime example.

Borrow local The first is temporary in our view. The majority of Russian companies prefer nowadays to borrow on the local market rather than internationally, simply because it's now cheaper to borrow at home. For example, a top Russian mobile telecommunications company can borrow in rubles for four years at about 8%, then swap rubles into dollars at 6%, which makes the cost of dollar funding effectively around 3%. However, if the same company were to borrow on the Eurobond market it would have to pay 4% for the money. This kind of deal is possible thanks to high liquidity and demand from local participants (mainly local banks), which is keeping domestic interest rates low. But this sort of arbitrage will disappear slowly as credit spreads in the Eurobond market keep falling, while in the domestic market the Central Bank of Russia (CBR) is increasing rates in order to fight inflation.

The second difference concerns portfolio investments, which are very volatile. In the last couple of years, Russia has not enjoyed a big inflow of foreign portfolio investments. The herd mentality means foreign investors flooded into Russia precrisis during the boom years, but nowadays the herd prefers the other BRICS where economic growth is higher. Moreover, there is no guaranteed one-way trade in the Russian ruble as there was pre-crisis – the national currency having become more volatile as a result of the change of the CBR policy from forex targeting to inflation targeting.

Again, these changes have little to do with the investment climate, as nothing dramatically changed in Russia in the past few years. The changes have more to do with the trends and changing investment fads. For portfolio investors, Russia is a country where there are no restrictions on foreign capital flows, the market is big and liquid, and its infrastructure is well developed both for bonds and equities. The fact that Russia is not overcrowded and overbought only means more upside for the future.

The bottom line is we see the main factor behind continued capital outflow from Russia as flight to security by the wealth accumulated in the country over the past decade in a time of obvious global uncertainties. It is not Russia specific. It is typical for many big emerging markets. It is likely to continue, which will prevent the Russian currency from significant appreciation. However, continued FDI, possible improvement of portfolio flows, and more borrowing by Russian companies abroad should neutralise domestic capital outflow and support the ruble.

And there's the rub: while I sit in Moscow scouting out flats in Notting Hill on the internet, Englishmen in London are packing their bags with the idea of moving to Moscow, as they realise it is their best chance of becoming a billionaire. Both trends are natural – and impossible to reverse.

"Many foreign buyers have been withdrawing money from more uncertain economies and making long-term, more secure investments instead in London's bricks and mortar"

Overpriced drinks are a well-known phenomenon for anyone who has travelled in Central and Eastern Europe during the last decade. The country in question might be falling to pieces, but

BIG MAC PRICES, 2001 AND 2010 5

4

3

2

1

Source: The Economist, Bloomberg

The starting point for these discussions is, of course, currency rates. As the global economic crisis recedes, it has left a world where the emerging markets are in much finer fettle than the developed markets, meaning their

"It goes without saying that the cost of living in Moscow or Istanbul is not fully representative of the cost of living elsewhere in, say, Perm or Kayseri" the visitor is quite used to getting murdered on the bar bill, the restaurant bill, the hotel bill – in fact, for pretty much any "western standard" service you care to mention.

Ben Aris and Tim Gosling in Moscow, Clare Nuttall in Almaty

The lack of competition and the avarice of high-end service providers like posh hotels go some way to explaining the price difference – but not all the way.

Just why are so many things in emerging markets so expensive? After all, Turkey's GDP per capita is 72% lower than in the UK, and 77% lower than in the US. Even assuming that wealth is more concentrated in places like Turkey and Russia than it is in the UK and US, does it make sense that a coffee in Istanbul and Moscow should be more expensive than it is in London or New York?

currencies have generally rebounded against the US dollar, sterling and the euro.

This should come as no surprise. Since the end of the gold standard, the value of floating currencies is determined by a cabalistic combination of a country’s hard currency reserves, its basic macroeconomic position (the size of its debt and deficits), its economic output and the expectation of its future economic performance. From this perspective, the fact that many big western economies have gone from powerhouse to paralysis of course means that the value of their currencies is falling. On the flip side, most of the economies of Emerging Europe have come out of the crisis leaner as leverage in the system was

2010

Eurozone

US

UK

Turkey

0 Czech

magine the scene. A warm spring evening in Istanbul. A gentle breeze drifts in off the Sea of Marmara as residents start to gather in the bars and restaurants of the fashionable Nisantasi quarter. You choose a small, unassuming bar and order a cocktail to finish the day. So far, so good… but then the bill comes: 18 Turkish lira for a gin and tonic. At the current exchange rate, this equates to a bit over US$12. $12? You would be hard pressed to pay this sum in most bars in New York City. In London's West End, Corney & Barrow charges $11.50 (£7.00) for the same drink," Andrew Howell and Maria Gratsova, Londonbased analysts for Citigroup, write in a recent note on currencies in Central and Eastern Europe.

Hungary

"I

BEYOND THE BURGER

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Poland

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S Africa

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Russia

8

2001

squeezed out, and so the relative value of their currencies is rebalancing.

To see how far those currencies have appreciated and whether they have overshot or undershot, economists look at purchasing-power parity – the notion that a dollar should buy the same amount in all countries, so that over the long run the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country.

The most famous example of this theory in practice is The Economist's Big Mac index, which uses McDonald's ubiquitous burger as "the basket". The Big Mac is (virtually) the same in the roughly 120 countries in the world in which it's sold and so should, in theory, cost the same everywhere.

Looking at the latest Big Mac index, released in October 2010, this burger is cheaper in all the CEE countries than in the West, except in Turkey. However, between 2000 and 2010 that gap has been closing, with the discount narrowing from 41% to 21% over the period.

This is in line with the assumption that as the emerging markets develop, their currencies rise, as well as the greater recovery seen in those countries since coming out of the recent crisis.

And all the evidence suggests this gap has narrowed further since the last Big

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PRICE COMPARISONS (% LONDON PRICES)

Moscow

Kyiv

Almaty

Istanbul

Dubai

Joburg

Warsaw

Potatoes 1kg loose

54%

54.3%

36%

68%

118%

73%

39%

Wheat flour 1kg packet

117%

56.1%

82%

157%

51%

109%

74%

Milk 1 litre

137%

57.7%

85%

91%

209%

113%

78%

70%

47.7%

na

123%

87%

54%

86%

Gin & tonic single standard gin

98%

47.8%

84%

103%

149%

71%

79%

Beer 330ml can Carlsberg or similar

196%

73.5%

91%

172%

133%

88%

107%

Tall latte Starbucks or similar

188%

58.0%

99%

91%

95%

89%

105%

Bus ticket full fare adult average journey

45%

11.7%

16%

48%

127%

80%

48%

Petrol 1 litre diesel

41%

54.3%

25%

115%

20%

65%

81%

Taxi fare 10mins travel in city centre

72%

20.3%

17%

85%

37%

11%

29%

Postage 1st class stamp, domestic letter

111%

19.7%

180%

74%

72%

48%

91%

Newspaper Leading daily newspaper cover price

43%

60.6%

33%

38%

50%

102%

77%

Cinema ticket peak time, hollywood film

63%

21.9%

30%

49%

36%

29%

37%

Hotel 1 night standard 4* Marriott hotel

104%

61.1%

na

95%

49%

57%

38%

Haircut Men's cut standard, city centre

119%

60.8%

31%

29%

58%

71%

33%

Dry cleaning one man's shirt

110%

na

99%

64%

56%

196%

71%

Shoes men's trainers, low range Nike

145%

108.1%

177%

72%

74%

168%

123%

Stockings basic women's tights, pack 20

77%

85.8%

39%

67%

175%

69%

47%

Painkiller pack 24 paracetamol standard

88%

4.3%

9%

34%

64%

43%

103%

127%

79.6%

na

123%

95%

na

109%

75%

33.2%

4%

38%

65%

21%

35%

133%

1.4%

2%

27%

11%

7%

26%

Big Mac

Ikea

Billy bookshelf, white (80x28x202)

Office

prime rent per square metre

Retail

prime rent per square metre below 40%

Source: Citi and bne

40%-60%

60%-90%

90%-110%

110%-150%

over 150%

bne July 2011

Mac index, not surprising given that over the period the Hungarian forint has risen about 18% against the dollar, the Czech koruna 14%, the Polish zloty 12% and the Russian ruble 9%.

Beyond the Big Mac Fun as the Big Mac index is, it is only a guide to the relative value of currencies and doesn’t give a true reflection of the pricing environment in a country.

For example, the cost of a Big Mac in the McDonald's on Prospekt Nezavisimosti in Minsk is BYR13,400. At the current exchange rate of BYR4,972.00 to the dollar, the cost of a Big Mac is $2.70, against the London price of $3.77. This is way down from $4.46 a Big Mac cost at the start of January this year, when the currency was clearly overvalued. The Belarusian ruble has been going through a series of devaluations this year, but even at $2.70 the Belarusian Big Mac still looks pretty expensive compared with the Big Mac in Moscow, which costs $2.64, or Kyiv, which cost only $1.80.

And the black market currency traders that have reappeared on the Minsk streets since the government clamped down on foreign exchange trading in recent months agree: they are asking for BYR6,000 to the dollar, which would make the cost of a Big Mac $2.20. In other words, the speculators think the Belarusian ruble is still overvalued, whereas the Big Mac index suggests it is undervalued.

The picture is further muddied by the GDP figures: Belarus' GDP expanded 12.3% on the year in January-April – the fastest growth in the Commonwealth of Independent States (CIS) – but the World Bank said in June that the economy will slow to finish the year with just 2.5% growth. The strong growth suggests the currency should rise, but the expectation of a slowdown suggests it should fall.

Citigroup's Howell and Gratsova find similar problems with the cost of a Big Mac in Russia. "The $2.33 for a Big Mac in 2010 ($2.64 at last check) is on the cheaper side, which is hardly consistent with the impression one gets at a Mos-

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cow shopping mall. Clearly, McDonald's products are positioned and priced differently in different countries, so the signals from this index can be misleading," the analysts say.

On the other hand, the Big Mac in Turkey is one of the most expensive in the world at $4.63. So what is really going on?

Under the lettuce To get a better picture, Citigroup looked at a broader range of goods that should give a more accurate reflection on what things cost across the region. The basket is made up of 22 items covering a mix of food and beverages, transportation, leisure, "personal items" and real estate. Current prices for all of these goods were gathered for five big emerging market cities – Moscow, Istanbul, Dubai, Johannesburg, Warsaw (bne has compiled data for Almaty and Kyiv and added it to the table) – plus London and converted them to dollars. The righthand columns of the table display each city's price as a percentage of the London prices in "heat map" form, with the cheaper items shaded in blue and the more expensive items shaded in red.

The authors admit that their broader index still suffers from major shortcomings. For example, the price level of the capital may not be fully applicable of price trends in the country more

"When we started to import Naf Naf clothes, they didn’t sell very well – so we doubled the prices"

broadly. "It goes without saying that the cost of living in Moscow or Istanbul is not fully representative of the cost of living elsewhere in, say, Perm or Kayseri," they note.

Even so, a quick glance shows that this "Beyond the Burger" basket probably gives a truer picture of the currencies and price trends than the Big Mac index. While consistent with the Big Mac index the Turkish lira is overvalued

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and the Polish zloty undervalued, this basket shows the ruble is indeed overvalued as anyone who's been to Moscow would expect. "Based on what Moscow prices are telling us, the ruble does looks expensive," Citigroup analysts say. "It seems that the Big Mac really is misleading… The recent weakness of the lira down 5% versus the dollar since last October, versus 9% for the ruble and rand, has not done much to dent Istanbul's ‘expensiveness’.”

However, what's most striking about the table is the mix of expensive and cheap prices in each city is not the same. If the difference with London prices were purely a question of the currency value being wrong, then all the relative prices in each country should be the same: an expensive pair of shoes in Moscow should be just as expensive in Almaty, but they are not. Clearly, there are many other factors at work to make emerging market capitals so expensive for so many goods.

Friction and greasing palms Working out all the factors that go into making prices is a question of guesswork, as the market is only responsible for some of the most important influences.

The most obvious difference between countries that affects the costs of goods and services is what the economists refer to as “friction.” The simplest of these is transport costs. A pair of Nike trainers in

"A report found that 39% of Russians were willing to pay a bribe to win a tender or 'settle affairs'" Almaty costs 177% of those in London, because Almaty is about as far from the rest of the world as it's possible to be, so transporting anything there costs a lot.

The differences in import duties and local taxes also distort prices. For example, the duties on imported cars to Russia can run to 100% and so double the cost to the punter. The upshot is a thriving trade of Tajik residents of Mos-

cow trooping off to Berlin to buy cheap second-hand cars, which they then sell in Moscow for double the price.

Probably the most significant nontransparent input to prices is corruption.

The customs services across the whole of the CIS are notoriously bent and a huge industry has sprung up around the ability to reclassify goods like Prada shoes as humanitarian aid. "I recently paid $500 for a five-hour flight from Moscow to Madrid in economy class on Iberia Airlines. Before that, I paid about $950 for a three-hour flight from Novosibirsk to Chita. The math is simple: domestic flights cost two to three times what comparable flights abroad cost," Yulia Latynina, a famous Russian columnist and radio host on Ekho Moskvy, wrote in her column recently, concluding that graft adds at least 50% to the cost of nearly everything in Russia.

In Russia, "everyday" bribery has doubled over the last decade, according to the Economic Development Ministry. Russians paid at least RUB164bn ($5.9bn) in 2010 to buy off teachers, traffic policemen and others in "everyday" situations.

And Russian businessmen lead Europe in terms of backhanders. A report from Ernst & Young in May found that 39% of Russians were willing to pay a bribe to win a tender or “settle affairs.”

The problem doesn’t just afflict Russia.

The same survey found about a quarter of Turkey’s businessmen also admitted to paying bribes, and Turkey leads in giving expensive gifts to counterparties to help deals go through: 32% of respondents admitted to giving expensive presents to business partners, ahead of 26% in Russia.

And Ukraine was singled out for criticism by the head of the Organisation for Economic Co-operation and Development's (OECD) corruption monitoring agency in June. "With regard to the fight against corruption, Ukraine is trailing the pack among all the countries of a transitional type," Goran Klemencic, chief commissioner of the Slovenian Commission for the Prevention of Corruption, told a Ukrainian parliamentary committee meeting on corruption in

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May, adding that of the 24 recommendations on fighting corruption given to Ukraine in 2004, only one has been carried out.

However, calculating the cost of corruption is by definition extremely difficult, although the problem seems to be getting worse, thanks to the increased pressure on business following the global crisis: 81% of respondents to the survey said corruption has increased in the last two years.

Ironically, the cost of corruption is getting so high that anecdotal evidence suggests that in some business spheres it's becoming cheaper to pay the official import duties than grease the palms of an increasingly long line of greedy officials. Coupled to this is the state’s efforts to clean up some sectors: according to bne’s recent interview with the founder of Rolf, Russia’s largest car dealership, most of the car imports to Russia are now done legally, while the state has quietly cracked down on consumer electronic imports to close down the duty-dodging grey schemes.

Novelty items Friction and graft are pretty obvious factors that distort prices, but less obvious is the simple novelty of many goods.

For example, Poland is a member of the EU and so operates under the EU trade regime. In general, Warsaw is one of the most inexpensive cities in the Citigroup survey, but some items – new things like trainers and painkillers – are not.

Open borders, a simple import regime and arbitrage should cause prices to converge, but this misses the novelty factor and the role that competition plays.

As pointed out, posh hotels in Moscow charge exorbitant prices; a room at the Ritz Carlton in central Moscow can cost over $1,000 night and the hotel has reported 95% occupancy rates for every month this year, according to another bne survey. The Ritz Carlton gets away with these ridiculous prices thanks to the prestige factor, which attracts the richer slice of Muscovites looking to treat themselves and show off. The same is true for a cup of coffee: a tall latte is one of life’s little (and affordable) luxuries,

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so ordinary Muscovites, just like the oligarchs, are willing to pay over the odds for this treat.

Part of this willingness to pay more than in western capitals for goods has to do with underdeveloped brand awareness.

Inundated by advertising since birth, westerners grow up with a fairly well defined scale of the worth of goods. For many in Emerging Europe, however, the main indicator of a brand’s value is its price. “When we started to import Naf Naf clothes, they didn’t sell very well – so we doubled the prices and they sold much better,” a Naf Naf franchisee tells bne. Likewise, the Irish supermarket that used to stand opposite the Kremlin had a sign on its door: “Shop at the weekend: everything 25% more expensive.”

Tastes are still evolving, as typified by the transition from track suits, to shell suits, to Armani suits that most of the well-to-do have gone through over the last two decades. It is only now after buying houses in London and Berlin that the rich are starting to develop any taste of their own. The hoi polloi are much further behind when it comes to the choice of goods on offer: McDonald's has been operating in Russia for over 20 years, but Wendy's and Burger King both only entered the market in June.

The governments of the region are also doing their bit. While it is natural that prices are free for non-essential items like Nike trainers, governments have been deliberately holding down the prices of staples like milk and that basic insurance against disaster: potatoes.

Dachas still account for almost half of the agricultural production of most of the countries of Eastern Europe with potatoes the most important crop. Central planning is dead, but governments have resorted to administrative means and simply browbeating producers to hold down the price of goods like milk and flour during the food inflation hike in the summer of 2008, afraid of bread riots. But the same lack of controls means these prices can't be held down indefinitely and in Moscow milk prices rose last year back to market levels after the inflation spike passed.

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Likewise, the lack of reform can be seen in some sectors where Soviet-era distortions remain. Passenger rail tickets are still cheaper than commercial tariffs in most countries of the region, as is the cost of electricity, whereas the opposite is true in the West. But this is changing too, as Kazakhstan, and to a lesser extent Russia, has passed on the cost of reforms to the postal service to customers. And prices for petrol, gas and power are rising steadily across the region.

Still, the lack of progress with reforms is still represented in prices. Ukraine stands out on the price comparison basis as one of the consistently cheapest places in the CEE region, home to the cheapest Big Mac at $1.80 a munch, or 47% of the price in London. Almost all of Ukraine’s prices are extremely low, which is a reflection of the state of perennial crisis in the country over the last six years that has stymied reform. State services are still close to Soviet levels, with the cost of sending a letter at 19% of London prices and a bus ticket at 11%. Likewise, the cost of staples like flour, potatoes and milk are all also by far the cheapest in the peer group (which is also a function of its flourishing agricultural sector).

In fact, the only thing that is expensive, according to bne's survey of prices, are shoes, which cost a little bit more than they would in London.

Kazakhstan is further advanced than Ukraine and many of the prices for goods in Almaty are close to their London equivalents (although there are no McDonald's restuarants at all). But like many other CIS countries, potatoes are extremely cheap, while local services and even real estate prices are all rock bottom.

And finally there is plain old monkeying about with the exchange rate to promote growth, something many of the EU members would love to do, but can't because they are members of the euro. "In Kazakhstan, the current exchange rate is comfortable for exporters, who are the main contributor to economic growth under the current economic model. The government is targeting 7% growth for this year, and a weaker currency will help to achieve this," says Kassymkhan Kapparov, an analyst with Renaissance Capital.

14

I Perspective

bne July 2011

bne July 2011

Perspective I 15

Francis Fukuyama’s seminal 1992 book, “The End of History and the Last Man”, used work by the philosopher Georg Wilhelm Friedrich Hegel to suggest that only the democratic political system gives us the sense of esteem that we seek once we have met the more basic needs. So while autocracy is the constant starting point for all political systems, as we achieve higher incomes we make the transition to democracy. Indeed, for all the problems we have with democracy (see above), not one high-income country has replaced democracy with autocracy, despite the alternatives that have been proffered, from strong one-party rule in Asia to Islamic theocracy.

The time when countries tend to make the transition from autocracy to democracy can be measured. Our work suggests that the maximum risk for autocratic regimes is when per-capita GDP (in constant 2005 purchasing-power parity dollars) tops $6,000. It is no surprise that Tunisia did just that in 2008. As revolutions are often viral (even before Facebook and Twitter), this then helped spark the Arab Spring.

On the other side of the world, incomes in China, the most populous country on the planet, have also just topped the $6,000 mark. China is on course to take the democracy already present within the 70m strong communist party and spread it far more widely. The experience of others that have grown as strongly as China suggests that democracy is very likely within the decade and that, most reassuringly for markets, this can be achieved without any impact on economic growth.

The revolutionary nature of growth (and no-growth) Charles Robertson of Renaissance Capital

T

hese are revolutionary times, and we’re not just talking about the Arab Spring. What we’re seeing now is a marked change in investor attitudes as markets are forced to digest the much higher political risk emanating from developed markets. Meanwhile, they have yet to accept the evidence of falling political risk in large parts of sub-Saharan Africa and the likelihood that countries from Russia to China will be moving strongly towards ever more open political systems within the next few years.

The common theme in the US and the Eurozone is that the lack of economic growth makes tough political choices more difficult to make. By contrast, faster economic growth is paving the way for what will generally be a more positive outlook in the emerging markets. It is making democracy more secure in Nigeria and should achieve the same in Kenya and Ghana within a decade, while making dramatic shifts more likely in China and potentially also Russia.

The link between GDP per capita and political change is generally accepted among political scientists. As we get richer, we demand more political rights. This was the story of the West from 1800-1950 and is the story of emerging and frontier markets over 1950-2050.

Perhaps the simplest explanation comes from the psychologist Abraham Maslow’s hierarchy of needs. He argued that we all need our basic needs to be met: steak, wine and, according to Maslow, someone to go to bed with. Second, we need security, for our family, our property and our jobs, along with some morality to make sure we don’t go overboard in meeting our most basic needs. Third, we need love (so sex is more important than love – yes, Maslow was a man). Fourth, we need esteem, respect by others and respect for others. And lastly, we seek self-actualisation. To put it in per-capita income terms, once we have fed ourselves, housed ourselves and are thinking about buying a car, we begin to demand political rights.

No country we have looked at (all those with a population above 0.5m) has ever exceeded $15,500 in GDP per capita and still been labelled an autocracy, except for city-states and net energy exporters. This suggests that as a net-energy exporter, Russia might retain the autocratic features of its political system for many years, but our work suggests there is a very good chance Russia becomes a strong democracy within the coming decade. Based on the 150 countries and 60 years of history we have considered, Russia would be unique if this did not happen.

For those keen to promote democracy, the implications of our study might provoke a moral quandary. Higher per-capita GDP is key to both producing and sustaining democracy. This means the West will see its political wishes best fulfilled if they invest and trade with all emerging markets. Copying the US approach to China will be more successful than the approach to Cuba.

The good news is that once per-capita GDP starts to rise quickly, countries can reach wealth levels that make democracy likely, far more quickly than in the past. It took well over a century from the start of the UK’s industrial revolution before the 50% of the population that happened to be female first won the right to vote in 1918. The revolution in most emerging markets will be complete much sooner than that.

This is an abridged version of a piece of research by Charles Robertson, Global Chief Economist at Renaissance Capital in London.

"Our work suggests that the maximum risk for autocratic regimes is when per-capita GDP tops $6,000"

16

I Eastern Europe

bne July 2011

Medvedev blamed these "political games" for Russia’s long delay in joining the global trade club, but also had a swipe at the EU for playing similar games, particularly on easing visa requirements. "We seek to introduce visa-free travel with the European Union and other countries, but much here depends on our partners. We are ready to demonstrate our good will on this matter by taking concrete steps," said Medvedev.

Russia feels let down by Europe Ben Aris in St Petersburg

T

housands of top executives from the international business community joined political leaders in Russia's imperial capital in the middle of June for the annual Kremlinsponsored St Petersburg International Economic Forum.

The results of the forum underlined the Kremlin's main foreign policy initiative – promoting a multi-polar world – and the EU should be disappointed with its low profile at the meeting in terms of initiatives and deals. The plaintive remarks from Bob Dudley, CEO of oil major BP, were typical. Dudley was telling delegates that his company’s attempt to jointly explore the Arctic with Russia’s state-owned Rosneft "was in everyone's interests" at about the same time that Rosneft was announcing it would seek another partner after the deal with BP didn't go through.

Overall, one of the big messages coming out of the conference was that Russia is disappointed with Europe and is working towards closer coopera-

tion with the US and China. European leaders were invited to the forum as honoured guests, but the presence of Chinese President Hu Jintao was a stark reminder of Russia's increasingly close ties with its neighbours to the east – as difficult as those relations remain.

"The global financial crisis created big

doubt as to Russia's continued integration into the global economy. We have no choice here."

Games without frontiers While closer integration with Europe, which is by far Russia's largest trading partner, remains important, Medvedev

"There can be no doubt as to Russia's continued integration into the global economy. We have no choice here"

financial imbalances in a number of countries, including in Europe and the USA. New 'bubbles' can form in almost any market, as we have seen clearly, and with the global financial system the way it is, when they break, the whole world feels the effects," Medvedev said in his keynote speech. "There can be no

emphasised that joining the World Trade Organization (WTO) is Russia’s top priority for external trade relations.

"I think we can realistically complete the process [of joining the WTO] by the end of the year – if, of course, political games do not start up again," Medvedev said.

Eastern Europe I 17

bne July 2011

The visa question has become a sticking point in further developing ties between Russia and the EU, and was largely responsible for the lack of any results at the Russia-EU summit in Nizhny Novgorod on June 9-10, where WTO accession and visa requirements topped the agenda. The two sides are so far apart on the visa question that they couldn't even agree on a date to start the discussions on how to proceed: the deadline to start talking about action on introducing a visa-free regime between Russia and the EU was delayed again to the end of July.

Nor was there any movement on Russia's membership of the WTO, which is a precondition to starting talks on a badly needed new Russia-EU basic agreement.

Without agreements with the EU, Russia’s prospects for acceding to the WTO before the end of this year look less likely, despite the palpable optimism of both the Kremlin and many commentators.

And little progress was made in the Partnership for Modernisation; the European Investment Bank and Russia’s state-owned Vneshekonombank only signed a memorandum of understanding to mutually consider funding projects that are part of this programme with up to €500m coming from each side.

Indeed, the lack of progress in visa talks with the EU was thrown into relief by an announcement on the first day of the St Petersburg Forum by US Ambassador to Russia John Beyrle. The American diplomat declared that a new agreement to give citizens of Russia and the US three-year multiple-entry visas had been agreed upon – a significant easing of rules and a significant gesture. "Three years is just the first step," Beyrle promised a packed room of delegates.

A Russia-China gas deal?

Don't hold your breath bneChart

While Russian and Chinese officials spent early June insisting that they'd finally manage to thrash out a gas deal in time for the summit between Hu Jintao and Dmitry Medvedev, few expected the pair to manage to agree a price, as bne reported here.

In fact, the two sides have been trying to agree on a price since 2005, while general talks on starting gas trading have been ongoing for over a decade.

Since the latest failure, Russian officials have been busy telling anyone that will listen that they're not worried and a deal will be sealed by the end of the year. However, the chart below showing the International Energy Agency's forecast for China's gas needs through to 2020 suggests any agreement could still be years away.

While bne predicted that the latest attempt to come to a consensus would fail because Gazprom's confidence has been boosted by the effects of Japan and the Arab Spring on the global gas markets, this chart illustrates that China's gas import needs over the next decade should fall far below the 68bn cubic metres a year (cm/y) supply terms under discussion. "Even by 2020, the incremental import requirement is less than the proposed 30bn cm/y capacity of the Altai pipeline gas supply from Russia," points out Colin Smith from VTB Capital. And this "demonstrates why we expect China to remain highly sensitive over the price it is willing to pay for Russian gas."

CHINA GAS SUPPLY/DEMAND TO 2020 – IEA GAS SCENARIO bcm

2008

2015

2020

∆ 2008-15

∆ 2015-20

%pa

%pa

16.5%

6.3%

Gas demand

85

247

335

% total primary energy demand

3.3%

7.9%

8.5%

Production

80

137

185

8.0%

6.2%

Import requirement

5

110

150

55.5%

6.4%

LNG

5

50

51

38.9%

0.4%

Turkmenistan

0

40

60

na

8.4%

Myanmar

0

13

13

na

0.0%

Incremental import requirement

0

7

26

na

30.1%

Source: IEA, VTB Capital Research

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I Eastern Europe

bne July 2011

Belarus' share-trading moratorium lives on Graham Stack in Kyiv

J

anuary should have marked an important step forward for the embryonic Belarus stock exchange: the end of a moratorium on the population selling shares obtained during the voucher privatisation of the 1990s. But with Belarus heading further into economic and political crisis, the moratorium is back.

The moratorium was imposed in 1998 and effectively froze the whole privatisation process, creating the Belarus model of a state-owned post-Soviet economy. Lifting the moratorium, it was hoped, would mark the resumption of the privatisation process, and attract international investors. “Unfortunately, things haven’t developed quite as we expected them to,” says Sergei Tinnikov, deputy head of the Belarus Currency and Securities Exchange.

The original government plan was for the moratorium to be phased out in three phases. The first, for companies in which the state owns 75% or more, started in 2009; the second, for compa-

nies with a state stake of 50% or more last year, and the final stage - scheduled to start in 2011 – for companies where the state has a stake of 25% or less.

The third phase was understandably the most interesting, since it offered the potential for companies to effectively leave the control of the state – something which is almost taboo in a country where the state has relied on

However, the administration has apparently become alarmed at trading patterns in which it detects "corporate raiding", but which in reality likely constituted nothing more sinister than simply accumulating a share packet by buying up free float. With companies crying wolf, the government retrospectively froze share trading in a number of companies – in particular from the dairy sector – in March, suddenly claiming that they are strategically important for the country. "This has created huge uncertainty on the part of investors," says Oleg Gud of BG Capital, "since it is unclear not only what will happen in the future, but also what is going to happen with the trades that have been concluded but are affected retrospectively by the new ban."

“From the point of the view of the exchange, nothing untoward happened in the share trading to justify a renewal of the moratorium," says Tinnikov.

"Evidently however, some people had a different perception."

Now the market is frozen, waiting for a new presidential decree to resolve the impasse. According to Tinnikov, the new edict will include a list of companies – including up to 100 in the processing sector – that will be temporarily exempted from the moratorium.

The decree is likely to assign first dibs for share acquisition in such companies to regional executive committees – still called Ispolkoms as in Soviet times.

However there is no money in the

“Unfortunately, things haven’t developed quite as we expected them to”

its control of the economy to secure political control. Whilst none of these companies could be counted as "family silver", with the country's economy fairly buoyant and a large share of its light industry smaller-scale, it looked potentially interesting for investors.

budget to buy shares from workforce members, even at their nominal price.

Two steps forward, one step back The delayed repeal of the moratorium was not entirely unexpected. Ever since the plan to lift it has started rolling, the

bne July 2011

government has been pulling the brake any time things seemed to be getting out of control – its control. “It’s been two steps forward and one step back,” laments Gud. A list of 162 strategic companies including oil refining giant Belneftekhim and potash giant Belaruskali - which have mostly not yet been transformed into joint stock companies, were excluded from the repeal right from the start. Next companies involved in the second phase were given first dibs to buy their own shares. However, less than fifty companies actually used this right, which expired at the end of 2010.

The story illustrates the opposing forces at work in Minsk since it launched a liberalisation strategy in 2007 in an attempt to come to terms with new energy prices from Russia. Lukashenko has consistently shown himself unable to contemplate any real concession of power – including allowing any major private ownership in the economy - and thus the strategy has been crippled from the outset, despite the huge amount of government time and effort spent.

The much-maligned Directive No. 4 serves as one of the best examples of the quagmire this dilemma is producing. Issued by Lukashenko on the eve of the end of the moratorium's third phase on December 31 2010, the document laid down general principles to support the flourishing of private enterprise.

Among those was a demand “to secure unambiguous legal regulation and stability of business legislation.” Only weeks later came what market participants call the "legal nonsense" of a retrospective trading freeze.

However, with Belarus experiencing ongoing devaluation, and with an IMF reform programme not too far ahead in the future, cheap stock should be bountiful whenever the inevitable finally happens and the stock market springs to life.

Eastern Europe

Lukashenko reverts to his old tricks in bid to bail out Belarus

Tim Gosling in Moscow Having secured a bailout loan from Russia, Belarusian President Alexander Lukashenko is back to his old trick of trying to play both sides with a bid for help from the International Monetary Fund (IMF). The key requirement of both loan programmes is reform, and most notably wide-scale privatisation – but Minsk can't sell the family silver to both sides.

Suffering from a chronic trade deficit, the Belarusian economy has spent the first half of 2011 sinking rapidly into the mire as foreign exchange reserves dwindle. The government continues to try to regulate the crisis away, even after it finally gave in to a huge devaluation of 36% in May. That spread panic buying – and more recently protest – amongst a population that has traditionally swapped political freedom for social and economic stability. But the flawed re-election of Lukashenko in December – and the vicious crackdown on protestors that followed – pitched Belarus into international isolation. And with the US and EU applying sanctions, Russia suddenly found itself the lender of last resort.

After several months of talks, the first $800m tranche of a $3.5bn package secured from the EurAsEC CIS anti-crisis fund was issued on June 21. However, analysts note the loan is insufficient on its own in the face of financing needs closer to $10bn. Now tension between Minsk and Moscow is rising once more. In recent weeks, Lukashenko has threatened to throw out Russian journalists and close the borders to imports. In return, Moscow has reminded him it can plug the flow of money any time.

However, the real issue is the privatisation programme. Moscow announced in May that it had secured commitment from Lukashenko to embark on a three-year, $7.5bn sale of state assets. However, conflicting claims on the first two deals – for gas pipeline operator Beltranzgas and potash miner Belaruskali – have already erupted, with analysts such as Tim Ash at RBS noting: "Negotiations continue to stall over price, plus also perhaps control – important for potential bidders given the challenging policy environment in Belarus."

Minsk is likely to resist handing over all of the family silver to Moscow when it needs to persuade the West to stump up cash. The request for an IMF support programme of $3.5bn-8.0bn is a tough sell when many of the fund's stakeholders are simultaneously slapping sanctions on the country.

Yet the IMF hasn't dismissed the idea out of hand, though is stressing that, "the [Belarusian] authorities have to be committed to macroeconomic stabilisation and structural reforms."

That prompts Ash to conclude that the chances of Belarus reaching a new financing agreement with the IMF are remote – barring an (unlikely) sea change from the Lukashenko regime. "As yet, the regime seems to think that it is not under significant threat in terms of domestic social/political stability" and is still trying to buy time, he says.

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bne July 2011

Russia's privatisation chief discusses the 3-year programme

the first auction, then we will use a "Dutch auction" and try again [where the auction starts at a high price, but reduces it until there is a buyer ending the auction.]

INTERVIEW:

In 2010 and this year, we have sold most of the objects put up for auction, despite the failure of Murmansk, but if the object is a good one, then it will be sold.

bne: What are the major companies on the list that will most interest foreign investors?

Ben Aris in Moscow Alexey Uvarov

Russia's government, strapped for cash and keen to turn over as much of the badly run state-owned business to the private sector as it can, has restarted its privatisation programme after a decade-long hiatus. The last sell-off in the 1990s turned into a land grab that made the wellconnected fabulously wealthy, but Alexey Uvarov, who heads the state agency overseeing the latest privatisation programme, tells bne this time will be different.

bne: What is the goal of the privatisation programme – to make money or to get business out of state hands and into private hands?

AU: It is a combination of the two: money and management. The federal budget is in deficit, but raising money is not the overriding goal of the programme.

The privatisation will have a good effect on the companies that will become transparent and understandable to international investors, as they will be brought to the same high standards as in the West. We want our companies to meet this standard.

ended up in government hands during the transition of the last 10 years. They are state-owned, but most of these companies are sick and they will only be interesting to local business investors.

It is only the top 10% of the companies on the list that will interest the international investors. And these are big strategic companies that we plan to sell off gradually through to 2013 and raise RUB1 trillion ($33bn) in the process.

We expect to raise RUB200bn this year with the sales of stakes in Sovkomflot and a stake in Sberbank.

bne: How will these companies be sold? By auction, through IPOs or from

bne: How many companies are being

AU: The method we use to sell the com-

sold and how much money do you expect to raise?

pany will depend on the company itself.

There is no universal recipe. The size of the packets will also depend on the company. For example, we could sell a controlling package to a big foreign investor or sell them via IPOs in chunks with subsequent issues of shares.

AU: It is a three-year programme and it is very big. There are more than 1,400 on the privatisation list, of which about 90% are small and medium-sized enterprises. These are companies that have

The government has hired several investment banks which are studying the companies and will advise us on what is the best method for selling them.

bne: Following the infamous "loansfor-shares" auctions in the mid-1990s auctions have a bad name in Russia.

What can you do to ensure auctions are transparent and open to everyone?

AU: The auctions will be absolutely open and transparent. Unlike then, there is no privatisation law, only auctions, so anyone that wants to can participate. All they have to do is pay the deposit and then they can participate.

The auctions in 1995 were not really

It is only the top 10% of the companies on the list that will interest the international investors direct negotiation with foreign strategic investors? And will you sell controlling packets or in pieces?

bne July 2011

privatisations, as they were linked to the loans. This is a different case.

bne: While there are a few important companies on the list, won't it be hard to sell most of the companies? For example, in May the attempt to sell Murmansk port failed, as there were no bidders.

AU: We expect that about a third of the companies will not be sold at the first attempt. So what should you do with these companies? If they are not sold at

AU: In 2011 the major companies to be sold include [shipping giant] Sovkomflot and a 5% stake in [retail banking giant] Sberbank. In 2012, amongst the most important companies on the list are [state-owned energy transmission company] FSK, [state-owned hydropower holding] RusHydro, and another 10% of [Russia's second biggest bank] VTB Bank.

Sovkomflot is the biggest shipping company in the world, and it already works to international standards and works all over the world. It already has to compete with its international peers and so it is already ready to be sold. We plan to sell a 25% minus one share stake this year. it will probably be sold as an IPO, privatising the share through the stock market, and use it as an instrument to raise funds and improve the quality of the market. If it works well, then the value of the shares will go up and if it goes badly, then they will go down. Later we will sell another 25% and could sell a 25% stake plus one or two shares and that could happen in 2015. But the long-term goal is to leave the company completely.

bne: Another company on the schedule this year is Perm Pig, a state-owned agricultural concern in an attractive sector.

AU: Perm Pig is one of the strongest kombinats in Russia and 100% owned by the state. We have given the mandate to the investment banks to prepare the company for sale and they are looking at the market and the company to decide how best to sell it. It could be sold on the stock market or it could be sold to an investor, but in this case we will sell a 100% of the company in the privatisation.

Eastern Europe

I 21

bne: Some of these companies are very expensive – isn't there a danger of flooding the market with shares, as the market only has a limited capacity to absorb auctions of these sizes?

AU: The valuation of some of these companies is very high and we can't sell them all at once. We also understand that Russia's privatisation programme is in competition with the privatisation programmes of other countries, which are also selling companies to raise money for their budgets. There is a lot of activity on the international markets at the moment and investors have a great choice of companies to choose from, but there are limited funds available. But we believe it is possible to raise RUB1 trillion in the next three years. bne: The government has done an about face, as some of the companies on the list are included under the "strategic investment law" that was passed in 2008 and excludes foreign investors from some sectors. How will these companies be sold?

AU: The strategic objects will also be sold and can be sold to foreign investors, however, there will be a state commission that will review the sale. But there are only a few of this type of company on the list, like the Murmansk port. The deal will have to be reviewed by the commission, but the sales will almost certainly be approved. bne: You have a schedule for the sales, but the market conditions remain volatile. How important are the conditions for the sales? Will you go ahead with the sales even when conditions are bad?

AU: Market conditions are important, as we don't want to privatise objects irrespective of the price. We do want to sell these companies over the next three years, but we won't sell them cheap.

Getting a good price is not the top priority, but we are not going to sell at any price either. We are planning to sell Sovkomflot and Sberbank this year, but if the market conditions are very bad, we will delay the sale.

Market conditions are important, as we don't want to privatise objects irrespective of the price

Ben Aris in Astana

H

ow much state ownership in an economy is good for an emerging market? Looking around the world today, most countries have opted for an awful lot of state ownership, but while no-one disagrees that the private sector is the most efficient manager, academics say that at the start of transition the state has to be heavily involved.

“During the initial ‘Big Push’ phase of transition having a few dominant business groups – owner by either the state or the private sector; it doesn’t matter which – is not a problem, it is crucial,” Professor Bernard Yeung of the National University of Singapore said during a presentation at the EBRD’s annual general meeting in Kazakhstan in the middle of May. Enter the dragon China is a case in point. The press and international investors are all of a flutter with their love of China these days, so

much so that the country’s phenomenal growth has led some to suggest that the western free market model – the socalled Washington consensus – should be abandoned and the Chinese model, where the line between business and politics has been erased, is the way to go.

Yeung points to the economies of Latin America in the 1980s as examples of countries that failed to make the change, and indeed there are plenty of examples of economies that fell into the stagnation trap in Western Europe as well.

In the "Big Push", government has to invest heavily to pump liquidity into the economy and kick start economic activ-

“All emerging markets follow a similar pattern” Dubbed "The Beijing Consensus" by Joshua Cooper Ramo of the UK's Foreign Policy Centre in a 2004 paper, this version of capitalism emphasises innovation over democracy, sustainability over GDP per capita income, and an explicit link between geo-politics and geo-economics. For instance, artificially holding down the yuan’s value against the dollar has resulted in a massive flow of capital from west to east.

ity. The Chinese economy hasn’t faced a collapse like Russia’s, but it needs a massive amount of investment to lay the ground work for a market economy to function properly.

Guriev says once the economy is working, the key is for the state to disengage and hand over the job of driving economic growth to the entrepreneurs and small- and medium-sized enterprises.

Yeung adds that once the economy starts

And here is where it starts to get tricky.

During the "Big Push", governments set up powerful lobbies and vested interests that don’t want to see their companies downgraded or sold off. In the inevitable political tussle that comes with a decision to change from pushing to nurturing, a lot of very powerful voices emerge to argue the time is not right.

While China is clearly in the middle of its Big Push, it can be argued that Russia has already reached the point where it needs to transition to a more caring, less involved, kind of government. The trouble is there is no clean break between the two stages. “You have to understand that the transition from one phase to the next one is not uniform,” says Guriev. “The needs [of the economy] change from region to region inside Russia, and from sector to sector.”

Special needs Russia has made a lot of progress, but the needs of its economy are very mixed.

A joint survey conducted by the Moscow Higher School of Economics and Russia's leading economy magazine Expert in May found that since the total collapse of the economy in 1991, both incomes and consumption per household have soared since 2000, and easily outstripped the progress in any of the other major emerging markets. While between 150m and 300m in those markets still live in abject poverty, the average Russian has seen their income per capita increase by 45% between 1991 and 2008, while the volume of consumption per capita more than doubled.

Put in concrete terms, the survey found that the average Russian could buy twoto three-times more cigarettes, alcoholic beverages, cars and clothing with their 2008 salary compared with what their 1991 pay packet would cover. All in all, 80% of Russians have seen their income rise in the last 20 years – and in most cas-

Russia the best place to become a billionaire

bne Russia may not be the richest large economy, or the fastest growing large economy, or Europe's largest economy, or even the economy that hosts the world's financial centre, but it is pretty clearly the best place to be if you want to become a billionaire.

The rate of return on investment in Russia is amongst the highest in the world – for the well connected or the aggressive risk-taker that is. It has been the large economy in which the chance of becoming a billionaire has been the highest over the last 15 years.

"After all, there certainly weren't any billionaires in Russia in 1991 when the Soviet Union was dissolved, and probably none until 1994 when the first businessmen began to secure control over privatised property. But since then, Russia has been churning out billionaires by the dozen every year; today, there are 101 according to Forbes and no sign of the number slowing down anytime soon," says Jacob Nell, an analyst with Morgan Stanley in Moscow who compiled the table below.

Between 2004 and 2011, Russia produced one billionaire for every 1.87m people, compared with the US, the next best place to be, where one billionaire was created for every 2.29m people, or in the UK with one for every 4.13m people.

China, the darling of the emerging markets, doesn't do half as well, producing one billionaire for every 11.76m people in the last 15 years, while in Germany the man in the street had no chance of becoming a billionaire at all, as the overall number of billionaires remained stuck at 52 since 2004.

RUSSIA – THE LAND OF OPPORTUNITY 60%

50%

40%

30%

20%

10%

0%

Probability of becoming a billionaire since 2004, per million citizens

Germany

When to let go? the state's role in transition economies

When to let go “All emerging markets follow a similar pattern,” Yeung said, speaking at the forum held in the windswept capital of Astana. “At the start of the process, the state has to engage in a ‘Big Push’ to get the wheels of commerce turning, simply because it is the only entity with the money or resources to do anything.

However, once the economy is up and running, at some point it must change to a ‘nurture’ strategy and step back.

If it doesn’t then there is a danger of strangling the growth it started, and stagnation.”

to function, it also starts to use up its resources, so a key element of nurturing is “creative destruction” – companies that are not efficient must go bust to allow their resources to be put to better use elsewhere. A lack of creative destruction is the short road to stagnation.

Eastern Europe

China

Everyone is mesmerised by the dragon market’s 10%-plus annual growth rates and billion-strong population, but is China’s ballistic growth and the state’s involvement in the economy really such a good thing? Yeung was joined by Sergei Guriev, the director of Russia’s New Economic School in Moscow, on his panel, and the two men agreed that state involvement in the economic is a necessary stage, but it will eventually strangle an economy unless the government can eventually let go.

bne July 2011

UK

bne July 2011

US

I Eastern Europe

Russia

22

Source: Forbes, Haver, Morgan Stanley Research

I 23

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I Eastern Europe

es it has increased by at least one order of magnitude – while only one in five Russians has seen no change in income since the end of the Soviet Union.

Sectors connected to this boom in retail spending power have been the clear winners – things like retail, services and the media – and clearly the state is already in the position where it need do little more than nurture more growth in these areas. For example, Magnit – the biggest supermarket chain in the country – will see over $10bn in turnover this year, but it still only has a 3% market share.

On the other hand, the manufacturing sectors are clearly still struggling. The state’s involvement in the power and automotive sectors has been highly successful and attracted tens of billions of dollars in foreign investment. However, the national champions in sectors like shipping, aviation and metallurgy have yet to really get going.

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A question of timing Still, the Kremlin seems to have got the message, and the two stages are personified in Prime Minister Vladimir Putin and Russian President Dmitry Medvedev, who will both stand for re-election in the next 10 months.

Putin is in charge of the day-to-day running of the government and manages the oligarchs’ companies like the CEO of ZAO Kremlin. There are regular meetings between Putin and the oligarchs, where the latter need to get the state to sign off on their investment plans. At the same time, Putin has set up and oversees the running of several industrial national champions.

On the other side of the fence is Medvedev, who has begun judicial reforms, launched the first real anti-corruption campaign and recently sacked a raft of senior state officials from their seats on the boards of Russia’s biggest stateowned companies.

Whatever you think about the balance of power and effectiveness of these two men, the state has committed itself to getting out of business and re-launched the privatisation process, which is planned to raise up to RUB1 trillion ($33bn) in the next three years. State-owned banking giant VTB has already sold another 10% of its stock this year, despite poor market conditions, and will likely sell a similarsized stake next year. Its sister statecontrolled bank Sberbank will sell some 7% of its stock later this year, along with shipping powerhouse Sovkomflot and several other strategic assets.

The stakes are high. Russia used up a lot of its spare capacity in the crisis and slower growth of about 4% is not fast enough to prevent things like infrastructure slowly crumbling. This autumn’s elections will make a big difference, but even assuming the government stays on course, it still has to get the speed of transition from its "Big Push" to nurturing the economy right – and that won't be easy.

A new Russian sovereign wealth fund FUNDS:

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of the Russian Venture Company, a state-backed fund promoted by Prime Minister Vladimir Putin to kick start the country's venture capital industry. “I am not a politician, I am a fund manager, and the primary goal of the RDIF is to earn returns for the investors,” says Dmitriev sitting in a café on Red Square the day before the Kremlin’s annual investment jamboree in St Petersburg began on June 16. “We thought long and hard about the best form for the fund, to make it as attractive as possible to investors. The state finance will be limited to a minority role of no more than 50% minus one share in any project. It means the co-investor doesn’t have to invest into anything they don’t believe will earn returns. I don’t see the RDIF as a political initiative, however the political goals of the government will be achieved from these investments – but as a by-product.”

Dmitriev is currently hiring staff, most of whom will be Russian professionals, whilst the first $2bn will be released by the state in September. The first investment is anticipated by the end of the year, says Dmitriev. After that, the state-owned debt agency and de facto development bank Vnesheconombank (VEB) will release another $2bn each year over the next four years. The Kremlin hopes that will attract $90bn from private co-investors. “Russia is a very attractive investment destination and people have to some extent lost sight of what the country has to offer,” says Dmitriev. “It is the sixth largest economy in the world - even Russians forget this fact - and the number of people that are earning more than $10,000 a year has tripled in the last six years.

Ben Aris in Moscow Kirill Dmitriev

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resident Dmitry Medvedev has launched a drive to improve Russia’s investment climate and is putting $10bn of the state’s money where his mouth is: the Russian Direct Investment Fund (RDIF).

The new $10bn sovereign wealth vehicle aims to attract the world's leading funds to co-invest in major projects. The hope is that it will dramatically increase

private equity investment by reducing the perceived risk of doing business in Russia.

backed investment fund designed to promote capitalism by financing the growth of independent business in Russia.

The appointment of Kirill Dmitriev to run the fund is a testament to the commercial nature of the project. One of Russia’s new generation of rising business leaders, Dmitriev cut his teeth working as a manager at Delta Private Equity Partners, a US-government

He then set up the highly-successful Icon Private Equity – a $1bn fund that invested in projects across the Commonwealth of Independent States. At the same time, he founded the Russian Association for Venture Capitalists and advised the government on the creation

"I am not saying that everything is good," he adds, "but the rising incomes have led to an incredible amount of change in a remarkably short time.”

Hand-holding role The structure of the fund is designed to allay foreign investor fears about investing into Russia. Such worries are illustrated by the Russian stock market, which has been the best performing significant market in the world over the last decade, but is still stuck with an

Eastern Europe

average price/earnings ratio below 7 – a stark contrast to the early teens enjoyed by other major emerging markets. Russia also performs way below emerging market peers in terms of both incoming portfolio and direct investment volumes.

A major focus for the RDIF then is to offer major investment firms some reassurance. With the state limited to a minority stake, investors will not only have the security of a controlling stake, but more importantly the state will share the risks and be subject to the same rule of law and corporate governance practices as its co-investors.

The structure of the fund is also designed to allow it to tap into the expertise of what are planned to be the best investors in the world. The investment commit-

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potentially a very profitable investment.

The same is true for the pharmaceutical sector. Russia has the fastest growing market in the world, but 80% of the products are still imported.”

Creative discussion Among the international investors that have already expressed an interest - and will probably end up on the international advisory board - are Goldman Sachs, Blackstone, the Abu Dhabi Investment Authority, Kuwait Investment Authority, China Investment Authority, Permira and Caisses des Depots.

The point of roping in all these big names is to create the same sort of creative discussion found at events like the World Economic Forum meet in Davos, with the difference that the funds can

“Russia is a very attractive investment destination and people have to some extent lost sight of what the country has to offer” tee, which will meet whenever needed, can approve deals up to $250m and will feature professional investors from both Russia and around the world.

The supervisory board, which will meet four times a year, will determine the strategy and also approve deals up to the $500m maximum. Government officials will join that board, but international institutional investors and professionals will make up the majority. The final level of supervision will be an international advisory committee composed of representatives from the leading global funds, which will get together once a year.

“There will be some ‘no-brainer’ investments as the primary goal of the fund is to produce returns, but we also want to leverage the expertise of our partners,” says Dmitriev. “For example, we have talked to a private equity fund that is a global leader in health sector investments in the US and Europe. Very few private investors in Russia have invested into private sector healthcare, but clearly there is need for them. So this is

actually act on their insights. At the last Davos meeting, the main global themes that came out were the rise of the middle class, the rise in commodities and energy, and the importance of infrastructure, points out Dmitriev – all of which are key Russian stories and represented in the fund’s target sectors.

The CEO says he is looking for investors willing to make a long-term commitment with an investment horizon of five to seven years, and where the RDIF would not own controlling stakes in businesses, but could do so alongside investment partners. “The fund will not replace the other institutional reforms and both the president and prime minister have been very vocal about the need to improve the investment climate,” says Dmitriev. “But the idea of co-investment is to reduce Russian risk and make foreign investors more comfortable. If they come and invest $1 now with the RDIF and make money, then these foreign investors will come back on their own and invest $10 down the road.”

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Bogdan Turek in Warsaw

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acked by Beijing and powered by extremely competitive bids, Chinese construction firms have been pushing into Central and Eastern Europe and winning major infrastructure contracts. CEE is seen as a bridgehead to the wider European markets, but that strategy is at risk of already crumbling in Poland.

On June 13, Poland's highway construction authority (GDDKiA) cancelled a contract with China Overseas Engineering Group (Covec), the first Chinese firm to win a major public works deal in the EU, to build two stretches (totalling 90 kilometres) of the A-2 motorway, which will connect Warsaw to the German border via Lodz.

The schedule demands the route be open by the start of the 2012 European Football Championships on June 8, but there are now serious doubts over whether that will happen, with Covec struggling to deliver within the low price with which it won the tender in September 2009.

Work had already halted in May, after the Chinese company ran up PLN130m (€32m) of overdue payments to the 20 Polish subcontractors it hired to provide labour. The subcontractors duly pulled their employees off site, and now the project is already two months behind schedule. Covec spokesman Yang Wencheng says that the company is still talking with GDDKiA and other Polish authorities to seek a way out of the mess. “We are continuing negotiations and cooperation,” he claims, without elaborating.

Lessons to be learned Observers says it’s a good lesson for China and Poland, both of which had a lack of experience in striking and managing such infrastructure deals.

China's EU bridgehead crumbles in Poland

Pawel Antonik, CEO of Strabag Societas Europaea, whose company is also working on sections of the A-2, says Covec may have miscalculated the cost of the completing the contract, having bid to build the stretch of motorway for just PLN1.3bn, a price which provoked rival

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bidders to protest that the Chinese were price dumping.

Critics also claimed that it would be impossible to complete the project for such a price, but the Polish government, presented with a potential tab of around half the amount it had estimated it would have to find, dismissed those concerns.

Antonik says it costs Strabag €8.3m to build 1 km of road, while the Covec contract set costs at €6.4m. However, as he points out, "Covec is a state company, and it’s not a secret that the Chinese authorities will subsidise it to enable it to enter the European market." It could be assumed then that Covec will have this

"Strabag says it costs ¤8.3m to build 1 km of road, while the Covec contract set costs at ¤6.4m" option to fall back on rather than abandon the project if it fails to renegotiate the contract with the Polish authorities.

That said, Chinese construction companies in Europe are limited in their usual advantages, Antonik explains. Cheap Chinese construction materials can’t be imported as they don’t meet European standards, so labour costs are the only lever left to help them slash costs. “However, the cost of labour is generally only 10-12% of the contract in infrastructure construction,” he says, calculating that even if they could cut such labour costs by half, the Chinese still can’t achieve the kind of competitive edge Covec pushed without state subsidies.

One US manager who worked in China for many years and asked for anonymity says subsidies are a normal procedure there. “When we were bidding against them, they often went for very low-ball pricing, sometimes 50% of the market price, and everyone was convinced they were getting government support. On

Polish companies boosting outward FDI

Bogdan Turek in Warsaw Polish entrepreneurs needed almost a decade to gain experience and confidence in investing abroad, but their presence on foreign markets, although still small, has grown more than 30% since Poland joined the EU. Outward flows of foreign direct investment (FDI) from Poland reached no higher than ¤277m between 1996 and 2000, but jumped to ¤2.6bn in 2005, the Polish National Bank's (PNB) archives show. “The breakthrough came in 2004,” said an official from the PNB, who points to the huge boost since.

“The data on outward foreign investment after three quarters of 2010 add up to about ¤35.5bn."

The management of Polish companies investing outside the country’s borders say they need to look to other markets in order to grow. Piotr Piatas, deputy CEO of Comarch, a software house headquartered in Krakow, says the Polish market was already saturated with the company’s IT solutions, so it started investing abroad 10 years ago. Comarch is now one of more than 1,000 companies, compared with 691 in 2005, that have acquired stakes in foreign companies or opened their own branch offices abroad. "We had to go abroad to widen our client base,” Piatas says.

Darius Ner, CEO of Comarch in Chicago, says the decision to open an office in the US was a daring experiment. “Finding the first clients on the US market was a problem due to a lack of local references and lack of trust in technologies that are not American.” However, Comarch now has pushed its expansion to 13 offices across Europe, North and South America, Asia and the Middle East.

According to the Ministry of Economy's press office, the number of Polish companies making investments overseas is also expanding rapidly. Whilst no more than 39 took the plunge in 2006, a total of 208 committed capital outside the country in 2007.

For some of these Polish companies, the global economic crisis was an opportunity to make their move. When three Romanian companies owned

by Romcolor Group that produce paints, cement and plaster compounds got into trouble last year, Polish paint and glue producer Atlas Group leapt to buy majority stakes. CEO Henryk Siodmok says he's delighted with the decision, which means Atlas can sell on several new markets, including Hungary, Serbia and Moldova, and adds that the company already plans a ¤5m expansion in Romania.

Selena – a Polish manufacturer and distributor of construction chemicals – pounced in Spain in 2009 when Industries Quimicas Loewenburg (Quilosa) was near bankruptcy. "We bought a 51% stake in Quilosa,” Selena's deputy CEO Kazimierz Przelomski explains. “The funds stabilized the company's financial situation whilst the acquisition has increased our production capacity and our share on the western market.”

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construction projects, they paid extremely low wages and the workers built their own shelters and slept on boards."

However, Chinese companies appear to be discovering that this model is much harder to implement in the EU. Owning the Stalowa Wola steel mill in southern Poland in March, LiuGong Construction

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Back on the A-2, Covec officials could only watch as subcontractors pulled their equipment off site in protest at the overdue payments and the Polish workers blocked a nearby road, reported the TVN24 channel. However, this is not the first time Covec has struggled with timing or quality on its overseas infrastructure projects - Polish media claims that a hos-

"On construction projects, Chinese firms paid extremely low wages and the workers built their own shelters and slept on boards" Machinery was reported to be shocked to encounter labour protests in May when it offered a poor social benefits package to the 2,500-strong workforce.

“There are still talks with the Chinese on the issue,” the Stalowa Wola press office says. “The new investor has not familiarized itself with the working conditions or the labour rules here.”

pital it built in Angola began to fall apart almost immediately, whilst it failed to finish an irrigation project in South Africa.

Counting the cost Not surprisingly, Cezary Grabarczyk, Poland’s minister for infrastructure, is trying to remain optimistic that the problems will be solved soon. “I don’t think that the

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Chinese company, for which a highway construction contract is a sort of a passport to an almost unlimited construction market in the EU, intends to risk its future on the European market,” he says.

cumulative GDP gain totals PLN18.436.6bn in 2009 prices, with the high point in 2012, when an estimated 820,000 visitors will be spending on transport, accommodation, and numerous other goods and services.

Just as predictably, the leader of the opposition Law and Justice Party, Mariusz Blaszczyk, claims GDDKiS did not check the credibility of Covec. "There’s no way the highway will be built on time."

Meanwhile, reflecting China’s strategy to leverage its huge financial muscle to secure a share of European markets, Slawomir Majman, CEO of foreign investment agency PAIiIZ, worries that cancellation of the project would deal a blow to the development of Polish-Chinese economic relations and a number of deals currently under discussion. “Our relations have improved and the flagship for the Chinese was the construction of the highway,” he says. “Several Polish companies are about to sign contracts with Chinese companies. A cancellation might scare the Chinese."

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However, Professor Witold Orlowski, chief economic advisor at PricewaterhouseCoopers’ Warsaw office, complains that whilst these numbers do a good job in fuelling enthusiasm for the event, they’re very hard to verify.

“Infrastructure investment would have been happening anyway," he claims. "As for investments carried out strictly for the event, like stadiums, we don’t know if the money spent on them wouldn’t be better spent on something even more growth-spurring."

Poland hypes Euro 2012 economic kick

Wojciech Kosc in Warsaw

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laims that Poland’s economy stands to get a significant kick from the 2012 Uefa European Football Championship make for pleasing propaganda, but the official view on the event’s potential effects looks exaggerated.

Set to co-host one of Europe's most prestigious sporting events with neighbouring Ukraine from June next year, Poland should certainly be able to raise its international profile. At the same time, the event will also offer opportunities across virtually all sectors of the economy – at least according to a report from PL.2012, the company managing the organisation of Euro 2012 in Poland.

Overall, the report claims, the event will drive a GDP gain of 1.4–2.7%

spread across 12 years from 2008 to 2020, with the development of transport infrastructure a leading edge which should peak next year. The year following the tournament, the report

In short, "calculating exactly how much extra GDP growth Poland is going to post thanks to Euro 2012 is next to impossible. It’s a common misconception to attribute more palpable GDPinfluencing factors, like infrastructure developments, to the fact that Poland co-hosts Euro 2012," Orłowski says. “But their financing had long been decided on at the national and the EU level. The event may have triggered their faster execution, but certainly didn’t make them happen."

In other words, many development projects already had their financing agreed with the EU bodies helping to fund them before the right to host Euro 2012 was won, and would have gone forward regardless. Examples include a rail line linking central Warsaw to the

"Calculating exactly how much extra GDP growth Poland is going to post thanks to Euro 2012 is next to impossible" hopes to see it boost foreign direct investment inflows by 2.4%, whilst additional revenue from inbound tourism could reach as high as PLN5bn (€1.26bn). The absolute value of the

Chopin Airport (the first entirely new railway line built in Poland in decades), the recently delivered section of the S8 expressway, which forms part of the ring-road system around the capital,

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and the expansion and modernisation of the airport terminal at Wrocław.

Orlowski suggests some of the biggest potential gains are less tangible even than those hard-to-measure GDP gains, with the country's global profile across the globe top of the list. “Just like Barcelona after the 1992 Olympic Games, Poland has a chance to establish itself very firmly on the world’s tourism and business agenda,” he says.

Backfiring Of course, every opportunity has the potential to transform into a crisis, meaning any major problems around the championships could damage Poland's reputation. Whilst PLN80bn is being invested into the country's infrastructure, some key sections are still at risk.

"Unfortunately, little has been done to develop the stadiums so that they are not just stadiums"

The highest profile example currently is the A2 motorway linking Warsaw to Lodz and on to Germany, which saw the (cut price) contract with Chinese road builder Covec pulled on June 13, after a standoff lasting a matter of weeks. It's tempting to assume that without the pressure of Euro 2012, Poland's roads agency may not have moved quite so quickly to tear up a contract offering it a discount of close to 50% on the amount it expected to pay in the original tender and find a new contractor.

In contrast, the tournament didn't manage to light a fire under Polish State

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and sensationalised", with a spokesman stressing they are "procedural and are not safety" significant. "We will work cooperatively with the NRC and expect to obtain all necessary approvals as planned this fall," he says.

Railways, which only agreed terms with Slovak development company HB Reavis to renovate Warsaw West – one of three key railway stations in the Polish capital – on June 16; much too late for the station to be of use for the expected passenger influx next summer.

The legacy headache As with any global sporting event, however, at city level it's the sporting arenas and their legacy that could cause the most headaches. The PLN1.2bn National Stadium in Warsaw is already running into problems, and has seen construction and electric installation design issues set back its delivery date from June to the end of November, which has seen several pre-Euro 2012 events cancelled. The specially built stadium in Gdansk is in a similar situation.

Orlowski says the mayors of host cities – Warsaw, Gdansk, Poznan and Wroclaw – are going to face a period immediately after Euro 2012 during which the costly venues will weigh on their budgets rather than bringing in cash.

“Unfortunately, little has been done to develop the stadiums so that they are not just stadiums, but also elements of more complex business and commercial developments,” he points out. “The complementary functions will, of course, arrive over time, but before it happens, the stadiums could be loss-makers."

That will leave the state and local governments covering the shortfalls from the taxpayers' purse, and could have a long-term negative impact on the local economy.

Poland's host cities wouldn't be the first – the debate over the legacy of stadiums built for global sporting events appears to grow longer each and every year.

As KPMG noted in a study on the 2010 Vancouver Winter Olympics: “These [events] projects grow ever more vast – with expectations of what will be delivered being ramped up every time as each organizer tries to out-perform their predecessor – there may yet come a tipping point at which even the accelerated delivery of shiny new infrastructure assets is not worth the enormous investment of time and money.”

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Safety is the key selling point for Areva's bid, something which has taken on added significance since the events in Japan. Its EPR reactor includes a host of safety features, though they inevitably make it more costly; in 2009, Abu Dhabi chose the South Korean bid over Areva's reportedly 50% more expensive one.

Pressing the nuclear tender button sage. Hardly a week goes by without US Ambassador to Prague Norman Eisen singing the praises of Westinghouse's bid, and given his close ties to President Barack Obama, it's clear the administration is giving its full backing.

The Russians certainly know how to play the geopolitical game – April saw a gaggle of high-profile Russian politicians and businessmen, including Deputy Prime Minister Alexander Zhukov and presidential economics adviser Arkady Dvorkovich, in Prague to play a charity ice hockey match against their Czech counterparts. The Russiafriendly Czech president, Vaclav Klaus, has already come out in support of the Russian bid, though the general population and a good section of the political elite regard the country with a degree of suspicion.

Westinghouse will need all the help it can get. Its bid took a knock in May when the US Nuclear Regulatory Com-

To allay suspicions, Atomstroyexport says the Russian state atomic holding Rosatom could build a nuclear fuel

Nicholas Watson in Prague

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n October, the phoney war will end and the Czech Republic's huge project to build two new nuclear reactors begins in earnest with the publication of the tender parameters. The importance of this deal for the three bidders – France's Areva, the US' Westinghouse Electric and a Russo-Czech consortium led by Atomstroyexport – promises to make this a hard-fought and close-run battle.

In 2009, the Czech utility CEZ invited applications for the country's biggest ever tender to build two new reactors at its Temelin nuclear power plant, with an option for up to three more reactors at other sites around Europe, in what could amount to an investment estimated at over €20bn. It subsequently announced the three bidders had qualified to participate in the tender, and a mass lobbying effort began via the press.

Westinghouse, now a unit of Japan's Toshiba, has been particularly noticeable in its attempts to get out its mes-

Areva is offering the most apolitical pitch, but is no less desperate to win for that. "This is the number one priority project for us," says Thomas Epron, Areva's chief representative in Prague.

"This is the number one priority project for us" mission (NRC) raised new concerns over the design of its AP1000 reactor and said it wasn't prepared to license it, even though ground has already been broken for one such reactor near Augusta in Georgia.

Westinghouse hit back by saying the design issues are being "misinterpreted

production facility on Czech soil "in order to achieve higher energy independency of the Czech Republic" and has promised to subcontract about 70% of the work in building the two reactors to local firms. Critics point out that Atomstroyexport's Czech partner Skoda JS is actually part of the nuclear division of another Russian company OMZ.

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Floating Home Credit

bne PPF Group, the investment vehicle of Czech tycoon Petr Kellner, is in the preliminary stages of planning an international IPO of its subsidiary holding Home Credit B.V. (Netherlands), sources have confirmed Russian press reports as saying.

Home Credit B.V. hosts the group holding companies of its consumer finance business throughout Central and Eastern Europe, namely the Czech Republic, Slovakia, the Russian Federation, Kazakhstan and Belarus.

Russian daily Kommersant cited unnamed sources close to the bank as saying the shareholders are ready to conduct an IPO by selling part of existing shares (20-30%, the sources specify) in the autumn of 2011. According to bne's information, PPF has hired Deutsche Bank, Citigroup, Merrill Lynch and JP Morgan to lead manage the IPO in London.

PPF wouldn't comment on market rumours, but left the door open to the possibility of some sort of deal. "The facts and the assumptions in the [Kommersant] article are wrong," said Milan Tománek, head of PPF Group Communications in Prague.

According to bne's understanding, PPF is looking for the IPO to value the firm at 3.5x to 4.0x book value, which would translate into a valuation of around ¤3.5bn. "Given Home Credit & Finance Bank's leadership (27% in consumer lending) in a highly profitable segment, its multiples could be higher than those at the recent placement of Nomos Bank (price/book value of 1.5x), though pricing will clearly depend on the placement parameters and market sentiment," says Ainur Medeubayeva of Troika Dialog.

Petr Kellner's Home Credit Group has been enormously successful, especially its Home Credit & Finance subsidiary in Russia. A corollary of this is that it made Home Credit & Finance a target of Russian state-controlled VTB Group, which was in talks with its PPF owners in November 2010 about buying it before those negotiations collapsed over price.

The problem this left for Kellner is that he still didn't have the funds required to expand Home Credit into the lucrative new markets he has identified in Asia and North Africa, such as India, Indonesia, China and Egypt.

Thus the decision to IPO the European segment to fund the growth in the new emerging markets.

"CEZ is undertaking all necessary steps to prepare ourselves for financing the project from the balance sheet without exposing the company to risk of lowering its credit rating"

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None of this will count for much should the tender be cancelled. Industry insiders allege that CEZ has initiated a contract with McKinsey & Co to have the consultancy draw up a contingency plan if the tender goes south as proof the project is in trouble; others say this is normal procedure for such perilously long-term projects like nuclear – CEZ aims to pick the winner in 2013 and have the new reactors up and running by 2025 at the latest, some 17 years after the project was first initiated.

In the Czech Republic, public opinion is hardly an issue – a recent Gallup poll found support for nuclear power stood at 63%, even after Japan. Rather, a more likely source of trouble is the financing.

The cost of building Europe's first pressurised water reactor in Finland was estimated by Areva at €3bn in 2003, but has since grown to around €6bn amid delays. Together with the possibility of further safety measures stemming from the EU's reactor stress tests and uncertainties over the price and demand forecasts for electricity, some experts believe state guarantees will be needed to finance Temelin's expansion.

"Without state guarantees, this project is dead," argues Jan Ondrich of the advisory firm Candole Partners, adding it has echoes of the collapse in 2010 of Constellation Energy's plan to build a reactor in the US after the firm could not accept the conditions attached to a $7.5bn federal loan guarantee.

Alan Svoboda, executive director of sales and trading at CEZ, claims the utility is the least indebted of the top-10 utilities in Europe. "Plus, we are undertaking all necessary steps to prepare ourselves for financing the project from the balance sheet of CEZ without exposing the company to risk of lowering its credit rating."

However, Richard Miratsky of Moody's says that while CEZ's leverage has historically been below the industry average, "it has been increasing quite steeply over past two years and it's a question how CEZ will manage its leverage in future, given its significant capex investment programme."

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Lessons to be learned The book concludes that nine lessons can be learned from Latvia's experience in the crisis, the most important of which is probably a strong argument that a currency devaluation really can be resisted if the alternative route of internal devaluation is seriously pursued. “The nine points are what we learned from the crisis when it became clear that the strategy was working. In 2009, we were working more in a crisis management mode and taking decisions to avoid the insolvency of the state,” says Dombrovskis.

the same period, while so far consolidation totals around 15% of GDP.

Despite still being outside the Eurozone, Dombrovskis believes member states of the single currency might benefit most from Latvia's example. “We can make a comparison with Greece. It is in the Eurozone and has to reform in order to stabilise its finances. Maybe they have not been too successful so far, but it's quite clear there is no other way for them. We could have discussed devaluation, but unless they want to quit the Eurozone they don't have that option, so eventually it will be internal devaluation and reform.

“The idea to write a book came in spring last year when there were clearly the first signs of the stabilization of the economy,” Dombrovskis tells bne in an exclusive interview. “My office contacted Anders Aslund, whom I had met before and who

The new author also suggests that the question of devaluation should be considered from outside the arena of bankers and politicians. “To an extent we can see the social consequences of devaluation in Belarus. Some economists were

The Latvian economy: my part in its downfall Mike Collier in Riga

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y writing a book called, "How Latvia Came Through the Financial Crisis," Latvian Prime Minister Valdis Dombrovskis is taking a risk. The title's use of the past tense leaves him open to accusations of hubris, whilst it also hints at a Spike Milligan-esque "How I Won the War" swagger curiously out of keeping with this most mild-mannered of politicos.

The tome – written in collaboration with Swedish economist Anders Aslund – provides a handy reference guide to the complexities of Latvia's rapid economic descent and continuing slow crawl back from the abyss.

It's not hard to see why such a volume is required. In a recent BBC radio broadcast, Andrew Hilton of the Centre for the Study of Financial Innovation in London bemoaned the pointlessness of asking Greece to “impose austerity that no other country has ever experienced in peace time.” Clearly, little Latvia escaped his notice. Whilst the Greeks were asked to consolidate their budget by 7.5% of GDP in the first year of their bailout programme (but managed just 6%), Latvia achieved fiscal consolidation of 9.5% in

“The title was the last thing we wrote"

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effect of enhanced competitiveness following devaluation will disappear very quickly, and then you're back to the same problem and having to devalue every decade, or every five years."

At times in the book, it feels that the authors – or rather Aslund – is a little too keen to point out the flaws in the 2007 forecasts of rival economists such as Paul Krugman and Nouriel Roubini.

Whilst that may be a valid observation, it becomes repetitive and starts to sound like backbiting in an insular circle of professional rivals.

It also grates that a couple of the items on the list of lessons (such as Latvians' supposed euro-enthusiasm and the benefit of having revolving-door governments) are so debatable. However, Dombrovskis gamely defends his coauthor, before making a final bid to justify his claim that he can now look back at Latvia's crisis. “If we talk about the economic crisis, then the recession was over in the second half of last year by the accepted definition of two quarters of successive growth. In the last quarter, we had growth of 3.6%. Clearly, there is still high unemployment and

related social and emigration problems, but we are back to economic growth, so we are in a post-crisis period,” Dombrovskis says.

Unsurprisingly, that's not the view of Janis Urbanovics, leader of the Harmony Centre opposition party that will be Dombrovskis' main rival in September elections. “I'm afraid I haven't read the book he is promoting, along with some other people who believe the crisis is over,” Urbanovics tells bne, “but it seems to me the prime minister is playing a rather poor joke.”

Nine lessons from the crisis 1. Devaluation is not the necessity that many economists make it out to be.

2. Euro adoption plans helped by providing a fixed exchange rate and a budget deficit target.

3. It is better to carry out as much of the adjustment as possible early on.

4. Cuts in public expenditures are economically and politically better than tax hikes.

5. The large international rescue effort was appropriate.

6. Vibrant democracies are capable of reducing their public expenditures by 10% of GDP in one year.

was one of the few prominent economists who argued against devaluation. His reaction was immediately positive. Basically we were exchanging notes. I wasn't dictating, we had a couple of meetings and did a lot of emailing.”

saying devaluation was a very easy solution – at least for the central bank and government – but certainly it's not an easy solution for the general population, who see their savings and incomes halved overnight.”

“The title was the last thing we wrote," Dombrovskis points out. "If we talk about the financial crisis, this is clearly over. There is no sign of financial instability and the budget deficit is down to manageable levels.”

“Devaluation always tends to hit the least protected members of the population hardest, and doesn't really deal with your structural problems," he continues, turning back to his homeland. "Being a small, open economy means that the

I 35

7. The benefits of stable government have been exaggerated.

Latvia benefited from being able to switch government quickly.

8. Populism is not popular when the population understands the severity of the crisis.

9. International macroeconomic discussion was not useful but even harmful.

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the serious bids have come in from Russian oil majors, including TNK-BP, Gazpromneft, and Rosneft, as well as two bids from Western Europe – one from Biosyntec, a French cigarette filter maker, and another from Transfigura, a Dutch oil trader.

The Polish government wants to sell its 53% stake in Lotos as part of a privatisation programme that aims to raise PLN15bn (€3.8bn) this year and PLN10bn in 2012, key to the government's hopes of keeping public debt below 55% of GDP. The transaction is thought to be worth about PLN3.5bn, but the ownership premium for taking control of the company is expected to be worth about PLN1bn more.

Treasonous The government has purposely set up the transaction so that any sale would take place after this autumn's parliamentary election, but even the preparations for the sale are likely to be extremely politically fraught.

Poland cautious over giving keys of Lotos to Russians Jan Cienski in Warsaw

Aleksander Grad, the treasury minister, has already been threatened with a possible treason charge if Lotos is sold to a Russian company. "If the Lotos Group is sold to a Russian energy company or a company controlled by the government of the Russian Federation, Aleksander Grad will stand before the State Tribunal," threatened Dawid Jackiewicz, an MP from the right-wing opposition Law and Justice party. "It doesn't matter if it happens in this, the next or any other term of parliament."

P

any of the bidders, although it said one of the offers was chosen "conditionally."

On June 16, the treasury ministry said in a statement on its website that it has shortlisted four unnamed bidders for a 53% controlling stake in refiner Lotos and that the four had until November 16 to make binding offers. It did not name

"If Lotos is sold to a Russian energy company or a company controlled by the government of the Russian Federation, Aleksander Grad will stand before the State Tribunal"

oland's treasury ministry has drawn up a short list of bidders interested in taking control of Lotos Group, Poland's second largest refiner, but the odds of the transaction coming to a successful conclusion look increasingly remote because the most serious contenders are those unloved Russians.

The treasury ministry has already received preliminary offers, and according to reports in the local press, all of

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implication of selling off a large and strategic business to the Russians.

Although Grad stressed that his ministry is not conducting a "make-believe" privatisation, he has said the treasury "has a very careful approach" to the sale. "We have imposed very stringent requirements for investors. We want the future investor to ensure the company that it will continue to develop and have access to oil deposits."

Tusk has said: "There is no ideological reason to give a categorical 'no' to an investor from any particular country, including Russia," before going on to say that possible dependence on Russia demands a certain "care and restraint" on the part of the government.

The government's caution over selling strategic energy companies could be

seen in the botched attempt to sell Enea, the country's third largest power generator. First a bid by Jan Kulczyk, Poland's wealthiest man, was scotched by the treasury in large part because of political worries, and later talks with France's EDF fell apart, and the company remains unsold.

Swimming upstream The uncertainly over Lotos's future owner is causing problems for Pawel Olechnowicz, the company's longtime CEO, who has embarked on a programme of increasing its own access to upstream oil resources.

Currently, Lotos has very little of its own oil, mainly coming from platforms it owns on the Baltic Sea. It recently acquired AB Geonafta, which has onshore fields in Lithuania, and has also invested in oilfields lying off the coast of Norway. The

The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS.

Both Grad and his boss Donald Tusk, the prime minister, have been careful to say that a successful Russian bid cannot be ruled out – making such a comment would fall afoul of EU regulations – but they are also obviously wary of the

goal is to increase oil extraction to 1.1m tonnes by 2015 and 5m tonnes by 2020. If it reaches that level, that would amount to about half of Lotos's current annual refining capacity.

However, in order to dramatically expand its upstream capacity, Lotos could use the help of a deep-pocketed investor. "We aren't thinking of an exotic investor from the other side of the world, someone not involved in the upstream business," Olechnowicz said in a recent interview.

"The best for us would be someone from northern Europe."

Lotos also incurred significant debt as part of its programme of expanding the capacity of its refinery in northern Poland. The company last year had a profit of PLN651m on revenues of PLN19.7bn.

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www.bne.eu

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Hitting the poor However, the move inevitably has its critics. The Hungarian Trade Association argues that any gains made from the new taxes will be outweighed by a fall in VAT receipts as people avoid the newly-taxed products, a view echoed by the accountancy firm BDO Hungary.

The association also worries that it will lead to more tax evasion and Hungarians driving over the border to shop more cheaply. International retailers have yet to respond directly, but the CIAA, a European food and drink lobby, says such taxes are "discriminatory" because they target specific types of food and hit people on low incomes hardest.

Health experts like Nagy are having none of it: "As an organisation we welcome it." He has no time for the food industry's contention that fatty, salty or sugary foods are not harmful if eaten in moderation. "The intention of the food industry is to make it more complicated than it is. If you go to a food store, you can basically decide what is healthy and what is not."

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ungary is gearing up to impose the world's most comprehensive "junk-food" tax in September in the hope that it will improve people's eating habits and reduce a large deficit in the healthcare budget. But will it really change habits or just raise more money for the cash-strapped state?

The government estimates it will bring in an annual income of HUF20bn ($100m) that it will direct towards healthcare, which is around HUF100bn in deficit. Hungary, with a public debt of 77% of GDP, is among the most severely indebted countries in Central and Eastern Europe.

The tax rates are still to be revealed, but the speculation is that sugary drinks will

be taxed at around HUF15 (€0.05) a litre. It is also thought salty snacks could be liable to a tax of around HUF400 a kilogram. Deciding what tariff to apply to fast foods that come in a wide variety, like pizzas or burgers, could be more troublesome, says Godfrey Xuereb, head of the population-based prevention team at the World Health Organisation. The composition of each would have to be calculated for a tax bill to be drawn up.

The bill should "pass easily," predicts Gabor Csiba, president of the Strategic Alliance for Hungarian Hospitals, and the man who came up with the idea.

"The government is very forceful and can decide more or less what goes through parliament," confirms Andras Nagy, chairman of Hungarian Heart Association.

The ruling Fidesz, a rightist party that Csiba serves as a councillor, controls two-thirds of parliamentary seats after a landslide election victory in April last year. It has since courted controversy.

The legality of a "crisis tax" on foreign retail, telecommunications and energy companies imposed in October is being looked at by the European Commission.

EU outrage at a media law at the start of the year were pooh-poohed, as are concerns expressed this week about a rapid rewrite of the constitution.

The tax also has the support of 54% of the population, according to a poll in June by the Nezopont Institute, a think-tank close to Fidesz. It is not clear, though, how much interviewees knew about the tax.

Csiba dismisses the idea that the taxes will be too small to change people's eating habits. "The rate of tax is not small because Hungarians' salaries are not high, so people must choose healthy alternatives or the revenue from the tax will be high." Hungarians already spend around 17% of their household income on food, with a sales tax among the highest in the EU. Consumers pay VAT of 25% on most types of food and drink except dairy and bakery products, which have VAT of 12%.

If Hungary goes ahead with the junk food tax, it would be the first of its kind in the world. Romania's health ministry considered a similarly wideranging scheme to raise €700m a year, but shelved the idea in March, saying it would be inappropriate at a time when food prices are rising dramatically. It is already normal for Romanians to spend nearly 40% of their household income on food. Only 8% of them are obese, compared with around 20% of Hungarians and about 30% of Americans.

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A car industry reaches out

Nicholas Watson in Prague It's 20 years since Volkswagen first bought a stake in Skoda. And during that time, the Czech automaker grew from being a builder of low-cost vehicles for the region to one that exports to the giant BRIC markets and has begun cannibalising sales of the parent brands.

When Skoda was sold to the German carmaker in 1991 it produced around 560 units a day of two models; in 2010, it sold a record 762,600 vehicles spread across five distinct models, around 10% of VW's total sales for that year.

The challenge for Skoda and the rest of the Czech car industry over the next decades is to remain competitive. IHS Global Insight expects car production in the Czech Republic to reach 1.23m by 2015 through the expansion of existing facilities, but the industry faces increasing competition from other countries in the region. Daimler chose Hungary for its first Mercedes factory in Central Europe and Audi is investing almost €1bn to expand its factory there.

Petra Safkova, senior manager at PwC in Prague, says that while there's probably not that much space to improve the costs of production in the Czech Republic, "suppliers and [original equipment manufacturers] could make their production more efficient by removing the bottlenecks and improving the efficiency of the supply chain."

Another challenge for the Czech car industry stems, ironically, from its very success. Skoda cars had fitted neatly into VW's product line, which had Audi at the top, followed by VW. But the quality of Skoda cars surpasses that of Seat, a struggling Spanish division of VW, and is now bumping up against the parent brands. There's plenty of anecdotal evidence of European executives dumping their Audi A6s for the top-of-the-range Skoda Superb that goes for about 40% less, while there were unconfirmed reports of internal discussions going on at VW about "dumbing down" the Skoda brands because it was cannibalising sales a year from the VW and Audi brands.

"Skoda want to double their sales [to 1.5m units by 2018], but how do you do that without cannibalising your mother brands? Frankly, the Skoda cars can't get much better before people start asking themselves why pay more for the Volkswagen," says Tim Urquhart, senior analyst at IHS Automotive.

VW thinks the answer lies in the huge emerging markets to the east, which could lift the German carmaker above Toyota to become the world's biggest.

Besides the Czech Republic and Slovakia, Skoda makes cars in five other countries: India, China, Russia, Kazakhstan and Ukraine. Skoda has seen its sales grow fastest in Asia. In India, it sold over 20,000 units last year, up 38% from the year before. But that was dwarfed by its sales in China, which reached over 180,000. "About one in four of every Skoda sold last year was sold in China – that's a remarkable achievement," says IHS' Urquhart.

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A

s expected, the incumbent AKP won the Turkish election on June 12. Although Prime Minister Recep Tayyip Erdogan failed to secure the overall majority he sought, he's still likely to push ahead with constitutional reform. Some worry this will take his eye off the economy.

Erdogan's ruling Justice and Development Party (AKP) won 326 of the 550 seats in Turkey’s parliament, taking 49.9% of the vote and just four seats short of the majority needed to form a single party government for a second term. The PM had hoped to push the party's seat count to 367, which would have given him a two-thirds “supermajority” and allowed him to write a new constitution without having to go through a referendum.

AKP fell short though, with the main opposition party the Republican People's Party (CHP) taking 26% of the vote, and the far-right Nationalist Movement Party (MHP) clinching 13%.

"We will embrace everyone, whether they voted for the AKP or not," Erdogan said in a victory speech on the night of the election. However, only time will tell how inclusive the writing of the new constitution will be, with Erdogan unlikely to struggle to find four additional MPs to support him.

The current constitution was written following a 1980 military coup and, as a referendum in September illustrated, the majority of Turks believe it needs to be amended. However, the need for a complete rewrite is questioned by some. Now the election is over, the coming months are likely to be dominated by that debate, with Erdogan’s apparent wish to turn Turkey towards a presidential system front and centre.

Justin Vela in Istanbul

It's the economy, Erdogan

“Even within the AKP there are quite a few who are opposed to the idea,” says Sahin Alpay, a columnist at the progovernment Zaman newspaper. “Then if you ask commentators and intellectuals, an overwhelming majority is against. I have seen some surveys that show maybe there is some 50% support among the public – there’s a lot of support for whatever Erdogan thinks.

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Myself and many others would raise hell over it.”

on an economy showing alarming signs of overheating.

Such opposition is only likely to be encouraged by Erdogan's failure to secure the overall majority in the parliament. Whilst the government may still try to push its will through the house, the country's numerous competing groups – ranging from secularists to Islamists to Kurds – will all insist on having their say in the process.

Economic challenge In the face of poorly performing assets this year, the markets are keen to see attention paid in particular to fiscal and monetary policy in order to deal with signs of overheating. Inflation is on the rise and analysts at Danske Bank worry the current account deficit could hit double figures this year.

"In our view," says Citigroup analyst Ilker Domac, "the AKP remains reso-

In May, headline inflation rose the most since January 2002, coming in at 7.17% year-on-year, up from 4.26% in April, according to TurkStat, but the Central Bank of the Republic of Turkey is still forecasting full year inflation will come in at 5.5%.The current account deficit – which is forecast by the government to widen this year to $39.3bn, or 5.4% of GDP, due to domestic demand for energy and imported consumer goods – is cited as a reason by rating agencies such as Moody’s for keeping the country below investment-grade status.

"We will embrace everyone, whether they voted for the AKP or not" lute in pressing ahead with its ambition to rewrite the constitution. The fact that AKP fell short of gaining 330 seats doesn’t necessarily imply that the party will pursue a more inclusive approach in the constitutional reform process, as gaining the support of an additional 4 deputies may not prove to be too difficult. Consequently, whether the AKP will pursue a more conciliatory approach in this process will have important implications for political stability. " However, whilst expectation around the country is for political reform to dominate the agenda in the coming months, analysts worry that the economy needs more attention. Whilst the markets are generally happy to see the AKP - which is credited with ushering in a period of political stability and economic growth – remain in power, there is also concern.

Turkey’s story has changed this year.

Until 2010 the country celebrated growth of around 9% of GDP per year under the AKP – second only to China among the G20; today analysts worry that a messy post-election period will distract the government from focusing

government to press ahead with a comprehensive reform package aimed at bolstering macroeconomic stability and addressing Turkey’s structural weaknesses. In our view, this will be crucial for improving the secular outlook for Turkish assets, as the country needs a new credible story to reach investmentgrade status and beyond."

For months investors have wanted the central bank to change its policy of keeping interest rates low while hiking bank reserve requirements, which is largely seen as ineffective. Critics say the policy does not take into account the expected year-end rise in inflation, nor sufficiently curb lending for credit happy Turks.

Danske Bank suggests loan growth is still running at a stunning annual pace of around 35%. Yet there is no sign the central bank is preparing to change course. On June 23, the central bank kept interest rates on hold and gave no hint that it will soon resort to more conventional measures to cool the overheating economy.

With Turkey’s growth model overly reliant on the central bank’s stockpile of foreign reserves, Domac says, any new policy should focus on permanently raising the savings rate to help finance growth. Structural reforms are also necessary to increase the country’s productivity and competitiveness.

"Looking ahead," the Citigroup analyst frets, "we believe that the jury is still out on the political will of the new AKP

"The AKP remains resolute in pressing ahead with its ambition to rewrite the constitution"

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Turkey's power to the people

David O'Byrne in Istanbul

I

f there has been one constant in the history of both the Turkish people and their country, it has been the relentless move westwards: from the steppes of Central Asia to Anatolia, and from there to Europe. And as of June 1 – 482 years on from the Ottoman siege of Vienna and 12 years on from Turkey's recognition as a candidate for EU membership - the country has made another step to the West with the interconnection of its national power grid to that of the pan-European ENTSO-E network.

Turkey's position is still only provisional and subject to an 11-month "test phase", but it has allowed for cross-border trading to commence and it is expected to be followed next year by full interconnection.

Started in 2010, the interconnection became a physical reality in September last year when Turkish grid operator TEIAS was hooked up with its counterparts in Bulgaria and Greece via three 400 kilovolt (kV) connections, allowing up to 400 megawatts (MW) to flow into Turkey and 300 MW out. With testing successfully completed in May, ENTSO-E took the decision to allow cross-border trading with the first trades quickly undertaken despite unfavourable market conditions. "We've made some small trades from Greece and Bulgaria to Turkey and in the reverse direction to Greece, to test the system," says Mustafa Karahan of East European power trading group EFT, who also heads up Turkey's Electricity Traders Association (ETD), adding that a couple more of Turkey's 117 licensed trading companies have also tested the system.

Slowly does it However, trading is likely to be slow for some time, explains Karahan, as wholesale prices in the three countries are very close. But in the long term, he predicts a booming market as regional countries exhibit differing power imbalances. "Bulgaria and Romania both have excess capacity thanks to the nuclear plants, while Greece has excess power in winter but insufficient power in summer when demand is high," he says, point-

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Syria's national electricity company to supply up to 500 MW via an existing 400 kV line. A spokesman for Aksa tells bne that the deal was not related to current unrest in Syria and had been under negotiation for some time, a fact confirmed by ENTSO-E, which said it had approved the trade of up to 380 MW for up to one year.

Taxing times But for Turkey itself the next step should be the establishment of a full over-thecounter (OTC) market to allow power to be traded before it is produced, a step which Karahan explains is essential for the establishment of real market prices.

That, though, could take some time due to Turkish tax law, which levies a stamp duty of 0.825% on any contract which bears a value. "OTC contracts are typically traded around 10 times before the power is generated – an 8.25% tax would make trading impossible," says Karahan, adding that in his capacity as head of the Electricity Traders Association he has been lobbying Turkey's

Macedonia's ruling nationalists triumph in snap elections

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Snap vote The election was called a year earlier than legally necessary after bitter political disputes led to an opposition walk-out in January. The boycott was triggered by a police raid on leading Macedonian television station A1 in November, which led to the freezing of its accounts and those of a publishing house which issues three well-known newspapers, on the grounds of tax fraud.

The media are all owned by Velija Ramkovski, a local tycoon - previously close to Gruevski but who fell out with the PM several years ago. The TV station and newspapers were critical of Gruevski, and the opposition accused him of effectively trying to censor them.

While the government insisted at first that it had the majority and moral mandate to continue ruling, it agreed to early elections when the events took their toll on Macedonia's international image.

Weeks of squabbling over changes to the electoral law then saw the date pushed back.

Andrew MacDowall in Skopje

"Our long-term goal is to have a regional trading pool based in Istanbul, like the 'North Pool' operated in Scandinavia" ing out that Turkey's rapidly growing demand and rapidly expanding capacity offer a wealth of options. "Our long-term goal is to have a regional trading pool based in Istanbul, like the 'North Pool' operated in Scandinavia."

In addition to trades with near neighbours in the Balkans, Turkey also has natural trading partners to the east.

"Georgia has too much capacity in summer and not enough in winter, while Azerbaijan is always short," explains Karahan, listing Iran, Turkmenistan, Iraq and Syria as other countries with which Turkey has traded power in the past and could do so again.

Indeed, trading with Syria in June moved a step closer with Turkish power company Aksa Enerji inking a deal with

energy ministry for OTC contracts to be exempted from repeat stamp duty.

With Energy Minister Taner Yildiz having recently announced his support for a full OTC market in Turkey, there appears to be a good chance of the excess tax being waived. In the meantime, the association has finalised an alternative system that will allow power contracts to be traded on the Istanbul derivatives market Vadeli ve Opsiyon Borsasi (VOB). "I think we'll be trading 25-33% of the power from the private generating capacity within two years," he says, explaining that with currently 29 gigawatts (GW) of Turkey's 50 GW of installed capacity operated by private sector companies, he doesn't foresee any problem finding companies to trade power.

M

acedonia's ruling conservative nationalists look set to stay in power after topping the poll in the country's June 5 general election, despite an impressive resurgence by the opposition.

ment in protest at Gruevski's alleged authoritarianism in January.

The VMRO-DPMNE party, led by controversial Prime Minister Nikola Gruevski, will take a projected 55 seats in the 123-member parliament having won 39% of the vote. The opposition Social Democrats (SDSM) are expected to take 42 seats on 34% of the vote. In what is effectively a separate contest between ethnic Albanian parties, the VMRO-DPMNE's sometime junior coalition partner, the Democratic Union for Integration (DUI) – led by former guerrillas – triumphed, taking a projected 15 seats on 10.2% of the vote.

Usually, the winning party will go into coalition with the largest Albanian par-

The result reinforces the position of the youthful Gruevski, PM since 2006, as Macedonia's dominant political personality. However, the unexpectedly strong showing by the SDSM is a boost for the opposition following its call for an early poll after it launched a boycott of parlia-

In the last parliament, VMRO-DPMNE and its many smaller electoral partners, plus the DUI, held 81 seats.

The win is the latest in a line of notable victories for Gruevski, who has confounded the Macedonian political pendulum which has previously seen incumbents turfed out after a single term. He won the 2006 and 2008 elections - in the latter poll, also called early, humiliating the Social Democrats - as well as sweeping the board at the 2009 local elections, and seeing the VMRO-DPMNE-backed

"The election was called a year earlier than legally necessary after bitter political disputes led to an opposition walk-out in January" liamentary group, and VMRO-DPMNE is almost certain to reform its government with the DUI. While theoretically the SDSM could form a coalition with the DUI and its major ethnic Albanian challenger, the DPA, which took 5.9% of the vote and eight seats, SDSM leader Branko Crvenkovski has already conceded defeat.

candidate, Gjorge Ivanov, installed as president the same year.

Nationalist vote The result indicates Gruevski still enjoys widespread support despite the distinctly fishy Ramkovski affair, though this support is clearly far from universal. One reason for his popularity is his relatively tough line on the "name dispute" with

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Greece. Athens has blocked Macedonia's Nato membership and EU accession process on the grounds that it objects to the title "Republic of Macedonia," claiming that it suggests Skopje has designs on the Greek region of Macedonia. Forecasting organisation Business Monitor International and a range of Greek commentators have stated that Gruevski's re-election would make a settlement in the near term unlikely.

However, the returning government is already under pressure to seek a resolution, with EU High Representative Catherine Ashton and Enlargement Commissioner Stefan Fule tempering their praise for the "competitive, transparent and well-administered" election with a note on "the importance of the government taking steps to ensure good neighbourly relations" - diplomatic code which needs no translation.

Another point that remains to be seen is whether the incoming government will push on with stalled economic and administrative reforms demanded by the EU. Gruevski built up considerable goodwill internationally by making progress on these fronts in the early years of his first administration, but enthusiasm seems to have waned since the global recession knocked Macedonia's small, open economy sideways, and Athens put the brakes on accession.

Instead, attention has been focused on the rather grandiose Skopje 2014 project, which is either a grand plan to overhaul the slightly scruffy capital and get the economy moving or an expensive and nationalist-inspired vote-buying exercise which was accelerated in the run-up to the election, depending on whom one asks. Gruevski's return to power suggests that the project, which

"Analysts have warned that a reduced parliamentary presence is unlikely to rein in Gruevski's less consensual instincts"

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much to the annoyance of the Greeks includes a monument to Alexander the Great, enjoys support amongst the population either way.

Naughty, but nice However, outside the country, accusations of authoritarianism remain. Election observers from the OSCE noted concerns about "blurring of the line between state and party", and analysts have warned that a reduced parliamentary presence is unlikely to rein in Gruevski's less consensual instincts.

The SDSM, for its part, was hoping to scrape a win against the odds, but will be very happy with its showing, a clear sign that it has recovered from its 2008-2009 low. A good performance by prime ministerial candidate Radmina Sekerinska and some of its rising stars suggests the party could face a future without without its talismanic leader, Branko Crvenkovski.

Importantly, a significantly increased parliamentary presence should increase its ability to hold the government to account.

Meanwhile, daily newspaper Utrinski Vesnik labelled the campaign the nastiest in Macedonia's history, with several cases of vandalism against party offices noted, as well as perceived threats against individual candidates. Certainly, divisions between the opposition and government are bitter, but almost all the incidents have been minor. In fact, the election has been widely praised as free, fair, and peaceful. Most importantly, there was little sign of the ethnic violence that has scarred previous campaigns, and getting through both the vote and the post-election period without communal tensions boiling over would be a sign of Macedonia's progress since the 2001 conflict.

Mol's Balkan blues deepen

www.mol.hu

Guy Norton in Zagreb

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ungary's leading oil and gas company Mol looks set to provide the hard-pressed legal profession in Croatia with some much-needed revenue in the coming weeks as it seeks to defend its reputation after allegations over its management of Croatian peer Ina, in which it's the largest shareholder.

19, which has sparked accusations of negligence by Mol and Ina. Environment Minister Branko Bacic told Croatian news agency Hina that he would await the completion of an investigation into the causes of the explosion before deciding whether to bring any charges over the incident.

authorities it had initiated an investigation based on the suspicion that two government officials abused their positions and received bribes. Alongside Sanader, former deputy prime minister Damir Polancec has been charged with aiding and abetting the abuse of office, although he is not suspected of accepting a bribe.

Amid reports that a growing number of lawyers are either unemployed or have been forced to take menial jobs in order to make ends meet as a result of the economic downturn in recession-hit Croatia, a select band of lawyers is set to reap a handsome reward for defending the Hungarian company's corporate governance record.

Given the damaging nature of the bribery allegations, Mol was quick to issue a denial of any wrongdoing. "There has not been any payment, or agreement on

According to Croatian daily Vecernji List, which broke the news about the bribery investigation, a series of payments where made by Mol to accounts belonging to

The latest scandal to hit Mol broke on June 20 when it emerged that the Croatian anti-graft agency Uskok had initiated an investigation into whether Mol paid a â‚Ź10m bribe to former Croatian prime minister Ivo Sanader to gain management control of Ina as part of a revised shareholders' agreement concluded in June 2009, a month before Sanader unexpectedly resigned from office. The emergence of the new allegations caused the Mol share price to hit a four-month low in trading in Budapest.

The bribery allegation comes on the back of an explosion at an Ina refinery in the Croatian town of Sisak on June

"Mol will take strict legal measures against those who spread such allegations and accusations" any possible payment, with not a single one of the players and decision-makers of Croatian politics, either directly or indirectly, either before or after a shareholders' agreement," says Mol spokesman Domokos Szollar. He added that Mol would take "strict legal measures against those who spread such allegations and accusations."

Payback For its part, the anti-corruption agency Uskok confirmed to Hina that based on evidence supplied by Austrian and Swiss

Robert Jezik, a Croatian businessman with close ties to Sanader, who is currently in jail in Salzburg awaiting extradition to Croatia on the basis of corruption and abuse of office charges. Sanader recently dropped his appeal against Austria's decision to extradite him to Croatia; Sanader fled to Austria in December 2010 as a far-reaching investigation into bribery closed in on him.

Cedo Prodanovic, a Croatian lawyer who is defending Sanader, says he has spoken on the phone to his client who "firmly

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to its success in arbitrating between republics.

rejected" the bribery accusations made against him. Podanovic claims the accusation formed part of a series of unjust allegations made against Sanader by Robert Jezic who is seeking to mitigate the seriousness of charges made against him by Uskok. Since December last year, Jezic, who owns leading Croatian petrochemical firm Dioki, has been under investigation by Uskok on suspicion that

What a difference a day makes.

On June 10, Croatia received the news it has been waiting to hear for the best part of six years: the European Commission recommended the conclusion of EU accession negotiations. That means Croatia is scheduled to become the 28th member of Europe’s elite political-economic club on July 1, 2013. A bright, new future seemingly beckons for the country.

Just a day later, however, 10,000 demonstrators spent the afternoon hurling cobblestones, flowerpots and tear gas canisters at 400 or so Gay Pride marchers in Split, illustrating a darker side to the country's development.

The shameful events illustrated just how much work remains to be done if Croatia is to be seen a truly upholding the liberal social values that lie at the heart of the EU project. The incident has already drawn opprobrium in European circles, with the Dutch ambassador to Croatia noting that it shows the need for strict monitoring of the country in the two years before it joins the club, especially in the field of human rights and the treatment of minority groups. In recent years, Jewish, Roma and Serbian associations have all complained that the authorities in Zagreb pay no more than lip service to their grievances.

Although the country’s popular president Ivo Josipovic fiercely condemned the events, calling them a demonstration of Croatia's "non-European" face, Zeljko Kerum – the controversial mayor of Split who refused to endorse the march in the first place – suggested that it had passed off better than expected given that Croatia is one of the most Catholic countries in the world. In Kerum’s mind, the Croatian brand of Catholicism is clearly of the "fire and brimstone" Old Testament variety rather then the "love thy neighbour" New Testament kind. To put recent events in context, on the same day that the riot police had to rescue a small band of gay rights activists from a lynch mob in Split, just across the Adriatic hundreds of thousands attended Rome’s Gay Pride gathering, with hardly a carabinero in sight. Is the Italian brand of Catholicism so much more tolerant than its Croatian counterpart? The Croatian theologian that claimed the Gay Pride participants in Split "got what they asked for" suggests so.

What could bring the lesson home in Zagreb is that such incidents threaten to have real economic consequences for a country that has been mired in recession for the last two and a half years. Split, the self-proclaimed capital of Croatia’s Dalmatian coast, promotes itself as a 21st century metropolis and is the key tourist gateway in a country where that industry accounts for nearly a quarter of gross domestic product, and almost half of all foreign currency revenues. As tourist minister Damir Bajs recently admitted, the anti-gay riots were a poor advertisement and threaten to undermine efforts to promote Croatia as a tourist Mecca open to all.

"The accusation forms part of a series of unjust allegations made against Sanader

by Robert Jezic who is seeking to mitigate the seriousness of charges made against him by Uskok" together with Sanader and two officials at Croatian power company HEP, he agreed a deal whereby HEP would supply Dioki with electricity at sub-market levels, whereby HEP allegedly lost out on HRK6.3m (€0.85m) of revenues.

Meanwhile, Mol is already set to go to court in Croatia to contest charges of market manipulation in the trading of Ina shares. The company has requested a judicial review and annulment of a ruling by Croatia's financial markets regulator Hanfa at the end of May charging Mol with deliberately spreading information that gave false and misleading signals about its intentions when it launched a public tender for Ina shares in December 2010. According to Hanfa, although Mol stated that its public tender was designed to give current and former employees of Ina as well as private individuals the chance to sell their holdings at a significant premium to the then market value – Mol offered, HRK2,800 when the outstanding price was around HRK1,750 – it failed to state that its real goal was to raise its share in Ina to over 50%.

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How the Eurozone crisis resembles "Yugoslav syndrome" Phil Cain in Graz, Austria

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n the year of the 20th anniversary of Slovenia's independence from the former Yugoslavia, economist Joze Mencinger, who some say laid the foundations of Slovenia's post-independence economic success, argues that the back-biting among Eurozone members is a grim reminder of the "Yugoslav syndrome" of the 1980s.

"More and more people in Germany believe they are being exploited by Greeks, while Greeks are becoming convinced they are being exploited

by Germans," Mencinger tells bne in a interview. "In the 1980s, economic stagnation led many Yugoslavs to similar conclusions, with many blaming their economic problems on exploitation by Yugoslavia's other five republics."

Of course, he acknowledges there are differences; after all, Yugoslavia was a communist dictatorship, unlike the EU, which is an association of demo-

cratic states. But the parallel still holds, Mencinger argues, because Yugoslavia's communist regime was relatively open, free-thinking and liberal, particularly in Slovenia. "One could say that Yugosla-

The EU also only functions thanks to democratic deficit, Mencinger says.

Its stability is maintained on the basis of "inertia - the ability to disregard its own rules, the constant creation of new institutions and empty talk." Negative though it sounds, these "strange pillars" are actually crucial for keeping the EU together and, even more so, for enabling enlargement. Italy and Belgium, he says, would never be part of the Eurozone if the EU had insisted on limits on the size of government debt, and the Lisbon Treaty would never have come into being had the EU paid attention to public opinion: the EU Constitution, which had much in common with the Lisbon Treaty, was rejected in referendums in France and the Netherlands in 2005, yet still the Lisbon Treaty was adopted at the end of 2007.

Don't mention it Some of the EU's political taboos also seem oddly familiar. "In the 1980s, it was considered inappropriate to doubt the Yugoslav slogans of 'brotherhood and unity' or the 'identity of interests within socialist Yugoslavia'," Mencinger says.

"Now, it seems to be thought inappropriate to doubt the euro or the 'identity of interests in Europe'."

The idea of a "Europe of two speeds" is no newfangled notion, he says. In

"In the 1980s, it was considered inappropriate to doubt the Yugoslav slogans of 'brotherhood and unity' or the 'identity of interests within socialist Yugoslavia'. Now, it seems to be thought inappropriate to doubt the euro or the 'identity of interests in Europe'." via had a party-less democracy functioning only because of a democratic deficit." The existence of the Yugoslav central government, while undemocratic, could be justified by pointing

Yugoslavia, the problem of drawing up policies to suit republics with widely differing levels of development was justified by describing the country as an "asymmetric federation." The yawning

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economic "asymmetry" between the relatively-wealthy Yugoslav republic of Slovenia, where Mencinger was minister of the economy in the run-up to the republic's declaration of independence in June 1991, was one of the biggest reasons for its decision to break away. And just as there are no legal mechanisms for a country to leave the Eurozone, constitutional lawyers fretted over the legality of Slovenia's withdrawal from Yugoslavia, with some saying it contradicted its decision to join Yugoslavia twice, first in 1919 and then again in 1945.

Slovenia swapped Yugoslavia for the EU and the euro, having become an EU member in 2004 and then joined the Eurozone in 2007. In doing so, he says, it handed back the economic attributes of a country, like having control of money supply, taxes and border controls. Nevertheless, he was in favour of Slovenia joining both the EU and the single currency, and is not in favour of Slovenia trying to extricate itself from either EU association now. Doing so, he believes, would result in unacceptably "high costs and uncertainty."

Beware of Greeks Mencinger doubts, however, that the EU and Eurozone are made "not only for good, but also for bad times" and so is sceptical about their long-term future as they currently exist. He is also doubtful about the effectiveness of the

"The EU in 2011 is where Yugoslavia was in 1983. At that time, Yugoslav politicians were desperately looking for how to rescue the system"

EU's efforts to re-balance Greece's debtburdened public finances, the discovery of which sparked the current euro crisis. The EU's assistance packages, he says, are only making matters worse in Greece, while the only benefits being the income accruing to the French and German banks which arranged the bailout.

"The calculation is simple: if your debt is 160% of GDP and interest rates are higher than growth rate, the debt can only grow or be written off."

He cannot see an end to the EU's woes at the moment, but Mencinger does not think we are yet witnessing the EU's end times. "The EU in 2011 is where Yugoslavia was in 1983. At that time, Yugoslav politicians were desperately looking for how to rescue the system and the country." He is hopeful that EU politicians will do a better job or, if they cannot, that better times will come along before the situation becomes critical.

As a Keynesian - an economist who thinks the state needs to keep the private sector in check – he says he is not interested in the long run. When asked to predict the long-term future of the EU, he says, "The EU will certainly not last as long as Austria's Habsburg empire." So, with 66 years gone since the seeds of the EU were sown after World War II, there could still be as many as 326 more to go.

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A long hot summer in Kyrgyzstan Izabella Mier-Jędrzejowicz in Osh

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ne year on from the ethnic violence that almost destroyed the southern city of Osh in the wake of the second Tulip Revolution, tensions are still high. Politicians jockey for position rather than mending fences, and the work of the international organisations is proving divisive.

The burnt out centre of the ancient bazaar in Osh has been shut for more than a year now and its trade has spilled out onto the surrounding streets, cluttering up the roads with live chickens and cheap Chinese plastic goods. With the help of over $100m in foreign aid, the town is slowly being reconstructed after the inter-ethnic violence that exploded on June 10, 2010 between the city’s Kyrgyz and Uzbek populations. But the empty bazaar stands as testament to the clash of interests bubbling under the surface.

Ostensibly, it was a scuffle over casino winnings that sparked the war (as everyone refers to it in Osh). Uzbeks gathered in seconds, alerted by mobile text messages, and as the police struggled to disperse the crowd, Kyrgyz gathered on the other side of town. Street fighting broke out and over the next four days spiralled into pogroms, gender-based violence and looting. The violence slowly subsided, not because of the presence of the Kyrgyz army, but thanks to a rumour of an imminent retaliatory attack by the Uzbek army from over the border.

A UN International Commission of Inquiry counted a total of 470 dead, thousands injured and up to 300,000 displaced. The Uzbek minority suffered the brunt of the violence, accounting for just under three-quarters of the dead and injured, according to the commission’s findings. “Neither of the ethnic

groups is to blame… The preconditions lay in the weakness of the state, and the consequences in the army’s inability to stop the fighting,” the commission’s report concluded.

Locked in As is so often the case, in reality the ethnic violence was a consequence of the revolution that saw the corrupt and increasingly authoritarian regime of Kurmanbek Bakiyev ousted in April 2010. The provisional government that replaced him is still struggling to gain full control of the country.

One element in that struggle is that the war has revived tensions between ethnic Kyrgyz and the large Uzbek minority who live in the south of the country – an enforced ethnic mix that is a legacy of Stalin's penchant for weakening nationalism by transferring populations. Locked

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in by mountains, Osh has nowhere to expand; jobs and land are scarce and ethnic tensions have always been high.

In short, the revolution has bequeathed a continuing power struggle between the dethroned political elites and supporters of the provisional government. Uzbek leaders have organised rallies supporting the new authorities, whilst the local elite has turned to nationalist rhetoric to appeal to local Kyrgyz voters.

The ethnic Uzbeks, hoping to resolve issues ignored for many years, are easily mobilised. Their main grievance is their under-representation in the local administration. For instance, of the 110 judges in southern Kyrgyzstan, only one is Uzbek. “That is what Kadyrbek Batyrov wanted,” says an Uzbek activist from Jalal-Abad referring to the former parliament deputy who has fled criminal charges for his part in the disturbances.

“He didn’t call for autonomy, he called for equality.”

The tension is also driven by competition to control nefarious privileges, such as control of the drug smuggling trade, with 10 out of 12 opium routes out of Afghanistan passing through the city.

Failure and mistrust all round There is now the potential for years of anger and resentment in Osh. Nobody is allowed to be neutral, and the accusations continually bubble under the surface, waiting to erupt. “The Uzbeks are getting all the foreign money,” one Kyrgyz woman says bitterly. “The Americans are giving them everything new houses and even fridges. We have to fend for ourselves.”

“People see the aid as a way for foreigners to exercise control over the country"

Meanwhile, the government is failing to resolve the issues, and even denies their existence. No peace-building proposals have been presented and the army remains as weak as it was 12 months ago.

The police, in their eagerness to bring perpetrators to justice, use arbitrary arrest then extort money from those they have detained, according to reports from Amnesty International and Human Rights Watch published in June. “We call this police entrepreneurship,” says a human rights monitor from OHCHR.

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Amnesty International claims that the predominance of Kyrgyz in the police force means Uzbeks are the natural victims of this business. Of the 271 people taken into custody in the last year in relation to the violence, 230 were Uzbek.

However, the revenue is urgently needed.

Kyrgyzstan faces a yawning $500m hole in this year's state budget, due mainly to agreements to raise wages for teachers and doctors, and to rebuild houses in Osh and other southern towns that were destroyed in last year's ethnic violence.

Stoking the tension further, there are now accusations from inside donor agencies such as the UN and Organization for Security and Co-operation in Europe that the local administration is siphoning off international aid money for personal benefit. This has only antagonised a growing conflict between the Osh administration and the international organisations.

Reprivatise Some of the companies likely to be sold were nationalised immediately after the April 2010 revolution, when the new interim government took over five banks and a number of other assets that it said were linked to the family of ousted president Kurmanbek Bakiyev, in particular his influential son Maxim. They include power company Severelectro and fixedline telecom company Kyrgyztelecom, both of which had been privatised to investors allegedly connected to Maxim Bakiyev immediately before the revolution. In fact, the deals were one of the key grievances that sparked the revolt.

"There is now a plan to carry out appraisals of these companies then to sell the shares held by the state. The government needs money to cover the budget deficit so it wants to sell these assets," says Umet Daletbaev, managing director of Bishkek-based Aiten Consulting.

Osh mayor Melisbek Myrzakmatov wants to resolve the problem of land shortage by developing a new urban plan, replacing the bazaar and old housing in the Uzbek quarters with modern high-rise buildings, but the international agencies object. The upshot is paralysis, with the government lacking the finances to carry out the plan.

Meanwhile, the work of the international agencies is provoking anger amongst the Kyrgyz as their support is going mainly to the Uzbek community, which lost 90% of its property in last year's violence. That the offices of these organisations are all situated in the Uzbek quarter of the city does little to convince many Kyrgyz otherwise, although one international diplomat claims: “We’ve organised all the teams in one area so that we can evacuate everybody at once.

It’s not important that it’s Uzbek.”

The result is deep mistrust of the international organisations amongst the Kyrgyz community, which makes already tricky mediation projects next to impossible. “People see the aid as a way for foreigners to exercise control over the country," says Tursunbek, an activist from local NGO ‘Tolerantnost’, who asks that his full name be withheld. "They don’t trust anybody – not the government that is all corrupt, not the international organisations who they see as Americans come to rule them, and not us, the NGOs that work with them. They think we steal all the money.”

On the block in Kyrgyzstan Clare Nuttall in Bishkek

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he Kyrgyz government is planning to privatise several of the largest state-owned companies as it seeks to plug a $500m budget deficit. Companies going on the block include the successor to AsiaUniversalBank (AUB), Zalkar Bank, and other assets controversially nationalised after the April 2010 revolution.

The government is understood to have drawn up a list of around 30 enterprises to be privatised. In addition to Zalkar, they include several major companies in the telecomunications and energy sectors – two of the most profitable areas of the economy.

However, with the autumn presidential elections approaching, decisions may be put off until the end of the year. The parliament's ruling coalition has several times been on the brink of collapse in recent weeks, and the government has been too preoccupied with trying to hold it together to have much time for lawmaking. Tempers have been

running high, and punch-ups between deputies from rival parties are not uncommon.

Indeed, the parliament is in such a sorry state that MPs sacrificed seven sheep in April to drive evil spirits from the building. Although one MP, Ondorush Toktonasyrov, slammed the ritual as a sign of a "backward mentality," most of his colleagues attended the cer-

There are still questions over the legality of the nationalisations of these and other companies. With the parliament disbanded, the interim government carried out the nationalisations by decree, which was not provided for under the constitution.

Prior to its nationalisation, AUB was Kyrgyzstan's largest bank, the merger of the country's two largest financial insti-

"Even without the nationalisation controversy, privatisation in Kyrgyzstan has been a struggle" emony in the hope of making things run more smoothly, although not with any notable success. The intense political wrangling is set to increase as the presidential elections approach, making it highly unlikely any solid progress on privatisation will be made before the end of the year.

tutions – AUB and Kyrgyzpromstroibank – in November 2008 having created a local giant. AUB's former management led by Mikhail Nadel has always denied having inappropriate links to the former regime, however, it has made no headway with the new government in getting the bank back.

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Joint stock exchanges

Clare Nuttall in Bishkek Kyrgyzstan’s three stock exchanges had to share the meagre $20m of total turnover last year. However, the Central Asia Stock Exchange (CASE) has shut down, and the Kyrgyz Stock Exchange (KSE) is now merging with its remaining rival, Stock Exchange of Kyrgyzstan (BTS).

Despite the uncertainty in the run-up to the autumn 2011 presidential elections, KSE president Aibek Tolubaev hopes that planned privatisations of state-owned companies will stimulate the newly merged exchange, and is aiming to carry out the first international cross-listing of a Kyrgyz company by the end of the year.

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Trading volume on the KSE plummeted to just KGZ439m (around $10m) in 2010, due to a combination of the slump in frontier markets investment during the international economic crisis and the April revolution and subsequent ethnic violence in Kyrgyzstan. In a country where much of the population literally keeps its savings under the mattress, trading is in any case low by international standards. However, the 2010 figure was less than 10% of that seen in 2008, when trading volume peaked at KGZ5.2bn ($130m), before falling to KGZ4.2bn ($90m) in 2009.

The drop in business is not necessarily a shock, since the last few years have thrown up one challenge after another. “The pressure of the financial crisis was felt in 2009. International frontier market investors used to be active on the exchange, but now the biggest investors are local,” the KSE president Tolubaev tells bne. “Foreign investors want the political and economic system to be stable, so a lot were also lost after the events in 2010. We don’t expect anyone from foreign countries to come to Kyrgyzstan before the presidential elections this autumn.”

Kyrgyzstan has moved closer to democracy, holding Central Asia's first open elections in October 2010. However, fears of a recurrence of last year's political turmoil, added to the forced nationalisations and the disregard of property rights after the revolution, have scared off a lot of foreign investors.

Crushed Founded in 1994, the KSE is owned by several Kyrgyz banks and insurance companies, alongside the Kazakhstan Stock Exchange (KASE) and the Istanbul Stock Exchange. It accounted for almost 80% of total turnover in Kyrgyzstan in 2010. The CASE and BTS, both created later and with a single shareholder, accounted for just 15% and 6% respectively.

However, after the April 2010 revolution, the CASE, which was linked to the family of former President Kurmanbek Bakiyev, “was crushed”, Tolubaev explains. Following that, the KSE and the BTS started negotiations, and an agreement to merge was signed on March 5. The two exchanges are now in the process of consolidating.

"The investment climate is better than a year ago, but the political situation is still not very stable, so people are afraid to make big investments into Kyrgyzstan.

The government needs to reassure both the Kyrgyz population and potential investors that property rights will be respected," says Aktilek Tungatarov, executive director of the International Business Council (IBC) in Bishkek.

"The outcome of the presidential elections will affect all sectors of the economy, so decisions are being put on hold. Privatisation is being planned, but I think it will not be soon. The ministries have goals and plans but they are not implementing them, because when there is a new president, there could be a change of plan," Tungatarov says.

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Tolgoi coal mine to the population.

However, the government's role remains somewhat variable, with policy still bouncing between encouragement for foreign investment and placating the electorate via promises of national ownership. While some explorers are still feeling the sting of past nationalisations and legal alterations, 2010 has been a spectacular year for investment, with policy firmly on its side. That said, a recent Rivers and Forests law swept up many issued licenses, providing a warning that this is still Mongolian land.

AUB was put under the control of the central bank in April 2010, and has since been restructured and divided into a "good bank" and "bad bank". The "good bank", Zalkar, was created in December 2010. "The government is planning to privatise Zalkar Bank, which is based on the assets of AUB, by the end of 2012. We are still among the top 10 banks in Kyrgyzstan, and have around 40,000 clients," Zalkar's chairman Maksatbek Ishenbaev told a panel at the European Bank for Reconstruction and Development (EBRD) annual meeting in Astana on May 21.

EBRD officials have indicated they may be interested in the sale of Zalkar.

Buyer beware The other challenge will be to find buyers for the assets. Even without the nationalisation controversy, privatisation in Kyrgyzstan has been a struggle.

"Successive governments have been looking for a buyer for fixed-line operator Kyrgyztelecom for over 15 years," points out Denis Bagrov, senior lawyer at Grata law firm.

As Tolubaev points out, Kyrgyzstan is not really big enough for more than one bourse. “We would like to see some changes to legislation so there can only be one stock exchange,” he says, adding that he hopes to see activity pick up this year and that international investors will return following the elections. The International Monetary Fund (IMF) forecasts 5% GDP growth this year, but the country’s reputation as an investment destination was severely tarnished by last year’s events.

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Hunting for treasure on the Mongolian steppe Oliver Belfitt-Nash in Ulaanbaatar

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igh-profile projects are attracting attention to Mongolia's huge potential for the mining industry, prompting the government to start encouraging investment more effectively. A small group of explorers continues to map the country's resources, laying the ground for new investment.

The cold, barren steppes of Mongolia are unforgiving. After a straight five-day drive through -30°C on a chokingly dry winter morning, a few pairs of boots crunch onto the frozen dust and turn towards a pile of yellowish rock in front of them. Most likely the drive will have been for nothing, but there’s the chance these explorers have just discovered a multi-million-dollar gold mine.

Recent years have seen Mongolia developing into a thriving new frontier market. In the 1990s, it welcomed a small

group of young financiers and resource explorers, but the early birds were bitten by an underdeveloped parliamentary and legal system, leaving them with little more than thanks from the government to show for their efforts.

Things have come a long way since then. We now see the Oyu Tolgoi copper and gold mine – at $4.6bn the largest financial undertaking in Mongolia's history – boasting development ahead of schedule, whilst an epic share scheme is to dole out 2.8m shares in the Tavan

With elections set for 2012, many expect legal issues to tighten around foreign miners, but at the same time a four-year boom should follow for investors. Hence, as the bigger mines come into production and the government starts to face up to the attention of international investors, behind the scenes some explorers are searching for new pastures green.

Tip of the iceberg Andrew Stewart heads the local office of Xanadu Mines, an Australian-listed explorer in Mongolia looking for copper, gold and coal resources. Since 2005, the company has been sifting through the thousands of licenses available, collecting data and deciphering Soviet reports.

They now hold a rich portfolio of prospective assets and eagerly await the next wave of drilling results from a number of deposits. “Compared to mature exploration terrains like Australia, Mongolia is at the tip of the iceberg.” he says, spreading out a map of Mongolia on the table. “In Australia, they’re having to explore below 1 kilometre underground now, but here we’re finding great results above 100m!”

The map divides the huge country into tiny rectangular clusters, a different colour for each resource. Stewart’s eyes light up as it unrolls. “We have every-

“The Oyu Tolgoi discovery illustrates the enormous exploration potential – we’re hoping to find the next big thing”

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thing here – copper, gold, tin, tungsten, molybdenum, lead, zinc, fluorite, uranium, oil and, of course, coal.”

There are currently 5,234 mining licenses issued in Mongolia. They are spread amongst families, or through small and large companies, until someone takes the plunge and starts drilling.

Exploring is a risky business, and the millions spent on digging a hole could easily sink into the ground without a trace. On the other hand, a single set of drills can turn a piece of barren land into a multi-billion-dollar asset. “The Oyu Tolgoi discovery illustrates the enormous exploration potential," says Stewart. “We’re hoping to find the next big thing.”

Boots on the ground Today, hyper-spectral mapping and geo-technical surveys have reduced the role played by lady luck. Even so, “we still need our boots on the ground,” says Stewart."The Soviet surveys are still often used to determine where to start the search, and a great deal of luck is involved. Yet in Mongolia, it seems, the odds are in our favour."

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David Dring, CFO of Sharyn Gol, the oldest operating coal mine in Mongolia, says the Russians didn’t even bother grading the coal. “There was no need.

Coal was delivered straight to the nearest power plant. However, with further studies on Sharyn Gol, what was a 50m tonne operational mine to them has now become a JORC standard high grade 320m tonne thermal coal resource.”

“Compared to mature exploration terrains like Australia, Mongolia is at the tip of the iceberg” “This is another truly world class asset,” claims Stewart, pointing to a little known phosphate deposit in the north, “and the area has hardly been explored at all. I wasn’t sure about it before, but now I’m a big believer.”

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state, with almost half the population living on less than $2.50 a day, according to the World Bank. Food and fuel are the main expenditure for much of the population, so rising prices quickly exacerbate poverty levels.

The Russian surveys are a useful starting point for many exploration operations, but as soon as cash is spent and further studies conducted, the world of license bidding becomes a game of secrecy. If you know something is there and bid high, others will soon cotton on.

Hence, the authorities have been trying to control prices, but success has been limited. In Dushanbe, market traders have been ordered to keep prices within limits, and in May several butchers were arrested for failing to keep within the 24 somoni ($5.30) per kilo cap on meat products.

Despite the harsh work conditions and dreaded infrastructure bottlenecks, the opportunities now emerging in Mongolia are likely to attract the attention of those less dedicated to the country than Stewart, who has been working in Mongolia for 10 years through Vale Mining and Ivanhoe Mines before starting Xanadu. “This is a beautiful country to work in, and now it has everything you need. The Mineral Law hiccups in 200304 have passed,” he declares.

As the Mongolian government’s 23 "strategic" assets come into the limelight, there will follow other smaller assets, and a flow of exploration news won't be far behind. For investors who want to get in before the crowds, it's the explorers they'll be watchng.

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High food and energy prices threaten Tajik recovery Clare Nuttall in Almaty

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xposed to the mercy of international price fluctuations, Tajikistan is feeling renewed pressure on its current account, but a project to reduce reliance on imports at the country's most important economic asset only illustrates how long a haul the country is in for.

The Tajik government has said it hopes to stop inflation exceeding 9% in 2011, and is also taking steps to improve the current account balance – including exploring the options to reduce dependence on imported raw materials at the country’s largest enterprise, the Tajikistan Aluminium Company (Talco).

However, economic problems rarely remain confined to the business sector for long. The combination of poverty and rising prices, together with the constant

threat of insurgency from neighbouring Afghanistan, pose a growing threat to security. A report from the International Crisis Group says the country is “profoundly vulnerable socially, economically, politically and militarily.”

Combined with a 44% hike on petrol export duties introduced by Russia, anticipation of higher grain prices this year and speculation on the local market are all driving prices up. Recent months have seen food prices soar by around 30%, which is only compounding the effect of raging inflation on groceries felt in the second half of 2010.

As seen elsewhere in the world this year, such rapidly rising prices pose a threat when they hit the poor, a danger of which Dushanbe is well aware.

Tajikistan is the poorest post-Soviet

Current problems Although Tajikistan managed to maintain growth during the recent global crisis – increasing GDP growth from 3.9% in 2009 to 6.5% in 2010, according to the International Monetary Fund (IMF) – the current account remains a concern. Whilst it shifted to a surplus of 2.2% of GDP in 2010, over the previous five years it saw an average deficit of 5%. "In general, we are concerned about the inflationary tendency,” Jamshed Yusufiyon, first deputy chairman of the

"Tajikistan is the poorest post-Soviet state, with almost half the population living on less than $2.50 a day" National Bank of Tajikistan, tells bne.

“This is because of the openness of our economy, and some features of the balance of payments. Imports and exports total almost double Tajikistan’s GDP, and the current account deficit is chronic.”

Therefore, the government hopes to reduce dependence on imports at Tajikistan’s largest company, Talco. On April 1, Talco directors announced plans for a $2bn investment programme to allow the plant’s smelter to use a larger proportion of domestic raw materials. Currently, Talco currently imports

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around 90% of the raw materials and equipment it needs to run the smelter, but is working with Canada’s Hatch to upgrade the plant to allow 60% of inputs to be sourced domestically.

According to Yusufiyon, the matter is crucial for Tajikistan. “We are developing a major plan to supply the plant with our own resources,” he says.

“Some research has been carried out already, and the numbers are quite realistic. However, it will be a long road to assess all the documentation, and more studies are needed.”

There are questions both over where Talco will raise the $2bn it needs to rebuild the plant, and indeed whether it will actually be possible to source the required inputs in country. Despite hosting one of the world’s largest aluminium plants, Tajikistan does not possess any bauxite. “Aluminium production is energy intensive, so to make it properly you need low-cost electricity, which effectively means hydropower. That’s why aluminium plants are located in areas like the Pacific North West, Canada, Norway – and Tajikistan. However, everything else needs to be imported,” says Ken Arne, senior associate at minerals industry consultancy Behre Dolbear.

Although there is a small deposit of bauxite in south Kyrgyzstan, near the

"Talco is the most important economic asset in Tajikistan – and one of the biggest political footballs"

Tajik border, none has been found in Tajikistan, despite extensive searches in the Soviet era. Aluminium can, however, also be produced from alumina oxide, and rocks with high alumina oxide content have been discovered around 200 miles east of Talco. The government is considering opening a quarry and building a railway to ship the output to the smelter. “The mining process would be very straightforward, but they would have to build 200 miles of railroad, and extracting alumina from rock is more expensive than starting with bauxite, as there are several extra stages. This would require a big capital investment into a new processing plant,” says Arne.

“Talco is the most important economic asset in Tajikistan – and one of the biggest political footballs."

The Tajik government is also hoping to give the economy a boost with some ambitious projects in the mining and hydropower sectors. The Roghun hydropower plant will solve a lot of Tajikistan’s electricity shortages and free up surplus power for export, although it is a controversial issue internationally due to strong opposition from Uzbekistan. Meanwhile, a tender currently being carried out by Bolshoy Konimansuri is intended to bring a top international mining company to develop Tajikistan’s largest silver deposit.

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Georgian libertarian champions frontier banks

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gramme known as the “Liberty Act” and helped keep the economy afloat in the aftermath of the August 2008 war with Russia and the global financial crisis that arrived the same year. "Georgia is an established borrower now. Hundreds of institutional investors worldwide have invested in Georgian securities since 2004,” Gurgenidze says. “People discovered Georgia through Bank of Georgia equity, then the Bank of Georgia Eurobond – it all goes from there, and is now an established destination.”

Molly Corso in Tbilisi

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eorgian banker Lado Gurgenidze is building a reputation for turning bad banks around and tells bne that he hopes to be involved in his third publicly owned bank later this year – in Rwanda of all places. He claims that as long you provide enough liquidity in the shares, investors are willing to venture back into frontier markets such as those in the former Soviet Union and Africa.

Strong investor confidence in his latest venture in Georgia is one more sign that Gurgenidze is a bankable commodity in frontier markets. In May, investors bought 470m shares of Liberty Bank for over GEL11.7m (€4.83m). An additional 150m shares, notes Gurgenidze, will be available later this year. “In general we are committed to increasing the free float of the bank even beyond that immediate block of shares,” Gurgenidze says. “It makes them more liquid. The bigger the portion of the pie that is in the hands of the many, the greater likelihood that a buyer will be able to find a willing seller and vice versa.”

The offer was the latest chapter in a story of success since Gurgenidze, along with Romanian partner Dinu Patriciu, bought the bank in September 2009. In that time, Liberty Bank claims its market capitalisation has catapulted from GEL27.7m to GEL99m – a rise of 257%.

Gurgenidze, a former Georgian prime minister, has a history of turning around troubled banks. In 2004, he left a successful career as a London-based investment banker to take over as CEO of Bank of Georgia. Within two years he had

http://talco.com.tj

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reorganised the bank and engineered an IPO on the London Stock Exchange, making it the first Georgian company to be traded internationally. It also became the first Georgian company to seek funding through a Eurobond and achieve a credit rating from the international agencies.

A rose by any other name Today, Gurgenidze is clearly proud to be building on that legacy with Liberty Bank. Awards, certificates and tributes to his tenure at Bank of Georgia crowd one wall of his office at Liberty Bank’s headquarters in Tbilisi, competing for space with framed newspaper articles on his achievements, as well as sporting equipment and Georgian stock and bond certificates from the turn of the 1900s.

The office also serves as a tribute to his muse – the libertarian philosophy that has coloured Georgia’s return to solvency after nearly a decade as a failed state prior to the "Rose Revolution" in 2003.

To that end, meeting rooms at the bank are named for libertarian economists, and feature a portrait of Barry Goldwater, the former US senator and presidential hopeful closely associated with liberalism (and also known as a hawk on the Soviet Union). Unfashionable as it may be in some quarters nowadays, keeping government out to allow the market to regulate itself is a cornerstone of Gurgenidze’s polices, both in government and in his business deals.

As prime minister from November 2007 to November 2008, he leveraged the first Eurobond for the country, initiated a wide-ranging economic reform pro-

The profile of his previous bank – "100% liquid” – he insists should be the goal for any public company. However, he says there is no target for Liberty Bank, at least not yet. “All we know is that we need to increase the free float, and thus enhance liquidity. We need to keep on doing this as we grow to continue to support the growth of the balance sheet and the loan book, and in general that is what public companies are all about,” he states. “Is it going to stay on as an independent, publicly traded bank or will it be sold to a strategic investor? Both are equally valid and legitimate eventual scenarios. So long as it creates value for the shareholders, it doesn’t matter.”

Meanwhile, Gurgenidze is already onto his third financial project – Rwanda's Bank of Kigali – where he serves as chairman of the supervisory board, and is hoping to oversee an IPO this year.

However, the Georgian banker can come across as surprisingly modest, refusing to attribute Liberty Bank’s success to his track record, and commenting only that, “it's easier the second time around.”

Frontier markets, he points out, are “flavour of the year," as investors have turned to higher risk, higher yield opportunities. “Part of that has to do with [the US' second round of quantatitive easing] and the liquidity in the market. Yet a lot is driven by the fundamentals – there are a lot of small, exotic economies that are in surprisingly good shape and have been surprisingly resilient. Now that the money has returned, as long as there are enough investable instruments in these markets, it's all kind of coming together,” he says.

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Special Report: Ukraine on trial

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Trials and tribulations in Ukraine James Marson in Kyiv

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rom a hot, packed Kyiv courtroom on Friday, June 24, Ukrainian opposition leader Yulia Tymoshenko fired a warning shot at her long-time rival, President Viktor Yanukovych. "My voice will be even louder from prison because the whole world will hear me," she said during a day of verbal sparring with the judge at her pre-trial hearing.

The trial, where the former prime minister and Orange Revolution leader will stand charged of abuse of power over a natural gas deal with Russia, starts on June 29, and will be the first of three cases against Tymoshenko to reach court. Prosecutors allege that she abused her power in concluding a gas deal with

Russia in January 2009 that locked Kyiv into a gas price formula linked to the price of oil, which has sent the country's gas payments spiralling in the past few months.

Tymoshenko's theatrical performance at the hearing – the court was "a farce," the judge "a puppet" – highlighted the

dilemma that Yanukovych, who denies any political motivation to the charges, is now facing.

The temptation to lock up his great rival and throw away the key must be great.

Despite losing the presidential election to him in early 2010, Tymoshenko remains the most powerful opposition

"The trial could turn Tymoshenko into a martyr and galvanize her support, as when she was jailed briefly under former president Leonid Kuchma in 2001"

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figure and her party is the greatest threat to Yanukovych's Party of Regions in next year's parliamentary ballot. But there are two major reasons that could hold the authorities back from sending Tymoshenko down.

Proceed with caution First, it could turn her into a martyr and galvanize her support, as when she was jailed briefly under former president Leonid Kuchma in 2001. Tymoshenko is at her best in a scrap. Second, the West has given Yanukovych plenty of warnings to proceed with caution in the trial of Tymoshenko and around a dozen other former members of her government currently under investigation.

With the EU and Ukraine close to agreeing on an association agreement, including a deep free-trade agreement, any decision to jail Tymoshenko could throw a spanner in the works. The Americans have also voiced concerns, including a telephone call from Vice President Joe Biden in March.

Yanukovych needs the West as a counterweight to Russian influence in Ukraine. Following the deal last year to extend the stay of Russia's Black Sea Fleet in a Ukrainian port until 2042 in exchange for a cut in the gas price, the Kremlin has pushed hard for further concessions – for instance, a merger of the countries' state gas companies, or a stake in Ukraine's gas transport system.

From the very start, the authorities have done their best to convince the West that the probes into Tymoshenko and her for-

Photo: © European Parliament

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mer colleagues have nothing to do with politics and are part of a wide-ranging crackdown on corruption. Few people in Kyiv take that seriously.

The public relations battle was kicked off by the authorities last October when a $2m report into alleged corruption in Tymoshenko's government was published by three top US legal and investigative firms. Tymoshenko hit back in June with a report by Covington & Burling, a US law firm, and BDO, an accounting firm, saying they had found no evidence of wrongdoing in the other two cases, concerning the purchase of medical vehicles and the use of carbon credits. She has also complained to the European Court of Human Rights about her treatment.

The current government doesn't miss an opportunity to use the case for political PR as well, blaming the country's continued economic woes on this gas deal. But this has failed to shift the blame entirely: Yanukovych's approval ratings are drifting towards single figures as inflation continues to bite. This must make the temptation to take Tymoshenko out of the picture all the more tempting.

Some analysts suggest that handing her a suspended sentence is the most likely outcome, which would see her walk free, but barred from the parliamentary elections next year. The next few weeks are sure to be a hot and uncomfortable time, not only for Tymoshenko in the courtroom, but also for those who are deciding her fate.

"My voice will be even louder from prison because the whole world will hear me"

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– preside over a sprawling network of companies with Baltic bank accounts that have extensive dealings with the Ukrainian state, covering everything from arms exports to machinery imports.

Massive Ukrainian government moneylaundering surfaces

Companies headed by Vanagels and Gorin won a government order in a March tender on behalf of state-owned oil company Chernomoreneftegas, Ukraine's Black Sea oil producer, for the delivery of $400m worth of oil drilling equipment.

The tender was won by Cardiff-registered Highway Investment Processing LLP, which lists Stan Gorin as a director according to the UK's Companies House.

The only other company to "compete" in the tender was Falcona Systems Limited, registered in New Zealand and listing another Latvian, Inta Bilder, as director. It will come as no surprise that this company was founded by Interhold, which lists the ubiquitous Erik Vanagels as a director.

Graham Stack in Kyiv

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hat do Ukrainian tank exports to Kenya, flu vaccine imports from Oregon and oil rig imports from Wales all have in common? They are all deals carried out by the same shell companies that are linked to a small set of Latvian directors. A scandal is unfolding in Ukraine that could be dubbed Vanagels-gate as more details of dodgy and outright illegal deals using a string of shell companies emerges, which can be traced directly back to the upper echelons of the Ukrainian government.

When the merchant vessel Faina was intercepted on its way from Odesa to the Kenyan port of Mombasa by Somali pirates in September 2008, international concern focused not only on the plight of the crew of 21, but on the cargo of 33 T-72 tanks, heavy weaponry and ammunition that the pirates found on board. The ship was bound for Mombassa, Kenya, but the pirates (and later US intelligence officers) said the actual destination was Juba in Southern Sudan – a country that is currently under a blanket UN arms embargo.

Who did the ship belong to and who was pocketing the profits from the embargo busting illegal arms shipments? Faina is owned by an anony-

In other words, there was no competition for the oil equipment order, which was parcelled out to the Latvian cabal in a sham of a tender. According to Ukrainian weekly Zerkalo Nedeli, the produc-

"The Latvian cabal is politically non-partisan, having done similar deals under the previous Ukrainian administration" mous Panamanian company Waterlux AG, which lists two more anonymous Panamanian companies: Systemo AG and Cascado AG, as executives. The latter two companies in turn both list Latvians Erik Vanagels and Stan Gorin as president and treasurer, but at the time no-one could make much of this information, dismissing the Latvians as mere nominees.

According to an investigation conducted by bne, Vanagels and Gorin – together with Latvian colleagues such as Juri Vitman, Elmar Zallapa and Inta Bilder

er's price for the oil equipment was only $248.5m, so someone made a handsome $150m profit from the deal for doing nothing more than some paperwork.

The Latvian cabal is politically non-partisan, having done similar deals under the previous Ukrainian administration.

On May 28, a US court in Oregon found that US-registered company Olden Group LLC had illegally overcharged the Ukrainian government $19m for flu vaccines during the swine flu scare of autumn 2009, according to a government press release.

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President Viktor Yanukovych ordered an investigation into the medicine purchases after taking office in 2010.

The investigation by US detective bureau Trout Cacheris found $40m of state purchase of vaccines and medical equipment in the two previous years had all been put through the same network of offshore intermediaries with bank accounts in Lithuania and Latvia.

Vanagels, Gorin and another member of the network, Juri Vitman, were linked to all these companies, which the investigation found routinely inflated prices by 50%.

Vanagels' role is only coming to light now as the local press starts digging out more and more information on the Latvian cabal and its ties to the present and past administrations. The network's activity can be traced back over a decade to the establishment in the

bne July 2011

pointing to a father and son team – one, a 44-year-old Latvian businessman is apparently the active party, while the Erik Vanagels that features so ubiquitously as a director is his 71-year-old father. Neither responded to attempts to contact them by bne. bne visited the listed address, which was a fairly rundown place behind a jeans store – not the sort of place one would expect to find someone who owns an oil rig. The man who answered the door, dressed in overalls, said Vanagels – or rather a relative of Vanagels (possibly a sister in law or sister) – used to live there "a long time ago." He had no idea where they were now.

Are Vanagels and Co. anything more than nominees fronting for Ukrainian officials? Apart from the overlapping Baltic directorships and bank accounts,

"There was no competition for the Ukrainian oil equipment order, which was parcelled out to the Latvian cabal in a sham of a tender" mid-1990s of Ukraine's state weapons export monopoly Ukrspetseksport.

Evidence suggests Venagals, Gorin and Zallapa have scores of companies dating from that time registered around the world – Ireland, the UK, New Zealand and Panama – and those are only the ones that have come to light so far.

The Ukrspetseksport connection continues right up to the present day as the Faina scandal reveals. Ukrainian court records reveal that contracts for goods shipments carried by Faina's sister ship, MS Brilliant, which plies its way weekly from Odesa to Syria on behalf of an Ukrspetseksport partner company, were in the name of Panamanian offshore Ridemax Systems Inc, a sister company of Waterlux AG. The talented Mr Vanagels According to British director records, there are in fact two Erik Vanagels, both registered at the same Riga address,

one pointer to a coherent organisation is that Vanagels and Co. do not only head shell companies, but also act as directors of a wide assortment of online foreign exchange trading sites. The online High Yield Investment Product (HYIP) schemes are basically glorified Ponzi scams, such as HYIP "cherryshares" that went offline in December 2010 to the despair of its investors.

The site was owned by New Zealandregistered Brooksell Universal Limited, which was under an Inta Bilder and Vanagels directorship.

In December 2009, the US Securities and Exchange Commission (SEC) cracked down on a Latvian Ponzi scheme called Rockford Funding, alleging it had taken over $10m off gullible investors in a matter of months.

It transpired that investors' money had been transferred to Latvian banks Rietumu Bank, Regional Investment Bank JSG and Trasta Komercbank. Of

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the linked companies listed by the SEC, one was a UK company set up by Vanagel's Milltown Corporate Services and Ireland&Overseas Acquisitions – companies in the 1990s that were heavily involved in setting up suspected Ukrspetseksport fronts in Ireland and England.

A second company named by the SEC, Panamanian Houseberg Impex Inc, was none other than a sister company of Waterlux AG, the owner of the ill-fated Faina, bringing together two apparently very different worlds – piracy and arms smuggling, and online scamming.

While the Vanagels network clearly poses questions about Ukraine's capacity to fight corruption, with these schemes systematically conjoined to the state, it also raises questions about the willingness of Baltic banks to comply more than superficially with moneylaundering requirements, especially in a post-crisis situation where the legal easy money has dried up.

The US sent shockwaves through Baltic banking by blacklisting two Latvian banks in 2005 under the Patriot Act on suspicion of terrorist money laundering, one of which was forced to close. A diplomatic dispatch from Turkmenistan in December 2007, released by Wikileaks, bemoaned, however, that little seemed to have changed in Baltic banking, with Turkmen officials increasingly holding cash in Riga bank accounts.

Parex Banka, now state-owned after getting into trouble in 2008, confirmed to bne that Juri Vitman – one of the Vanagels' network named in the Trout Cacheris investigation – was a client manager at the bank until 2006.

The danger for the Baltics is that money-laundering activities re-import corruption to home territory. One such Latvian affair involving impounded cars was unmasked in 2008-09 and featured a security company with ties to interior ministry officials – Stab 58 – and a New Zealand front company called Geomark, which has almost inevitably, Erik Vanagels listed as director.

Trial separation seen for Ukraine and IMF

Tim Gosling in Moscow

S

tuck between demands for further reform and rapidly dwindling popularity, Ukraine's government is predicted by analysts to opt for the populist route ahead of parliamentary elections next year and postpone cooperation with the International Monetary Fund (IMF). It should get away with it – as long as global liquidity remains high.

Kyiv agreed to implement a raft of reforms when it secured a $15bn bailout with the IMF in summer 2010, and promptly provoked outrage amongst the population when it raised gas prices and proposed changes to the tax regime soon after. That earned the government two tranches under the IMF stand-by programme totaling $3.4bn.

However, despite pushing on with independence for the central bank and

liberalisation of the foreign exchange markets, progress on the most important issues has slowed dramatically this year in the face of opposition from the electorate. Meanwhile, although the IMF has softened its stance somewhat, it looks unwilling to cede further ground, having already delayed the next payment by two months.

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age to 60 – and another rise in utilities prices. But with reports suggesting as much as 90% of the population opposes these measures, they may be too tough a sell for the government right now – especially given President Viktor Yanukovych's approval ratings plummeted close to single digits in April. Despite almost daily appeals by officials in the media looking to persuade the population that pension reform is "vital," such reform is yet to even make it into the Verkhona Rada for initial discussion, and time is running out. "While the government has been understandably leery of pushing too hard on the reform pedal, hoping to avoid a black eye like the pushback surrounding its tax reform in fall 2010, we have also seen little activity to involve critics on developing more palatable solutions," points out Brad Wells at Concorde Capital.

The current parliament session breaks on July 8 for its summer recess, and with parliamentary elections set for October 2012, it's starting to look unlikely that Kyiv will satisfy the IMF's demands soon. "A more likely scenario," reckons Olena Bilan at Dragon Capital, is that "Ukraine will turn to the IMF again after the parliamentary elections, when the window of opportunity for unpopular policy measures will reopen."

In other words, Ukraine and the IMF look likely to embark on a temporary separation until 2013 at least.

Wiggle room Adding weight to such ideas is the relatively healthy state of the government's finances, which should give the government some political wiggle room.

"Ukraine and the IMF look likely to embark on a temporary separation until 2013 at least" The IMF's Ukraine representative Max Alier repeated on May 16 that among the key requirements to qualify for a third tranche are pension reform – including moving the female pension

Replenished by earlier IMF disbursements and inflows of foreign capital, central bank reserves hit a new historical high of $38bn in April, whilst economic recovery and strong budget rev-

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enue growth (28% in the first quarter of the year) offer the option of delaying cooperation. That position of strength also suggests the country is unlikely to face short-term economic challenges.

Conversely, "raising charges for utilities and gas would only add to rising inflation," points out Alexei Moiseev, chief economist at VTB Capital.

Neither should the lack of new IMF loans hit Ukraine's ability to borrow internationally to plug a budget deficit expected to come in at a minimum of 2.8% this year – at least not in the short term.

Although Ukrainian Eurobond spreads are likely to move out as the mid-June deadline for the reforms approaches, the cost increase for the country to borrow should be limited enough.

Bilan expects five-year credit default spreads for Ukraine (contracts that protect bondholders against the risk of default), currently at 455 basis points (bps), could widen by about 100 bps in response, with sovereign Eurobond yields adjusting accordingly, "but we still expect the Finance Ministry to tap the Eurobond market later this year."

Moiseev believes the immediate impact is likely to be minimal as long as global liquidity remains so high. However, he says the country's access to debt

markets could suffer next year following the US move to normalise its monetary policy. "Historically, Ukraine has always been seen as one of the most risky emerging markets, and is the first to lose access."

Cutting loose from the anchor The less tangible effects of Ukraine's timeout in its relationship with the stand-by programme provide more reason for apprehension, however. "The key concern," suggests Bilan, "is that without the external anchor the IMF has been, fiscal discipline may worsen ahead of the elections and actual contraction of the general government deficit in the coming years will be much more modest than demanded by the IMF (from 5.7% of GDP in 2010 to 2.8% this year and 2.5% in 2012), despite strong budget revenue growth.

Moiseev, meanwhile, worries about the effects a temporary estrangement could have on investment. "The IMF programme is most important in terms of the comfort it offers to foreign banks, which are needed to power economic development by lending to private investors. The private banks don't want to be the lenders of last resort – they only like to lend when a country doesn't really need to borrow of course," he notes.

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afternoon. Only on the following Monday, May 30, a full week after the original publication, did the depositaries actually enforce the decision, and freeze circulation. By end of trading on Friday, May 27, the two most liquid stocks – coal companies Pokrovskoe Mining and Yasynivsky Coke – had plunged 45% and 35% respectively, wiping $30m-40m off their respective market caps.

Donetskal share freeze hits Ukrainian market's credibility Graham Stack in Kyiv

T

he bungled freezing of shares in 12 Ukrainian companies at the end of May saw millions of dollars wiped off their market capitalisation and has damaged the stock market's credibility. And the murky manoeuvring behind the move will only hurt Ukraine's investment image further.

Ukraine's securities commission quietly announced it was freezing trading in the shares of 12 companies belonging to the Donetskal steel holding on May 24.

Whilst few found out about it until five days later, it took the depositories a week to act, by which time a sell-off had hit the two most liquid stocks for up to $80m.

"Ukraine will turn to the IMF again after the parliamentary elections, when the window of opportunity for unpopular policy measures will reopen"

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The weekly gazettes published by stock market regulatory commissions are not known as riveting reads, but it's usually assumed that at least some – such as the depositories, which are legally bound to do so – will read them. But not in Ukraine apparently.

When on May 24 Ukraine's Securities and Stock Market Commission (SSMSC) gazette published 12 decisions freezing

the shares as of May 20 for 12 months, there was no reaction whatsoever from market participants. Not until Friday lunchtime on May 27 did a user called Bekstitser post a reference to the decree on the most-popular traders' forum in what was suspiciously his debut post.

"A great shout went up," says Agshin Mirzazade, head of research at Foyil

At the same time, there is now a huge question over the validity of all the trades that week. Donetskstal has filed a lawsuit against the decision. There is a chance, say analysts, that the commission will cancel the decision, which would mean all trades will remain valid.

That of course would be bad news for those who rushed to sell their holdings.

It would also wipe out any suspicion that market manipulation was behind the delay in broadcasting the decision loud and clear.

Wider damage The whole mess is clearly damaging for the credibility of Ukraine's fledgling stock market. "It's an outrageous decision," says Mirzazade. "It really damages the market. It's the first time the commission has acted this way, and there are two very strange things about it. Firstly, the commission gave no warning of the suspension of trading to the depositories, and did not even communicate the decision itself asides from the 'publication'. Secondly, the freeze on the stock

"The whole mess is clearly damaging for the credibility of Ukraine's fledgling stock market" Securities, recalling the moment his traders read the news. Although it had taken them four days to learn about the decision, they were quicker off the mark than both the UX exchange and the very depositories to whom the SSMSC decision was primarily addressed.

Thus trading in all 12 stocks continued through to the following Friday

related to the whole stock including minorities, which is unprecedented."

However, insult was only added to injury when people tried to get at the reasons behind the decision, originally taken on May 20. The SSMSC announced that the move was prompted by a letter it received dated May 19 from an unnamed member of

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Ukrainian companies head west

bne On June 20, sunflower oil producer ViOil became the latest in a long line of Ukrainian firms that either have or are looking to list their shares on a foreign bourse, with Warsaw and London the preferred destinations. The limitations of the local stock exchange mean this trend is expected to continue and even pick up.

ViOil's IPO of new shares on the Warsaw Stock Exchange, due to be completed in mid-July, is expected to raise at least $140m, which it will use to fund its attempt to capture a greater share of the global sunflower oil export market than the 4% it currently holds. Credit Suisse is running the offering, which will target both retail and institutional investors in Poland as well as international investors.

It's this greater access to capital, of course, that's driving these companies westwards. Since 1995, Ukrainian companies have raised more than $4bn in equity capital on international stock markets. "We believe this trend is driven by solid capital resources available on international markets, which are limited to certain exchanges and their respective regulations," say analysts at Kyiv-based Phoenix Capital.

While many see the local Ukrainian market as having bright prospects in general, the domestic stock market currently has little room to provide new listings with decent liquidity, while uncertainty over Ukraine's investment climate is still hurting international investor interest. At the same time, the existing equity on the domestic market is narrowing as major private shareholders buy back shares from the market. "As a result, we see that there will be fewer investment ideas on the

domestic stock market, while more Ukrainian stories will be emerging on foreign exchanges," Phoenix says, adding that it expects this trend to pick up, while domestically listed stocks, such as DNEN, AZGM and MZVM, risk fading away.

MAJOR PLACEMENTS OF UKRAINIAN COMPANIES ON INTERNATIONAL MARKETS

Company

Stock Exchange

Years of placements

Total proceeds raised, $mln

Astarta Agroton Kemel Milkiland KSG Agro Industrial Milk Company Sadovaya Group Regal Petroleum JKX Oil&Gas Cadogan Petroleum MHP Landkom Avangard Ukrproduct XXI Century KDD Group DUPD Ferrexpo MCB Agricole Mriya TMM Real Estate Sintal Agriculture Land West AgroGeneration

Warsaw Frankfurt, Warsaw Warsaw Warsaw Warsaw Warsaw Warsaw London London London London London London London London London London London Frankfurt Frankfurt Frankfurt Frankfurt Frankfurt NYSE Euronext

2006-2011 2009-2010 2007-2011 2010 2011 2011 2010 2002-2009 1995-2010 2008 2008-2010 2007-2009 2010 2005 2005 2007 2007 2007 2008 2008 2007 2008-2009 2007 2010

$113 $96 $575 $70 $40 $30 $31 $372 $133 $300 $511 $140 $208 $11 $138 $146 $306 $450 $61 $90 $105 $48 $43 $16

Total

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Yury Ryzhkov of Astrum Capital suggests the businessmen may have had a falling out provoked by current negotiations over debt restructuring. "What may have happened is that the creditors demanded to see a list of Donetskstal shareholders, and when it was produced, the MP's name was not on the list. This may have prompted him to take such action as a bargaining chip." In this case, argues Ryzhkov, the issue is likely to be resolved speedily, because the shareholders will be keen to push on with the rationalizing its debt burden.

However, Ryzhkov allows for a second scenario that is connected with Pokrovskoe Mine. Ukraine's largest coking coal plant is a key supplier of coke and manganese to the holding's steel producers, but is also an attractive asset thanks to its profit margins. The analyst suggests that one of the large shareholders in the mine may have tried to sell their stake to a Russian concern. Given the strategic importance of Pokrovskoe to the entire Donetskal holding, however, the existing

"The freeze on the stock related to the whole stock including minorities, which is unprecedented." shareholders would be keen to have first dibs on the stake. "If the holding loses control of Pokrovskoe, it is finished," says Ryzhkov.

Letter of protest The next step is for market participants to send an official letter of protest to Prime Minister Mykola Azarov and President Viktor Yanukovych, Mirzazade says. Most investors won't be holding their breath on that one though; the government is adept at saying all the right things about improving the investment climate, while doing the exact opposite.

For instance, the same day the SSMSC quietly published the decision in its gazette, it also issued a press release

Reform in Ukraine – mixed progress

COMMENT:

$4,031

Source: Bloomberg, Phoenix Capital estimates

Olena Bilan of Dragon Capital parliament, which referred to an as-yet unknown ruling by a court in Cyprus on a Donetskstal shareholder dispute and complaints from a disaffected shareholder. The letter also suggested vaguely that the dispute represents a "threat to state interests," which provides the SSCM with the legal grounds to freeze the shares.

It is now widely believed that the disaffected shareholder and the MP are one and the same person: Party of Regions MP Gennady Vassiliev. Vassiliev was

Ukraine's Prosecutor General in 20032004 under former president Leonid Kuchma, whilst at the same time his brother, Aleksandr, was head of the Donetsk regional tax administration.

Head of the SSCM Dmitry Tevelev, a surprise appointment in 2010, is also a Donetsk man, having held prior management posts in energy companies controlled by Ukraine’s richest man, steel magnate Rinat Akhmetov, and with no previous experience of stock market regulation.

Vassiliev is said to have played a key role in the creation of the Donetskstal holding during his spell as Prosecutor General, but understandably in a largely unofficial capacity. Newspaper Kommersant quoted a Donetskstal source as saying, "all these years he's been saying he's a shareholder, but he's never produced anything on paper to prove it."

The coal and steel group is thought to be controlled by oligarchs Viktor Nusenkis and Leonid Baisarov, with Vassiliev assumed to be a "partner."

T

his report presents our first comprehensive attempt to quantitatively assess the reform program put forward by Ukraine’s new leadership last year. Using global investment attractiveness rankings as benchmarks, we analyse the country’s recent achievements and potential progress over 2010-14.

Though Ukraine is unlikely to replicate the results that top global reformers achieved in the past five years, we

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think that with elections in the country becoming less frequent and the political will in place, progress on the most pressing issues would enable Ukraine to somewhat improve its position in global rankings, offsetting the poor track record of previous years.

Comprehensive reform agenda, yet controversial first steps • In June 2010, newly elected President Viktor Yanukovych laid out a five-year reform agenda which became one of

quoting a speech by its head Tevelev at a recent conference on the country's investment climate in Kyiv. "The SSCM is resolved to become the advocate of investors in Ukraine," Tevelev insisted.

"Investors need reliable protection, and such protection has to be guaranteed by the state."

The reality appears to be very different, and the idea of the stock market regulator reduced to a weapon in internecine corporate wars will strike terror into the heart of any investor. But all is not yet lost: on June 21, a court of first instance overturned the ban on trading stocks of the company PJSC Donetskstal, although not the ban on trading the other 11 companies in the holding. The SSCM is set to appeal the decision.

the most comprehensive action plans produced by any Ukrainian administration in recent history. Working on their 2010 priority action plan, the authorities made progress in a number of areas including those outside of International Monteary Fund (IMF) oversight, such as tax legislation, energy sector privatisation and business deregulation. But underperformance on other fronts overshadowed the early achievements, with increased corruption, customs delays, slow VAT refunding, imperfections of the new Tax Code and non-transparent distribution of grain quotas all adversely affecting investors’ perception.

Measuring recent reform progress • However, the local business community seems to assess the first steps largely positively, at least according to the Investment Attractiveness Index compiled by the largest business association in Ukraine. Going forward, Ukraine’s progress in different reform areas will be revealed by its position in key global rankings including the Doing Business,

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"The local business community seems to assess the first steps largely positively"

Corruption Perception Index, Economic Freedom and Global Competitiveness.

• Analyzing the government’s first steps, we think upcoming ranking releases will show a mixed picture. Assuming the business climate in the rest of the world has undergone no major change over the past year, Ukraine may move up 23-33 points in the World Bank's Doing Business ranking. Yet the survey-based Corruption Perception Index will likely show Ukraine staying where it was, if not falling.

What’s next?

• The government’s 2011 priority list centres on pension, land and health-

care reforms. The authorities also plan to move forward with energy sector privatisation and business deregulation. Despite the 2011 action plan being another step in the right direction, the timeframe for its implementation is shortening as the October 2012 parliamentary elections approach.

The IMF-required pension reform and energy tariff hikes will likely become the last "brave deed" for the authorities this year.

• The political landscape should again become conducive to reforms after next year’s parliamentary elections, giving authorities another window of opportunity to move forward. Analysing the

experience of Georgia, Rwanda and Qatar – the most successful reformers over the past five years – we think Ukraine’s reform progress will be more modest, especially in fighting corruption.

• Yet progressing gradually in selected areas such as investment and property rights protection, financial markets development and business deregulation, Ukraine may see its 2016 Economic Freedom score improve by 5 points to 51. Despite looking small in absolute terms, this will mark a notable achievement for a country whose rating has been declining since 2005.

It remains to be seen, however, if the current administration has the political will to continue to deliver on its reform programme, ultimately reducing the economy’s exposure to the global commodity cycle.

KEY REFORM STEPS IMPLEMENTED SINCE MARCH 2010 Action Fiscal Policy and Tax System • Enacting the Tax Code • Enacting amendments to the Budget Code aimed at redistributing revenues in favor of local authorities • Enacting State Procurement Law compliant with international practices • Restructuring VAT refund arrears accumulated in 2009 by issuing government bonds, and eliminating further arrears • Introducing fixed pension contribution for individual entrepreneurs • Hiking excise rates to boost budget revenues • Approving conservative state budget law for 2011

Reform Agenda

x x x x x

IMF requirement

x x x x

Business deregulation • Slashing number of economic activities requiring a license by 30%, from 78 to 55 • Number of economic activities that require permits reduced by 60% to 94 • Halving number of state control bodies, to 38 from 85 • Enacting new construction law to reduce time needed to start construction from 374 to 60 days

x x x x*

Energy Sector and Privatization • Eliminating gas price privileges for industrial enterprises • Creating independent regulator for utilities services • Hiking gas tariffs for households and utility companies by 50% since August 2010 • Improving payment discipline by reintroducing fines for overdue utility payments • Abolishing moratorium on energy enterprise privatization, preparing energy and coal companies for sale

x x x x x

x x x x

Other • Strengthening NBU independence by enacting new Law on Central Bank • Elimination of tariff privileges for cargo transportation

x x

x

Note: *not stated explicitly in the reform program but was repeatedly cited by officials as one of objectives.

Sources: Verkhovna Rada, Cabinet of Ministers, IMF

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I Events

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Upcoming events 2011

Russian Stock And Financial Markets: Future Trends (22 - 25 August) FINEXPO +7-495-646-14-15 Sochi, Russia info@finexpo.org www.ff.finexpo.ru/english/

CCS 2011 (September 2011) EastEuro Link London, UK www.easteurolink.co.uk/CCS-2011/

5th Annual Private Banking in CEE, SEE & CIS (13 - 14 September) Fleming Europe Prague http://finance.flemingeurope.com

Eastern Europe Summit (14 - 16 September) East Capital Istanbul

Gas Infrastructure World Caspian 2011 (21 - 22 September) Terrapinn Hyatt Regency Baku, Azerbaijan www.terrapinn.com/2011/gas-infrastructure-caspian/

JetFin RUSSIA 2011 (29 September) JetFin +41 22 839 8080 Grand Hotel Kempinski, Geneva, Switzerland sophie.lavaud@jetfin.com www.jetfin.com/russia2011-geneva/program_en.php

CFO Forum (29 - 30 September) EBCG Prague, Czech Republic, hotel TBA www.ebcg.biz

IPO and SPO in Russia and CIS (3 - 5 October) C5 London, UK www.c5-online.com/2012/640/ipo-and-spo-in-russia-and-cis

4th CFO Summit Emerging Europe & CIS 2011 (11 - 12 October) FINANCIAL GATES +49(0)60 31-73 86-17 06 Vienna, Austria info@cfo-summit-ee.com www.cfo-summit-ee.com/

International Cash and Treasury Management (12 - 14 October) EuroFinance +44(0)20 7576 8555 Rome, Italy

24th BACEE Country and Bank Conference (13 - 14 October) BACEE Budapest www.bacee.hu/eventstocome.aspx

FMCG in Russia (17 - 19 October) Adam Smith Conferences +44 20 7017 7444 Marriott Grand Hotel, Moscow, Russia events@adamsmithconferences.com www.adamsmithconferences.com/rr19bneb

Russian CFO Summit (24 - 27 October) Adam Smith Conferences +44 20 7017 7444 Moscow, Russia events@adamsmithconferences.com www.adamsmithconferences.com/br18bneb

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I Eurasia

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