Business New Europe December 2012 edition

Inside this issue: A literary guide to investing in Russia Latvia's Parex-ysms continue Oil on Albania's troubled waters A Georgian nightmare unfolds December 2012 www.businessneweurope.eu

Special Report: Outlook 2013

ROADMAP TO REFORM Russia looks to 22 roadmaps to fix the economy's structural problems

How to invest in Eastern Europe and China

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bne December 2012

Contents

Editor-in-chief: Ben Aris (Moscow)

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Managing editor: Nicholas Watson (Prague)

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News editor: Tim Gosling (Prague)

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Eastern Europe: Graham Stack (Kyiv)

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Central Europe: Robert Smyth (Budapest) Jan Cienski (Warsaw) Mike Collier (Riga) Matthew Day (Warsaw) Tom Nicholson (Bratislava) Kester Eddy (Budapest) Steven Roman (Tallinn)

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Southeast Europe: Justin Vela (Istanbul) David O'Byrne (Istanbul) Bernard Kennedy (Ankara) Ian Bancroft (Belgrade) Bogdan Preda (Bucharest) Branimir Kondov (Sofia) Guy Norton (Zagreb)

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Design: Olga Gusarova-Tchalenko

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21

33 COVER STORY 6 The Insiders

CENTRAL EUROPE 24 Latvia's Parex-ysms continue

8 Roadmap to reform 26 A nuclear freeze 12 Perspective 13 Chart of the month

28 Czech govt weary, but maybe wiser 29 Cut to the bone

EASTERN EUROPE 30 Poland's helpful opposition 14 Anti-graft drive claims first big fish

31 Polish banks begin to feel the pinch

15 The Shuvalov Affair 16 Latvia's bad bank guns for Rosneft deputy

33 Lithuania's pendulum swings back 35 Tallinn's (free) ticket to ride

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17 Gazprom's woes deepen 19 Russia's store wars Please direct comments, letters, press releases and other editorial enquires to editor@bne.eu All rights reserved. No part of this publication may be reproduced, stored in or introduced to any retrival system, or transmitted, in any form, or by any means electronic, mechanical, photocopying, recording or other means of transmission, without express written permission of the publisher. The opinions or recommendations are not necessarily those of the publisher or contributing authors, including the submissions to bne by third parties.

No liability can be attached to the publisher for these comments, nor for inaccuracies, errors or omissions. Investment decisions or related actions taken on the basis of views or opinions that appear herein are the responsibility of the reader and the publisher, contributors and related parties cannot be held liable for these actions. bne is the property of bne Media Ltd · Reg number: HE 185230 · Michalakopoulou 12, 4th floor, Suite 401, P.C 1075, Nicosia, Cyprus · Postal address: Schluterstrasse 19, Berlin 10625, Germany

21 Lebedev cashing out of Russia 22 Whither Ukraine

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bne December 2012

Many talk about Capital Market Transactions in Central and Eastern Europe.

Contents

50

We do them.

40

58

SOUTHEAST EUROPE 38

EURASIA 48

A rare joint venture

49

A rigged market

50

Social policy is Kazakh Achilles' heel

51

Regional airport revamp

Surprising (con)census in Bosnia

52

The EU's risky symbolism over Iranian gas

45

A step nearer

46

Macedonia PM's problem with names

40

42 43

44

Oil on Albania's troubled waters No Romanian holiday from scandals

Confused picture for Russia

62

Ukraine down and possibly out

64

Central Asia still going strong

A Georgian nightmare unfolds

65

Central Europe penned in by crisis

53

Sold in Central Asia

66

Baltic states – A good year

54

Building the new Silk Road

67

Southeast Europe different but the same

OPINION

69

Turkey – so far, so good

A literary guide to investing in Russia

70

UPCOMING EVENTS

The Serbian three-step

58

Raiffeisen Bank International has relationships in Austria and Central and Eastern Europe second to none. Close relationships, too, with major investors worldwide. Investors value our regional know-how and market access, giving issuers firm placement at the right price. www.rbinternational.com

SPECIAL REPORT– Outlook 2013 61

56

Best Regional Bank in Central and Eastern Europe

I5

Six reasons to be optimistic

6

I The Insiders

bne December 2012

Getting the WTO mindset

Peter Mandelson

I

n October, I witnessed the first snowfall of winter in Moscow. In between navigating the puddles of melting sludge I found most of my discussions being dominated by Russia's World Trade Organization (WTO) accession. Having spent a good chunk of my time as EU Trade Commissioner trying to get Russia's membership over the line, it was good to talk to people about the impact of joining the WTO rather than the merits of doing so. Whether talking to business or political leaders, most people were keen to know what I thought this might mean for Russia, or rather, I suspect, what we in Western Europe thought. For a system that has prioritised stability over the past decade, the accession brings the promise of change. This is inevitably generating a sense of opportunity, but understandably also some apprehension.

Readers of bne will not need me to tell them of Russia's has massive latent economic potential. You can't speak to any ambitious European business who does not sense the opportunities in Russia if they are not already operating there. Some 140m middle-income consumers, right on our eastern border. An educated workforce. Lots of land. The fiscal underpinning of massive hydrocarbon wealth – if it is well managed.

But the economic challenges seem as big now as they did a decade ago. The Russian economy is less diversified now than it was ten years ago. Dependence on energy products has risen from 44% in 2001 to 69% at the end of 2011. The Russian state is still too dependent on energy revenues. Foreign capital is nervy to put it mildly. Russia's key trade relationship with the EU remains turbulent and difficult. Where does WTO entry fit into this picture? Does it fit in at all? I believe potentially it does.

Saving Russian importers How much will WTO membership actually change for traders? The Russian average tariff for manufactured and agricultural goods will fall to the lowest among the BRICs over the next five years. This will probably save Russian importers several billions a year, but the tariff cuts are relatively small.

Russia has also agreed to bind export duties on over 700 products. There are new tariff rate quotas on meat and wood products, which are key for the EU and important imports for the processing industries in Russia. Overall, the change in trade profile is not large – especially when compared to the equivalent change in China's 2000 accession. Nevertheless, they will undoubtedly make Russian more attractive as a trade partner.

It is my hope that WTO accession is a sign that Russian leaders understand that trade is a vital tool to build wide-ranging, mutually beneficial and durable relationships. The key here will be Russia's own orientation. If it sees its own economic sphere as rooted chiefly in the Eurasian Customs Union (of which the other two members are not members of the WTO) and its regional ambitions, it will not make the most of the opportunity for closer economic integration with partners around the globe.

"Exploited to its fullest, WTO accession provides the opportunity for strengthening Russia's relationship with Europe"

On investment, the basic challenge hasn't changed in the ten years that I have been closely involved with doing business and trading in Russia. Russia can be a risky and unpredictable place to do business as a foreigner – it is ranked at 112th in the World Bank's latest "Doing Business" survey. Perception of "Russian risk" among international investors has risen to alarming levels, prompting significant capital flight – over $80bn in 2011.

bne December 2012

Here the WTO entry could play a crucial role. The bottom line is that WTO entry matters for what it implies about the political and economic outlook of the state that seeks it. The policies that really make a difference for the acceding state tend to be the package of reforms and capacity building that accompany accession. Joining the WTO generally includes a certain level of reform and openness, and a tolerance for foreign competition. This is why it acts as a useful signal to inward investors. In principle it is something on which Russian firms could trade in attracting joint-venture partners.

However, in Russia's case this has been somewhat uneven. In large part I fear this is because the leadership has not actually seen the value of WTO membership in these terms, but as a club that Russia should not be outside of for power political and national pride reasons. Leaders in China and Vietnam saw it as a vital signal to the world of their own mindset and intentions, and used it to great effect to attract foreign investment. Russia's signals are a lot more ambiguous.

Nowhere are those signals being read more carefully and closely than in Europe. For Russia's trade relations there is no getting away from the upmost importance of the EU-Russian relationship, to both parties. The level of interdependence is very high – the EU accounts for half of Russia's exports and Russia is the EU's fourth biggest export partner. Although the US is often seen a key geostrategic partner for Russia, the EU trade relationship with Russia is 16-times larger than that between the US and Russia.

Russia's view of Europe swings between enthusiasm and ambivalence. I have always believed that Russia is the answer to a set of questions for Europe and vice versa. How does Russia prosper off its energy resources, diversify its economy, integrate its economy with the global economy? How does Europe create energy security, expand the trade networks that have built the Single Market, unlock new supply chain opportunities? The answer to all these questions is some variation on a better, closer, more long-term relationship between Russia and the EU. Anybody who tells you different is missing the bigger picture.

Game-changer Is Russian WTO entry a "game-changer" for EU-Russia relations? Probably not. Trade relations remain tense in many respects. Irritants like the new Russian recycling tax for cars, implemented only weeks after WTO entry are seen in Brussels as a dispiriting sign of things to come.

Nevertheless, WTO membership can be the first step in resetting the foundations of the relationship. It has been hard to organise a trading relationship on the scale of that between the EU and Russia outside the framework of the WTO. Russian accession offers a real opportunity to put in place the structures for a more functional, productive and valuable relationship that delivers for both partners. There will

continue to be disputes; in an ideal world these disputes will be resolved through WTO courts, and less politicised.

Overall, the impact of Russian WTO accession is hard to gauge. It is hard to gauge because accession is a necessary, but not sufficient condition for bringing about change.

Exploited to its fullest, WTO accession provides the opportunity for strengthening Russia's relationship with Europe, building wider trade links around the world, diversifying the

"There will continue to be disputes between Europe and Russia – in an ideal world these disputes will be less politicized and resolved through WTO courts" economy, and securing foreign investment. The opportunities are great, but Russia must take further action to realise them. Whether this will happen is dependent on whether Russia sees accession as the end of the process, or just the beginning.

Peter Mandelson was European Trade Commissioner between 2004 and 2008. He is now Chairman of Global Counsel.

8

I Cover story

bne December 2012

In addition to the set-piece reforms to things like the power sector and capital markets, a series of 22 "roadmaps" have been introduced, many of which are directly connected to lifting Russia up the World Bank's rankings, five of which have already been approved.

Moreover, a new sense of pragmatism has entered the Kremlin's rhetoric: unlike the Gref plan of 2000 (Russia's first attempt at systematic reform, named after the then-minister of economic development and trade German Gref), these are roadmaps, not plans: the Kremlin knows where it is and where it wants to get to, but concedes the path it needs to follow is not clear. Russian Prime Minister Dmitry Medvedev's cabinet is in charge of the process and already it has thrown out two roadmaps – the power sector reform and Russia's innovation strategy – because they were unrealistic. The respective ministries have been ordered to go back to the drawing board and told to do better.

Roadmap to reform Ben Aris in Moscow

T

he Kremlin is scared. As the Russian economy emerges from the 2008 crisis, it is sliding smoothly and quickly into stagnation. In response, President Vladimir Putin challenged his government to implement 22 roadmaps to finally address some of the deep structural problems that have made Russia such an unattractive place for business over the last two decades. But the stakes are high, as the economy has already headed into a slump from which it will be hard to recover.

The Kremlin has not been sitting entirely on its hands in the last ten years, but with petrodollars pouring into the state coffers, what has been done mostly dealt with immediate problems. And even this unenthusiastic effort was stymied by the

But Russia can no longer afford to be complacent. It will soon run out of money, as the oil dollars can only be expected to finance state spending for another few years. After that, rising imports and lacklustre growth will make deficits a permanent feature of the federal budget.

panies from next year when all Russia's companies will be forced to use International Financial Reporting Standards (IFRS), which will increase the amount counted as profit several-fold. It has also restarted the privatisation programme with the successful sale of a stake in Sberbank. However, neither of these measures will provide anything like the amount of money needed to maintain Russia's growth. Nothing short of fundamental change will do now.

Already operating on a razor-thin surplus, the government is clearly on the hunt for extra revenue. In the middle of November, a rule to force state-owned companies to pay 25% of their profits as dividends was confirmed – and this will become doubly expensive for the com-

Russia's reform efforts have moved into a new phase. President Putin got the ball rolling in February by calling for Russia to improve its standing in the World Bank's annual "Doing Business" ranking to 50th place by 2015, out of a total of 185 countries, and then to 20th place by 2018.

reluctance of the statists that populate the upper echelons of power and undermined by the stealing.

Cover Story I 9

bne December 2012

Better late than never The 2008 crisis has changed the nature of the game. During the boom years, the Russian economy was supercharged by a combination of sky-high oil prices and abundant cheap debt from abroad that kept economic growth at between 6% and 8% for most of the naughties. The crisis has changed all that and slower economic growth is now a permanent feature, leading economists to call for a new economic model that shifts the emphasis from the public to the private sector – a call the Kremlin seems to be heeding.

The Economic Forecasting Institute of the Russian Academy of Sciences published a quarterly macroeconomic preview in November saying, "the ongoing developments in the economy can already be described as a crisis of the mechanisms of growth and economic management. Other growth mechanisms must be found as government and quasigovernment companies currently provide up to 40% of capital investments."

If anything the task ahead will be even harder than before the crisis, which is when the reforms should have started.

The government-led rescue effort has

resulted in the state actually increasing its share of GDP. A survey by BNP Paribas released in November said that state-owned companies now control 50% of GDP against the global average of 30%, and are particularly strong in oil and gas (40-45%), banking (49%) and transport (73%).

Policy that loosened Communist Party control over commerce from 1925 to stave off economic collapse. Private commerce flourished, giving rise to the "Nepman" – very similar to the crass "Novy Russky" of the 1990s, who became rich overnight from the arbitrage created by the remaining government restrictions.

The government's policy-making was paralysed by domestic politics until May; the powers-that-be had to concentrate all their efforts on securing first the Duma elections in December 2011, then presidential elections in May this year.

However, on the day of his inauguration, Putin went straight from the lectern where he gave his acceptance speech to his desk, where he signed several decrees to slash red tape in the construction sector.

The new reform effort is still very much in the planning stages, but Russia got off to an encouraging start when it moved up eight places in this year's World Bank "Doing Business" survey to 112th place.

"Whilst many changes are relatively minor, we believe that [the roadmaps] add up to a more positive environment for investors," argues Kingsmill Bond, chief Russian strategist for Citigroup in Moscow.

And not a moment too soon, as Russia's economy is already heading into trouble. Economic growth was a relatively healthy 4.9% between January and March of this year, but slowed sharply to 2.9% between July and September. It is expected to remain at these subpar levels next year too. Economists at the Central Bank of Russia say anything under 4% is equivalent to stagnation and Russia cannot afford to fail in its reform effort this time round. "For Putin this is evidently his last chance to get on top of a situation, which is objectively not going his way. And if he does not take advantage of the moment now, he will not have such an opportunity again. It

The fire-fighting approach to reform of the boom years quickly shows up when you drill into the ten variables that go into Russia's ranking. And so does the challenge Russia faces in completing its transformation into a "normal" country.

Russia does surprising well in some aspects. Despite its reputation for lawlessness, Russia ranks 11th out of the 185 countries polled for contract enforcement. And this year it did particularly well in tax administration, improving from 105th to 64th, overtaking the US in the process. This was partly due to the fact it has a very simple flat tax regime for the most important taxes, but also because paperwork has been slashed and punters were encouraged to

"Rising imports and lacklustre growth will make deficits a permanent feature of the federal budget" is also important that the (excessively) repressive policies of recent months allow Putin to act as if from a position of strength, and not one of weakness," says Nikolai Petrov of Carneigie Endowment.

submit their returns online: the number of people and companies filing their tax forms via the internet has jumped from 10% in 2000 to 75% now, according to the Federal Tax Service.

Putin's NEP Petrov has dubbed the roadmap reforms "Putin's NEP" after Lenin's New Economic

However, Russia does less well in many other areas and is amongst the worst in several crucial aspects. Although

10

I Cover story

Putin acted swiftly to launch reforms to regulations in the construction sector, Russia remains in 178th place for the ease of getting construction permits. No progress has been made here at all. Even more surprising, despite being one of the biggest energy producers in the world, Russia is the second hardest place on the planet to get a factory or shop connected to the electricity grid (184th). And especially damaging is the inefficiency of the customs service (162nd). "As to the negative, we have three areas that clearly stand out where the situation is very poor, and it is no coincidence that we have developed roadmaps for these three areas," Economic Development Minister Andrei Belousov said following the release of the ranking. "Customs in particular remains a bottleneck for our entire economic development."

Belousov lashed out at the Customs Service in November, which is supposed to send lists of goods categories ahead of shipping to importers that would cut the time it takes to clear cargo. However, it has only done this for only a few goods and makes everyone else wait in line.

Moreover, the waiting time in those lines has not got shorter.

Encouragingly, it is exactly those things that Russia is worst at that have got the most attention from the Kremlin and the roadmap list closely matches the variables that make up the World Bank's ranking (see table).

Clearly, Putin is very serious about lifting Russia up the rankings over the next half decade. And Belousov was not unduly pessimistic, saying it is still very early days; reforms for construction, customs procedures and connections to electricity grids are only due to be implemented next year. "The roadmaps really only began to be implemented in the second half of this year – just now," said Belousov. "Of all the roadmaps, the implementation term for only five measures has come into effect. Thus we expect the main impact to be next year and in one year‌ The real task that I set is to become one of the top 100 countries in the ranking on these three indicators in the near future. This is completely realistic already next year."

bne December 2012

More progress has been made at the regional level, where a parallel effort is going on. The new administration of Moscow City has taken up the baton and is dealing with the same issues. Deputy Mayor Andrei Sharonov says the average time it takes to process the paperwork for the connection of non-stationary retail outlets to power grids has recently dropped from 3-6 months to 15 days. And next year MOESK, one of Russia's largest inter-regional distribution grid companies, plans to introduce a "single window" for all applicants for 150 kilowatts or less that will reduce the delays further.

Foreign attraction All these reforms are supposed to make it easier to do business in Russia, but they are also specifically targeting foreign investors. If Russia is to modernise, it desperately needs the technological know-how and management skills that come with foreign direct investment (FDI). However, Aton Capital recently released a paper, "Foreign investment into Russia: not that foreign, but very profitable", that showed Russia has one of the lowest levels of FDI per capita in all of Central and Eastern Europe (see "Chart of the Month").

But things are changing slowly as the crisis pushes investors out of Western Europe as much as Russia's emerging middle class pulls them in. Russia is on course to become the biggest consumer market in Europe sometime in 2018 and has already seen a raft of international fast food chains and other consumer companies arrive over the last 18 months, but the trick will be to go up the industrial weight spectrum.

The Kremlin set up the Russian Foreign Investment Advisory Council (FIAC), headed by First Deputy Prime Minister Igor Shuvalov and chaired by the CEO of Ernst & Young, James Turley. The FIAC conducted a survey earlier this year that suggests foreign investors are beginning to warm to Russia and the hope is that the roadmaps will help build the momentum. For example, the number that thought Russia was "enjoying success and attracting investment" had risen from 8% in 2007 to 35% today. Businesses that were "satisfied with the business climate"

grew from 57% to 71%, and the number that thought the government was "taking the right steps" was up from 47% to 72% over the same period. Turley says he is impressed by the government's efforts to cut red tape and believes the roadmaps will reduce the administrative barriers by 94% when fully implemented.

FAIC surveyed 42 large corporations working in Russia and found that red tape is business' biggest concern, followed by corruption and then poor infrastructure. On the plus side, Russia's accession to the World Trade Organization and its large consumer base were the main attractions.

Russia is at another of its periodic crossroads, but this is by far the most serious yet. With economic growth of only 2.9%, Russia is already stagnating.

Indeed, the experts at the Higher School of Economics (HSE), the intellectual force behind reforms, say the macroeconomic forecast in the draft budget for three years to come is unrealistic and Russia's economy could grind to a halt by the end of this year.

In the past, the Kremlin could afford to ignore reform because oil money more than made up for the lack of change. But even with oil currently at around $100 per barrel, the state is barely in profit and growth is slowing. And if the global economy keeps growing slowly, Russia will still only show a GDP growth rate of no more than 1.3% in 2015, predicts the HSE. Rising pension obligations, the increasing bill for imports and the massive amounts that the government needs to spend on things like modernising Russia's infrastructure mean the Kremlin can literally not afford to fluff these reforms.

bne December 2012

Cover story

Agency for Strategic Initiatives: roadmaps to reform – goals and deadlines AREA Customs Rank in 'Doing Business' on foreign trade Import

number of documents

Time to prepare all documents, days

Time of customs clearance, hours Export

number of documents

Time to prepare all documents, days

Time for customs clearance, hours Support of exporters Increase in non-resource exports value compared to 2011 diversification of exports coefficient Electricity connection Rank in 'Doing Business' for electricity connectivity Number of stages to get connection Number of days to get connection Cost of connecting to power network, % of GDP per capita Construction permits Number of procedures Time to get construction permit, days Cost to get construction permit, % of GDP per capita Better access for SMEs to state companies contracts % of state companies purchases from SMEs Property registration Rank in 'Doing Business' for property registration Number of steps to register property Waiting time in government office, minutes % of registrations over internet % of positive feedback on the quality of registration services New business registration Rank in 'Doing Business' for new business registration Number of steps to register new business Time to register new business, days Cost of new business registration, RUB Minimum charter capital, RUB De-monopolization and anti-monopoly policy OECD Product markets regulation index OECD Product markets regulation index rank New business density, businesses per 1000 population % of economic agents, thinking that competitive environment improved Share of state companies in GDP Creation of national system of competencies High productivity jobs, mln % of highly qualified employees Doing business ranking on education quality Doing business ranking on management quality Doing business ranking on innovation Regulation improvement Creation of feedback system for entrepreneurs Better access to state contracts system Better protection of investors' rights Improvement of control over dangerous industrial objects Improvement of tax administration Improvement of business climate in regions Source: www.asi.ru/initiatives/npi/

2012

2015

2018

160

79

17

10 25 96

6 15 24

4 7 2

8 25 72

4 15 24

4 7 2

6% 2.5

35% 3.5

110% 6

183 10 281 1852

60 6 45 938

20 5 40 25

51 423 184

15 130 104

11 56 101

10%

18%

25%

45 5 60 5% 60%

11 1 15 50% 80%

4 1 10 70% 90%

111 9 30 6,100 10,000

60 5 5 3,000 -0

20 3 3 3,000 -0

3.03 39 2.6 24% 40%

2.03 32 3.9 35% 30%

1.53 27 5.2 45% 20%

12 16% 52 110 85

17 22% 35 70 60

STATUS Approved

Approved

Approved

Approved

Developed Developed

Developed

Developed

Developed

In progress In progress In progress In progress In progress In progress In progress

I 11

bne December 2012

to Dubai and then another leg to the long-haul networks of Asia, the Indian Subcontinent, Africa and Australia/New Zealand," he says.

The airline's other CEE routes, to Prague and Moscow, have already been paying dividends. Emirates began a daily passenger/cargo route to Prague in 2010 and has already upgraded the daily flight from an Airbus 330 to a Boeing 777, which has an extra 86 seats to take the total to 364.

Moscow from December 1 will have one of its two daily flights upgraded to an A380 – the double-decker, wide-body, fourengine jet airliner that along with the 777 is becoming the backbone of Emirates' fleet.

Flying high in CEE Nicholas Watson in Prague

B

ne has learnt that Emirates intends to start a new route from its Dubai hub to Poland and grant Russia the ultimate accolade of putting Moscow on its Airbus 380 route list. While such an expansion by the world's largest airline is a vote of confidence in the Emerging European market, it's less good news for the region's struggling flag carriers that are desperately looking to be rescued by such global airlines.

According to Richard Jewsbury, Senior Vice President Commercial Operations of Europe and the Russian Federation, Emirates will begin from February a new daily route to the Polish capital of Warsaw, and is the process of hiring local staff and setting up a call centre there.

The Emirates number-crunchers regard Poland as a definite growth market for both passenger and cargo traffic (Emirates is also the world's second biggest cargo airline after Fedex) given its relatively strong economic performance since the 2008 crisis. "Poland never went into recession following the crisis and while the recession in Europe is having and will have a broader impact on Poland, we still see it very much as a growth market," Jewsbury says. "There's a lot of investment going into Poland, so there's good cargo potential both inbound and out, as well as strong passenger demand inbound and outbound from business and tourism."

Jewsbury adds that Emirates can also take advantage of the fact there's currently little eastbound long-haul competition out of Poland. "Most of traffic travels over the European hubs, so we bring in a fresh new offering in that it is non-stop

Trading places Emirates' expansion in CEE is an acknowledgement of the better growth potential of the emerging part of Europe than in Western Europe, as well as the shift in trading patterns toward the emerging markets that has become more marked since the 2008 crisis.

HSBC’s latest Global Trade Forecast released earlier this year predicts that while overall trade in Europe is expected to grow 80% by 2026, most of that growth will come from CEE countries. Slovakia and Poland, for example, feature in its top three fastest growing exporters in the EU27, increasing activity by 6.37% and 5.93% a year respectively over the next five years. Poland's overall volume of trade is expected to grow at a rate of 110% to 2026, compared with the world average of 86%, while Russia’s overall trade is expected to grow 166% by 2026.

Since the global crisis hit, there's also clearly been a trend of emerging markets trading more between themselves and less with developed markets. China, for example, has already become Brazil’s biggest consumer of raw materials, and will soon be the biggest for Africa too. A 2011 report by Citigroup predicts intra-emerging market trade to overtake trade within the advanced economies by 2015 and to exceed trade

"For the foreseeable future, I don't think you will see us doing any M&A"

Perspective I 13

bne December 2012

Emirates' profits in the six months to September 30 may have soared 68% on year and taken its cash pile to $4.1bn, but it has no intention of using any of that to rescue any of the region's struggling airlines. Czech Airlines (CSA), LOT Polish Airlines, Serbia's JAT Airways, Romania's Tarom, Latvia's airBaltic and others are all trying to avoid a similar fate to Hungary's Malev, which collapsed earlier this year. "The short answer is that in my view, for the foreseeable future, I don't think you will see us doing any M&A because we have to focus all our efforts on our organic growth, whether that be new routes or aircraft upgrades, and that takes all our time and energy," says Jewsbury.

This view appears to be shared by other global airlines.

In June, Turkish Airlines halted its interest in LOT, while Emirates' close competitor Etihad in neighbouring Abu Dabi appears to be in no rush to take up Serbia's offer to take control of JAT. CSA, which the Czech government said on November 9 it was going to make another stab at selling, looks equally forlorn, with the CEO of Cesky Aeroholding, the parent of CSA, saying bluntly on television in November that the risk of not being able to find a strategic investor at the moment "is higher than 70".

Russian FDI – not very foreign, but very profitable

CHART:

R

ussia has a terrible record of attracting foreign direct investment, but what little arrives tends to be extremely profitable.

Most of the investment that Russia has received has been returning flight capital. Cyprus has long been the biggest investor into Russia, accounting for 28.3% of the total investment stock of $455.9bn over the two decades to the end of 2011. However, if you add in the other offshore havens favoured by Russians such as the Netherlands or British Virgin Islands, then Russians account for a staggering 64% of Russia's entire stock of FDI, according to a report released by Aton Capital in November.

But even if the bulk of the investment is Russian, it is still good for the economy and extremely profitable. "Money is money, and investment is investment, and its source is not necessarily the issue. Even if the bulk of FDI is not genuinely foreign, but rather Russian, it still represents funds being spent," says Peter Westin, Chief economist with Aton.

Westin says that the change in the total stock of FDI (that includes reinvested profits) between 1995 and 2011 was $454.2bn against the cumulative inflow of $353.2bn over the same period. "This suggests a return of 28.3% for FDI into Russia. Only seven other emerging markets in the world have done better," says Westin. "If we instead look at the average annual appreciation of inward FDI, we see that Russia, with 90%, is second only to FDI into South Africa."

And Russia is in a league of its own when compared to its BRIC peers: China’s FDI has lost money over the same period and investors also saw their investments depreciate in both Brazil and India.

Even during the crisis years, FDI is still doing very well, returning an averaged 46% between 2009 and 2011 – considerably higher than the 9.3% average return for the other countries of Central and Eastern Europe and a lot more than equity investors earned.

Average annual appreciation of FDI 1995-2011 (%) 140% 120% 100% 80%

between advanced economies and emerging markets by 2030. "There's been a changing face of traffic patterns since the crisis," says Jewsbury, "We're seeing heavy trade between Asia, Africa and South America, many more 'cross flows', and that's driving an increasing amount of our growth."

Emirates' expansion in CEE is certainly a vote of confidence in the region, but offers less hope for the region's struggling flag carriers.

60% 40% 20% 0 -20% -40% -60% -80%

in Pe a Ph B ru ili raz pp il i Al nes b M an al ia Th ays a ia Ta ila jik nd is t Ky Me an rg xic yz o Ar Re m p en ia Co Ch lo ile m bi a Bu Ind lg ia Ge aria or g Az Taiw ia er a ba n i Sl L jan ov at ak via R Ka E ep. za gy kh pt Be sta la n Po rus Uk lan d Ro rain m e Hu an Cz n ia ec ga h r Li Re y th p ua .

Es nia to Tu nia M rke or y oc K co Sl ore ov a e Ru nia S. ss Af ia ric a

I Perspective

Ch

12

Source: UNCTAD, Aton estimates

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bne December 2012

more telling, however, are reports that the estimated cost of the average bribe is up 33-fold over the same period. The rising risk of getting caught taking a backhander has pushed prices up.

And as bne reported at the start of this year, Putin is also playing his part. He started to institutionalise the anticorruption drive this spring, after attacking graft in the utilities sector at the end of 2010. This has resulted in a ban on state-owned companies handing subcontracts to companies whose ultimate beneficial owner is unknown (which usually means the CEO's wife).

Between 40% and 60% of contracts with these faceless companies were broken by state-owned companies in the spring.

Anti-graft drive claims first big fish bne

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n November 6, President Vladimir Putin sacked Russian Defence Minister Anatoly Serdyukov, who is accused of stealing $95m, marking the first time the Kremlin's revitalized anti-corruption drive has reached into the inner circle.

The sacking appears significant and already has the international press asking if this is the start of a serious effort to crack down on corruption.

In fact, the Kremlin has been serious about corruption since Dmitry Medvedev took over from Putin as president in 2007 and began sacking and jailing public servants in earnest.

The trouble was all the figures caught out by the drive were small fry, making it easy for commentators to dismiss the evidence.

The momentum has certainly been building slowly. Russia's score on Transparency International's Corruption Perceptions Index has fallen from a peak of 154 in 2008 to 143 this year. Probably

That was followed by the appointment of Boris Titov as ombudsman for business, who could emerge as Russia's anti-corruption tsar. A vocal critic of the Kremlin during his time as head of a non-oil business lobbying group, Titov's complaints are also seen as constructive, and he is close to Putin.

In his new official role, Titov is about to be given some real powers, which he says he intends to use in a bid to reduce corruption.

Taking it up a notch However, the sacking of Serdyukov ratchets the whole game up a notch, as he is the highest-ranking official ever to be accused of graft. The defence minister was ousted following an investigation into an alleged $95m fraud at his notoriously corrupt office and the very public announcement made on TV on the morning of November 6 was clearly designed to ripple out as far as possible.

Until now, the Kremlin's strategy has been to fire a series of warning shots across the bows of bribe-takers, to get the message across that taking money is

"Serdyukov is the highest-ranking official ever to be accused of graft"

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bne December 2012

no longer acceptable; but it has stopped short of systematically investigating every branch of government. The Kremlin can't go that far – corruption is so pervasive that government would simply collapse if the police arrested everyone who had taken a backhander.

Sergei Shoigu, Russia's most popular politician after Putin himself, has been named as the replacement defence minister. Shoigu is no stranger to the army, serving as a general before becoming the emergency situations minister, and then governor of the Moscow Region (which is separate from the city administration) earlier this year.

At this stage it's not entirely clear how much to read into the sacking of Serdyukov, who has held the post for the past five years. However, for those watching the anti-graft drive build, it was clear early on that, to be effective, someone from the elite would have to be hung out to dry if it was going to succeed. Serdyukov is the unlucky man selected to play that role.

There is also a practical aspect to this sacking: Putin has been pushing to massively increase military spending in order to modernise the armed forces, and clearly doesn't want a big chunk of that cash siphoned off. The president's open criticism of the utilities sector, which also preceded big increases in state investment, illustrated a similar concern.

All that remains to be seen is what, if any, punishment Serdyukov gets, or whether he even goes on trial. Given the Kremlin has taken an incremental approach to dealing with graft, it is entirely possible that Serdyukov will not be charged, let alone jailed. While this will bring down international condemnation for not being tough enough on "cronies", that is not how the elite in Russia will see it. Rather, they will be profoundly shocked by the sacking and Serdyukov's public humiliation. That's likely the goal – it is now clear that no one is exempt from investigation.

The Shuvalov Affair

Michael Weiss of Henry Jackson Society Of all the scandals to rock the Kremlin in recent years, none has been as potentially damaging or as swiftly damage-controlled as the case of Igor Shuvalov, the first deputy prime minister of the Russian Federation.

Beginning in December 2011 and extending into May 2012, two previously little-noticed transactions – one involving the purchase of a sizable stake in an imperiled Anglo-Dutch steelmaker, the other involving Shuvalov's by-proxy investment in Gazprom during its "liberalization" period – have been extensively investigated by the international financial press. Public interest in these deals has been driven, in part, by the tabloid sensationalism of watching some of Russia's oligarchs appear as supporting characters in a melodrama set in the heart of Vladimir Putin's presidential administration.

The "Shuvalov Affair" would be less fascinating if Russia's reputation for transparency and accountability did not make it – as described in US State Department cables – a "virtual mafia state". Journalist Luke Harding summarized these cables' contents in his memoir detailing his time as The Guardian's much-chivvied Moscow correspondent: "Arms trafficking, money laundering, personal enrichment, protection for gangsters, extortion and kickbacks, suitcases full of money and secret offshore bank accounts in Cyprus and Switzerland: the cables unpick a dysfunctional political system in which bribery alone totals an estimated $300bn a year, and in which it is often hard to distinguish between the activities of government and organised crime."

Accused by prominent Russian opposition figures of taking bribes and profiting from insider trading, Shuvalov claims that his family's vast fortune – estimated today to be in excess of $200m – was obtained lawfully and transparently. In this, he has been supported by an array of past and present government officials. Alexander Voloshin, a former chief of staff to both Boris Yeltsin and Putin, wrote on his blog: "Shuvalov is a direct, consistent and principled person of progressive views: He has always been for de-monopolising the economy, for privatisation and for a leaner government. I believe it is for his principles and also his management abilities that the president and prime minister value him. For the same reasons he has plenty of opponents and ill-wishers. And for the same reasons it is now that he is being attacked."

Nevertheless, certain counter-claims advanced by Shuvalov and his surrogates in support of his defence cannot be corroborated with the available evidence. In instances where a proffered corporate document might extinguish all lingering doubt about Shuvalov's business practices, none has emerged. Moreover, allegations of possible conflicts of interest in which Shuvalov profited from companies in which he was, at least tangentially, involved in reforming as a government official are not so easily dismissed as his defenders suggest. Most of the controversy surrounding Shuvalov has been rebutted or contextualised by unnamed sources, who various press organs have described as having close ties to him and his activities during the episodes in question. However, other anonymous sources contradict these claims.

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general power of attorney for Krini Holding. In 2004, Krini Holding took a loan of $40m from Parex to purchase an energy company Severneft, which held a licence issued for a gas field on the hydrocarbon-rich Yamal Peninsula.

Eduard Khudainatov's brother Zhan than became CEO of Severneft.

Latvia's bad bank guns for Rosneft deputy Graham Stack in Berlin

L

atvia's asset recovery vehicle Reverta is gunning for Zhan Khudainatov, the brother of Rosneft deputy CEO Eduard Khudainatov – and possibly for Eduard himself, bne can reveal. According to Reverta, the Khudainatovs have defaulted on loans totaling $78m – and have now resorted to gross fraud to ditch their creditors, lawyers claim.

The case highlights the conflicts of interest, fraud and corruption at the very top of Rosneft, now the world's largest listed oil company, and gives an idea of the kind of issues that awaits BP as it becomes a 20% stakeholder in Russia's new national champion.

Reverta, the "bad bank" successor organisation to the nationalized Parex bank, tells bne that a mysterious Swiss company called Krini Holding Limited, linked to Rosneft deputy CEO Eduard Khudainatov and his brother, took out over $100m of loans from Parex through 2008, acquiring a Siberian gas company and building processing facilities. The assets were sold in early 2012 for just over $400m, but most of the loan was never repaid, forcing Reverta

to take court action in Russia against the companies and individuals.

The $400m side-business allegedly sold this year by Rosneft's deputy CEO Khudainatov – a state executive throughout almost his entire career – encapsulates how the Kremlin's tightening grip on energy has twinned with officials making vast private profits. This is the

Khudainatov at the time was not a private businessman, but CEO of the state-owned Gazprom subsidiary Severneftegazprom, developing the massive Yuzho-Russkoe gasfield also on the Yamal Peninsula. His apparent undisclosed private business interest in the gas branch thus created a glaring conflict of interest.

There seems little doubt Eduard Khudainatov was the main man at Krini Holding. "We have documents showing a general power of attorney of Eduard Khudainatov for Krini Holding, his personal guarantee for the company and proof that he personally performed a number of transactions on behalf of the company," says Viktoria Burkovskaya of Moscow law firm Egorov Puginsky Afanasiev & Partners, which is representing the Parex successor company Reverta in Russian courts. "These documents point to Eduard Khudainatov's close mutual ties with the company."

Rosneft failed to respond to email, fax and telephone enquiries on the matter

"During the Parex change of ownership in 2008, shareholders stole certain documents pertaining to key bank deals with Russian customers" elephant in the room that BP will now confront following the deal agreed in October that will see the UK major take a 20% stake in Rosneft following a merger with its Russian joint venture TNK-BP. Conflicts of interest According to documents seen by bne, in 2004 Eduard Khudainatov held a

over the course of a week. Eduard Khudainatov has previously denied any link to Severneft or Severorgsintez, or any linked companies.

In 2006-08, an affiliate of Severneft, Severorgsintez, took a further $87m in loans from Parex to construct processing facilities on the Yamal Peninsula for gas extracted by Severneft. The loans

bne December 2012

were guaranteed by Severneft, and Eduard Khudainatov in 2006 provided a personal guarantee for Severneft, according to documents seen by bne.

Loan repayment on the Severorgsintez loan was due to start in 2010, but nothing was paid back. Parex/Reverta started legal moves in Russia to reclaim the debt, one of their 10 largest outstanding loans.

The Khudainatovs then took very evasive action: in August 2011, Severneft assigned its assets and licence to a new subsidiary, Severneft-Urengoy.

Severneft and Severorgsintez then simply liquidated themselves, despite the outstanding loan. Adding insult to injury for Reverta, in January SeverneftUrengoy was sold to Russian chemicals giant Eurochem for a whopping $403m, roughly four-times the investments made in licence and facilities by the Severneft owners.

Seeing their clients flush with cash while welshing on debts, Reverta took off the kid gloves and filed a complaint of gross fraud against Zhan Khudainatov and other directors of Severneft and Severorgsintez in April 2012 – offences that carry a minimum five-year sentence in Russia. "The case is at the pre-investigation stage," says Burkovskaya.

Dance of the PEPs Khudainatov's rise to riches started when in early 2000 he headed Vladimir Putin's first presidential electoral campaign in the Yamal-Nenets autonomous district, part of the Tyumen region, where most of Russia's vast oil and gas reserves are located. And when Putin was elected president in March 2000, he duly named Khudainatov the federal inspector for Yamal-Nenets, tasked with ensuring the Kremlin's writ ran in the district.

Yamal-Nenets soon became the scene of a fierce war waged by the Kremlin under Vladimir Putin and his new Gazprom management to regain control of the huge Yuzhno-Russkoe gasfield, which the previous 1990s Gazprom management had mysteriously divested to private gas trader Itera. In 2002, the

Eastern Europe

Gazprom's woes deepen

bne Already embattled at home and abroad, the Russian gas company Gazprom is facing the daunting prospect of losing up to 40% of its domestic clients after their long-term contracts come up for renewal next year it has emerged.

Gazprom is already feeling the heat from domestic independent producers – especially Novatek – which already account for a quarter of domestic gas supplies. Gazprom's domestic sales have fallen from an estimated 307bn cubic meters (cm) in 2007 to a forecasted 270bn cm this year.

Abroad, many European customers are successfully renegotiating their gas supply contracts with Gazprom, thanks to the increased competition from shale gas and other gas suppliers. This situation is only expected to get worse after increased supplies of liquefied natural gas (LNG) become more widely available in the coming years.

Now Gazprom director Gennady Sukhov admitted to the local press in November that 88.8bn cm of contracted supply out of a total of 281bn cm sold on the domestic market in 2011 – a bit more than half its total production – is up for renewal next year. Worse, all the domestic contracts in question are for commercial supplies of gas and are amongst its most attractive.

Novatek has aggressively been stealing clients from Gazprom since 2009.

Russian power producer Fortum and German energy holding E.ON both switched to Novatek earlier this year. Meanwhile, Gazprom's share of gas sold to state-owned utilities giant Inter RAO has fallen from 57% in 2011 to a forecast 29.7% for this year, and could drop below 20% by 2013, local daily Vedomosti reports. Gazprom's diminishing share could be further eroded by the entry of a new player in the market after state-owned Rosneft set up a gas business in November, which will start supplies from 2016, including to Inter RAO. The state is clearly becoming increasingly worried about Gazprom's future. President Vladimir Putin publicly lambasted the company earlier this year, telling it to "meet the new challenges" and work out a new export strategy. The lack of political support the company seems to be receiving in the face of this growing competition suggests the government is toying with the idea of breaking the company up into its export and domestic constituent parts.

I 17

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company holding the licence, Severneftgazprom, was finally returned to the Gazprom fold – and Khudainatov made CEO in 2003. Yuzhno-Russkoe, which went into operation in 2007, is now the main supplier to the Nord Stream pipeline, via which Russia directly supplies gas to Germany under Baltic Sea. Thus Khudainatov's apparent private acquisition of Severneft in 2004, as alleged by Reverta, seems the flipside to the Kremlin's tightening grip on the energy sector – and could count as a reward for loyalty.

And according to bne enquiries, the counter-party in the Severneft deal was another top state energy official, Semen Vainstok, who was at the time CEO of state oil pipeline monopolist Transneft.

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the Kremlin's inner circle buying him immunity. Vainstok left Russia for Israel in 2008, with no criminal charges ever brought. He could not be reached for comment.

Ironically, the murky background to the Parex-Severneft loans may also now let the Khudainatovs off the hook – at the expense of Latvian taxpayers who bailed out the bank in 2008. Anti-money laundering legislation demands tight scrutiny of banking arrangements for state executives, known in the jargon as politically exposed persons (PEPs). But Parex before nationalisation in 2008 flaunted the regulations, specialising in dodgy banking services for PEPs. "The bank's philosophy was that all commercial loans should fund bribery," former

"Loan repayment on the Severorgsintez loan was due to start in 2010, but nothing was paid back" Before its sale to Krini Holding, Severneft was owned by oil company GorizontNeft and Stroikredit Bank, both closely linked to Vainstok at his old stamping ground of Lukoil-West Siberia, according to company documents seen by bne.

In 2007, Russia's accounting chamber investigated Transneft's finances under Vainstok's watch. According to the report, as leaked to anti-corruption blogger Alexei Navalny, during Transneft's construction of the East-SiberiaPacific oil pipeline some $4bn had been siphoned off by 2007 by structures believed linked to Vainstok, including by Stroikredit Bank.

The Severneft 2004 deal points to Vainstok's close commercial ties with

head of international relationships at Parex, John Christmas, tells bne.

The murkiness means that documentation of the Severneft loans is incomplete. "During change of ownership in 2008, documents pertaining to key bank deals with Russian customers including some originals of the Severorgsintez collateral agreements have vanished," says Burkovskaya. "As our internal check is still proceeding, we cannot comment on this situation further before the end of that check."

BP's Sechin question The $400m question regarding Eduard Khudainatov is: who pushed his rise to the top, and did they take a cut in the side business?

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The one man who stands out in promoting Khudainatov's career is Igor Sechin, Putin's energy tsar, now CEO of Rosneft.

In 2008, after the Yuzhno-Russkoe field went online successfully, the then deputy PM Sechin promoted Khudainatov to be deputy head of Rosneft, where Sechin was chairman of the supervisory board. Then in 2009, Sechin made Khudainatov CEO of Rosneft. In March this year, re-elected President Vladimir Putin made Sechin CEO of Rosneft, and Khudainatov – who is reported to refer to Sechin simply as "the boss" – humbly stepped back down to deputy CEO without a murmur of complaint.

Sechin for his part in January, when still deputy PM with a remit for energy, obliged state energy executives to disclose their and their families' assets as part of a belated anti-corruption drive after mass protests in Moscow – but exempted Rosneft from the order.

Sechin said Rosneft met with obligations voluntarily but it is not known that Khudainatov disclosed large cash holdings. Rosneft discloses only that Khudainatov holds a stake of 0.0605% in Rosneft, worth $43.5m at current market cap.

According to Putin, BP's recent decision to take a 20% stake in Rosneft and two seats on the board should lead to greater transparency in the company. But the example of Khudainatov's business interests on the side – a rule rather than exception in Russia – will be a warning to BP of the compliance risks entailed in Russian state business. “Those seats could help us influence corporate governance,” BP's press service tells bne, but would not comment on what conditionality over hiring they will seek from Rosneft.

I 19

Magnit more than doubled its profits in the first half of the year and is rapidly closing the gap on its main rival X5 as Russia's biggest supermarket chain in terms of revenues. Yet it still only has a 4.2% market share and all the top five players together control only 16% of the business, according to VTB Capital.

Cutthroat competition All the chains are seeing similar results, with the growth of the Russian food retail market expected to average 7.8% in 2011-2015 – though that's still down from the boom years growth rates of around 17% a year in 2007-2011, according to Rosstat.

Russia's store wars Ben Aris in Moscow

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ussia's economy may be slowing, but the supermarket business there is flying. If Poland famously was the only EU country not to go into recession in 2009, then Russia's organised retail sector was the only one in the region to see sales and investment continue to climb at the same pace as before the bust at the end of 2008.

There are several factors going into supporting Russia's food courts and hypermarkets. Wages continued to rise throughout the crisis, while unemployment is currently at a 20-year low of 3.8%. The last item that consumers cut in times of trouble is food. But most importantly, the organised retail sector is a blue-sky sector with years of growth ahead of it.

And this year's flu epidemic in Russia – an annual occurrence – was unusually mild, leaving more Russians than usual with healthy appetites.

Magnit remains the investor darling.

During the worst of the downturn three years ago, the company actually reported a 33% increase in sales as Russians abandoned more expensive imports for cheaper Russian-made

food products that are Magnit's stock in trade. And revenues were up by the same amount over the first seven months of this year.

The company didn't slow its investment programme, opening hundreds of new stores, and saw its annual revenues climb above $10bn for the first time.

This year, the company will have opened nearly 600 stores of all formats

This slowdown is leading to cutthroat competition. "We see several opportunities for growth that could help us get ahead of our competitors in a year or two. The key objective for us is to constantly seek out new opportunities and also be aware of what our competitors are doing. It then takes them a year or two to catch up," Sergey Galitskiy, Magnit's founder, told investment bank Renaissance Capital.

"For example, we are trying to catch up with X5 in terms of sales volume, while they are busy acquiring questionable assets for ridiculous amounts of money."

X5 is giving Magnit a run for its money.

The company, owned by the Alfa Group, is growing fast and expects to

"We are trying to catch up with X5 in terms of sales volume, while they are busy acquiring questionable assets for ridiculous amounts of money"

by the close of the year, up from the 5,722 outlets it operated as of August.

Magnit is growing so fast in some towns that the Federal Anti-monopoly service (FAS) accused the company of breaching Russia's anti-trust rules and exceeding a 25% market share in a town in the Ulyanovsk region.

see revenues up by 8% to top $16.6bn by the end of this year, according to Metropol. X5 bought the discount chain Kopeyka earlier this year and is in the process of rebranding all its stores.

However, the company has been hit by the loss of its CEO, Andrei Gusev, who quit in July and has yet to be replaced.

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Ukraine's Akhmetov becomes richest man in CIS Ukrainian businessman Rinat Akhmetov has overtaken Russian tycoon Alisher Usmanov to become the richest man in the Commonwealth of Independent States, marking the first time that Russia has been ousted from the top slot.

Akhmetov owns 100% of Donetsk-based conglomerate System Capital Management Group and has a net worth of $18.9bn, according to Bloomberg's "The World's 200 Richest People" ranking. Akhmetov's wealth increased by $4.5bn this year. Usmanov controls Metalinvest and made a packet from an early investment into Facebook, and is estimated by Bloomberg to be worth $18bn.

His assets grew by a "mere" $660m this year.

Akhmetov is also richer than Lakshmi Mittal, the owner of a bigger metallurgical asset, ArcelorMittal, who also has investments in Ukraine. Over the year, Mittal lost $880m, which ranked him at 41st with a net worth of $17.4bn.

Mexican telecommunications mogul Carlos Slim remains the richest man in the world with $77.5bn, followed by Microsoft co-founder Bill Gates with a net worth of $64.4bn.

Akhmetov's appearance at the top of the CIS list is surprising, as the Ukrainian economy has been deteriorating all year while the Russian economy is growing relatively strongly. Akhmetov is the only Ukrainian on the list that includes a total of 20 Russian names. Amongst the other names are: Leonid Mikhelson at 42nd with $16.9bn; Viktor Vekselberg is 43rd with $16.8bn; Vladimir Lisin at 44th with $16.7bn; Alexey Mordashov at 48th with $15bn; Roman Abramovich at 51st with $14.7bn; Mikhail Fridman at 53rd with $14.4bn; Mikhail Prokhorov at 55th with $13.9bn; and Vladimir Potanin at 58th with $13.8bn.

The only other non-Russian CIS member in the top 100 is Georgia's new prime minister, Bidzina Ivanishvili, with a net worth of $6.3bn.

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The Dixy Group, which specialises in small format local stores, was up to over 1,200 stores by August and saw revenues rise by 21% over the same period to just under half a billion dollars. Its growth has been accelerated after it bought a smaller rival, the Victoria chain. In addition to the merger, the company rolled out another 165 new stories over the first seven months of the year (101 were opened in May and June alone) and wants to have opened 300 new stores by the end of the year.

Discounter O'Key by September had expanded its staff by a third from the year before and has seen margins go up by a quarter over the same period.

And the company also intends to spend $20m on buying one new hypermarket and several new stores to maintain its fast pace of growth. Over the next two years, the company will spend

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Eastern Europe

11% stake if he can. Lebedev already sold part of his holding in the airline last summer, but the speed of his retreat from Russia seems to be gathering pace.

another $25m on rolling out 100 new convenience stores and six new hypermarkets.

Despite all the growing room, the supermarket business (along with things like mobile phones) is already a modern market-based sector that is very similar to its peers in the West.

Going forward, the fierce competition between the rival chains is starting to make itself felt as the easy gains are exhausted. "Rising saturation is pushing retailers to add new formats and expand geographically, which will inevitably lead to a consolidation phase in two to four years," says Andrei Nikitin, a retail analyst with Alfa Bank.

In August, Magnit announced it was going to invest â‚Ź350m into farming as a way of producing its own brands and so cutting costs, opening up a new front in Russia's store wars.

Lebedev at Chatham House in 2012

Lebedev cashing out of Russia bne

"Saturation is pushing retailers to add new formats and expand geographically, which will inevitably lead to a consolidation phase in two to four years"

I 21

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ussian tycoon and owner of the UK's Evening Standard and The Independent newspapers Alexander Lebedev has been selling off assets recently in a move that looks like he is leaving Russia.

The flamboyant Lebedev, thought to be worth $1.1bn by Forbes magazine, is maybe best known for a punch-up when he knocked real estate businessman Sergei Polonsky off his chair during a live TV debate on Russia's NTV channel in September 2011.

The former professional boxer and ex-KGB spy was later charged with hooliganism for that incident, but has never been close to the Kremlin, which sees him as a quisling and has pressured him to sell some of his more strategic assets. In August, he seemed to give in, announcing that he was pulling out of Russia due to the "relentless pressure" by the Kremlin. "I simply have no other choice, because over the past three years my business was being purposefully and deliberately destroyed by Directorate K

of the Federal Security Service (FSB), the Economic Security Service of Russia," Lebedev wrote on his blog post at the time.

On November 5 Lebedev announced he will shut all the regional offices of his cash cow, the National Reserve Bank

At the end of 2011, Lebedev's National Reserve Corporation (NRC) agreed to swap its 25.8% stake in aircraft leasing company Ilyushin Finance for several aircraft and a debt restructuring, starting his withdrawal from the aviation sector. He then sold his two radio stations, Pioner Radio and Dobriye Pesni, to billionaire Mikhail Gutseriyev for $14m in March this year. And in October this year he sold his 49% stake in failed budget carrier Red Wings to an unnamed company registered in Cyprus.

Coincidently, within weeks of the deal the state announced new rules that will make it significantly easier for budget airlines to operate in Russia and EasyJet is supposed to add a Moscow-London route starting next year.

Lebedev's TV punch-up may be the catalyst that has accelerated his selling after the state brought charges earlier this year of "a politically motivated grave violation of public order" that could earn him a long spell in prison.

The outsider Lebedev's years as a senior KGB officer should have been a golden pass into Russia's ruling elite. But while it got him started, he has always remained a Kremlin outsider.

"The TV punch-up may be the catalyst that has accelerated his selling after the state brought charges earlier this year" (NRB), and sell off the real estate as well as 75% of the bank's loan portfolio, worth RUB16.8bn ($542m), according to Russian business daily Vedomosti citing Lebedev.

The same week he sold a 1.5% stake in Russian national air carrier Aeroflot on the open market for a reported RUB40 per share, and also told the Russian press he intends to unload his remaining

His career began in banking when NRB was a client bank of state-owned gas monopolist Gazprom in the early 1990s.

However, despite his good connections with Russia's elite, he never benefited from these ties overtly. As a fluent English speaker he was often on TV in the 1990s overtly criticising Boris Yeltsin's government, much to the Kremlin's chagrin.

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"While Lebedev's years as a senior KGB officer got him started, he has always remained a Kremlin outsider"

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The 1998 financial crisis nearly wiped Lebedev out, but once the boom got going in about 2004 he re-emerged on the national stage and became very active in the aviation industry, taking a large minority stake in Aeroflot and setting up aviation leasing company Ilyushin Finance.

2003 and 2007, again vocally criticising the government, especially through his co-ownership of liberal Russian newspaper Novaya Gazeta. He is also a contributor to opposition leader Alexei Navalny's Anti-Corruption Fund, which has received donations from other reform-minded senior businesspeople.

He also told this correspondent in an interview at the time he personally suggested to Vladimir Putin, then as now president, setting up the United Aviation Company, Russia's aviation national champion – an idea the Kremlin picked up but without Lebedev's participation.

But seeing the writing on the wall, Lebedev began actively preparing an escape route. In January 2009 he bought the troubled Evening Standard for ÂŁ1 and began his move to London, adding The Independent a year later for the same price.

Later in the decade he made a nuisance of himself as a Duma deputy between

to force exporters to sell half of their hard currency revenues to the state.

The state's foreign currency reserves have tanked in recent months, dropping below the crucial three-months of import cover economists say a country needs to maintain the stability of its currency.

The population is beginning to panic and bought 20% more foreign currency in October, according to the NBU, or $2.169bn in total. The central bank has been forced to dip into its reserves repeatedly to defend the hryvnia, contributing to more than a $11bn drop in reserves to $26.8bn as of the end of October, falling 8.5% in October alone.

Whither Ukraine?

Ben Aris in Moscow

S

imilarities between the US and Ukraine are not immediately obvious, but both countries have just completed presidential elections where the incumbent won, and both are headed toward an economic crisis which if ignored will have severe consequences for their economies. But Ukraine is in a much worse position; while pundits seems pretty confident that US politicians will thrash out some sort of deal

to prevent the economy going over the "fiscal cliff" and back into recession, the chances of Ukraine suffering another destructive devaluation of the hryvna are much higher.

In a move that smacks of desperation, on November 19 the National Bank of Ukraine (NBU) announced it was going to use new powers handed to it by the Rada (parliament) at the end of October

Economists estimate the hryvna is between 10% and 20% overvalued. The exchange rate was UAH5 to the dollar for several years, but slumped to about UAH8 to the dollar after the collapse of Lehman Brothers in 2008 and the government has been propping it up ever since. The currency lost 44.6% to the dollar between September 2008 and September 2009, but has stabilized at about UAH8. "All these problems are impacting the economy, which slumped to 1.2% in the third quarter, down from 2.5% in the first half of the year, and was in negative territory in October for the first time since the fourth quarter of 2009," says Dmitry Sologoub, an analyst

bne December 2012

with Raiffeisen Bank International. "The economy is likely to finish the year with little more than 0.5% growth for 2012 and a further worsening cannot be ruled out with growth falling to zero."

Stand-by me The mandatory sale rule is a throwback to the chaos of the 1990s and Ukraine was amongst the last countries in Eastern Europe to abandon the rule in 2005. NBU spokesman Oleksandr Kutereshchyn said in the middle of November that the mandatory sale rule would only be in place for six months and it seems the game plan is to buy some time while the government negotiates a bacon-saving deal with the International Monetary Fund (IMF) to re-start the stalled $15.4bn stand-by loan agreement. However, the IMF has dug its heels in and insists on hikes to domestic gas tariffs and more flexibility in the exchange rate, neither of which the government seems willing to contemplate. Indeed, the mandatory sales rule is clearly designed to maintain exchange rate stability and is diametrically opposed to the IMF's stand on the currency.

With Ukrainians in a foul mood following the irregularities in the election that saw President Viktor Yanukovych re-elected, the government appears more interested in maintaining

Eastern Europe

social stability than dealing with the brewing crisis. But the government can't keep this up for long. The hryvna is also under pressure from the widening current account deficit, which also deteriorated sharply in September to $9.3bn in the first nine months of the year from $5.9bn in the same period of 2011, as demand for exports, especially steel, withered on world markets and imported energy costs rose.

Raiffeisen's Sologoub is even more pessimistic about next year and Ukraine's future will depend greatly on what happens in the rest of the world. With little tools available to the government, the only thing that will stave of a worsening crisis is a recovery in the demand for steel. Barring that, the situation will continue to deteriorate.

Still, despite the darkening picture the government has two get-out-of-jail-free cards to play. Either it can cave into the IMF's demands and tap its standby loan, or it can cave into Russia's demands to join its Customs Union that comes with a big sweetener: Russia has promised to slash Ukraine's cost of gas to $160 per thousand cubic metres from the current $424, which would go a long way to alleviating the pressure on the hryvna.

"Either Ukraine can cave into the IMF's demands and tap its stand-by loan, or it can cave into Russia's demands to join its Customs Union"

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bne:infrastructure

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

Register and sign up for the list here: www.businessneweurope.eu/ users/register.php

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According to the minority investors, this state-led split of Parex into a "good" bank and a "bad" bank, leaving the minority investors in the bad bank, was unfair. "They left us in Parex bank and transferred all of the good assets out without any permission from us. It was an expropriation by the state," argues Antti Partanen, a senior fund manager at Danske Capital.

Now the investors have given the Latvian government an ultimatum – give up shares in Citadele or face international arbitration. "We are still talking with the government, but we are ready to move into international arbitration in Stockholm at any time," Partanen says.

Latvia's Parex-ysms continue Aaron Benjamins in Riga

N

ovember marked four years since the collapse of Latvia's then second-biggest bank Parex, an event that pulled the country deeper into the global financial crisis and nearly bankrupted its banking system. But even as the country's banking sector recovers and economic growth in 2012 looks as though it will top 5%, the fastest in Europe, Parex's former minority shareholders aren't celebrating.

Danske Capital, Firebird Management, KJK Capital and East Capital, who collectively have nearly €100bn in assets under management, together owned over 8% of Parex before its implosion. And like the bank's other minority investors, they lost out when the bank was effectively nationalised in 2009. But now they say the Latvian government is endangering its own reputation among international portfolio investors by refusing to

compensate such shareholders, who claim the state illegally diluted their shareholdings and expropriated private property by transferring Parex's healthy assets into a "good" bank founded in 2010 called Citadele.

After Parex collapsed in November 2008, the government intervened to prevent

in which the minority investors held no shares, but the state holds 75% and the European Bank for Reconstruction and Development (EBRD) 25%.

Citadele has continued to develop its commercial banking operations and finally returned to profitability this year. Parex, on the other hand, lost its

"They left us in Parex bank and transferred all of the good assets out without any permission from us – it was an expropriation by the state" a systemic bank failure, ultimately buying 85% of the shares from major share holders for a nominal one lat. In 2009-2010, the bank's share capital was raised, while many of the remaining healthy assets were transferred out of Parex into the newly created Citadele,

banking licence and continued to hold the toxic assets. Its name was changed to Reverta, and its sole business activity for the past few years has been to try to recover as much as it can from the non-performing loans it's still lumbered with.

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He warns that the investors would immediately launch arbitration proceedings if the government tries to sell Citadele – the ultimate goal of the state. "Our shareholding in Citadele, after the dilution, is 2.36%; if they sell the bank, then there will be no more point talking and we will go to Stockholm."

The Latvian government needs to take notice, the investors argue, because the bad publicity associated with court proceedings could scare off future investors, such as those the state hopes will participate in the coming yen bond issue. This could, among other things, raise the borrowing costs of a country that is already considered a worse place to invest than its Baltic neighbours Estonia and Lithuania, they say. "There is a reason the daily volumes on the Tallinn board of the [Nasdaq OMX stock market] are ten-times higher than in Riga, despite being a smaller country," says Kustaa Aima, a partner of KJK Capital, another minority investor in Parex. "Equity investors have not put in a large amount in Latvia compared to elsewhere. The allocations to Latvia are going to be smaller and smaller – they need to be more dedicated at attracting portfolio equity investors."

Harvey Sawikin, co-founder of Firebird Management, which has some $1.25bn in assets under management dedicated to Central and Eastern Europe, says he is unhappy with regulation and the judicial

system in Latvia. "It's not the first time we have been screwed," he complains.

"We have got to the point where we thought we weren't wanted there."

The real losers Vladimirs Loginovs, Head of Commercial Department at Latvian Privatisation Agency, the state body that currently holds the government's 75% stake in Citadele, disagrees that investors are shunning his country because of a bad reputation among portfolio investors. Moral hazard, he says, is the government's key concern – the investors simply made a bad investment choice, and they, not Latvian taxpayers, should bear the cost of that. "Instead, we are seeing that they are going after the deep pocket of the state. They know we don't want to have a scandal, so they are using blackmail for this," he says.

He points out that the state still has around LVL700m (around €1bn) invested in the bad bank Reverta and Citadele, and that it will likely lose much of this. "We know for sure LVL200m in Reverta is lost. I don't like the argument [posed by the minority investors] that the state ripped them off and we are now enjoying life. I think the taxpayers of this country will ultimately pay much more than those funds."

He also dismisses the investors' charge that the government illegally transferred assets from Parex into Citadele. "The split and transfers were made at fair value and in accordance with the laws, and with the full knowledge and approval of the European Commission," he says.

But he acknowledges that the Latvian government is in a difficult position.

It needs to sell Citadele as part of its bailout agreement with the International Monetary Fund (IMF) and the bank rescue agreement with the European Commission. Previous efforts by advisor Nomura Securities to find a buyer failed last year. Now, Loginovs says, a partial sale via an IPO on the Riga bourse is one of the options being considered – but the minority investors are a big obstacle to this.

"Even a small tranche of LVL25m-40m would be hard for the market to absorb, so yes we need every investor," he says.

He points out that the funds complaining over the Parex collapse are exactly the sort needed – smaller ones focused on the region. "I think an offering of a stake in Citadele would be off the radar of bigger funds managing money in London or New York," he says.

"We want to have good relations with these investors, but at the same time the Latvian government does not respond to blackmail, and it does not give out shares in Citadele Bank for free. If they want shares in Citadele, we are willing to discuss selling them shares."

In response, Danske Capital's Partanen asks rhetorically: "Why should we pay for shares that we already own?"

In court The investors have already been to court over the matter. They claim they won in a judgment last October in Latvia's Constitutional Court, which ruled that the method used by the state to increase the share capital in Parex without permission from minority shareholders was unconstitutional. Yet the court did not order any compensation for the investors. "It wasn't retroactive, so [the decision] didn't help us, but it could help us in any future arbitration proceedings," Partanen says.

More recent litigation over the sale of Parex's Belarus leasing company may also help in arbitration proceedings, he says, by helping in the discovery of new evidence.

The arbitration in Stockholm would focus less on the alleged share dilution, and more on what the investors claim was an illegal transfer of assets out of Parex and into Citadele, Partanen says. "It was theft by the state, which is in contravention of bilateral investment treaties signed by the Latvian government."

Loginovs says the method the state used to increase the share capital of Parex won't be used in future.

But despite the decision of the Constitutional Court, he still rejects the claims of the investors.

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Unsurprisingly, CEZ played down the latest bump in what is becoming an increasingly disjointed tender process, pointing out to bne that such an order is unlikely to have any influence on the tender because the company is not planning to award the contract until next year anyway.

A nuclear freeze Nicholas Watson in Prague

T

he Czech competition authorities have temporarily blocked the state power company CEZ from signing a contract to build two nuclear reactors while they consider an appeal from France's Areva against its disqualification from the tender, but stopped short of suspending the whole tender procedure as the French company had requested.

The decision of the Office for the Protection of Competition (UOHS) may not be the body blow to the tender that Areva, angry at its exclusion, is trying to engineer. But it certainly injects more uncertainty into a process that is becoming increasingly messy since CEZ's surprise decision on October 5 to turf the French state nuclear company out of the tender to expand the Temelin plant, leaving only Toshiba’s US subsidiary Westinghouse and a Czech-Russian consortium to contest the estimated CZK200bn300bn (€8bn-10bn) project.

In a written statement emailed to bne, the chairman of the UOHS, Petr Rafaj, said that: "the Office imposed on the contracting authority CEZ a ban to conclude the contract in the award

procedure of a completion of the Temelin nuclear power plant." However, in a decision that will give CEZ some comfort, Rafaj said that: "the Office rejected the Areva proposal to suspend the award procedure" – something the French firm said it would push for after CEZ rejected on October 30 its attempt to get back into the tender.

Effectively, UOHS is saying that it won't freeze the tender procedure, but CEZ can't accelerate the process by choosing a winner now and signing the contract while a legal appeal is still pending.

That's true, though some analysts point to the notoriously slow decision-making at UOHS, something which is only likely to be exacerbated by the hugely complicated (and highly sensitive) nature of this case. On November 9, UOHS told CTK that it has set up a special team to pour though the 60,000 pages of documentation and will seek a number of expert opinions. Because the case is so complex and extensive, the office said it cannot estimate when it will make a decision.

Dark matter These further complications raise yet more questions about why exactly CEZ chose to risk the fate of country's flagship tender by disqualifying Areva, rather than letting the process run its course and choosing either the Russian or American bid, both of which have strong backers amongst the Czech elite. Westinghouse has received strong support from the White House and also partnered up with the famously wellconnected construction firm Metrostav; Vaclav Klaus, the Russophile Czech president, hinted at the end of last year that he favours the Russian-led bid.

bne December 2012

Central Europe

In particular, Necas singled out the fact that Areva "ostentatiously refused to commit themselves to a final price."

However, sources close to the French side dispute this, saying Areva submit-

the two other bidders' submissions yet they were given the opportunity to clarify these at meetings, have spawned many murky theories. One has it that faced with insurmountable financing

"We don’t think this endangers the process – it may even accelerate it, since it's obvious that negotiating with two is easier than negotiating with three" ted a final price, only with the caveat that it could be even cheaper depending on market conditions.

This, as well as the claim that CEZ flagged up only nine issues with Areva's tender submission and failed to contact the French company over any of them, while many issues were found with

difficulties, CEZ management has found a way to abandon the controversial project while saving face by blaming the French.

For its part, CEZ has only said that its decision to dump Areva out of the tender involved both commercial and legislative reasons, which analysts say

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

To further prevent such a situation from arising, sources tell bne UOHS also informed CEZ that any changes it subsequently makes to the tender must be reported to the office within 24 hours.

could mean anything from personnel issues to technical or legal problems.

And Areva is receiving scant support from the other bidders. "Our view is that CEZ made it very clear from the beginning that there were certain rejection criteria that if tripped would create a situation where you would be eliminated from the process and that was understood by everyone: clearly Areva tripped that rejection criteria," Mike Kirst, Westinghouse's EMEA vice president for strategy and external relations, told bne on October 31.

Kirst went on to say that he didn't think Areva's disqualification would have any long-term impact on the tender. "We don’t think this endangers the process – it may even accelerate it, since it's obvious that negotiating with two is easier than negotiating with three."

The latest news would appear to upset that sanguine view.

| Eastern Europe | Russia | Belarus | Ukraine | | Central Europe | Estonia | Latvia | Lithuania | | Poland | Czech | Slovakia | Hungary | Southeast Europe | Slovenia | Croatia | Serbia | Romania | | Bulgaria | Turkey | Moldova | Albania | Bosnia | | Croatia | Macedonia | Montenegro | Kosovo | | Eurasia | Kazakhstan | Georgia | Uzbekistan | | Kyrgyzstan | Turkmenistan | Tajikistan | | Azerbaijan | Armenia | Mongolia |

In what has been described as a testy interview by a normally unflappable

What you need to know

"Unsurprisingly, CEZ played down the latest bump in what is becoming an increasingly disjointed tender process" prime minister, Petr Necas told local daily Hospodarske noviny on November 2 that Areva's exclusion was entirely the fault of its local team, who "failed managerially… to place a bid in line with the public procurement law."

Sign up today for a free month trial of all our services

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www.bne.eu

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This should alleviate some of the pressure on the Czech National Bank, which has been left on its own to try to stimulate the economy. However, in the same week that Necas spoke, Governor Miroslav Singer announced that the next mooted policy step – intervention to weaken the crown – is unlikely to be needed before the middle of next year.

Czech govt weary, but maybe wiser Tim Gosling in Prague

A

fter weeks of wobbling, the Czech coalition managed to survive its seventh vote of confidence in two years on November 7, in the process securing a simple majority in parliament for a controversial tax bill.

The painful struggle to get this tax bill through seems to have hammered the point home about how unpopular the austerity measures are these days and the government now says it will ease back on its ambitions to slash the budget deficit, although not until 2014.

On November 12 – in the same week the country recorded its fifth straight quarter of GDP contraction (0.3% in the third quarter) and two weeks after the central bank cut its benchmark rate to near zero – Czech Prime Minister Petr Necas announced that his government now wants to ease the pace of budgetdeficit cuts starting in 2014.

While the strict fiscal discipline of the centre-right coalition has helped bring down the country's borrowing costs,

analysts also say it is now hurting an economy that has spent the entire year in recession. The policy has also seen political support for the government hit new lows, making it susceptible to a seemingly never-ending series of crises.

The goals set out in the government's latest convergence plan envisage a

While the government's apparent softening of its deficit reduction target has a significant time lag, it has already received support from some investors. "Even if the latest economic data has disappointed already bearish expectations," analysts at the Swedish bank SEB wrote, "this softer tone may bring hopes for an end to the recession.

Furthermore, a somewhat less restrictive fiscal stance reduces the need of more simulative monetary policies."

Power struggle The coalition's softening in its stance appears motivated by the closeness of the call it has just survived, as well as the tighter grip that Necas has managed to take of his Civic Democrats (ODS), the senior party in the governing coalition.

Despite the protestations about the potential economic damage from the tax bill, which is expected to generate CZK22bn (€866m) in extra revenue, the real trigger for the drama surrounding the bill was a power struggle within the party, with many seeing the hand of ODS-founder President Vaclav Klaus behind it.

"Austerity has seen support for the government hit new lows, making it susceptible to a never-ending series of crises" budget deficit of 1.9% of GDP in 2014 and 0.9% in 2015, but that now appears off the cards for the time being, with the government saying it will aim instead to simply keep the hole in the budget below the 3% threshold set by the EU. "When we'll have economic growth of around 2%, we can return to deficit reduction again," Necas said.

The vigour with which Necas was finally able to put down the party rebellion was surprising, hinting that the Czech right wing may finally have taken on board just how close it is sailing to oblivion. On top of a series of corruption scandals, the fiscal austerity programme has caused the government's support to collapse, and the opposition Social

bne December 2012

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Democrats and even the Communists managed to hammer the coalition parties in recent local and senate elections.

The PM's apparent victory over the arch euro-sceptic Klaus, whose term as president will end next year, could even see the Czechs come in from the cold in Brussels. One of only two EU states to have declared its opposition to the plan, the Czech Republic may be ready to sign the bloc's fiscal pact, Austria's finance minister claimed on November 15.

"The vigour with which Necas was finally able to put down the party rebellion was surprising"

Cut to the bone

bne With the Czech central bank's latest interest rate cut, it has now effectively run out of space for monetary policy to stimulate the economy, leaving only unconventional means open to it.

zero," and pledged to keep them at that level for a "longer horizon until inflation pressures increase significantly" – an event the central bank doesn't foresee before 2014.

The Czech National Bank (CNB) sliced a further 20 basis points (bp) from its benchmark interest rate on November 1, to leave it at 0.05%, as the country continues to battle the downturn. The cut brings interest rates to a record low, and follows a pair of 25-bp cuts earlier this year in June and September.

The problem for the CNB is that the German October Purchasing Managers' Index (PMI) surprised on the downside, meaning that in the short term, no matter what the authorities try, export orders are unlikely to perk up.

While it's a bellwether for much of CEE as a whole, the Czech Republic's huge dependence dictates that whence Germany leads, so it goes.

However, the recession-led approach to zero interest rates has not been accompanied by government policy. The centre-right coalition continues to push the austerity that has made the country so popular with bond investors. Yet the market has increasingly begun to question the wisdom of that fundamentalism. Heavily exposed to export demand out of the Eurozone, the Czech economy fell into technical recession in the first quarter and GDP shrank another 0.2% in the second.

The CNB's new forecast, announced after the rate cut, retained its September prediction of a full-year contraction of 0.9% for 2012, but slashed the outlook for 2013 to just 0.2% growth from the 0.9% it previously hoped to see. At the press conference, CNB Governor Miroslav Singer admitted that rates are on "a technical

The CNB has been saying in recent weeks that it's determined to try however, suggesting the local currency, the koruna, is the next tool set to be put to work, using intervention to weaken the currency in an attempt to spur exports. Singer did no more than confirm once more that intervention is the most likely next option. Capital Economics says it's not surprised. "Any move towards unconventional measures is unlikely to happen quickly," it wrote. "The CNB remains a highly conservative institution. What's more, big questions still hang over next year’s budget, and we suspect that policymakers at the Bank will want to make a full assessment of fiscal policy before leaping into unconventional monetary policy. All of this suggests that further monetary stimulus may not come until early next year."

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The comments marked a break with Kaczynski's long-standing policy of skating on the edge of saying what he had really thought had happened two years ago in Smolensk, leaving the strongest allegations to his supporters.

Some of them accused Russia's Vladimir Putin of being behind the crash (sometimes with allegations that Tusk was also involved), and the speculations of what brought the plane down have ranged from a Russian missile to Russian kill squads who murdered the survivors, to machines which pumped helium into the air, changing its density and crashing the airliner.

Poland's helpful opposition Jan Cienski in Warsaw

D

onald Tusk, the Polish prime minister, is facing a slowing economy, dissent from within his Civic Platform party and fraying ties with his European partners over the next EU budget – but he is still a very lucky man because of the calibre of the opposition he faces at home.

That is because the right-wing Law and Justice party (PiS) has been captured by a lunatic bloc dedicated to the proposition that the April 2010 air disaster which killed president Lech Kaczynski and 95 others, many of them senior officials, at Smolensk, Russia, was a nefarious plot and not an accident. This has acted to spook centrist voters and defang the opposition, led by the dead president's twin brother Jaroslaw Kaczynski, as a credible alternative to Civic Platform – something that is proving to be of immense help to the government as the economy reacts to the Eurozone crisis.

The air crash returned as a major topic in late October when Rzeczpospolita, the country's leading business paper – complete with a salmon-coloured

economics section – published a blockbuster revelation on its front page, that traces of nitroglycerin and TNT had been found on the wreck of the Polish government airliner.

Hours after the paper had hit the stands, Kaczynski and his lieutenants, surrounded by grieving families of those killed in the air crash, were touting this as proof that the crash was "murder" – and not simply a tragic accident. "Murdering 96 people,

Both Polish and Russian government investigations found that the cause of the crash was that undertrained Polish pilots tried to land the airliner in dense fog. No traces of bomb damage have been found on the wreckage.

bne December 2012

The shift to the centre saw immediate results; his Law and Justice started to steadily gain in opinion polls. In early October, it had the support of 39% of those polled while Civic Platform had only 33%, the first time in many years that Kaczynski's party led.

As a result Tusk rushed to relaunch his government, spelling out a new economic programme and admitting in television interviews that he had been forced to act by Kaczynski's resurgence.

His party also appeared to be fracturing between its liberal and conservative wings over controversial issues like abortion and refunding in-vitro fertilisation.

But Kaczynski's fiery declaration of the crash being murder again put off voters. A new survey finds that Tusk's

Central Europe

party is back on top with the support of 42% of those polled while PiS was at 30%. Pawel Wronski, a columnist for the Gazeta Wyborcza newspaper, wrote: "The president of PiS has blown up like a grenade… The carefully constructed image built since the spring by PiS PR specialists of Jaroslaw Kaczynski, who

with a genial smile listens to specialists debate about the future of Poland, has been blown to smithereens."

Leszek Miller, a former premier for the ex-communist Democratic Left Alliance, wryly notes that he has the impression

that Tusk really needs Kaczynski. "He reminds what could happen to Poland if Kaczynski gains power."

Tusk's lucky streak looks set to continue, with Law and Justice party spokesman

The Rzeczpospolita story allowed Kaczynski to say what he really thought.

Unfortunately for him, the prosecutor's office called a news conference just after his and denied the whole story and the paper also followed with a retraction of its story – both the editor in chief and the reporter responsible have since been fired. The end result has been to destroy Kaczynski's recent attempt to migrate towards the political centre.

T

he first signs of a downturn in the Polish banking sector arrived in the form of gloomy third-quarter earnings reports – an indication that the crisis buffeting the rest of the EU is beginning to make itself felt in Poland.

The centre ground Kaczynski had held a series of wellpublicised conferences including one with some of the country's leading economists, where he sat and quietly listened to a serious discussion of the

country's economic situation and of his party's programme. He also named a technocratic professor as a candidate for prime minister in case his party succeeded in unseating Tusk, seeking to calm voters worried about Kaczynski again being premier (he was in charge of the government in 2005-2007).

Adam Hoffman proclaiming that the party will "continue occupying itself with Smolensk despite the fall in opinion polls."

Kaczynski's fiery declaration of the crash being murder again put off voters.

"The party will continue occupying itself with Smolensk despite the fall in opinion polls" including then president of the republic and other exceptional public officials is an incredible crime and anyone, even through fraud or partisanship who has the slightest thing to do with this will have to bear the consequences," Kaczynski declared, before calling on Tusk's government to be dismissed.

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Polish banks begin to feel the pinch Jan Cienski in Warsaw

PKO BP, the country’s largest bank, saw its third-quarter net earnings come in at PLN921m (€222m), a 9% fall over the same period a year earlier, largely because of a fall in new loans and an increase in troubled credit. Another bank, Getbank, which had been an aggressive mortgage lender in the boom times before the crisis, reported a net profit of just PLN61m, down 35% compared with the same period a year earlier – due to higher-than-expected net provisioning requirements tied to a weakening of asset quality, mainly mortgage loans. "We seem to be entering a period of slower growth," says Zbigniew Jagiello, CEO of PKO BP, a bank controlled by the state treasury.

The estimates are that the banking sector's overall profits will be slightly lower this year than last, when banks earned a record PLN15.7bn. As a result, a series of mid-sized banks are laying off workers – about 2,500 employees out of a sector-wide workforce of

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about 125,000 have lost their jobs and more branch closures and layoffs are planned.

for Raiffeisen Research. "As long as the subsidiaries are profitable, no one wants to sell."

Problems home and away Poland's banks face both foreign and domestic challenges.

What sales have happened have been prompted by troubles at the parent banks, such as the 2011 sale of Bank Zachodni WBK by Allied Irish Banks and this year’s sale of Kredyt Bank by Belgium’s KBC, both bought by Spain’s Santander to create the country’s thirdlargest banking group.

On the foreign side, there are worries that the two-thirds of the sector owned by foreign institutions will be negatively affected by the ongoing crisis in the Eurozone and reduce liquidity support to Polish affiliates.

According to the Vienna Initiative, which aims to prevent a disorderly deleveraging from the CEE region that

On the domestic side, banks are still battling the hangover from the real estate boom, when mortgages denominated in foreign currency,

"As long as the subsidiaries are profitable, no one wants to sell" would imperil banking systems and economies, says cumulative funding withdrawal from the region stands at 4% of GDP since mid-2011, and the rate picked up in the second quarter of this year from the previous quarter. "The foreign ownership of the major banks in Poland exposes the system to the euro area turmoil and has the potential to act as a transmission channel for greater volatility and deleveraging trends in the Polish market," notes Moody's Investors Service, the rating agency.

However, Poland’s banking sector is relatively well funded, with a loan/ deposit ratio of about 116%. With rapidly rising deposits, there is little danger of a credit crunch even in the event of a funding cut-off.

Polish banks are also insulated because they have generally been quite profitable. When Germany’s Commerzbank announced that it was retrenching in the CEE, it made a specific point of excluding its Polish affiliate BRE Bank from any cutbacks.

"The west European banks are really keen on keeping their franchises," says Gunter Deuber, banking analyst

particularly Swiss francs, were very popular. However, when the crisis hit in 2009 and the zloty dropped sharply against the franc and the euro, banks and borrowers saw that this form of lending was a lot riskier than they had expected and very few new mortgages of this sort are being offered. "They have become a really marginal product," says Artur Szeski of Fitch Ratings.

In all about 57% of all mortgage loans are denominated in foreign currencies, down from 65% at the end of 2009.

Central Europe

Polish construction companies thought that they would do very well out of the infrastructure boom fuelled by EU structural funds, and banks were happy to lend. However, many firms engaged in cutthroat competition to get contracts, which the government has been unwilling to renegotiate, and large swaths of the sector are now facing bankruptcy as it becomes clear they cannot turn a profit on their projects.

"Non-performing loan problems are coming from the real estate market and from the construction sector," says Szeski.

As the economy slows, the Polish Financial Supervision Authority, the banking sector regulator, has eased some of the lending restrictions it imposed after the first wave of the crisis, hoping to avoid a dramatic slowdown that could harm the economy. However, Jagiello expects new lending to grow at only about 5-6%, lower than the double-digit rates that were common a few years ago, which means the sector is unlikely to see the record-breaking profits of last year.

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gets. Butkevicius has also said he plans to continue Lithuania's drive towards membership of the Eurozone, albeit with a 12-month delay to 2015.

The number of problem loans is slowly inching up, hitting 4.7% of total loans this September, up from 3.7% at the end of 2009, and the number of bad loans is expected to grow as the economy slows. While the level of bad mortgage loans is still low, at only 2.6%, there are growing worries about the construction sector – accounting for about a fifth of all corporate lending.

"Non-performing loan problems are coming from the real estate market and from the construction sector" However, such loans only form about 22% of the overall loan portfolio. "That is too small to create much of a danger to the stability of the banking sector," says Jacek Rostowski, the finance minister.

bne December 2012

Lithuania's pendulum swings back bne

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ithuania's new prime minister, Algirdas Butkevicius, said on November 8 that he intends to halt plans to build a new nuclear power plant for the Baltic region. His pledge threatens another defeat for President Dalia Grybauskaite, one of the project's biggest supporters, who saw her attempt to block Butkevicius' planned coalition come to naught later in the month.

In an interview with news portal 15min.lt, Butkevicius stated: "The people expressed their viewpoint at the referendum, and I will carry out their wishes. The Seimas [parliament] must draw up a bill as soon as possible so that the plan to build the [nuclear power plant] is ruled null and void, and we will support it."

Butkevicius is leader of the Social Democrats, which won the most votes at October's parliamentary elections.

The poll had a non-binding referendum attached at the Social Democrats' insistence on the planned €5-7bn Visaginas plant, due to questions over the cost and financing of it. At the same time, Butkevicius said he is not against

nuclear energy per se, and that discussion of a different project at Elektrenai – Lithuania's largest thermal power plant – could follow at some point.

The new PM's words did little to calm the tension in Vilnius, with Butkevicius at loggerheads with Grybauskaite as she fought to prevent him including the Labour Party, which came in third at the recent polls, in his coalition due to claims of vote rigging against it. On

For her part, Grybauskaite – seen as left-leaning when elected – has worked surprisingly closely with the previous centre-right Homeland Union government, which came second in the polls.

During the spat she did practically everything but demand openly that the Social Democrats form a left-right coalition with the outgoing party. She dropped her opposition to Butkevicius' coalition only on November 19, after a constitutional court investigation gave the bulk of the latest vote the all clear.

That calmed fears that the county could slide into a full-blown political crisis, with analysts unsure of whether the president or parliament has the final say under the constitution.

However, Butkevicius could face another battle over his plan to scrap Visaginas from both the president, Lithuania's Baltic neighbours, and even Brussels and Washington.

Widening support Grybauskaite has strongly supported the previous government's more confrontational approach in trying to reduce Lithuania's energy dependence on Russia. The new nuclear power plant at Visaginas is a cornerstone of that strategy. Meanwhile, it's notable that neighbours Estonia and Latvia,

"The political 'pendulum', in which voters' sympathies regularly swing between the left and the right wing of the political scene, impedes the continuation of various political and economic processes." top of pulling the Visaginas plan, the new coalition has pledged to ease the country's harsh austerity programme – although remains committed to the previous government's 2013 fiscal tar-

previously reticent about making an unequivocal commitment to join the regional nuclear project, have exhibited far more support since the referendum cast doubt upon the project by returning

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bne:infrastructure

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

bne December 2012

Central Europe

"Butkevicius could face a battle over his plan to scrap Visaginas from both the president, Lithuania's Baltic neighbours, and even Brussels and Washington"

a result that showed 63% of voters are against the plan.

The pair displayed their renewed enthusiasm again on November 9. Following a meeting in Vilnius attended by the foreign ministers of all three states, the Baltic Council of Ministers and the Baltic Assembly released a statement pledging continued support. "The Visaginas Nuclear Power Plant is an important project which will increase the energy security of the region," the inter-parliamentary body said, according to Bloomberg.

While a final decision must be made by Lithuania's parliament and government, the Visaginas project is sound in terms of security, safety and economics, the Baltic gathering, including Estonian Foreign Minister Urmas Paet and Latvian Foreign Minister Edgars Rinkevics, said in the joint statement. In a separate email, Audronius Azubalis, the Lithuanian foreign minister (at the time at least), said cancelling Visaginas "would mean a refusal to proceed down the route we have agreed with the United States and the European Commission" and could be misunderstood by international partners.

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bne December 2012

Stopping the pendulum Analysts at the Centre for Eastern Studies (OSW) suggest that her own re-election prospects are behind the president's fight against Butkevicius.

free public transport than meets the eye.

The official line presses all the right eurobuttons about social cohesion, empowerment and environmentalism, as Tallinn Mayor Edgar Savisaar explained at an October conference dedicated to the initiative due to take effect on January 1, 2013. "Families with low or medium wages and with children have really suffered during the recession... [and this] will allow more mobility, will allow the unemployed to be cohesive and will promote commerce as consumers can move around freely," Savisaar told delegates in the unusual surroundings of a Tallinn multiplex cinema.

But perhaps the first hint that local politics plays at least as much of a part in the scheme than municipal philanthropy came when Saavisaar said: "A Scandinavian mayor told me, 'You in Tallinn have no idea how excited you have made opposition parties and how nervous you have made us'."

The coalition that the Social Democrat Party has formed enjoys a constitutional majority, which enables it to impeach the president, and she has been accused of unconstitutional acts; her blockage of the coalition could clearly be interpreted as such, suggest some analysts.

At the same time, Grybauskaite's push for a rainbow coalition involving Homeland Union is also likely motivated by an urge to put a stop to the erratic policymaking that has held back Lithuania's progress in recent years. "Unsuccessful attempts to bring these parties into closer co-operation were also made in the past by the then president Valdas Adamkus," OSW points out. "He thus wanted to reverse the consequences of the political 'pendulum' principle, [according to which] voters' sympathies regularly swing between the left and the right wing of the political scene, impeding the continuation of various political and economic processes."

The pledge of Butkevicius to halt Visaginas is a perfect example, the analysts point out. "The project to build a new nuclear power plant‌ was [originally] initiated by the left and contested by the right. When the right took power, they cancelled all the decisions which had been taken in connection with this project and proposed their own model.

This in turn is unacceptable to the Social Democrats, who are presently taking power."

I 35

Tallinn's (free) ticket to ride Mike Collier in Tallinn

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ike the small kid at school who over-achieves to compensate for his stature, Estonia has a thing about proving itself. The Baltic state of 1.3m was the first country in the world to introduce online voting and pioneered the use of free public internet. It was also the first former Soviet republic to join the Eurozone, and precisely two years after that took place on January 1, 2011, Tallinn will become the largest city in the world and the first capital to provide free public transport to all of its residents.

At first it sounds counter-intuitive for this strident champion of the free market (which also championed flatrate taxes) to be offering something so reminiscent of state socialism. But as ever in Baltic affairs, there is more to

The move to free public transport was approved by a city plebiscite last March, in which 75% of Tallinn residents voted in favour – a figure surprising only in that it wasn't larger, and explained by the fact that die-hard opponents of the Centre Party veteran (including the ruling government coalition) find it impossible to vote for any initiative with Saavisaar's name on it.

To his opponents, free public transport is a populist move aimed at shoring up Savisaar's ebbing support among pensioners and other low-income groups, including a large number of ethnic Russians, that form the core of his power base.

With the size of Tallinn's budget dependent upon the number of registered residents it has paying

"You in Tallinn have no idea how excited you have made opposition parties and how nervous you have made us"

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municipal income tax, offering free public transport to residents (and not visitors or commuters officially residing in neighbouring counties) is simply a way of Tallinn poaching cash from other municipalities that need it far more, Savisaar's critics maintain.

"No one is going to lose public money – in the end, our revenue base will be strengthened by this decision. When people say free public transport will be paid for by those who do not live here and those driving cars, it is not true," Savisaar maintains. "According to our estimations, there are 20-40,000 people who live here, but are not registered as residents... I wouldn't be surprised if more people decided to move to Tallinn as a result of this."

Whatever the real reasons behind what is known in academic circles as zero-fare public transport (ZFPT), it is undoubtedly a bold move, taking the idea to a new level. Currently the largest city to provide a comparable service is Aubagne in southern France, with just a quarter of Tallinn's 400,000 population, according to Sweden's Department of Transport Science in the Royal Institute of Technology (KTH), which has been commissioned to monitor and evaluate the success or otherwise of the Estonian experience. The KTH's initial report can barely contain its excitement at the prospect of "a full-scale experiment that provides an unique opportunity to investigate the impacts of such policy."

"The main objectives of this policy measure are: to lead to modal shift from private car to public transport, to increase the mobility of unemployed

bne December 2012

and low income groups and to increase the municipal income tax by providing a stimulus to register as a resident of Tallinn," KTH says, neglecting to mention what its critics argue is the main objective: to get Edgar Savisaar re-elected as mayor.

Valuable experience Having the Swedes on board provides not only a fig leaf of academic impartiality, but will also generate some genuinely useful data, as the experience of most other municipalities with free public transport offers little in the way of guidance.

The small Belgian town of Hasselt, for example, began offering free buses in 1996. "On the first day, the number of users changed from 1,000 to 8,000 – and stayed there," says Marc Verachtert, the city's general manager. "We made a lot of people mobile. Beforehand only a quarter of people visiting hospitals used buses; afterwards that changed to threequarters," Verachtert says, admitting that before the buses were free he had never actually used them himself, but has now been turned into something of an evangelist for the cause.

But in Tallinn, which has a well developed network of trams, buses and trolleybuses totalling more than 700 kilometres and free transport already available to many social groups (only 8% of passengers pay full fare), the prospect of a similar surge in the numbers using the network is unlikely, deputy mayor Taavi Aas tells bne. "Our projection is that passenger numbers will increase by around 15% in the first few months. There is certainly no

Central Europe I 37 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

bne December 2012

danger that the network will be overloaded," Aas believes.

He is cagey about the prospect of relaxing the rules so that visitors to Tallinn could make use of the network for free, despite regular complaints that the large number of tourists the city attracts rarely make it beyond the walls of the souvenir-heavy Old Town.

On the other hand, Aas is unabashed about speculating on teaming up with other major cities: "We have already had very interesting discussions with neighbouring cities including Helsinki, Riga and Vilnius. They are very interested and in the future you might be able to use one card in all these cities," he says.

What you need to know

Unlikely though that prospect seems, Aas points out that in most major cities transport is already heavily subsidised.

In Tallinn, ticket revenues account for just 30-40% of the annual transport budget, so subsidising the remainder isn't quite as drastic a step as it first seems. Cities such as Vienna, which charges a nominal €1 fare on its inner network, are in effect providing free public transport already, though thankfully for Estonia that €1 prevents that city from claiming to be the first capital city to do so, according to Savisaar.

So on one point at least, Aas and Savisaar from the Centre Party and the government that has such a strong aversion to them are in complete accord: the eternal Estonian need to prove they are as good as the big boys. "At last Tallinn has done something that our Nordic neighbours can learn from!" boasts Savisaar.

bne’s veteran team of journalists have more than 100 years of collective experience of reporting on this dynamically growing region and can explain the “why” of “what” is going on.

"Our projection is that passenger numbers will increase by around 15% in the first few months"

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bne December 2012

high public debt carries macroeconomic and fiscal risks," the IMF said after a visit to Tirana in October. "Receipts from privatisation of natural resource wealth should be utilized primarily to lower debt, but also to clear unpaid government bills."

Privatisation is also being pushed by the European Commission, which a week after the conclusion of the tender recommended Albania receive conditional EU candidate status. This was, however, subject to "judicial and public administration reform measures being completed and the parliamentary rules of procedures being revised," according to EU Enlargement Commissioner Stefan Fule.

Problems of endemic corruption, cronyism and weak institutions have held the EU back from giving such candidate status to Albania two times in the past. Yet the news about who actually owns the company that won the tender will have done little to improve the mood in Brussels.

Oil on Albania's troubled waters Phil Cain in Graz, Austria

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he Albanian government is on track to complete by December 3 the high-priced sale of a state oil company to a consortium controlled by a businessman considered part of the inner circle of Prime Minister Sali Berisha. If the winner of the tender raised eyebrows, there are even more questions being asked about why such a well-connected player should have offered quite so much for Albpetrol; after all, as Andrew Neff of IHS Energy notes: "Normally you would expect someone connected with the government to be underpaying."

On October 3, the prime minister announced that a US-run consortium had pledged €850m to buy Albpetrol, more than twice the next-highest bid and three-times the third-placed offer.

This deal should be signed off before the deadline of early in December, according to local media reports.

infrastructure, salaries, pensions, the canalisation of rivers, irrigation and road-building.

The windfall, which equates to around 8% of Albania's annual GDP, and the half-share of oil revenue from the

Economic pundits were also pleased at the prospect of the funds being used to chip away at the country's growing

"Normally you would expect someone connected with the government to be underpaying" revived Albpetrol will be spent in a way which benefit all Albanians, proclaimed Berisha. He promised that the new funds would be pumped into improvements in schools, hospitals,

public debt. This currently stands not far shy of its legal ceiling of 60% of GDP, a level that is causing concern among international lenders such as the International Monetary Fund. "Albania’s

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bne December 2012

Friends in high places Two days after Berisha's announcement, it emerged that the Singaporeregistered winning consortium, called Vetro Energy, is actually 51% owned

by Albanian oil magnate Rezart Taci, considered part of PM Berisha's inner circle. One of Taci's companies, Taci Oil, organises costly charity football matches and donates the proceeds to a children's charity run by Liri Berisha, the wife of the PM. The remaining 49% of Vetro is owned

by Chicago-based SilkRoad Equity, a little-known private equity firm. Two US companies are also involved – Huddleston Energy Advisors and Home Creek Energy – which the company argues justifies the initial description emphasising Vetro's US credentials.

Taci bought Home Creek Energy this summer, according to its president and CEO, Anthony Maye.

Home Creek's expertise lies in rejuvenating oil wells that have fallen into disuse, Maye tells bne. Around 1,800 of Albpetrol's 3,000 oil wells

are out of operation. Huddleston's expertise is more in 3D seismology, but it preferred not to comment on its involvement in Albania.

Taci's Vetro stake is held through YPO Holdings, a Singapore-based company.

Taci said he had kept his involvement in the bid secret from the public because he did not want it to have any influence on the bidding process. The Ministry of Economy, Trade and Energy was unavailable to answer whether if it was also kept in the dark about Taci's involvement.

This would not be the first time that Taci has been revealed as the winner of a privatisation auction only after the deal was done. In 2008 it was announced that a US-Swiss consortium

Also-rans The runners-up in the sale of Albpetrol were China's Win Business, which offered €297m, and the next highest bid of €106m from Canada's Bankers Petroleum, which already operates the country's Patos-Marinza oilfield.

Albpetrol had valued its own assets at about €320m.

Bankers Petroleum CEO Abdel Badwi explains Vetro's large overbid by noting that the Albanian government extended Albpetrol's gas transmission rights from five years to 30 years within days of the deadline to submit bids. His company had no time to redraft its bid and do due diligence on a new offer, he complains.

The extended transmission licence could add significantly to Albpetrol's profitability, Badwi reckons, should

"History has shown us that the privatisation of assets in former communist countries is not always a positive development" bought state oil refining business ARMO for €128m. Now, however, ARMO is completely under Taci's control.

Together, Taci's businesses, which include a bank and television station, are reckoned to have had a turnover of €250m in 2011.

Taci has had a difficult relationship with the Albanian media. He and his two bodyguards were accused of beating publisher and political commentator Mero Baze unconscious in an upscale Tirana bar in November 2009. The attack happened soon after Baze made a series of reports accusing Taci of tax evasion. A year later, Taci was acquitted of all charges, but his bodyguards were found guilty of assault and fined.

"I totally deny the allegations that I participated in the brutalities that caused severe injuries to Mr Baze. I not only deny my involvement, but I also condemn violence that so often marrs our modern society," he said in a statement at the time.

anything come of plans to build the Trans-Adriatic Pipeline (TAP), which is designed to carry Azerbaijani gas to Italy through Greece and Albania.

However, Andrew Neff, a senior analyst at the IHS Energy group, questions whether the extra money that was paid can be attributed to any expected revenue from the TAP, which he reckons is unlikely to be built. "Not many people in the oil industry give TAP much chance."

A more likely explanation for the high price paid for Albpetrol, Neff argues, is that Taci – a chess enthusiast – may see ownership of Albpetrol as a platform from which to take over Bankers' oilfields. As such, the Albpetrol story may fit into a broader pattern. "It is generally seen as a positive move, but history has shown us that the privatisation of assets in former communist countries is not always a positive development," says Neff.

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company's board in Romania knew about the bribes paid to politicians to facilitate the growing of its business.

Simultaneously, Cristian Sima – a broker and owner of private investment company WBS Holding, who became a fugitive in October after making bad investments and losing the money of some of Romania's most influential politicians, bankers, fashion designers and even journalists – resurfaced in Iceland and confirmed Lundin's story in a televised interview. Sima specialized in investments on the international forex and derivatives markets via his British Virgin Islands-registered company.

No Romanian holiday from scandals Bogdan Preda in Bucharest

I

t's been a terrible few weeks for Romania as corruption again dominated the headlines.

This EU member state, which still has to suffer the ignominy of an EU monitoring process five years after it joined the bloc, is again headed into trouble with Brussels as the head of Romania's National Integrity Agency (ANI), an antigraft watchdog set up after it joined the EU, accused politicians on November 13 of trying to intimidate his organisation in the run-up to the December elections, after it notified three ministers and a state official earlier that it was investigating them for possible conflicts of interest.

"The political pressures we have recently seen are the most aggressive since ANI was founded," Horia Georgescu told newswires. "They are meant to discourage and intimidate the agency's ongoing investigations."

The outburst from Georgescu followed a pair of high-level corruption scandals involving bribery and the embezzlement

of tens of millions of euros that have dragged in some big foreign names.

One case involves the former Swedish telecommunications giant Ericsson, which allegedly paid Romanian politicians for the awarding of the €40m national emergency service system

Sima confirmed that Lundin was a managing partner in his company and revealed bribes were paid to Romanian politicians via the accounts of Romanian journalist Bogdan Chirieac at WBS Holding. Back in Romania, Chirieac denied any involvement and said he would sue Sima for making false statements. "I can prove that Ericsson sent money to Bogdan Chirieac and that Bogdan Chirieac sent the money to some other people," Sima said.

Sima also said in the interview that he fled to Iceland because he fears retaliation by businessmen and politicians who are after him because he lost their money or because he's holding information about their business

"The political pressures we have recently seen are the most aggressive since ANI was founded"

contract. This hit the headlines on November 6 following an investigation by the Rise Project, an investigative journalistic website, which obtained documents from a Swedish arbitration court that conducted a hearing into Thomas Lundin, whom Ericsson has accused of embezzling funds during his time as country manager in Romania in the early 2000s. Lundin denies having pocketed the money and claims the

dealings. He said bribery wasn't limited to Ericsson, but also to scores of other foreign businesses in Romania, such as pharmaceutical companies. He refused to name them when asked during the televised interview.

Calling up a bribe The other case centres on the vice president of France's Societe Generale local subsidiary BRD, and concerns

bne December 2012

loans totalling some €22m reportedly disbursed by some of the country's biggest banks against forged documents since 2010. Besides the VP of SocGen's Romanian BRD, Claudiu Cercel, the case involves another at least 30 people, such as Economy Ministry officials, a former Securitate communist secret police counter-intelligence general, plus an alleged ringleader and his accomplices.

Prosecutors started their investigations based on evidence from phone tapping and recordings of meetings between bankers and others involved in supplying falsified documents to get as many as 40 loans from 16 banks across the country, and statements from clerks familiar with the cases, Romanian newswires reported.

Retired counter-intelligence general, Dragos Diaconescu, the alleged ringleader Daniel Ruse and some of their alleged accomplices have been put under preventive arrest. To one who knows how slowly things in Romania usually work when it comes to taking action against dozens of executives or state officials at once, this is a first. Further, detaining for questioning the VP of the country's second-biggest bank by assets, one of the country's most respected bankers, while at the same time accusing him of being among the main people who backed the scam is also strange.

Romania already suffered a notorious series of bankruptcies of some of its biggest post-communist banks back in the early and mid-1990s; banks such as Bancorex, Banca Agricola, Dacia Felix Bank and Columna Bank are but just a few examples whose defrauding cost taxpayers a total of about $3bn back then. Even during those times no one saw 33 people being detained at once.

In a normal country, such arrests occur regardless of the usual political cycle.

However, in Romania such frauds usually start to be unearthed before major political battles, as will be the case on December 9 when the country will hold parliamentary elections, in which the governing alliance between the Social Democrats and the National Liberals is predicted to win most seats

Southeast Europe

against the Alliance for the Right Romania, which is supported by President Traian Basescu.

I 41

bne:infrastructure

That's considered the best explanation of why these cases have emerged now, rather than a positive sign of a society and a system that is starting to heal, possibly under pressure from the EU, or that Romania's new government is trying to clamp down on endemic corruption.

There could be another element on top of all this. Given the global economic troubles and Romania's lack of attracting and keeping foreign investment, the money that was sloshing around until a few years ago is becoming scarcer.

That means less money for the same number of bribe-takers. Furthermore, now that the political landscape is about to change following the December elections, some politicians are resorting to igniting battles like these to try and preserve momentum and advantages.

The cases will heap further international pressure on Romania, which has been in repeated clashes with Brussels this year over its inability to become a normal western democratic state.

The EU accused PM Victor Ponta and his government of trampling over democracy and undermining judges in trying to impeach the president earlier this year.

The economic crisis has hurt all the economies of the world, but now governments across the Central and Eastern European region are planning to spend trillions of dollars on infrastructure investment as the most effective form of economic stimulus to put their economies back on a sustainable growth path.

This investment was badly needed even before the crisis hit 18 months ago. Decades of work lie ahead, which presents a unique opportunity for investors of all kinds.

Every two weeks, bne will publish an online a round-up of the main investment projects, analysis, commentary, regulatory changes, investment plans, and funding news in bne:infrastructure.

Romania and next-door Bulgaria, which joined the EU at the same time, are both still subject to post-EU membership monitoring over issues like corruption, which Bucharest considers humiliating but, if the latest scandals are anything to go by, unlikely to end anytime soon.

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This view is shared by Jovan Kovacic, president of the East West Bridge thinktank, for whom one of the main challenges facing the coalition is that Vucic's drive against corruption is bound to unearth dodgy dealings by some members or sponsors of three coalition partners – the Progressives, the Socialists and the small United Regions of Serbia. "But the way things now stand, the leadership of allied parties are ready to weather the challenge and all pay lip service to Vucic's commitment," Kovacic says.

Aleksandar Vucic Photo © Medija centar Beograd

The Serbian three-step Ian Bancroft in Belgrade

T

he Serbian coalition has relatively successfully navigated the first 100 days in office, yet speculation is growing that new elections could be on the horizon due to tensions within the coalition over rooting out corruption and a rising temptation to capitalise on the disarray amongst the opposition.

The tapping of the phones of Tomislav Nikolic, Serbia's president, and Aleksandar Vucic, the defence minister and first deputy prime minister – both big beasts of parliament's largest party, the Serbian Progressive Party – has added to the sense of drama. Accusing fingers have been pointed at the Interior Ministry, headed by Prime Minister Ivica Dacic of the Socialist Party, who has promised a full and thorough investigation.

Vucic – who has been tasked with overseeing the country's intelligence agencies and leading the fight against corruption and organised crime – has publicly-accused Miroslav Miskovic, Serbia's richest businessmen, of plotting to bring about the government's demise because of its anti-corruption drive, a view strenuously denied by Miskovic.

To date, Oliver Dulic, a former minister and member of the now opposition Democratic Party, has been charged with

corruption, whilst a major investigation has been launched into the collapse of Agrobanka, whose licence was revoked at the end of May after its management approved a large number of illegal loans.

David Kanin, an adjunct professor of international relations at Johns Hopkins University and a former senior intelligence analyst for the Central Intelligence Agency (CIA), tells bne that Vucic has many responsibilities and still

Disarray Helpfully for the government, the Democratic Party – Serbia's former governing powerhouse until it was turfed out of office in the summer elections – remains in a state of disarray.

Former president, Boris Tadic, recently announced his decision not to stand for the leadership, leaving Belgrade's mayor, Dragan Djilas, with a free run. Having, in Kovacic's view, "threatened to sunder the party into two" by refusing to step down, Tadic will now become an honorary president of the party. The leadership battle has been defined not by a debate about the party's core values, but by considerations of loyalty, suggesting that the party will remain riven by factionalism for the foreseeable future.

The change in leadership will likely lead to further changes at the local level. As

"One possible near-term threat to the coalition would materialize if Vucic's legal sniffing begins to cut too closely to the Socialist bone" is testing out the various powers and problems inherent in his considerable workload. "So far, he appears to be calibrating a threat to investigate corruption allegations involving (among others) Socialist notables, so as not to risk a political crisis, says Kanin. As such, "one possible near-term threat to the coalition would materialize if Vucic's legal sniffing begins to cut too closely to the Socialist bone."

Kovacic notes, "this period will be used by the ruling coalition to oust… Djilas from his post, but this manoeuvre will eventually backfire, since he enjoys majority voters' support in the capital and the ruling coalition does not have an adequate politician able to fill Djilas' shoes."

Recent poll suggests that the new government has been well received after 100 days in office. As Kanin points out,

bne December 2012

the government is "better organized than its predecessor – no matter Western preferences for the Democrats' proWestern views – and has quickly put together domestic and international policies."

Further consolidating their grip on power by exploiting opposition deficiencies, however, may become too much of a temptation for the coaliton parties. "The opposition is still totally inefficient. The nationalist DSS [Democratic Party of Serbia] is not really an opposition and will do nothing to jeopardize the ruling coalition.

Furthermore, it could serve as a joker in ousting the [Democratic Party] from power in Belgrade," says Kovacic.

Especially the Progressives, Kovacic suggests, may feel increasingly emboldened to further consolidate their hold on power, particularly given the sense in the party that it underperformed in the last parliamentary elections.

However, Kovacic warns that Vucic needs to start delivering on his promises to fight corruption. "The press reports and tabloid sensationalist reporting will not suffice to cover up the other failings and unkept election promises including immediate boost of the standard of living or distribution of professional positions among public enterprises, etc," he says.

Once Djilas has, in Kanin's words, established "his leadership, retooled his party and credibly engaged in a threecornered political competition with Dacic and Vucic", the Serbian three-step will increasingly define the country's politics. Whilst Dacic is, as Kanin notes, "limited in his manoeuvrability by his party's limited electoral appeal… [he] skillfully is playing off Democrats against Progressives in municipal political battles being waged in the wake of the recent elections."

Were strains within the government to become too great, the threat of new elections could be deployed as a means of testing the coalition's cohesion – and Serbia's history of regular elections would once again rear its ugly head.

Southeast Europe

Surprising (con)census in Bosnia

Ian Bancroft in Belgrade November's accusation by the West that the leaders of the Bosnian Serb Republic are trying to undermine the peace deal which has held the warscarred former Yugoslav republic together since 1995 would appear to show the ethnic tensions in this troubled corner of Europe remain unsolvable. Yet ahead of next year's census, the first in Bosnia since 1991, results from a small preparatory sample reveal encouraging changes are afoot.

Valentin Inzko, the High Representative for Bosnia-Herzegovina, told the 15-nation Security Council on November 13 that the Bosnian Serb authorities continue to pursue a policy that is aimed at rolling back previously agreed steps that have been taken to implement the Dayton Peace Agreement that ended the bloody war in 1995. That deal split the country into two ethnic-based entities: the Muslim-Croat Bosnian Federation and the Bosnian Serb Republic, or Republika Srpska.

"The most recent and troubling of these is an initiative sent by the president to the Republika Srpska National Assembly attempting to create conditions that would unilaterally force the dissolution of the Armed Forces of Bosnia and Herzegovina," Inzko said.

Such accusations are nothing new. The Bosnian Serb leaders often speak publicly about how they'd like to see the country split – and do so as a way to increase their bargaining position whenever there are talks over the complex constitutional issues that plague this divided country. In October, the leader of Republika Srpska, President Milorad Dodik, called Bosnia an artificial country and a mistake. "Bosnia and Herzegovina is definitely falling apart and it will happen sooner or later. As far as I am concerned, I hope to God it dissolves as soon as possible," Dodik said.

Yet, as Inzko remarked, Dodik is only "the most frequent, although certainly not the sole, proponent of [Bosnian] state dissolution."

These divisions suggest little has changed since the country erupted into war in the early 1990s. Yet some 35% of respondents in a recent sample census survey identified themselves as "Bosnian and/or Herzegovini" – a designation that is widely understood as a more civic identification compared with one of the three constituent nations: Bosniaks, Serbs and Croats. Were such results to be repeated next April when the census proper is held, it could have profound ramifications for the ongoing debates about the country's constitutional structure.

Ethno-national identity remains at the very core of Bosnia's institutional set-up. Quotas in elected offices and the civil service, for example, are currently allocated according to results from Bosnia's last census back in 1991 – prior to the war that left roughly 100,000 dead, displaced several million and fundamentally altered the country's ethnic distribution.

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market, which has seen private generation companies dash to construct cheap gas fired power plants to meet power demand growing at 8% a year. Generating licences have already been issued to 21 new Combined Cycle Gas Turbine (CCGT) plants of 100 megawtts (MW) or over, totalling 12.3 gigawatts (GW), while applications for generating licences have been submitted for a further 60 plants over 100 MW totalling 29.2 GW.

The EU's risky symbolism over Iranian gas David O'Byrne in Istanbul

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he EU ban on importing Iranian gas risks alienating Turkey – the key state in the route of Brussels' long-planned southern "gas corridor", which will bring Caspian, Central Asian and Middle Eastern gas to Europe.

At first glance the EU’s decision to ban gas imports from Iran appears to be nothing more than a symbolic gesture, aimed at further signalling to Tehran the EU’s opposition to its nuclear programme. What UK Foreign Secretary William Hague described as, "a sign of our resolve in the European Union that we will step up the pressure."

for manoeuvre. The take-or-pay contact between Turkish state gas importer Botas and the National Iranian Gas Exports Company (NIGEC) was drafted under international law and is legally binding for 25 years from 2001 when

With Turkey already struggling to find enough new gas supplies to meet expected growth in demand, it simply isn’t in a position to abandon 20% of its imports to fall in line with the EU ban and indeed energy minister Taner Yildiz has confirmed that he won’t be pressured into them, telling reporters on November 6 that: "Turkey does not plan to reduce gas supplies from Iran [when an exemption from US sanctions expires on December 3], as the EU sanctions against Iran will not cover existing contracts."

This could be viewed as an acceptable result by right-wing European politicians intent on blocking Turkey’s accession, but it also raises questions over the EU’s long-mooted plan for Turkey to become the route for its so-called "Southern Gas Corridor" – a planned pipeline or pipelines carrying gas from the Caspian

"How much easier for all concerned if the Azeri gas could be sold in Turkey as a replacement for previous imports from Iran" flow started, leaving Botas little option but to continue taking the 10bn cubic metres a year (cm/y) or face legal action.

and Middle East to Europe, which has long been envisaged as the best way to avoid over-dependence on gas imports from Russia.

Exactly what the implications are for Turkey’s EU candidacy if it continues to import gas from Iran in contravention of the EU ban, are still unclear.

At the same time, Turkish gas demand is expected to reach 48bn cm this year, rising to around 50bn cm in 2013 despite a slowing economy – perilously close to the 51.8bn cm/y maximum limit of the country's current gas import portfolio.

As such, it is supposed to increase diversity of supply, encourage competition, and lower prices. All admirable aims, and at least on paper, achievable given the planned pipelines actually get built, across Turkey.

Little room for manoeuvre Legally speaking, Turkey has little room

And that demand is set to grow further with liberalisation of the Turkish power

All the more odd then why the EU would be seeking to encourage Turkey to

No EU state actually imports gas from Iran or is in a position to do, so no problem. Or at least there wouldn’t be if EU candidate state Turkey, were not dependent on Iran for 20% of its gas imports.

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abandon 20% of its gas supply, risking starting a new spat with Ankara which has already frozen relations with Brussels until January, during the period of Cyprus holding the EU presidency.

The irony of the ban is that Ankara is actually in a position to end imports from Iran, albeit only in three or four years' time, and only at the expense of taking the very gas with which the EU hopes to kick start its Southern Gas Corridor.

That gas, 10bn cm of planned production from the second phase of Azerbaijan’s Shah Deniz gas field, has been earmarked for transit to Turkey’s European borders from where two rival pipelines are competing to carry it to European markets.

Plans envisage a consortium of Azerbaijan’s Socar (51%), Turkey’s Botas (20% and Shah Deniz consortium members BP, Total and Statoil (29%) building a new pipeline from Baku to western Turkey, dubbed the Trans-Anatolian Gas Pipeline (TANAP) at an anticipated cost of upwards of $7bn.

Currently the only factor delaying investment upstream in Shah Deniz is the need to finalise plans for carrying the gas to Europe, and hence secure customers.

How much easier for all concerned if the gas could be sold in Turkey as a replacement for previous imports from Iran.

Not to say over $7bn cheaper, with the gas able to be carried to Turkish buyers through Botas' existing transit network, offering potentially higher margins for the producing consortium, and lower prices for consumers.

Of course, it would spell the end of the EU’s Southern Gas Corridor. At least until the development of further gasfields in the Azeri Caspian releases more gas for export, or Azerbaijan and Turkmenistan succeed in agreeing on the transit of Turkmen gas through Azeri territory and manage to construct the necessary infrastructure. Developments few expect to see any time in the next decade.

Southeast Europe

A step nearer

bne Fitch ratings agency offered Turkey an early Christmas present on November 5 as it upgraded the country to investment grade. However, few expect fireworks, with the markets having been rating Turkish assets at investment grade for some time already.

Fitch raised Turkey's foreign currency debt rating to 'BBB-' (from 'BB+'), making it the first of the three major ratings agencies to return the country to investment grade – a status it lost in 1994. The agency cited "a moderate and declining government debt burden, a sound banking system, favourable medium-term growth prospects, and a relatively wealthy and diverse economy".

Despite less encouraging comments from Moody's Investors Service the previous week, the move by Fitch had been anticipated by the markets since it said in October that it could upgrade the country before the end of the year.

Ankara has been complaining bitterly for years that its rating is unfairly low, citing its low government debt, strong banking sector, and generally constructive fiscal policies. Turkey's argument has gained more credibility since the crisis decimated the finances of better-rated European countries.

The Fitch upgrade reflects the government's success in guiding an economy that was ballooning on the back of domestic demand to a "soft landing".

That has seen economic growth slow from the 8.5% recorded in 2011 to a 2012 forecast of around 3%. At the same time, the current account deficit has dropped from double figures to around 7.5%, and inflation has slimmed.

Deputy Prime Minister Ali Babacan welcomed the move, calling it appropriate and overdue, and pushing for S&P and Moody's to follow suit.

"Turkey's achievement of this credit rating is expected to mark the start of a new era in the access of our public and private sector institutions to international capital markets," the minister insisted in a statement.

Moody's appears the most likely of the two, having said that it could offer an upgrade should the government continue to deflate the economy. However, analysts at RBS remain wary about that prospect. "While the current account deficit has improved from 10% to around 7.5% this year, Turkey's real GDP growth will bounce back from a low this year (2012 is the trough), which will likely cause deterioration in the current account in 2013," they write. "Additionally, as growth picks up, inflation (currently high at 7.8% YoY in October) will very likely resume upward momentum."

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Macedonia PM's problem with names INTERVIEW:

Kester Eddy in Budapest

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acedonia offers investors the most competitive tax and low-cost business environment in Europe, it needs "several billion euros" in infrastructure investment in the mid-term, and its people are welleducated and hard-working, but very disappointed that the EU and Nato have allowed the dispute with Greece over the name of the former Yugoslav republic to block the road to membership of these organisations. That, in a nutshell, is the message Nikola Gruevski, prime minister of Macedonia, sought to give bne in an interview this week at the end of a two-day visit to Hungary.

But Gruevski, relaxed yet energetic, despite his packed schedule of meetings, is wary of talking to journalists about Macedonia's biggest challenge – the dispute over his country's official name – which exists because Greece says it fears the integrity of its province of Macedonia is threatened by the emergence of a "new" Macedonia on its northern border.

"I've had a negative experience with this – a German paper cut the quote, and I was trying to explain three months later that the second part of the sentence was not presented… this is such a sensitive issue, that anything said can be used or misused," he says.

The relationship between Macedonia and Greece has been regulated by the UN-brokered Interim Accord signed in 1995, by which Greece has agreed not to block Macedonia's integration in international organisations if done under the provisional reference/name of "the Former Yugoslav Republic of Macedonia".

But, Macedonia argues, Greece has broken this pledge by blocking its entry to Nato in 2008 and the opening of EU accession talks for almost five consecutive years. "Macedonia would like to find

as soon as possible a solution to this issue; it's in our interests to solve this, improve our relations with our southern neighbour… but in the last one and a half years there have been no discussions, these stopped in June last year," he says.

The prime minister – an economist by education – stressed that he had offered dates to the Greek side, and also invited Athens to propose dates for discussions "at any time, any place," but all offers had been rebuffed. "In 2009, the European Commission for the first time gave a positive report on Macedonia, and made a recommendation to the European Council to open the negotiation process for EU membership. This was repeated in 2010, 2011 and for a fourth time in 2012, and in the last report the Commission recommended that negotiations should be opened without delay – for the first time they stressed this – without delay!"

Given that Macedonia has "fulfilled its obligations," the continued foot-dragging by both the EU and Nato is "unfair" and "very frustrating" for Macedonia and its people, Gruevski says.

Macedonian diplomatic sources, meanwhile, played down an early November move by Greece touted by one news source as "Macedonia warms to Greek name solution initiative", telling bne that such headlines were "problematic".

"There is no such thing as a 'Greek name solution initiative' – they've sent that memorandum to Skopje after almost a year of attempts by our PM and president to meet their Greek counterparts, for which either there was simply no answer on the initiatives, or they were negative," one source told bne.

"With this memo, obviously they want to fix the negative image that they have been avoiding talks with u ... it does not

provide any new elements from their already known maximalistic positions.

However we still wish to see it as a step forward (compared to the absence of any response from their side in the previous months to our initiatives), hence our MFA's response to the Greek memo that is with a positive tone."

Economic progress But if progress on political integration is stalled, Gruevski, whose has led a centre-right coalition government since 2006, has overseen rapid headway on the economic front, with sweeping changes to legislation that make the country "the most cost competitive in Europe," he insists. "GDP growth was 6.1% in 2007, and 5.0% in 2008. We then began to feel the negative effects of the crisis. This year growth will be between 0.5-1.0%," he says.

He admits that unemployment, which stood at a staggering 39% in 2006, remains at an unacceptable 31%, but stresses that given the knock-on effects of the European crisis and particularly the turmoil in Greece, merely avoiding a rise in the numbers of jobless is in itself a success.

Underpinning the record since 2006 have been four packages of businessfriendly legislation that have stripped out red tape and put both personal income tax and corporate tax at a common flat rate of 10% flat rate.

In addition, a drive to attract foreign companies has resulted in a variety of new entrants in Macedonia. Gruevski is particularly keen to point out companies such as Johnson Controls of the US, which set up a plant to produce printed circuit boards in 2008 and has since established a second unit, and Johnson Matthey of the UK, which likewise is expanding its catalytic convertor production after a positive experience with its initial Macedonian investment.

The increased activity has meant a surge in foreign direct investment (FDI), which jumped from a typical figure of €100m in the first years of the new millennium to €700m in 2007 and €600m in 2008.

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Kazakhstan's rare earths resources. On November 15, India agreed to export 4,100 tonnes of rare earths to Japan a year, but New Delhi is also understood to be interested in joining Sumitomo's joint venture in Kazakhstan and Japanese ventures in other countries, according to reports in the Indian press. This issue was due to be discussed during Indian Prime Minister Manmohan Singh's planned visit to Tokyo in mid-November, which has been postponed.

Other Central Asian countries have also attracted investments. Stans Energy acquired a rare earths processing plant and rail terminal in Kyrgyzstan in 2011, while Green Technology Solutions entered the Mongolian market in 2011.

The company signed an agreement with Mongolian mining company Ar Erkhes on the excavation of rare earth ores and their shipment to South Korea, which like Japan relies heavily on imports of the metals.

A rare joint venture Clare Nuttall in Astana

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azakhstan's state nuclear company Kazatomprom and Japan's Sumitomo Corporation opened a factory to produce rare earth oxides on November 2. The KazakhJapanese venture is one of several challenges from various parts of the globe to China's dominance of the international rare earths market.

Summit Atom Rare Earth Company (Sareco) has built a $30m factory in Stepnogorsk, near the Kazakhstani capital Astana. Kaztomprom holds a 51% stake in the joint venture, and Sumitomo 49%.

In the initial pilot stage, the plant will produce 1,500 tonnes of rare earth oxides a year, with plans to increase output to 3,000 tonnes by 2015. By 2017, capacity will be further boosted to 5,000 or 6,000 tonnes a year, though this will still be only a tiny fraction of global production, which was estimated by the US Geological Survey at 133,600 tonnes in 2010.

Kazatomprom said in a statement that the Stepnogorsk plant would mainly produce heavy rare earth elements such as dysprosium that are used in the

manufacturing of industrial magnets and electric cars, and are "the most scarce and in demand" type of rare earths. The recent price fall has had a greater impact on light rare earths, while heavy rare earths, like those being produced at the Sareco plant, are still high.

In future, in addition to oxides the plant could start producing magnets based on rare earth metals, which would represent a move from raw materials production to processing "in line with the principles of Kazakhstan's state programme of forced industrialinnovative development," Kazatomprom president, Vladimir Scholnik, said at the plant's opening ceremony.

Eastward bound Most of the oxides produced at the Stepnogorsk plant will be exported to

Japan, the world's largest importer of rare earths, which has been seeking alternative sources of rare earths since China announced in 2010 that it would cut export quotas. This resulted in a sharp increase in global prices for rare earths, which are used in a range of hi-tech manufacturing processes including smartphones, hybrid cars, hydrogen storage cells and the defence industry.

The Sareco plant's initial production of 1,500 tonnes of rare earth oxides will make up around 7.5% of Japan's annual demand for the materials, including 3.0% of its dysprosium demand. Japan may start imports from the plant in January 2013, Japanese newspaper Yomiuri reported.

However, Japan is just one of several countries hoping to get a slice of

"Japan is just one of several countries hoping to get a slice of Kazakhstan's rare earths resources"

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However, the real game changers for the global market are taking place in the US and Malaysia. Molycorp's Mountain Pass mine in California was the world's largest supplier of rare earths from the 1960s to the 1980s, but closed in 2002.

Molycorp announced in December 2010 that it was re-opening the mine, and started production in August 2012.

Meanwhile, Australian rare earths mining company Lynas Corporation announced a significant upgrade of its ore reserves at Mount Weld, western Australia, in September and expects to open a rare earths processing plant in Malaysia in December, despite opposition from environmental campaigners.

Other factors have also contributed to the recent drop in prices. The Chinese cut in exports sparked a complaint to the WTO from US, EU and Japan, and in August, China announced it would increase its annual export quotas by 2.7%, the first increase since 2005.

Domestic demand is also weaker in China, which has put a lid on prices because as well as being the largest producer of rare earths, China is also the largest consumer.

A rigged market

bne Rig shortages are already delaying drilling in the Caspian Sea, a trend that could intensify as drilling increases over the next decade. But because the Caspian is isolated from international waters, national oil companies are having to invest in their own rig production to alleviate shortages.

Between 2012 and 2020, drilling activity in the Caspian is expected to increase by 39%, with at least 217 wells to be drilled, compared with 156 in the previous eight years, according to a new report from the consultancy Wood Mackenzie. The Caspian’s combination of deep and extremely shallow waters requires all types of units including ultra-shallow water barges, conventional jack-ups and deeper water semi-submersibles.

A rig shortage has already led to drilling delays. "In Kazakhstan, for example, the state company KazMunaiGas has an ambitious exploration programme for the Caspian Sea, which for several reasons, including the slow process of licensing the blocks and finding partners to help drilling in the Caspian, has barely started," Matthew Shaw, senior analyst at Wood Mackenzie, tells bne. "Against the background of the slow pace of negotiations, has been the fact that there have been very few rigs available in the last few years, so there has been no rush to sign contracts."

The report points out that faced with an acute shortage of rigs, "a number of new units have been commissioned and more are planned." However, the Caspian is a closed market, unlike the fluid market for rigs on international waters. "When drilling in any other part of the world, whether it’s the North Sea, the Gulf of Mexico or South East Asia, it’s possible to bring in rigs very easily – albeit at a cost – from another part of the world," Shaw points out.

However, it's far more difficult and expensive to transport new rigs to the Caspian. "The isolated rig market can lead to large fluctuations in day rates as units move in and out of work. Overall well costs remain high owing to the expense (and long lead times) of importing materials and equipment," the report says.

Rigs can be transported to the Caspian from the Mediterranean through the Bosporus Straits into the Black Sea and then along the Don river, the Volga-Don canal and the Volga into the Caspian Sea at Astrakhan.

However, they have to be cut into pieces to fit under the Bosporus bridges and along the Volga-Don canal, which considerably adds to the cost of transportation.

Until recently, the only rig-building yard in the region was at Astrakhan, but both Azerbaijan and Kazakhstan have recently started production.

Kazakhstan's KazMunaiGas has sought to address the problem by persuading international companies negotiating for the rights to exploration blocks to help it build rigs. The first Kazakh rig was built with the help of the Korean consortium exploring the Zhambyl block, and KazMunaiGas now has a second rig under construction.

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break even than the Russian budget," she notes, adding that there is a danger that a worsening of economic conditions could cause the social situation to deteriorate.

Social policy is Kazakh Achilles' heel INTERVIEW:

Martha Brill Olcott, senior associate with the Russia and Eurasia Program at the Carnegie Endowment

Clare Nuttall in Astana

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ocial policy has become the "Achilles' heel" of the Kazakh government as it tries to spread the benefits of the country's oil wealth to encourage social stability. Astana's record so far has been mixed, raising questions about the government's ability to stave off unrest in future, according to Martha Brill Olcott, senior associate with the Russia and Eurasia Program at the Carnegie Endowment.

The 2011 Zhanaozen tragedy, in which a seven-month strike by oil workers erupted into clashes with police that resulted in at least 14 rioters being shot dead, highlighted the dangers of allowing discontent to ferment in the country's industrial towns.

Following the incident, the Kazakh government stepped up its efforts to ensure the country's oil revenues trickled down to the population.

However, according to Olcott, while the government has already launched a series of regional investment and diversification programmes, Astana's ability to maintain stability will depend on how successful these initiatives are on the ground. "The Kazakhstani government has always had a tension between legislating projects and actually implementing them in a way that produces the desired effect fast enough," Olcott tells bne in an interview.

"Introducing diversified economies in the old one-industry towns would

contribute to social stability, but economic diversification policies so far in Kazakhstan have been only partially successful."

There is a danger, she points out, that with patchy success across different parts of the country, communities that do not become quickly diversified may become even angrier if they see that the policies have succeeded elsewhere.

The current priorities in Astana are

Risks While Kazakhstan's economy has continued to grow, the country is already seeing a gradual slowdown, with the Ministry of Economic Development and Trade cutting its 2012 growth forecast to 5.4% on October 23 – down from an earlier government forecast of 5.8%. "Because it is so much better integrated into the global economy than any of the other Central Asian states, Kazakhstan feels that its recovery would

"There are risks to political stability in each country, and they are likely to play out in different ways" also likely to require local government reforms, since most of the responsibility for carrying out the various programmes will rest on local governments. "The question is whether – with the best will in the world to carry out their tasks – [local government] will have the capacity to succeed," Olcott says.

"It seems that social policy is going to continue to be the Achilles' heel in Kazakhstan, given the need to create more opportunities for people who feel either economically disenfranchised or that they are not being treated in an equitable fashion."

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be threatened in the event of another crisis, although this seems to have been averted, at least for now," Olcott says.

She says the two biggest global risks for Kazakhstan are a severe slowdown in China and a precipitous drop in the price of oil. Not only would these affect Kazakhstan directly, but because its economy is so closely tied to Russia economically, the impact on the Russian economy would ripple out to Kazakhstan and all the countries in the Central Asian region. "Kazakhstan's budget is, however, pegged on a lower oil price to

However, government officials say they have contingency plans in place should the economic situation worsen considerably. Furthermore, in only one of the five Central Asian republics have social tensions led to the toppling of a government, with Kyrgyzstan's two revolutions in 2005 and 2010, meaning the chances of Kazakhstan following a similar path are not very high given the two countries' divergent paths over the last two decades. "Kyrgyzstan has a very different political development trajectory from the other Central Asian states, because they not only have this cycle of revolution, but they also have a cycle of political protests going back to the Aksy revolt in 2002. Nobody else in the region has the same dynamic of political protest and unrest that goes back for over 10 years," Olcott points out.

Kyrgyzstan also continues to see political and economic turmoil, making this a cautionary tale rather than a model to follow for the Kazakhstanis, she adds.

There are, however, various risks to political stability in all of the five Central Asian countries, and the region as a whole faces new threats when the Nato withdrawal from Afghanistan is completed in 2014, creating a potential security vacuum. "I think that we are going to find each of the countries in Central Asia finding their own patterns for blowing off steam," Olcott says.

"I can't see the Kyrgyzstani pattern repeating itself across the region, but there are risks to political stability in each country, and they are likely to play out in different ways."

Eurasia

Regional airport revamp

Clare Nuttall in Astana With airline passenger numbers steadily increasing, Kazakhstan’s regional airports are gradually being rebuilt, but safety concerns have arisen at the airports not yet being addressed by the government’s modernisation programme.

A total of around KZT100bn ($665m) has been spent on modernising the country's regional airports, according to Kazakhstan’s Ministry of Transport and Communications (MTC). This is a crucial pillar in the government's attempt to revitalise these areas and avoid a rise in social tensions, as well as meeting the sharp increase in air passenger traffic on both domestic and international routes in recent years. The number of passengers travelling by air has more than doubled in the last five years to 4.1m in 2011, according to the Kazakhstan state statistics agency.

Of the 18 airports in Kazakhstan where scheduled flights are operated, the runways and passenger terminals at ten have already been modernised, and work at the remaining airports is due to take place in 2014 and 2015.

Those already modernised include the international airports at Kazakhstan’s capital Astana and largest city Almaty, as well as airports in regional centres such as Aktau, Atyrau, Pavlodar and Shymkent. Work at airports in several other cities is underway as the government attempts to bring all its airports into line with International Civil Aviation Organization (ICAO) standards. "The technical equipment and the state of the runways at several regional airports require reconstruction and modernisation in the near future. The total cost of these projects will be around KZT80bn," an MTC official tells bne. "We have to carry out feasibility studies in 2013 for the airports at Kostanai, Uralsk, Semipalatinsk, Ust-Kamenogorsk and Petropavlovsk, and in 2014-2015 to complete the full renovation of the airports."

While some work is being funded by the state, according to the MTC, Astana is planning to set up public-private partnerships – as yet barely tested in Kazakhstan – to fund the reconstruction of some passenger and cargo terminals in future.

However, progress may not be fast enough to avert problems. In September, the prosecutor’s office in North Kazakhstan region filed an application to close down the airport at Petropavlovsk following a damning report on safety standards at the airport from Vira Project. The report detailed structural problems in the airport terminal building and other safety issue, Interfax-Kazakhstan reported. A commission has been set up

by Kazakhstan's Committee of Civil Aviation to investigate the situation.

Kazakhstan's dilapidated airports fit into a wider pattern of problems in the country's airline industry, which has resulted in the country finding itself on the EU air safety blacklist. Currently, all Kazakhstan-registered carriers, with the exception of national carrier Air Astana which meets international standards, are banned from entering EU airspace over safety concerns. Kazakhstan’s air traffic control agency Kazaeronavigation is now working with the ICAO to rectify the situation.

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past week, a dozen former officials from the internal affairs ministry – Georgia’s umbrella policing body – have been detained on charges ranging from abuse of power to using malware to spy and discredit the opposition.

A Georgian nightmare unfolds Molly Corso in Tbilisi

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he growing number of arrests of former ruling party elites since the Georgian Dream coalition won the election on October 1 is leaving many to conclude that the incoming government is using its new powers to settle old political scores. And the return to Georgia and subsequent arrest of former defence minister Irakli Okruashvili on November 20 could prove the most dangerous for President Mikheil Saakashvili's circle, as the testimony of the former close ally and top-ranking official of the previous regime is sure to lead to more arrests.

The international pressure on the government to stop arresting former high ranking officials appears to have fallen on deaf ears. The arrest of Okruashvili, who is expected to go on trial on December 3 on charges of attempting to overthrow the government and extortion, follows fresh charges the day before against Brigadier General Giorgi Kalandadze, the former head of the Georgian Joint Chiefs of Staff, despite international pressure on the government to stop arresting former high-ranking officials.

Kalandadze was charged with unlawful

detainment, a crime that carries a life sentence. Former defence minister Bacho Akhalaia (who also once served as prison minister and minister of internal affairs) is currently facing similar charges.

Philip Dimitrov, the EU's Ambassador to Georgia, stressed at a press conference on November 20 it is "important that

Allies of former prime minister Vano Merabishvili were included in the round-up, including Shota Khizanishvili, a deputy mayor of Tbilisi at the time of his arrest November 16 on charges of illegal surveillance, who served as a deputy minister under Merabishvili when he was the interior affairs minister. Eleven other former officials from policing structures – including the powerful Department of Constitutional Security (the successor to the KGB) – were also arrested on similar charges.

The alleged crimes stem from allegations that the men planted malware in computers at the Georgian Dream headquarters to spy on the opposition prior to the elections.

Charges released by the Prosecutor's Office indicate that the surveillance was used to leak incriminating audio recordings to the media in the days before the October 1 parliamentary election. Other charges include deliberately destroying property at Cartu Bank, the Georgian bank founded

by Ivanishvili that was the targeted by the Georgian government last year after

"The speed and volume of arrests have prompted wide speculation about which Saakashvili ally could be next" there is no impression that justice is linked with political causes."

Ivanishvili announced his plans to enter politics.

But there is little indication that either Ivanishvili or his cabinet are heeding those concerns. The speed and volume of arrests have prompted wide speculation about which Saakashvili ally could be next. Both Data Akhalaia, the brother of Bacho Akhalaia, and Giorgi Baramidze, a former defense minister, have been named as the targets of new investigations. Over the

Pot, kettle, black Saakashvili supporters and members of his United National Movement (UNM) have blasted the arrests as being politically motivated.

Merabishvili, now the head of the UNM party, told journalists that his allies are being targeted as part of a special campaign to scare him and other former

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officials. "Bidzina Ivanishvili should have no hope that by such steps he will stir fear or anxiety among us. On the contrary, it will make us stronger."

Tbilisi Mayor Gigi Ugulava, another powerful figure in the UNM, has also spoken up against the arrests. After Khizanishvili was refused bail on November 18, Ugulava said the charges were "obviously" politically motivated.

Justice Minister Tea Tsulukiani, however, defended the arrests, asserting that cases are being made based on crimes committed, not on political alliances. On November 19, she also hinted that investigations are underway that could lead to Ugulava's arrest. Tsulukiani told journalists that "many questions" remain about Ugulava’s activities, but there is not enough evidence yet to arrest him.

Ugulava, once considered the UNM’s likely candidate for president in the 2013 elections, is a strong Saakashvili ally and powerful figure in the party.

He has served as the elected mayor of Tbilisi since 2010 so his position was not affected by Ivanishvili’s win at the October 1 polls.

The efforts of the new government are not restricted to arrests: both the Justice Ministry and the new parliament are also working hard to meet pre-election promises to release prisoners.

The prison ministry has released 300 prisoners it deemed were ready to return to society. In addition, on November 19 the human rights committee in the parliament, together with a working group of nongovernment organizations, proposed a list of 148 prisoners and Georgians in exile who would be exonerated as political prisoners.

The list, which is not final, includes members of coalition political parties who were arrested over the past eight years on a variety of charges, as well as former parliament speaker Nino Burjanadze's husband Badri Bitsadze who fled the country in 2011 after he was implicated in accidental deaths during the May 26, 2011 protest.

Eurasia

Sold in Central Asia

bne Both Turkmenistan and Uzbekistan in November made concrete moves towards privatising more state enterprises over the coming year.

On November 17, the Turkmen government announced that President Gurbanguly Berdymukhamedov has approved a privatisation programme for 2013-2016, which sets out procedures, plans and deadlines for a three-phase programme due to start in the new year. The second and third phases will take place in 2014-15 and 2016, respectively.

Ashgabat plans to privatise state enterprises in a range of sectors including construction, transport and communications, Deputy Prime Minister Annamuhammet Gochyev said, according to Turkmenistan.ru. A second list of strategically important enterprises that will remain in state hands has also been drawn up. The next step will be to pass legislation to allow those privatisations.

The drive is part of the Turkmen government's plans to develop and modernise the economy. Ashgabat plans a gradual transition to a market economy and the integration of the country into the global economy.

Uzbekistan, meanwhile, announced that the state committee for state property management and the state committee for de-monopolisation and development of competition would be merged. The new privatisation committee will be headed by Aziz Abdukhakimov, former acting chairman of the committee on management of state property.

According to the government, which announced in May that it planned to sell off around $500m of state-owned assets over the next two years, the committee will be responsible for developing measures to enable privatisation, introducing new methods of privatisation and introducing measures for anti-monopoly regulation.

However, given the recent spate of headlines surrounding the suspension of the licence of the Uzbek subsidiary of Russia's largest mobile phone operator MTS and a court order to seize its assets, some question whether foreign investors will be prepared to risk money in the country.

The fate of MTS' subsidiary remains confused, with a Tashkent court on November 9 reversing the September ruling on the seizure of its assets and ordering them to be returned to the operator. However, the court also determined that MTS Uzbekistan should pay a total of around $600m in fines and penalties. "While this decision could be viewed as a partial victory for MTS in an attempt to defend its interests in Uzbekistan, we think it is premature to assume that MTS will restore its operations in the country, as the $600m fine seems too high, in our view, given that it is almost half of the value of this asset," says Anna Lepetukhina of Sberbank CIB.

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side, which has already received considerable private sector investment.

An inter-governmental agreement was signed in June 2005. The basic infrastructure on the Kazakhstani side, funded by the government, is due to be completed by the end of 2014. This will include roads, power lines, water and heating.

The total cost of building the Kazakhstani zone will be KZT382.9bn ($2.5bn).

Overall, the Kazakh government envisages raising four tenge of private investment for every one tenge spent from the state budget, Kanakhina tells bne. Khorgos ICBC aims to attract investment from the other two Customs Union countries (Russia and Belarus), the rest of the Commonwealth of Independent States (CIS), and the Middle East, as well as domestic investors.

Building the new Silk Road

Eurasia

Some private sector investors are already active at the Khorgos ICBC, where they are building terminals, trade centres and other facilities. They include Japanese-Kazakh joint venture Senko Lancaster Silk Road Logistics and Orion Global, Faykon and NRG+ST. In August 2011, Kazakhstan’s national railway company Kazakhstan Temir Zholy (KTZ) took control of the Khorgos ICBC. Since taking over, KTZ has stepped up efforts to attract investment and bring in international partners.

Kazakhstan has ambitions to become a transit hub for trade between Europe and Asia, as the journey time from China to the EU border across Kazakhstan is just 14 days.

Astana is investing into road and rail infrastructure. The Kazakh section of the Western China-Western Europe

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international transit corridor runs from Khorgos across Kazakhstan to the Russian border. A new railway line between Khorgos and Zhetigen, a logistics centre near Almaty was completed in December 2011, and the Altynkol-Khorgos railway crossing is due to open before the end of this year.

On the Chinese side, the Jinghe-YiningKhorgos railway was completed in 2009.

Ultimately, there are plans to make Khorgos into not just a logistics centre, but a new industrial town. A presidential decree on the planned Eastern Gates SEZ was signed in November 2011. Some 5,840 hectares of land adjacent to the Khorgos ICBC has been allocated for the SEZ, which will include a trade and economic zone, a “dry port”, cargo airport, industrial zone and residential area.

Clare Nuttall in Astana

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he Chinese-Kazakh border crossing of Khorgos is being transformed into a business and logistics centre as Astana revives the ancient Silk Road that once crossed its territory. With the basic infrastructure almost complete, Kazakhstan is working to attract private sector investment.

China is already one of Kazakhstan’s main trading partners, with Kazakhstan importing billions of dollars' worth of Chinese consumer goods, while Beijing secures supplies of Kazakhstani oil, metals and other commodities. At a summit in Beijing in June, the two governments set the target of boosting mutual trade to $40bn by 2015.

However, trade volumes have been limited by bottlenecks – both physical and bureaucratic – at the two main border crossings, Khorgos and Dostyk.

Back in 2005, the two governments agreed to set up the Khorgos International Centre of Boundary Cooperation (ICBC), in a bid to simplify cross-border trading and develop the transit potential of both countries.

The ICBC is a trading, logistics and entertainment complex straddling the

border at Khorgos, which was once a stop on the northern Silk Road that ran from the ancient Chinese capital of Xi’an, around the Taklamakan desert and through the Tian-Shan mountains, before dropping down into modern day Kazakhstan.

Citizens of Kazakhstan, China and third countries will be able to stay in

Almaty, instead of flying seven hours or more to Hong Kong or Guangzhou," explains Kuralai Kanakhina, director of the department of international cooperation at the Khorgos ICBC. Straddling the border The ICBC is divided into two parts connected by a corridor. Of its total area of 528 hectares, 185 hectares are

"Businesspeople from Kazakhstan and other CIS countries who want to do business with Chinese companies will be able to go to Khorgos, which is just 356 km from Almaty"

the ICBC for up to 30 days visa-free. A special customs regime has also been introduced. "Businesspeople from Kazakhstan and other CIS countries who want to do business with Chinese companies will be able to go to Khorgos, which is just 356 kilometres from Kazakhstan’s financial capital

in Kazakhstan, and the remaining 343 in China’s Xinjiang Uighur autonomous region. The Kazakhstani zone will include a conference centre, exhibition area, hotels, an ethnographic park, tourist resort, and zone for transport and shipment terminals. Similar facilities are being built on the Chinese

KAZAKHSTAN Khorgos CHINA

“Khorgos” International Centre of Boundary Cooperation JSC. 28 Ten Inger str., Golovatsky village, Panfilov region, Almaty district, Republic of Kazakhstan.

T./F. +7 (72831) 3 63 11, 3 63 12, 3 63 13 www.mcps-khorgos.kz

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Our assumption is that the risk premium can be sustained for at least the first half of 2013, and perhaps longer, depending on what happens in Iran. At this stage, it seems more likely that a military strike will take place in 2013, which would drive the price higher, but only for a short period. The outlook for oil in 2013, therefore, is again favourable. Beyond the next six to 12 months, the outlook is much less so. If the growth projections for US, Canadian and Iraqi oil are realised, then the oil price will almost certainly face downward pressure before the end of next year and over the coming two to four years. That may well be the next big game changer for Russia, especially if budget preparations in the meantime are inadequate.

A literary guide to investing in Russia Chris Weafer of Sberbank CIB Oh, no, the dog howled mentally. Excuse me, but I won’t, I won’t let you. Now I understand it, to hell with them and their sausage. They’ve tricked me into a dog hospital.

Mikhail Bulgakov, “Heart of a Dog”

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ow would Russia’s great writers look at 2013? As part of our look ahead into 2013, we thought to elicit the assistance of some of Russia’s most famous classic authors. What would they make of the parameters and scenarios facing foreign investors as they consider the opportunities and risks lurking in 2013? For the nine factors that make up the investment case ahead, we have chosen nine authors to make the case using one of their works. Of course, when it comes to Russia one might use all of Dostoevsky’s works or sum it all up with Gogol, about whom Dostoevsky said “We all come from Gogol’s overcoat”. If you read “Dead Souls”, you will see exactly what is meant both as a social commentary and also as an example of how one can make money of even the most unusual circumstances. Russia, for all the bad headlines regularly generated, has been the most profitable country investment (among the major markets) over the past 10 years, notwithstanding the collapse in 2008.

The one problem when using classic works from Russian authors is that it is very difficult to find a book with a happy ending. The only event that counts as a happy ending is the release from misery, and that is usually in death. Perhaps somebody will have cause to write one soon. We list the main market scenarios and investment themes as illustrated by classic Russian works.

External threats: "War and Peace" Leo Tolstoy’s epic work is the obvious choice for how we anticipate the investment backdrop in 2013, ie. a very volatile first half to be followed by a more peaceful second half. The first part of Tolstoy’s novel is set against the backdrop of the war with Napoleon culminating in the battle of 1812. The war caused great economic and social destruction in Russia, but eventually the country prevailed. This is similar to the destruction caused by the 2008 global crisis, which led to a huge decrease in the country’s financial reserves and recession. But, as in “War and Peace”, the threats were restructured and the economy placed on a better footing to withstand the external threats.

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The peace in Tolstoy’s book was bittersweet with some of the author’s heroes not surviving. There was a better ending for Pierre and Natasha and, sort of, for Nikolai and Maria.

But even here, the approaching Decembrist Uprising looked ominously likely to destroy the peace again.

In an analysis later, Tolstoy argued that his novel illustrates that great actions and changes cannot be achieved by the work of any individuals or heroes, but only as the result of many smaller events driven by thousands of individuals. Perhaps a parallel can be drawn here with the emerging middle class in Russia and how this may eventually result in a new chapter, i.e. rather than as a result of a great leader.

Our assumption for 2013 is that the negotiations in Washington between the White House and Congress, in parallel with the continuing efforts of EU leaders to contain the Eurozone crisis, will sustain continued volatility in global markets and the risk-on, risk-off rotation. The hope is that these issues will see a more sustainable structural resolution put in place by the summer, which can then create a more benign backdrop for markets in 2H12. The new Chinese leadership will formally be in place from mid March and German Chancellor Angela Merkel faces an autumn reelection campaign. She or her party will not want to start into that period with the current issues unresolved.

Oil vulnerability: "Master and Margarita" Mikhail Bulgakov’s novel is an appropriate metaphor for Russia’s oil revenues. Oil was referred to as the “Devil’s Blood” in the countries bordering the Caspian Sea. Just as Professor Woland arrived in Moscow with the prospect of improving the lot of the city’s literary elite, oil revenues grew rapidly through Putin’s first period as president and transformed the country’s economy. But the sting in the tail came in 2008, when oil collapsed and wreaked havoc with the economy. Margarita, the heroine of the novel, is as tempted by Woland’s promise of an eternal good life as Russia was tempted by seemingly never-ending oil revenue growth before 2009.

Bulgakov’s novel is set in two locations, Moscow and Jerusalem, which is also appropriate given the current events in the Middle East and the effect they have on the risk premium for Brent and Urals.

Russia’s reform agenda: "Crime and Punishment" Fyodor Dostoevsky’s novel, according to an eminent reviewer, deals with Raskolnikov's (the core character) “conflicting feelings of self-loathing and pride, of contempt for and need of others, and of terrible despair and hope of redemption”.

This is a very apt analogy for the Russian reform agenda in that it is clear that these are issues which must be dealt with, but the preference is to avoid taking any action that may be politically or socially unpalatable.

The novel follows Raskolnikov’s efforts, usually agonized, to confront what may have been his motives for the murder he committed and in the near certainty of what the consequences of his action are. We have little optimism that the promised reform agenda will be aggressively pursued over the first half of next year, or even for longer. The government’s priority is to maintain domestic (social and economic) stability, and it has the financial resources to achieve that via the budget so long

"Of course,when it comes to Russia one might use all of Dostoevsky’s works or sum it all up with Gogol" as Urals stays above even $80 per barrel. However, the reform programme is very visible and the longer-term consequences of not achieving changes are very real.

Steady progress is being made in the area of financial sector changes and the Central Depository has now finally been put in place, with access to the local bond market expected to be granted to Euroclear and Clearstream in early 2013. The major reform debate expected over the first half of the year will be that of pensions. This is one of the “big elephants” in the room that has implications for budget spending, the retirement age and immigration policy, among other things. It cannot be ignored for much longer, but will provide a real test of both resolve and unity within the government structures.

Domestic economic expansion: "The Queen of Spades" In this work, Alexander Pushkin relates the tale of an elderly countess who strikes a bargain with the devil and exchanges

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her soul for the ability to always win at cards. Then, an army officer murders her for the secret of winning but is haunted by the woman’s spirit. Here is the devil again: he features in so many Russian works. This is essentially a story of obsession about winning and always staying ahead, even at the cost of one’s sanity and soul. We could have used this work to reflect on a deal with the oil revenues and the consequences of not reforming away from gambling on continued high oil revenues.

The expansion of the domestic economy is one of the key investment themes in Russia. This, including the strong growth in consumer spending, has been one of the key drivers of GDP growth in recent years and is the basis of our preference for stocks and themes in this area. But, as also referenced in the other works mentioned, if there is no reform and one continues to rely on luck, then eventually the good fortune stops. But for 2013 we retain a strong preference for stocks in this theme: retailers, technology-media-telecoms, real estate, transport and banks.

Strategic industries: "Dead Souls" Nikolai Gogol’s “Dead Souls” is certainly one of the definitive works of Russian literature that has a lot of relevance to events today. In the story, the author’s hero, Chichikov, dupes landowners into selling him seemingly worthless dead serfs.

Chichikov explains that he intends on using the dead souls as a means to reinvent himself as a gentleman landowner in Siberia. Okay, not quite a neat jump to the state’s ownership of strategic industries, especially in oil and gas, but close enough.

With a high-tax regime and state regulation, many of the stocks in these sectors have low valuations relative to emerging market peers and are more lowly valued by investors when compared with the fast growing domestic industries.

The state has a policy of pushing for higher dividend payouts and is promising sector restructuring as part of the eventual privatisation programme. If these do come to pass, then valuations will rise. Chichikov’s ruse was discovered by the landowners and he had to flee town with his plan incomplete. Gogol wrote a sequel to his work, but burnt most of it, so we do not know how he imagined Chichikov’s plan would eventually work out. In modern Russia, the state’s script for the energy sector has yet to be finished or published.

Regulated industries: "One Day in the Life of Ivan Denisovich" An interpretation of many of Alexander Solzhenitsyn’s works may have metaphorical relevance to many of the regulated industries, such as the utilities.

Small victories can be worthwhile. No matter how unappealing the outlook for some industries may be, there are opportunities for small victories to highlight attractive investment opportunities in some areas. Just as in the case of Ivan Denisovich Shukhov, small victories can make an otherwise miserable day seem less bad at the end of it. Shukhov might buy E.ON Russia and some of the MRSK distribution companies as examples of investments to brighten up an otherwise dim outlook.

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Changing social order: "The Cherry Orchard" Anton Chekhov’s “The Cherry Orchard” may be used to illustrate many of the issues facing Russian society today. The story concerns an aristocratic family returning to the family’s estate – which contains a well-known cherry orchard – just before it is auctioned to pay off debt. While presented with options to save the estate, the family essentially does nothing and the play ends with the estate being sold to the son of a former serf and the family leaving to the sound of the cherry orchard being cut down.

The play is often used as an example of the futility of trying to maintain a status quo when faced with the inevitable and especially if those in power refuse to accept what is happening and then suffer the consequence of losing everything. Of course, the problem is that those that then inherit the power do not really understand what they now have and, as it were, cut down the cherry orchard out of spite.

Economic tandem: "A Hero of Our Time" This is a complicated work, and that is saying something in Russian literature. Mikhail Lermontov’s “A Hero of Our Time” is often used as an example of “be careful what you wish for”.

The hero of the story, Pechorin, is in relationships with two women at the same time for a while and, when he rejects one of them, the other decides she does not want him after all.

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This is a story that mirrors the government’s tandem of trying to keep state control in the strategic sectors, while also promising to push ahead with economic and business reforms to make Russia more attractive to foreign investors.

Trying to satisfy two mistresses is impossible over a long period, and by the time you choose which you prefer, it may be too late and you could end up losing on both fronts.

Russia wrap: "Home of the Gentry" Ivan Turgenev’s work centres on Lavretsky, who was brought up on his family’s country estate home by a severe maiden aunt, known for her cruelty. He leaves Russia for Paris with his wife, Varvara, who later betrays him. Returning to Russia he falls for another woman, and after reading of Varvara’s death, he plans to marry his new love. Unfortunately, Varvara turns up alive and comes back to extort money from him and generally make his life a misery.

Is there a parallel in modern Russia? Having left the cruelty and severity of the Soviet past to embrace a Western lifestyle, and with the ambition to live happily ever after, is there also a chance of a return to a less optimistic and less happy existence full of regret and longing for what might have been? In the 21st century, thankfully, that chapter has not been written yet.

Marcus Svedberg of East Capital

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Even though there are large differences across our investment region going forward, when breaking down facts and figures, six countries – larger markets as well as smaller ones – stand out as winners.

The autumn meeting of the World Bank and IMF felt like a rather depressing get-together for the ten thousand economists and policymakers that assembled in Tokyo for a week of discussions.

year’s exercise. And there are actually good reasons to be optimistic.

Reasons to be cheerful Firstly, and perhaps most importantly, the tail risks have fallen dramatically as a result of the recent policy response in Europe in general and the European Central Bank (ECB) interventions in particular. There is now a real backstop and the risk of a collapse of the Eurozone is very small. Moreover, most analysts believe US policymakers will get their act together to prevent the US from falling off the fiscal cliff next year.

Secondly, growth has bottomed out, or is very close to doing so. Growth in the third quarter surprised on the upside in the US, while China most likely passed a trough. Even the Eurozone may have passed the bottom, although the recovery is expected to be weak. Moreover, inflation will not be a problem in any of the larger economies next year. The IMF believes it will fall by 30 bp in developed and emerging economies, to 1.6% and 5.8% respectively in 2013.

Thirdly, it has not really been a bad year in the world of finance, and the outlook is actually quite good. Most bond, equity and commodity markets have performed this year, and quite a few have noted double-digit gains. Recent announcements of continued monetary stimulus from the major central banks in the world suggest that the party, especially for equities, has only just started.

CEE – from recession to buoyant growth What does all of this mean for Central and Eastern Europe? The first point is that the general outlook for CEE is closely linked to the global development. Most economies in CEE have weakened on the back of the slowdown in the Eurozone, but growth may already have bottomed out in most countries. Inflation will fall even further and there is room to stimulate growth through monetary and fiscal policies in most economies.

Six reasons to be optimistic he outlook for the global economy may seem very dark after the World Bank and International Monetary (IMF) meeting in mid-October, but there are actually good reasons to be optimistic.

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The reason for the gloom is that the global economy is slowing down and most forecasts have been revised down. The IMF now believes world output growth will reach 3.3% in 2012 and 3.6% in 2013. This is 20 and 30 basis points lower than the forecast made in July, which in turn was lower than the one in April. All major economies, except for the US, which is rather flat and has started to surprise positively on employment and housing, are contributing to the slowdown and the downward revisions. Not even emerging economies have been able to withstand the slowdown.

The meeting also raised alarm over the negative consequences of too much fiscal tightening and deleveraging in the rich world.

It is easy to get carried away by the gloom, but experienced IMF-goers found the Tokyo event more upbeat than last

The second point is that there are big differences across the region. The European Bank for Reconstruction and Development (EBRD) believes average growth will increase from 2.7% in 2012 to 3.1% in 2013, but the weakest economies are expected to remain in recession, while the most buoyant experience double-digit growth. The problem is that the recovery in 2013 is expected to be weak in the most vulnerable countries. The low external demand combined with bank deleveraging in the Eurozone mean that the economies that are most integrated will not be able to recover quickly.

A handful of countries in the region will likely post negative growth in 2012 – Slovenia, Hungary, Czech Republic, Croatia and Serbia – and they will probably not grow more than 2% in 2013. The other new EU members will probably grow faster, but few will manage more than 3%, which is only marginally faster than this year. And some, such as Poland and Latvia, may even continue to contract, albeit from relatively high levels. The Russian economy is slowing down but should be able to stabilise at around 3.5%. The other Commonwealth

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of Independent States (CIS) economies, which tend to be the least dependent on the Eurozone, should maintain growth at around 5%. The Turkish economy has managed to slow down in an orderly manner, and growth is expected to pick up from 3% to 3.5% next year.

There are no general economic imbalances in the region.

Particular countries may, however, have particular problems that could cause economic or financial pressure. Inflation will remain a problem in Belarus, while Georgia and Turkey will continue to struggle with high current account deficits, which may put pressure on their currencies. The main risk for the region in general and the new EU members in particular remains the Eurozone. The tail risks have decreased, but financial deleveraging can still cause problems. Politics remains a tail risk in some of the least-developed countries – most notably Belarus, Bosnia and parts of Central Asia – even though the status quo could be maintained for years.

The vast majority of markets in CEE were in positive territory after the first three quarters of 2012 and the regional benchmark index was up 16.8%. There were, however, enormous differences in performance from quarter to quarter as well as within the regions. The Russian market, for instance, gained 18.5% in the first quarter but then dropped 17.5% in 2Q, before gaining 9.3% in the third. The difference between Turkey, which is the best market year to date, and Ukraine, which has underperformed throughout the year, is an astonishing 70 percentage points. Currencies have been volatile, but few have moved more than 5% this year. The HUF, PLN and TRY are the strong exceptions, while the RSD depreciated by more than 5%.

Market outlook A valuation model from UBS suggests that there are also large differences across the emerging world going forward.

Of the larger index markets, Russia is second only to China, while Turkey and the Czech Republic are among the top five in the world as well. Poland and Hungary, on the other hand, are at the bottom. Of the smaller markets, Bulgaria and Serbia are deemed the most attractive, and Kazakhstan is also in the top league. Lithuania, Estonia and Slovenia, on the other hand, are at the bottom.

These technical models should be interpreted with some caution, but that Russia and China should be able to outperform going forward also makes intuitive sense. They have underperformed year to date due to misplaced concerns (politics in Russia and economics in China), and are traditionally beneficiaries of monetary stimulus. It is possible to make the reverse case for markets like Hungary and Poland. They have outperformed so far this year, but have a more challenging economic and/or political near-term outlook. Other markets, such as Turkey, are more difficult to analyse based on performance and near-term economic and political outlook, and may therefore trade more on valuations and news flow.

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Confused picture for Russia Ben Aris in Moscow

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he crisis has fundamentally changed the game for Russia and never has an outlook for the new year been so confused. In the past, the speculation was always whether Russia’s economy would contract due to some external factor, or return to strong growth given benign conditions.

Going into 2013, the issue is whether Russia can put itself on the path to sustainable growth, as the economy was already beginning to stagnate by the end of 2012. The Kremlin has always seen reform as optional; now it is an imperative.

Inflation will come in higher than forecast in 2012 at somewhere about 6.7-6.9%. However, an interest rate hike in October makes analysts believe that it has been contained and the higher-than-expected inflation was partly driven by the poorer-than-hoped harvest. At the same time, core inflation in 2012 was about 5% and fixed-income traders at Renaissance Asset Managers are expecting it to trend down to 4.5-5.5% in the medium term.

Much will depend on the harvest – which is currently forecast to be over 100m tonnes of grain, a still reasonable level that could bring inflation down – and to what extent the Central Bank of Russia (CBR) will resist government pressure to speed up growth by loosening monetary policy. So far, the CBR has

"The Kremlin has always seen reform as optional; now it is an imperative" maintained, and added, to its reputation as an inflation-fighter by hiking rates against expectations in September to 8.25%.

Deficit days Having enjoyed strong surpluses for well over a decade, suddenly the state is expecting federal budget deficits going forward, despite an oil price above $100 per barrel.

However, there is some debate over where inflation will go next. Alfa Bank’s Natalia Orlova believes it will spike again in the first half of 2013 to as much as 8%, before trending down again in the second half. On the other hand, Maxim Oreshkin

The upshot is the state is clearly on the hunt for revenues.

Putin has ruled out tax hikes, leaving other revenue-raising options that will have both positive and negative consequences. On the upside is a new focus on reducing graft, encouraging small business, and increasing both productivity and efficiency. On the downside, it looks like the Kremlin will cut contributions to the state pension fund and is also

Investment Growth Moves to Negative Territory Due to Decline in Corporate Profits Capital Investment and 12-month Net Corporate Profits, % YoY 20%

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GDP growth fell from 4.9% in the first quarter of 2012 to only 2.9% by October and is expected to remain lacklustre in 2013, although the estimates of just how sluggish lie in a wide range, which reflects how much confusion there is over where Russia will go next. On the whole, economists are being conservative due to the lack of clarity, with a range of 2.8-3.5% growth for 2013 amongst the biggest investment banks, with retail trade, manufacturing, transport, communications and banks as the key growth drivers.

at Renaissance believes that the central bank's commitment to inflation fighting and the effectively floating ruble means that the heavy lifting has be done in the fight against inflation, meaning it will fall in the medium term.

Source: Rosstat, URALSIB estimates

Ukraine's economy has been slowing throughout 2012, from 2.5% in the first half of the year to 1.3% between January and September. Raiffeisen Bank International analysts forecast it will end the year at 0.5% or could even finish 2012 with a mild contraction – a dramatic turnaround from the 5.2% of growth posted in 2011.

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If anything, a deal with the IMF will now be harder to cut after the elections, as they were widely regarded as unsatisfactory by the international community. Indeed, Andreas Gross, the chair of the Ukraine election-observing delegation from the Parliamentary Assembly of the Council of Europe

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All of Europe was experiencing a slowdown towards the end of 2012, but Ukraine's problems have been exacerbated by its already weak situation. The administration of President Viktor Yanukovych has done little to address the country's structural weaknesses since it came to power in 2010 and any lingering will to implement reforms was killed by the general elections on October 28.

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More saliently, the elections also made renewing a crucial deal with the International Monetary Fund (IMF) to restart Ukraine's $15.4bn stand-by agreement politically impossible, as the government needed to avoid taking any politically tricky reforms until the elections had passed.

The forecasts for 2013 are in a broad range from 1% to 3%, reflecting Ukraine's heavy reliance on external markets and the uncertainty that is plaguing the global economy. A devaluation of the hryvna looks very likely, from the UAH8.2 Broad balance has turned deep into the red, $bn, 12MMA to the dollar in November to a 2013 range of UAH9.2C/A FDI Broad balance (rhs) UAH9.6, predicts Renaissance Capital. Economists estimate 10 6 the national currency is 10% to 20% overvalued and one of the IMF's key demands is the introduction of a more flex4 5 ible exchange rate regime that would allow the currency to 2 slide. The hryvna is under pressure due to dwindling hard 0 0 currency reserves, which fell by $11bn over the year to about $26bn (before the last Eurobond issue), dropping 8% in the -2 -5 month of September alone. The currency is also suffering -4 from the growing current account deficit, which widened -10 -6 to $9.3bn in the first nine months of the year from $5.9bn in the same period of 2011, due to slumping demand for the -15 -8 country's exports. Even a strong harvest and record grain exports were not enough to offset the contraction of the vital exports of steel.

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Ben Aris in Moscow

In terms of reform, Ukraine has belated started to actively develop alternative energy sources such as shale gas and in November began to import cheaper gas from Germany. But neither of these measures are a substitute for the deep structural reforms necessary to put the country on a sustainable development path, and on this front there has been little or no action.

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Ukraine down and possibly out

he outlook for Ukraine is poor and boils down to two dismal scenarios of varying degrees: whether the economy will stagnate in 2013 or descend into crisis.

spark a financial crisis. Ukraine must either negotiate a new deal with the IMF (probably by May if it is going to happen) and access its stand-by facility, or concede to Russian demands to join the Customs Union, which would come with a massive reduction in gas prices. High gas prices are currently bleeding the treasury dry.

With daily trading totals never rising above a few million dollars a day, liquidity was never very great in the first place.

While Ukrainian equities are extremely cheap, they are likely to stay that way until there is a new political trigger like a change of regime. The earliest that could happen is with the presidential elections in 2015. Having said that, there are still a handful of excellent companies that will continue to attract some interest, including: helicopter maker Motor Sich, utility Centrenergo, and agricultural concerns MHP and Kernel Holding.

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But the Kremlin has its work cut out for it. As 2012 came to a close, growth in capital investment had turned negative for the first time since 2009. Investment – both domestic capital investment and foreign direct investment (FDI) – is crucial to putting Russia on a path to long-term sustainable growth and should account for over 25% of GDP rather than the current 19.9% in 2012.

"Ukraine must either negotiate a new deal with the IMF or concede to Russian demands to join the Customs Union"

The Yanukovych administration has effectively killed the Ukrainian stock market, which was the very worst performer in the world as of November 13, 2012, down 41.51%. Portfolio investors have been burnt too often and on November 19 the emerging market index MSCI officially downgraded Ukraine to "very low liquidity" as part of its biannual rebalancing.

Telecommunications operator Ukrtelecom, which was privatised last year, was excluded from the MSCI Frontier Markets Indices in the rebalancing, joining another 11 companies that were already excluded in the previous rebalancing.

Nov -10

Reform-minded Of those things over which the government has some control, 2013 could be a crucial year for reform. Of the 22 roadmaps that are being thrashed out in 2012, a dozen or so are due to be implemented in 2013. Russia already improved its position in the latest World Bank’s "Doing Business" ranking from 118th last year to 112th spot after only six months of preparatory work, but the main impact of these reforms will start to be felt in 2013.

The roadmap reforms that are already in hand include: sorting out a market basis for power distribution; making it easier to get construction permits; streamlining the customs regime as well as tax administration (and lots of progress has already been made here); and making it easier to start a business.

Devalued Since the election, pressure to devalue the local currency, the hryvna, has been rising. The government attempted to buy time by introducing a draconian mandatory surrender requirement on exporters, who will now have to sell half their hard currency earnings to the central bank for six months, and at the same time issuing an expensive $1.25bn Eurobond to shore up its reserves. But these are temporary measures at best to stave off a devaluation, which could

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Industrial production and construction were also both slowing by the end of the year, down 4.7% and 9.0% in AugustSeptember respectively, which signals falling investment, say analysts.

Jul -10

But the slow growth leaves Russia, like most of the countries in Europe, stuck between the rock of austerity, necessary to avoid deficits, and the hard place of spending needed to boost growth.

Happily, the Kremlin has probably the easiest job of any country in Europe, because not only are its debts and deficits almost non-existent by European standards, but still being a country in transition means potential gains from making reforms are huge.

The bar to achieving success remains very low.

On several occasions in the past that the Kremlin has introduced these big set-piece reforms, they have usually produced the investment theme of the year. Some previous examples are the telecommunications reforms of 2001 that created the mobile phone market; the banking sector reforms of 2004 that led to an explosion in Sberbank’s share price; the dropping of the ring fence around Gazprom shares in 2006; and the break-up of the electricity sector that finished in 2008, which led to a soaring of utility asset prices.

(PACE), openly called Yanukovych and the Party of Regions of Ukraine an "authoritarian government," which brings Ukraine's relations with the EU to a new nadir.

Sep -10

The state has also become more fiscally conservative in an effort to shield Russia better from external shocks. The new “budget rule”, which comes into play in 2013, uses historical prices of oil to calculate how much money the government is likely to have to spend rather than forward-looking estimates. As the budget assumption for 2013 is $91 per barrel, on this basis against market estimates of about $110 the upshot is the budget rule will force some austerity on the government that will slow growth, but also leave the state’s finances better able to withstanding any external shock.

The roadmaps hold the greatest hope for a big upside surprise in Russia’s performance, both in terms of domestic growth and of attracting more foreign investment. And their potential is not being taken into account by the investment banks, which (as always) base their forecasts on Russia’s historical performance.

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May -10

playing with tariffs to create more cash.

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Jan -10

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Mar -10

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Central Asia still going strong

Central Europe penned in by crisis

Clare Nuttall in Astana

Tim Gosling in Prague

K

azakhstan's growth slowed in the second half of 2012 as the Eurozone crisis and the Chinese economic slowdown caused a fall in demand for its exports including uranium, copper and aluminium. However, growth across Central Asia and the Caucasus is set to average 5.5% in 2012, with a slight increase expected in 2013.

In the first nine months of 2012, Kazakhstan's GDP grew by 5.2% compared with the same period of 2011, according to government data. In October, the economy ministry revised its forecast for the year to 5.4%, down from an earlier government forecast of 5.8%. The International Monetary Fund (IMF) and European Bank for Reconstruction and Development (EBRD) both forecast growth of around 5.5% for 2012, with the IMF anticipating growth will pick up to reach 5.7% in 2013.

Investment bank Troika Dialog (now Sberbank CIB) points to a "serious deceleration" in Kazakhstan's industrial sector, which grew by just 0.7% in the first eight months of 2012.

Although the services sector, in particular retail and transportation, achieved double-digit growth, this was offset by 1.9% growth in construction and a 0.3% contraction in the agriculture sector after the grain harvest was hit by drought.

The "Kazakh economy lacks powerful growth engine such as foreign trade," Troika wrote in an analyst note on September 27. "If economic problems persist in the developed world and the Chinese economy slows further, one should not expect any improvements in Kazakhstan's economic performance next year (there are even more chances it could deteriorate)."

Oil output is expected to grow in 2013 when the massive offshore Kashagan oilfield comes online in the first half of the year. The long-awaited launch of commercial production at Kashagan is seen as the beginning of a steady increase in oil production that should last for several decades. Opec forecasts that oil production will increase from an average of 1.58m barrels per day (b/d) in 2012 to 1.65m b/d in 2013.

After being caught on the hop by the onset of the first wave of the crisis in 2008, Astana has put in place contingency plans if oil prices fall sharply.

On November 20, Fitch Ratings upgraded Kazakhstan's longterm foreign currency rating to 'BBB+', a move the agency said reflected the strengthening of Kazakhstan's sovereign

external balance sheet, low government debt and healthy growth prospects. Kazakhstan has continued to accumulate oil revenues in the National Fund, and Fitch forecasts sovereign net foreign assets will reach 45% of GDP by end 2014.

Inflation in the first nine months of 2012 has been well below the National Bank's target of 6-8%, although it is expected to accelerate slightly by the end of the year. Visor Capital forecasts a year-end inflation rate of 6.2%. Unemployment has crept upwards, reaching 5.3% in September.

Kazakhstan's banking sector is gradually recovering from the 2008 crisis, but the level of non-performing loans remains high, at 36.7% as of September 2012. The second round of debt restructuring for BTA Bank is set to be completed by the end of 2012 after the bank offered unexpectedly favourable restructuring terms to creditors. Troika says the sector "continues to gradually turn the corner, with a leaner and more balanced post-crisis banking system able to deliver low teen loan growth in the coming years". However, the EBRD warns that several indicators in the sector remain weak.

Best of the rest Elsewhere in Central Asia, both Turkmenistan and Uzbekistan saw robust growth, albeit a little slower than in 2011, forecast at 10% and 7.5% respectively for 2012 by the EBRD. Both countries have announced privatisation plans for 2013.

Azerbaijan, which has seen a drop in oil production offset by strong growth of the non-oil sector, is however expected to see GDP growth decline from 3.9% in 2012 to 2.7% in 2013.

Overall, countries in the Central Asia and Caucasus region are making a "solid recovery" from the international economic crisis, with the IMF forecasting average growth of around 5.5% for 2012 and 2013. This reflects both healthy revenues for oil and gas exports from the region's energy exporters, as well as remittance inflows to the energy importers.

The exception is Kyrgyzstan, where a drop in gold production because of technical problems at the Kumtor mine has brought 2012 GDP forecasts to close to zero, but a recovery is expected in 2013.

T

he four Visegrad states are following divergent strategies in their bids to defend themselves against the unfolding European debt crisis. It's an illustration of the countries' deep dependence on the EU that none of those tactics can pull them away from the trouble, and ironic that the only member of the Eurozone among them is the one doing best.

At one extreme, the Czech approach has remained steady – too steady, argue many – with Prague maintaining harsh austerity come what may. In November, the government finally admitted it needs to ease off a little on its fiscal deficit targets, but not until 2014. That leaves the Czech National Bank on its own again to try to provide some stimulus in 2013, despite having run out of conventional ammunition.

At the other end of the scale, Hungary has been consistent only in its erratic policymaking. That has helped the economy tumble into recession, with investors and the banks despairing of the government's capricious policies. Spending cuts and reform have been threadbare, while the government dances the hokey cokey with the EU and International Monetary Fund (IMF) over a bailout loan. There's little sign that will change in 2013 – unless it is forced to play ball by the markets, hard currency needs, or both.

To the north, Slovakia will be hoping its car plants can continue to drive the economy at the surprising pace it has managed in 2012. Starting out with a stance that sought to meet ambitious fiscal consolidation targets with a commitment to protect spending, the Smer government, which took office in April, has found itself forming policy on the hoof, as slowing growth saw it admit that on top of revenue-raising measures applied to business and the wealthy it has to look again at where it can save a few pennies. However, there's little fat to trim given the country's horrible unemployment figures, so the 2013 budget continues to hinge on uncertain growth prospects.

Next door, Poland's fall from its "island of prosperity" into the stormy seas in which everyone else has been floundering means Warsaw has had to be the most flexible in its strategy.

The government began the year stressing austerity, only to relax as the impact of the crisis became clearer. In the fourth quarter, it was looking to create tools to drive infrastructure

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investment without worsening state debt levels, and it has promised to continue to push growth as well as austerity, notwithstanding concern at the likes of the European Bank for Reconstruction and Development (EBRD) over "excessive reliance on public investment".

With inflation receding, the National Bank of Poland – the only central bank in Europe to hike rates in 2012 – finally offered a first cut in November, and it's likely to continue to ease monetary policy in 2013 as poor labour market indicators continue to squeeze the domestic demand that has done so much to protect the economy until now. The catastrophic state of the country's construction firms will do little to help in that regard.

Growing pains Erste Bank calls the European Commission's forecast for the Czech Republic to recover from a likely contraction of 1.3% of GDP in 2012 to 0.8% growth next year "optimistic". It sug-

"Poland's fall from its 'island of prosperity' into the stormy seas means Warsaw has had to be the most flexible in its strategy" gests 0.4% looks more realistic, while warning it may well have to lower that outlook before the end of this year.

The Commission sees Polish growth slowing to just 1.8% in 2013 as continued deterioration in domestic demand increases its exposure to shaky export markets. Meanwhile, it clearly expects the Slovak car trick to continue, pitching 2012 growth at a full 2.6% - the fastest in the Eurozone – with a slight deceleration to 2% in 2013 due to continued slowdown in Eurozone demand and ongoing fiscal consolidation. The likes of Komercni banka and Erste are in line on the 2013 prediction.

The Hungarian economy should just scrape back into positive territory with growth of 0.25% in 2013, reckons the Commis-

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sion, but that presumes the country does not fall victim to the numerous domestic risks it faces on top of the dangers of the Eurozone crisis. The EBRD worries that Hungary's "traditional strength in attracting export-oriented investment appears increasingly in doubt," while continued pressure on the banks means lending will slow even further and deleveraging by parent groups increase.

The banking sectors in the Czech and Slovak republics remain among the most stable – but also most conservative – in CEE. Despite some risks to profitability, Poland's banks also look solid.

Hungary's public debt, meanwhile, remains at around 80%, and having been locked out of international debt markets for

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the whole of 2012, many analysts suggest it will struggle to keep up with foreign currency debt obligations in the first half of 2013. Most are hoping that will finally push Budapest to rein in its unconventional policy-making in order to seal a bailout.

Across the rest of the region, sovereign debt issues spiked in 2012 as the wave of liquidity sparked by action from the US Federal Reserve and European Central Bank sent investors searching for returns and Visegrad yields to historic lows.

With commentators starting to talk of "bubble" in emerging market debt, Poland and Slovakia in particular spent November front-loading 2013 borrowing needs.

Mike Collier in Riga

T

he Baltic states had a good 2012 – on paper, at least.

They had the three fastest growing economies in the EU: Latvia is expected to grow 5% for the year as a whole, and Estonia and Lithuania 3%, against a backdrop of the Eurozone omnishambles as they completed reforms enacted during the three biggest recessions in the 27-member bloc.

Opinion is divided on whether 2013 will see the pace of growth slow. Capital Economics expects Estonia to lead the way in 2013 with 2.5% GDP growth, and Latvia and Lithuania on 2%. But Riga-based chief economist with Nordea bank, Andris Strazds, is much more optimistic for the Baltics: "I would say that anything below 3% growth next year looks overly pessimistic and could happen only if something really bad happens globally – for example, a major war in the Persian Gulf region results in the oil price going through the roof."

While the three Baltics should continue to marginally outperform other EU members, that's far less than other emerging markets and political risk appears to be on the rise.

The first example already appeared in Lithuania when the government of Andrius Kubilius was kicked out of office despite making good on its promise to pull the country out of crisis. "The defeat of Andrius Kubilius's conservative austerity economy and the election of Algirdas Butkevicius's more populist ticket seem to have broken the political and economic continuity that we have otherwise experienced during past

sion and European Central Bank due by July to deliver a final verdict on Latvia's readiness to be admitted to the Eurozone, the first half of the year could see opposition parties attempt to embarrass the government by challenging it in the constitutional court. "Regarding Latvia in the Eurozone – I think that the probability [of admission] is very high. A good public finance position, moderate inflation and relatively high growth outlook will positively affect the Commission's opinion. I think that the [Commission] needs a 'success story' in such a still uncertain environment in the euro area and Latvia at least is really a success story," says Danske Bank's Baltic specialist, Violeta Klyviene.

In Estonia too, the formerly watertight government of Andrus Ansip is starting to spring a few leaks. A funding scandal in his Reform Party and the abject failure of governmentapproved measures to stop national airline Estonian Air losing money (which markedly increased losses) has taken some shine off Ansip's reputation as a safe pair of financial hands, and a general perception that the government elite is increasingly distant from the lives of ordinary Estonians will increase pressure, particularly in the run-up to local elections.

Baltic states – A good year

elections in the Baltic States," says Hans Brask, director of the Baltic Development Forum.

But Lithuania's new PM finds himself in an immediate bind: elected to loosen the purse strings, any real moves by Butkevicius to do so could endanger the country's finances that have been so skilfully managed by former finance minister Ingrida Simonyte.

Perhaps even more ominously, a coalition also headed by Russian-born gherkin magnate and former fugitive Victor Uspaskich, plus impeached former president and stunt pilot Rolandas Paksas should not be short of drama, particularly with current President Dalia Grybauskaite making no secret of her disgust at having to deal with such a troika.

Referendums If not yet at Lithuanian levels, political risk is on the rise in the other two Baltic states, too. In Latvia, tensions are increasing between the centre-right Unity party of Prime Minister Valdis Dombrovskis and the more liberal Reform Party, partly because Reform's cadre of smart young ministers seem to be stealing all the headlines, but also because of concerns that too much of the cost of Latvia's economic turnaround is being paid for by the poorest sections of society.

Pressure is building for a referendum on the government's dream of euro adoption in 2014. With the European Commis-

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According to Swedbank's Martins Kazaks, the success or otherwise of the Baltics in 2013 will depend on their readiness to continue and refocus their reform efforts. "The postrecession rebound is by and large over," Kazaks tells bne. "To keep growing, the countries must create an environment that is increasingly favourable for productivity growth. This means continuing structural reforms. Many EU economies are sliding deeper into recession, which means that they will do exactly the same tricks that the Baltics did a few years back.

I 67

"I would say that anything below 3% growth next year looks overly pessimistic and could happen only if something really bad happens globally"

For instance, they will cut wages. It is no longer possible to do so in the Baltics, so more difficult steps must be taken - and while companies can indeed do much themselves, it will not be sufficent if the government does not take an active part.

And this again means deep reforms across the board: education, tax policy, regional development, etc."

Few people expect significant progress in 2013 on any of the high-profile joint projects that are supposed to be underway.

From the Visaginas nuclear power station – roundly rejected by a non-binding plebiscite in Lithuania – to a regional liquefied natural gas (LNG) terminal and a high-speed rail link, the Baltics will continue to talk unity while hedging their bets and concentrating on domestic issues. "About the realisation of any cross-border megaprojects such as Visaginas in the Baltics I'm pessimistic... The Baltic states don't have any track record of having completed any major cross-border projects during the two decades since regaining independence – unless you view joining the EU and Nato as such 'projects'," says Nordea's Strazds.

Southeast Europe different but the same Nicholas Watson in Prague

S

outheast Europe can basically be divided into those that have joined the EU and those are still trying to. But regardless of which side of the EU coin a country is on, the economic prospects for 2013 are pretty much the same: low growth if any, with the risk of a regional banking crisis should Greece be forced out of the euro.

investors in their Balkan hinterland, enjoying market shares of up to 25% in some countries. The Greek banks are already pulling back funding to subsidiaries in the region, and if this picks up, analysts say it could quickly lead to liquidity problems and, if not inadequately managed by local and regional authorities, a loss of confidence and bank runs.

Take the banks. This is one of the main channels through which the Eurozone crisis will reach Southeast Europe (the others are trade and the capital markets). Greek banks have been big

However, it's the slowdown in economic growth, and in some cases outright recession (Slovenia, Croatia, Serbia), stemming from the problems in the Eurozone that represents

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the primary source of concern for regional policymakers at this stage.

The last quarter of 2012 has brought little in the way of good news for the region, which overwhelmingly relies on Europe to sell its goods and services. On November 22, Eurozone business surveys showed companies toiling against shrinking order books and service sector firms laying off staff, putting the economies of the single currency on course for their weakest quarter since the depths of the crisis in early 2009.

In October, the European Bank for Reconstruction and Development (EBRD) released its latest predictions for the economies of Central and Southeast Europe that were lower than previously forecast, reflecting the delayed recovery and stagnation in the Eurozone. The EBRD said it now expects the seven economies in Southeast Europe to grow by only 0.7% this year and 1.7% next, having previously forecast growth of 1.0% and 1.8%. "Most countries in central and southeastern Europe as well as Ukraine will likely see lower growth than previously forecast as the baseline outlook for the euro area has worsened further," the EBRD's economists said. With the Eurozone economy faring even worse than thought, the EBRD may revise that down further as 2013 progresses.

This weakness in industry combines with weak consumers in most cases, reflecting a combination of pessimism, stagnant incomes, rising unemployment and sluggish lending. Slovenia, Croatia and Turkey, for example, have all seen consumption contract so far this year; while in Turkey that can be considered a much-needed pause, analysts say what is happening in Croatia and Slovenia could prove to be a more permanent adjustment.

However, there are bright spots, too. The finances of most of the region's countries are in far better shape than most of those in Western Europe. Sovereign debt as a percentage of GDP, for example, in all the countries is below the 60% threshold stipulated by the EU. Serbia remains one of the most challenged in this area, but even there its debt level is only 57.5% of GDP; compare that with the 100%-plus levels in Greece, Italy, Ireland or Portugal. Likewise, most budget deficit positions in the region are either already below or heading down to the 3% of GDP ceiling. Such solid fundamentals mean the countries are borrowing at rates far below those troubled euro economies.

Unlike their western peers, the region's countries also appear willing and able to make the necessary adjustments and reforms to attract investment. The World Economic Forum's 2012 Global Competitiveness survey showed big improvements in Turkey, Bulgaria, Romania, and Bosnia-Herzegovina relative to pre-2008, while this year's World Bank "Doing Business" survey picked Serbia as among the top 10 economies that have improved the most in the past year.

Marcus Svedberg of East Capital sees a lot of upside from a valuation point of view in frontier markets like Bulgaria and Serbia, which have underperformed this year. "It is obviously

bne December 2012

more difficult to say when these markets will revalue, but the recent rally in Slovenia (the market gained 20% in September on privatisation rumours) suggests that a revaluation can happen rapidly when there is a general risk-on mood combined with a specific trigger," he says.

Hard slog Bulgaria and Romania, despite both struggling with political problems and beset by corruption, look best placed to perform well economically in 2013. Bulgaria's economic growth remained lacklustre for most of 2012, but began to show more encouraging signs toward the end of the year. UniCredit Group expects GDP growth of 0.5% this year and 1.5% next year. Romanian GDP growth also showed some strength this year, and UniCredit predicts growth of around 0.5% in 2012, picking up to 1.3% in 2013.

Slovenia, the other EU country in Southeast Europe (and the region's only member of the Eurozone) has much bigger worries. It's one of those stuck in recession (1.1% contraction expected this year) and growth is not expected to get above 1.0% in 2013, if at all. The big weakness here is the banks, most of which are still state owned. Slovenian banks' provisions for bad loans rose 20% in the first nine months of this year, pushing the troubled sector into a loss for the third straight year. Bad loans amounted to 14.2% of all loans at the end of September, 3 percentage points higher than at the start of the year. The government is trying to reform the economy to avoid having to ask for an international bailout; the jury is still out on whether it will succeed.

Croatia is due to become the 28th member of the EU in July 2013, though the dire state of its economy will mean it will be the first CEE country to join the bloc with a deteriorating economic situation. That's a shame, reckons Moody's Investors Service, because "in the absence of pro-growth reforms and improvements in the country's institutional capacity, the anticipated benefits normally expected from EU accession are unlikely to fully materialize." In November, the finance ministry said it expects Croatia's economy to shrink 1.1% in 2012, making it a fourth year without growth, but said there were signs of improvement in the current quarter and expects a return to growth in 2013, forecasting the economy will expand 1.8%.

Serbia, the other big economy in the region, also faces numerous challenges in 2013 – a situation that hasn't been helped by one of the new government's first moves being to sack the central bank governor. This annoyed the EU and IMF, both of which it desperately needs to unfreeze a €1bn stand-by loan and shore up its credit position. The IMF predicts GDP will contract by about 2% this year, with a modest recovery expected in 2013. Underlying this is the fiscal deficit, which widened sharply in 2012 relative to the original budget and last year's level, and is unsustainably large. Public debt has also increased significantly, inflation is volatile and unemployment is high. "Fiscal consolidation is therefore an urgent priority," the IMF said in November.

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Turkey – so far, so good

David O'Byrne in Istanbul

D

espite dire warnings over the past 18 months that the floating interest rates and other "unconventional measures" employed by Turkey's central bank were about to unravel, they appear to have succeeded in bringing about the hoped-for "soft landing" of the Turkish economy. Now with an upgraded credit rating and the promise of a loosening of global liquidity, Turkey can reasonably expect an increase of capital inflows and accelerated growth.

The challenge will be to manage that growth effectively without allowing the economy to overheat or cause any worsening of the current account deficit – which will continue to be an issue requiring careful attention.

With energy the single largest contributor to the current account deficit, efforts will continue to maximize the use of domestic reserves. The exploitation of Turkey's huge AfsinElbistan lignite field is expected to meet over 5% of Turkey's power needs. However, as with Turkey's nuclear plans, it will be some years before slated new plants can begin generating electricity and Turkey will continue to rely heavily on imported gas for power. There is talk of new deals to bring gas from the Kurdistan region of Iraq.

Meanwhile, privatisation of Turkey's state power companies is expected to continue. The sale of the last five regional power distributors is slated to be completed by mid-2013, and tenders for the bulk of the state-owned power plants is expected next year too.

And following the successful offering of 25% in state owned Halk Bank in November, officials have already indicated that they have begun moves for a similar offering of shares in Ziraat bank – Turkey's biggest bank by assets, while the banking regulator has signaled that it is open to issuing banking licences to international institutions that want to start operations in Turkey.

Rocking the boat?

Ironically, just as the Turkish and global economies appear set to rebound, Turkey also appears set for a return of political uncertainty.

With the Justice and Development Party (AKP) now in its third term in power, the majority of senior ministers, Prime

Minister Recep Tayyip Erdogan included, are obliged to abide by party rules limiting them to three terms in parliament.

Welcomed a decade ago as the perfect antidote to Turkey's perennial problem of party leaders clinging to power way past their sell by date, the rule now appears to risk breaking up a winning team simply for the sake of it. More worryingly, at Erdogan's bidding, the AKP is working to change the constitution to give the president executive powers, when the sevenyear term of the current president Abdullah Gul ends in 2014.

As the president is elected by parliament and not by popular vote, it is expected that this change will allow Erdogan to be elected president and remain in charge without breaching AKP rules, and without any of his current senior ministers and possible challengers in parliament.

Constitutional changes require a two-thirds vote in parliament, so there is no certainty of the change being adopted, but it has already sparked rumours of a possible split in the AKP and over a possible return to active politics by President Gul when his term ends.

Most pointedly, critics have noted the irony of Turkey adopting a presidential system at the behest of a strong leader who has already enjoyed a decade in power, at the very time when Turkey's Muslim neighbours in the Arab world have been overthrowing their own atrophied presidential incumbents, and looking to Turkey as a model of an Islamic country with a functioning parliamentary democracy.

"There's an irony of Turkey adopting a presidential system at the behest of a strong leader at the very time when its Muslim neighbours have been overthrowing their own atrophied presidential incumbents"

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