bne:Magazine - September 2014 by Ben Aris

Inside this issue: Sanctions give Belarus a headache Feeling the pinch in Central Europe When Orban talks, business shudders September 2014 www.bne.eu

Mongolians fear being railroaded by China Special Report Fund Survey 2014

Europe's low-cost factory

bne September 2014

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) Anna Kravchenko (Moscow) Central Europe: Jan Cienski (Warsaw) Mike Collier (Riga) Tom Nicholson (Bratislava) Kester Eddy (Budapest) Southeast Europe: David O'Byrne (Istanbul) Ian Bancroft (Belgrade) Bogdan Preda (Bucharest) Guy Norton (Zagreb) Andrew MacDowall (Belgrade) Eurasia: Bureau Chief: Clare Nuttall (Almaty) Molly Corso (Tbilisi)

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COVER STORY 6 The Insiders

CENTRAL EUROPE 28 Feeling the pinch in Central Europe

8 Europe’s low-cost factory +7 7073011495

Advertising & subscription: Elena Arbuzova +7 9160015510 Business Development Director Alec Egan Business Development Director (International)

29 Tax and shale in Poland 14 Perspective 15 Chart of the month

30 Ukraine crisis exposes sharp divisions in CEE 32 When Orban talks, business shudders

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EASTERN EUROPE +44 7738783240

16 Sanctions give Belarus headache 17 Ukrainian industry ravaged by war 19 Civilians pay price for fighting in east Ukraine

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21 Investors fear time running out for Interpipe

34 A polarising Pole returns to the fray 36 Lithuanian town says sayonara to nuclear saviour 38 Nuclear in CEE – too tender by half 40 Crisis triggers Czech job hunt

23 The BRICS bank and the Great Schism 25 Sanctions take aim at Russia's Arctic push

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bne September 2014

Contents

SOUTHEAST EUROPE

EURASIA

OPINION

Turkish voters hand Erdogan presidency

Putin plays peacemaker in South Caucasus

Russia not invading, nor yet backing down

Turkey eyes up neighbours

Kazakhstan rethinks foreign policy

East-West trade war kicks off

Western Balkans count cost of floods

Kazakhstan re-jigs government

Albania struggles to develop vintage wine industry

Kazakh plans for gas face obstacles

Moldova uncorks new markets after Russian wine ban

Mongolians fear being railroaded by China

Macedonia buses in investment

Astana starts Expo 2017 preparations

Prime attraction

Ukraine crisis casts shadow over Montenegro

Too little, too late in Mongolia

SPECIAL REPORT â&#x20AC;&#x201C; Fund Survey 2014 72

Unloved and underinvested

Fondul Proprietatea pushes reform

UPCOMING EVENTS

I The Insiders

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The endless conundrum: domestic versus foreign-owned banks

Otilia Dhand of Teneo Intelligence

he global financial crisis put conventional wisdom on models of financial system ownership in Central and Eastern Europe (CEE) under the microscope. The debate on the merits of foreign- vs. domestic-ownership of banking has since polarized opinion, but is it possible that the whole dispute is misplaced? The foreign-owned banking system not only helped transmit the crisis to CEE, but it has also played a negative role in the recovery, slowing the region's climb back to growth. However, recent troubles in Slovenia and Bulgaria highlight that the risks of domestic ownership, whether state or private, remain palpable. So what’s the right choice? The evidence suggests neither is free of dangers, so perhaps rather than focus on a false argument, we should look for ways to manage the shortfalls of both. False prophets In the post-communist transition from planned to market economies, privatisation of large state owned banks to foreign investors was the mantra of reformers. That saw most CEE countries privatise their dominant state-owned banks by the early 2000s. With domestic capital of the necessary volume largely nonexistent, those sales targeted foreign investors. Indeed, one of the stated aims of privatization was that large foreign banks would bring both new financial resources and knowhow into the banking sector. The second major objective was for the large international financial houses to offer greater stability during times of

domestic economic turbulence and to insulate the financial sector from the impact of volatile transition-period politics. The 1997 Bulgarian banking sector collapse, which wiped out half of the country’s household savings, serves as a reminder as to why stability was as high on the list of priorities as the perceived need to divorce political and business decisionmaking in the financial sector. Since this form of privatization seemed to address many of the woes of CEE’s underdeveloped financial markets, most countries – with the glaring exception of Slovenia – chose this route. Post-privatization, the percentage of foreign ownership across CEE in the banking sector varied from 65% to almost 100%. The supporters of privatization did not have to wait long for evidence to support their stance. CEE experienced a foreignfunded credit boom between 2003 and 2008, which drove both domestic consumption and economic growth to new highs. Thus, foreign investment proved its merit. However, the idyll would soon crumble. The global financial crisis brought a profound challenge to the cosy picture of stability provided by large international financial houses. Rather than safeguarding CEE, those very banks became the main channel of contagion for the worst financial crisis since the Great Depression. Funding flows from foreign parents to local units reversed, and CEE fell into deep recession. The recovery was slow as international banks battled to clean their balance sheets or resorted to state bailouts. Vienna Initiatives I and II were the joint response to stem the outflows from CEE and ward off the looming capital starvation.

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Cure-all? Six years on, banks as well as regulators are still mopping up the spillover. Looking back, it now seems that the opponents of foreign investor focused privatization had a point – far from being a guarantor of stability, majority foreign-owned banks meant credit booms in the good times and sharp reversals in the bad. Not only pro-cyclical, but beyond the control of domestic authorities.

speculated to have jumped to another domestically-owned financial house: First Investment Bank (FIBank).

Calls for greater domestic ownership appear a logical conclusion. Hungary has taken the "repatriation" drive most seriously. Prime Minister Viktor Orban recently announced domestic ownership of banks has reached 50% again.

FIBank pulled through in the end, but the Bulgarian government was forced to place KTB under special supervision. Sofia has now also resorted to giving up its regulatory independence in favour of the EU’s Single Supervisory Mechanism in order to restore trust in the system.

However, just ahead of Orban's celebration came a reminder that domestic ownership of banks is not necessarily the cureall either. In late June, Corporate Commercial Bank (KTB) became the first Bulgarian bank to collapse since the 1990s, raising the spectre of the 1997 financial crisis. The avalanche of events that led to the collapse of KTB started with political rather than economic shifts. Bulgaria is notorious for dubious links between politicians and businessmen and earlier this year business interests started to realign in anticipation of a change in power at elections set for October. The two main actors in the early summer drama were Delyan Peevski, a media mogul and one of the foremost leaders of centrist parliamentary party Movement for Rights and Freedoms (DPS), and Tsvetan Vassilev, the majority shareholder of KTB. Following a fall-out – rumoured to be over Vassilev’s support for political newcomer and former TV presenter Nikolay Barekov – the pair traded accusations of plotting each other’s assassination, which triggered investigations with cross-border jurisdiction. Moreover, Peevski accused Vassilev of treating deposits in KTB as his personal funds. In early June, authorities raided the bank and later the same month, media (largely controlled by Peevski) published a letter, which alleged that a deputy governor at the central bank was under investigation for shortfalls in supervision of a bank "that has recently come into a public spotlight". Panic ensued. More than 20% of deposits were withdrawn within a week, leading to KTB's collapse. Large corporate clients, some of them linked to the state or Peevski’s business empire, were among those to transfer funds. This cash was

Within a week, FIBank faced an anonymous campaign alleging lack of liquidity. A bank run followed almost immediately. Bulgaria's two prominent domestically-owned banks faced potential ruin over one political spat.

Tangled The lesson is clear. The thesis on the systemic risk of political entanglement of domestically-owned banks is still valid. It does not mean all domestic banks are necessarily politicised, just that if they are, they present a systemic risk. Events in Slovenia, the country that avoided privatization in the first place, are equally instructive. Last year, Ljubljana narrowly avoided a troika bailout as it struggled to meet the costs of non-performing loans piling up in its state-controlled banks. The problems were blamed on the prioritizing of politicised decision making over business merit at the lenders involved. Although Ljubljana avoided the need for a rescue, the eventual clean up carried out in December cost the government an equivalent of 7% of GDP. The country’s second largest bank, NKBM, is now among the SOEs earmarked for privatisation, and two more banks may follow. Maybe it's time to abandon the ideologically tainted bickering on whether foreign or domestic ownership is better. The lesson to be learned here is that both models have their inherent risks and merits, and it would be more prudent to look for ways to mitigate weaknesses and capitalise on strengths. Perhaps the Single Supervisory Mechanism could go some way to disconnect banking supervision from the crux of domestic politics (as Bulgaria has now suggested) and keep an eye on multinational banks at the same time. But as ever, let us see what the implementation brings and where the loopholes lie.

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Europe's low-cost factory Clare Nuttall in Bucharest

Cover Story I 9

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outheast Europe is fast becoming the low-cost manufacturing centre for the continent, a transformation driven as much by changes to the Chinese economic model as by efforts within countries on the fringes of the EU to attract investors.

is the lowest rate in Europe, Albania’s minimum wage is just ALL22,000 (¤160), and minimum wages in Bulgaria, Macedonia, Romania and Serbia are all under ¤200, according to Eurostat data. Consequently, international firms are exploring new manufacturing locations.

Workers in countries like Albania, Moldova and Serbia are cheap, well educated and right on the EU’s doorstep. Added to the increasing savviness of most governments in the region in how to attract international investors, this has proved to be an attractive proposition for global manufacturers of products from clothes to auto parts who have been gradually migrating eastwards in a quest to keep costs down.

Closer to home Habitex Group, which specialises in producing high-end garments for German clients such as Basler and Gerry Weber, currently carries out the bulk of its production in Romania, where it has built its own factory. The company’s chief financial officer, David Jachir, believes there has been a shift from Asia to Europe. “As Chinese labour costs rise, there are two choices: either you go cheap and move to a region with lower costs – Bangladesh, Indonesia, Vietnam – with all the risks; the second choice is to go local, move production closer to the market to increase responsiveness and speed to market.”

But Southeast Europe’s transformation into an emergent manufacturing hub was triggered primarily by changes some 8,000 kilometres away in the industrial heartland of eastern China. Changing demographics are at the root of China’s transition away from a low-cost manufacturing location. As the population ages, China’s labour surplus is disappearing, creating upward pressure on wages. Concerned that a widening income gap could result in social unrest, Beijing is aiding this process by increasing the minimum wage and putting pressure on multinationals to raise salaries. Average wages rose by 8.6% in China in 2013, and are expected to increase by a further 8.8% in 2014, according to the China Daily. The government has announced plans to raise minimum wages by an average of 13% a year until 2015. The upshot of this is that it has eroded the wage gap between China and lowincome European countries, several of which now have lower minimum wages than richer Chinese regions. After increases across most of the country in April, the minimum wage in Shanghai – the highest in China – stood at CNY1,820 (¤223) per month. This is well above the MDL1,650 (¤89) that the Moldovan government set as its minimum wage in May. While this

The spring/summer and autumn/ winter seasons are being superseded by fast-changing “micro-trends” designed to get customers into their shops more often and spend more money. To make this possible, Zara produces 80% of its goods within Europe. Investors also report that Chinese producers have become harder to work with. The legacy of the recent economic crisis has actually been to improve the bargaining position of Chinese manufacturers. Initially, it forced many Chinese factories catering to the international market to close. This reduced the number of players on the market, putting those that remained open in a stronger position when negotiating terms with customers. Others have turned to the increasingly affluent domestic market, where buyers tend to be less picky, rather than “fulfill complicated orders for European customers,” says Jachir. Elena Baragan, commercial director of Nightserve, which produces specialist

"Several European countries now have a lower minimum wages than richer Chinese regions" Proximity to Western European consumers is another factor; it takes just days to receive goods from factories in Eastern Europe compared with the two months needed to ship from China. Albania, for example, is just 100km from southern Italy, encouraging a growing number of Italian shoe and clothing retailers to shift their production across the Adriatic, often working with local sub-contractors. EU rules allow goods produced in Albania (or BosniaHerzegovina, or Macedonia) to bear the “Made in Italy” label, provided at least part of the manufacturing process takes place within Italy. Speed has also become the allimportant factor for mass-market clothing retailers like H&M and Zara.

garments for the military and services such as the police and fire brigades, acknowledges that while costs are higher in Romania, which has been an EU member since 2007, there are advantages. “Since the crisis in Europe, the size of our orders are not so big and customers have wanted quick turnaround. Going to China for 150 vests is not cost effective,” Baragan says. Given Romania’s background in the textiles industry, quality is also higher, she adds. Indeed, while Romania is a centre of mass-market production, the country’s rising costs have been accompanied by an increase in skills – largely thanks to the influx of investors in the mid-2000s. This has seen the country gradually segue from a low-cost factory

I Cover story

to a producer of higher end goods and other activities such as IT and services outsourcing. James Hyslop, director for Romania at the European Bank for Reconstruction and Development (EBRD), highlights the impact of knowledge transfer and investment into human capital. Notable investors in Romania include Universal Alloy Corporation Europe, which set up production of aerospace components and supplies customers such as Boeing from a plant in northwest Romania. Deutsche Bank also endorsed the skills of the

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Romanian workforce when in May it opened a Global Technology Centre in Bucharest. One of just four worldwide, the Bucharest centre will hire 500 people by the end of 2016 to develop software applications. Bulgaria has also seen significant interest from foreign investors into high-tech sectors, according to the InvestBulgaria agency. Business process outsourcing has become one of the fastest growing areas of the economy, while the automotive and components sector is also growing.

However it has taken years of investment to come this far, and other countries in the region such as Albania and Moldova are as yet much further down the value chain. Cut from different cloth Spurred on by the trend towards fast, disposable fashion, clothing production tends to be a frontrunner in relocating to low-cost destinations in Emerging Europe. A large share of this production is on â&#x20AC;&#x153;lohnâ&#x20AC;? contracts, also known as CMT (cut, make and trim), under which materials are processed to

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exact technical specifications. Often the materials are delivered by the customer then re-exported. As a result, opportunities for wider development, by improving skills or creating opportunities for local suppliers, are low, say critics. There is also a darker side to the clothing and textiles industry across the region, revealed in a June report from the Clean Clothes Campaign. The report says that international brands including Hugo Boss, Zara and H&M are paying “poverty wages” to workers in Southeast Europe and Turkey. “[P]

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"Post-socialist European countries function as the cheap labour sewing backyard for Western European fashion brands and retailers"

ost-socialist European countries function as the cheap labour sewing backyard for Western European fashion brands and retailers,” says the report entitled "Stitched Up". Another industry that has been moving steadily eastwards since the 1990s is the automotive sector. Both car assembly plants and components manufacturers are increasingly moving further east to take advantage of lower labour costs; the high costs of transporting cars and car parts give the eastern part of the continent a further advantage over East Asia. Poland, the Czech Republic and Slovenia became auto manufacturing centres in the first wave of migration eastwards. Ten years on from their entry to the EU, costs there are looking less competitive than in the would-be EU member states further south. Serbia, like other Southeast European countries, saw FDI drop with the onset of the crisis and it has failed, as yet, to recover to pre-crisis levels. However, the Fiat factory in Kragujevac has not only lifted FDI and exports, but also helped spawn an army of suppliers to the Italian automaker. After taking over the old Zastava plant, which once produced Yugo cars, Fiat opened a brand new plant with an investment of ¤1.2bn. Fiat has now become Serbia’s top exporter. “By far the most intensive sector is [the] automotive industry, propelled by the capital investment by Fiat in the city of Kragujevac, central Serbia,” says Jovan Miljkovic, senior investment advisor at the Serbia Investment and Export Promotion Agency (SIEPA). Today, Serbia has more than 150 companies in the automotive sector, boosting both GDP and exports. Other international investors in this sector include Cooper Standard,

Magnetti Marelli, Johnson Controls, Leoni and Yura. “There is decadeslong commercial cooperation with a large number of foreign companies stemming from Western Europe, which consequently evolves into the natural outcome that those companies open their production facilities here in Serbia,” Miljkovic says. “Moreover, the Serbian labour force is very technically skilled and informed about the latest Western technologies, which facilitates the adoption of new technological processes.” It is a similar situation in Romania, where Renault took a majority stake in local carmaker Automobile Dacia back in 1999. Since then, Renault has invested ¤1.2bn in Dacia. There are now signs of a tentative move even further east as Moldova starts attracting auto-parts producers. Major investors include Draxlmaier and Lear Corporation, which according to USAID employ a combined total of over 4,000 people. They were followed by Gebauer & Griller, which in April opened a cable manufacturing plant mainly serving the automotive industry, with support from the EBRD. “Increasingly... the automotive industry is looking for ways to reduce its costs of production, motivating shifting of production from Poland, the Czech Republic, and Romania to countries with lower costs such as Moldova, which has an opportunity to secure more of this business,” according to a USAID presentation. Labour costs, however, “are a factor, but not a decisive one”, says Peter Sanfey, deputy director in the EBRD’s office of the chief economist. “Investors look at broader political stability, macro stability and the stability of the operating environment.”

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The welcome mat One of the most important signals is EU candidate status. “Especially for a country like Serbia with a troubled history, tying itself to the EU mast and committing to EU norms is very important,” Sanfey tells bne. “Some of the advantages of the EU accrue to countries well before they actually become members. The whole region seems to be moving in that direction.” The importance of creating a welcoming environment has helped less obvious investment destinations to redress the balance against EU-established countries like Romania and Bulgaria, which were two of the region’s earlier entrants to the bloc. Romania saw FDI drop 10.3% on year in the first half of 2014, according to central bank data. This follows changes to the tax regime and retroactive changes to incentives to renewable energy generators that have unnerved investors. Mariana Gheorghe, CEO of Romania’s largest company OMV Petrom, said in a recent interview with Agerpres that the company might cut investments if the government fails to create a more favourable fiscal framework.

The fall in FDI comes despite Romania’s natural attractions for investors. “When investors started moving into Southeast Europe just over a decade ago, Romania was one of the most obvious investment destinations in the region. The country promoted itself naturally, given its geographic

location, its large population, natural resources and its low-cost, welleducated and plentiful workforce,” says the EBRD’s Hyslop. However, he adds that, “Today there is less FDI going around, and countries are competing fiercely for investment. To better compete for these scarcer investments Romania needs a coherent policy framework for attracting FDI.” Bulgaria has also experienced a flow of investment into high value sectors such as auto-parts manufacturing and business process outsourcing. However, FDI inflows slowed in the first half of 2014, dropping by 33.8% on year. The fall is most likely due to political uncertainty; Bulgaria is currently heading for general elections following the second government collapse within 18 months. As countries from the region compete for a smaller pool of cash post-crisis, aggressive efforts to bring in new investment are paying off. Macedonia, a tiny country of just 2.1m, has made FDI a priority under longtime Prime Minister Nikola Gruevski, who was re-elected in April. While FDI inflows have not yet returned to their 2007 peak of ¤506m, at ¤251.2m in

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2013 and a forecast ¤300m-350m this year, they are already beating the precrisis average of ¤241m a year. Kliment Sekerovski, deputy CEO of the Agency for Foreign Investments and Export Promotion of the Republic of Macedonia, puts this largely down to the government’s efforts. Following numerous reforms, Macedonia was in 25th place in the World Bank’s "Doing Business 2014" survey. Skopje has sought to draw in investors with incentives such as low tax rates, a much-reduced regulatory burden, and free trade agreements with the EU and neighbouring countries. The EBRD wrote in its 2013 transition report that Macedonia is “vigorously pursuing new foreign direct investment... actively marketing itself as an investment destination.” This has paid off in commitments from the likes of Turkish-Chinese clothing

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manufacturer Weibo, which announced in April that it will invest $400m to build Europe’s largest integrated textile factory in a new industrial zone in northern Macedonia. Weibo’s statement says it picked Macedonia after a “thorough analysis of various region and investment opportunities.” Macedonia is by no means the only country in the region to have set up a proactive investment agency and seized on the special economic zone model to attract more investors. In Serbia’s second city of Novi Sad, the centre of the Vojvodina autonomous region, the Vojvodina Investment Promotion agency has brought in around 50 foreign companies that have invested a total of $2bn in the region, bne reported. The Foreign Investment Promotion Agency of Bosnia-Herzegovina says it is promoting the country’s low tax rates and “price competitive labour force”

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to draw in more investors. Across, the region, numerous hothouses – all offering tax breaks, new infrastructure and an educated, low-cost workforce – are competing with each other, as potential investors consider it as a manufacturing destination. Whether this trend will continue in the longer term hinges on how effectively the countries on the southeastern fringe of Europe can leverage the current wave of investments, and in future offer highly skilled workforces and a conducive business environment that will see them remain attractive after they can no longer compete effectively on cost.

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Dealing with the legacy of 2008 Nicholas Watson in Vienna

he hits on Emerging Europe’s banks continue to come thick and fast as legacy problems from the 2008 crisis continue to dog the sector. But will 2014 represent the year when the lingering problems of that torrid time are finally put to rest? The latest example was Erste Group’s ¤930m loss in the first half of the year due to problems at its Romanian and Hungarian subsidiaries, swinging from a net profit of ¤302m in the year-earlier period. The second quarter did the most damage, the bank ending the three months to June ¤1.03bn in the red. For investors, this didn’t come as a surprise. Emerging Europe's third largest lender had prepared the ground by warning on July 3 that it expected to make a net loss of between ¤1.4bn and ¤1.6bn in 2014 due to problems at its operations in Romania and Hungary. The bank’s shares dived in response; since January 15 they are down around 35%. CEO Andreas Treichl described that fall on CNBC on July 7 as “harsh” but “understandably so.” The bank’s decision to write down goodwill to effectively zero in places such as Romania and set aside ¤130m for the Hungarian government’s new plan to force banks to compensate customers for mispriced foreign-currency loans is what it hopes will be the last step in dealing with the hangover from the boom that went so spectacularly bust in 2008. “What we announced on July 3 was clearly our wish to put the crisis behind us and it’s fair to say that we did everything within our power and knowledge to make sure that as of 2015 we will not have to deal with such legacy issues,” Treichl told bne. However, he said he had become more “careful with making predictions given what has happened over the last few years.” Indeed, the details of the Hungarian government’s final plan to deal with the forex loan issue won’t be known until the autumn, so a “small, medium or large scale surprise” is still on the cards. Like many in the region, Hungarians took out a huge amount of mortgages and other loans in Swiss francs and euros during the boom years to 2008 when the local currency was soaring in value. However, since the crisis the forint has

sunk, multiplying repayments. Prime Minister Viktor Orban’s government has roughed up the banks since coming to power in 2010 with new taxes, and has been pushing a scheme to finally clean up the forex loans issue for the past year. On July 21, Mihaly Varga, Hungary’s economy minister, said the government would submit a bill on the conversions of such forex loans in late November or early December. “Whatever it is we must take this in our stride,” Treichl said, adding that the bank had no intention of leaving the Hungarian market, having been present there since the 19th century. “I think we belong in Hungary and we will stay there – I think it will be successful.” Many of Erste’s write-downs can be linked to the pre-crisis credit bubble especially in the real estate sector; the bank reported 4% higher provisioning costs in the second quarter for commercial real estate. However, Erste was keen to stress that non-performing loans across all segments and countries in the region were declining, suggesting that the bad debt is finally working itself out the system. Otilia Dhand, vice president of Teneo Intelligence, says international lenders like Erste are still mopping up the spill-over from the global financial crisis, which hit especially hard the CEE countries that had experienced credit-driven economic booms in the early 2000s. “This year, several central banks and governments in Europe moved to finally deal with the legacy of the crisis – the stockpile of nonperforming loans that have challenged banking sector stability and bogged down the economic recovery,” Dhand says. "The year 2014 appears to be the year of the final postcrisis clean-up." Coming on the back of a banking crisis in Bulgaria and the worsening state of the banking sector in Ukraine, which is teetering on the edge of a full-blown crisis, many believe there will be more bad news for the region’s banking sector in the months ahead. “I can’t exclude any nasty surprises in the region due to political decision or developments. I’m not in a situation right now to tell you the effects of a deepening of the crisis in Ukraine and Russia will have. If the crisis accelerates of course we will have to revise our forecast for all over Europe in 2015 and 2016,” Treichl said.

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Chart I 15

Ukraine crisis knocks CEE momentum

here were already concerns about the pace of economic recovery in the Eurozone – and therefore Central and Eastern Europe – even before the Ukrainian crisis broke. The growing tension between Russia and the West has made those worries a reality. As this month's chart from Citigroup illustrates, following a relatively strong start to the year, the Central European economies seem to be losing momentum. Taking economic indicators such as industrial output and retail sales, and adding both confidence readings and the effect of economic activity in Germany, Citigroup's chart does not paint a pretty picture for the five countries.

The chart has Hungary performing better than the others, while Poland – by far the most exposed to Russian trade – lags. However, even Hungary has lost some of its momentum in the second quarter, "most likely due to [the weaker] performance of the German economy," the analysts note. Meanwhile, the surprisingly weak Czech reading may be overly pessimistic due to a temporary slowdown in retail sales in the spring, they admit. However, the overall picture is clear: the economic fallout from the Ukraine crisis – whether directly or via the Eurozone – is set to hit CEE's efforts to get back on track.

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Sanctions give Belarus a headache Sergei Kuznetsov in Minsk

estern sanctions against Russia are a headache for Moscow's closest ally Belarus. In particular, the financing of the Belarusian economy is under threat, while investment and exports are deeply tied to its giant neighbour. In late July, the European Union unveiled new sanctions against Russian statecontrolled banking giants Sberbank, VTB Bank, Gazprombank, Vnesheconombank (VEB) and Rosselkhozbank. EU nationals and companies are now barred from buying or selling new bonds, equity, or other financial instruments with a maturity of more than 90 days issued by these institutions. The US and several other nations have also targeted the largest Russian banks as part of the campaign to push Moscow to drop its alleged support for rebels in Ukraine. The Central Bank of Russia has promised to take “adequate measures" to support the lenders. Meanwhile, Gazprombank, VEB and Rosselkhozbank have already applied to the government for financial support. In particular, VEB requires up to RUB60bn ($1.65bn) annually to finance new projects and the support it offers exporters. Russian banks currently own about 25% of the total assets of the Belarusian banking system. According to the International Monetary Fund (IMF), Russian subsidiaries in Belarus rely heavily on their parent companies for funding and capital, and “any weakening of the parent banks could have substantial spillovers.” “The Belarusian authorities have a keen interest in shifting part of the burden for financing the national economy to banks with foreign capital, in particular, Russian banks. This is important because Belarus has significant external debt repayments to service,” Alexander Mukha, a Minsk-based independent financial analyst, tells bne.

He adds that Minsk especially relies on Russian-owned banks to support agricultural enterprises and state programmes. “However, it's unlikely that the lenders will be able to increase their lending, because of current geopolitical tensions in the region," he suggests. "As a result of the western sanctions, some Russian banks will face a deterioration in access to international capital markets and an increase in the cost of foreign borrowing; this could lead to a rise in the cost price of resources for the local subsidiaries." However, Nadezhda Ermakova, the governor of the National Bank of Belarus, tells bne the Russian-owned banks in the country “have not been affected yet” by the sanctions. “Parental banks are not ceasing to support the liquidity of their local subsidiaries… Russian banks are not withdrawing resources from the subsidiaries, and are not going to do so in 2015,” she says. At the same time, Ermakova admits that in some cases local units are suffering delays in transactions that go through EU and US banks, because of restrictions against Russian parental institutions. In June, Belarus agreed a $2bn shortterm loan from VTB Bank in order to beef up the country’s depleted international reserves. Minsk expects to repay the loan at the expense of an intergovernmental loan negotiated with Russia. Ermakova hopes such facilities will remain open in the future. "However, currently, we don’t need a new bridge loan," she said. Deep ties However, Belarus' dependence on its neighbour extends well past financing; the economy's ties to the Russian economy run deep. The IMF has expressed concern that any substantial decline in Russian foreign direct investment (FDI) into Belarus caused by geopolitical turbulence could significantly affect the country's fragile

balance of payments. Russia accounts for about 70% of FDI. The IMF also expects that “growth in Russia - the destination of 35% of Belarus’ exports – will suffer as a result of sanctions, reduced confidence, and higher interest rates.” However, Minsk also has reason to be optimistic. Russia’s ban on food imports from the US, EU and others will likely boost Belarusian exports. “We need to take advantage of the situation and make money,” President Alexander Lukashenko said on August 15. Prime Minister Mikhail Myasnikovich says Belarus hopes to increase food supplies to Russia by 1.5 times in August – December. “Additional food supplies to Russia will be secured by increasing production at processing companies,” he explained. “Belarus should take this opportunity to improve its balance of payments,” Ermakova agrees. In the first quarter, the current account deficit stood at $1.675bn, with problematic export revenues continuing to crimp Belarus' fiscal situation. That issue has been draining the country’s international reserves for years, and they stood at just $6.2bn at the end of July. There is already some evidence emerging that Belarus will look to act as a surreptitious middleman, re-exporting produce arriving from the West. Minsk, a founding member of the free trade Customs Union alongside Russia and Kazakhstan, obviously rejects those claims. “We need to coordinate our plans with Russia, so that they do not accuse us of disregarding their policy,” Lukashenko insists. Stanislav Bogdankevich, former governor of the Belarusian central bank, believes that the government will try to prevent food re-export to Russia. “However, some companies, in particular state-owned firms, could try to get extra profit in this situation,” he tells bne.

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insurgency and Kyiv's “anti-terrorist operation”. The shutdowns have been snowballing as Kyiv's offensive has escalated through August, with damage to the power grid and rail links, and the collapse of security, paralyzing industrial giants. That's bad news for cash-strapped Kyiv. With Donbass the motor of Ukraine's export economy, the collapse will impact the export revenues Ukraine desperately needs to achieve economic stablisation.

Ukrainian industry ravaged by war Graham Stack in Kyiv

he Russian-backed insurgency in the Donbass region of east Ukraine is forcing numerous industrial giants to suspend operations. With the region accounting for over 25% of Ukrainian exports, the effect will hit hard currency revenues and the embattled hryvna. The flashpoint marking the start of the industrial collapse in Donbass was the Lysychansk oil refinery, which in mid-July went up in a huge pillar of black smoke. Symbolic as that explosion at Ukraine's second-largest refinery was, however, it will actually have little impact since the facility had already been mothballed for over two years. More troubling is the eerie emptiness in regional capital Luhansk, a formerly bustling industrial centre home to over 400,000. Half the population is estimated to have fled, with water, food and power shortages only compounding the constant shelling in recent weeks. Alongside hundreds of other companies, locomotive maker Luhanskteplovoz - the town's largest employer with a work

force of around 6,000 - closed its doors early August after its power was cut. Gorlivka, an industrial town of around 250,000 about an hour's drive from the city of Donetsk, is another industrial centre turned ghost town as it is surrounded by Ukrainian forces laying siege to rebels. The country's largest chemicals producer, Stirol, halted production in early May due to the risk of an environmental catastrophe, according to owner Ostchem – the holding group of oligarch Dmitro Firtash. Ostchem categorically denies statements made on August 12 by the locally-based press secretary of Stirol, who spoke of a potential toxic disaster if Kyiv were to continue its offensive. Ostchem claims he spoke under pressure from the local rebel leadership. Paralysis However, those shutdowns only signified the start of a wider collapse in the former industrial heartland of Donbass caused by the Russian-backed

Among the latest casualties are Ukraine's largest coking coal producer, Avdeevka, which stalled production on August 18 due to a power outage resulting from shelling. “Electricians have no more than 24 hours to restore power supplies. After that irreversible processes will begin in the coking batteries that will lead to their full standstill. And there are no guarantees of the resumption of operations,” owner Metinvest said in an ominous press release. While Ukrainian forces have recaptured most of the town of Avdeevka, they're still battling rebels in the neighbouring railroad node of Yasinuvata. Metinvest also announced the shutdown of Enakievo Steel Works on August 13, to ensure workers' safety after the town came under artillery fire, and suspension of operations at two further Donetsk plants August 18. Metinvest is the metallurgy division of System Capital Management, owned by Ukraine's richest man, Rinat Akhmetov and also incorporating DTEK. The power generator and miner announced Ukraine's largest mine, Konsomolets, will suspend operations after shelling on August 17 led to fire and power outages. Konsomolets mines 8% of the coal produced in Ukraine and employs 4,800. DTEK already suspended operations at six mines in the Luhansk region in July. Another Donbass industrial giant, Alchevsk metal works, suspended operations on August 15, due to disruption of rail connections. According to reports in pro-Kyiv media, attempts to repair the rails ended when rebels opened fire on workers, killing one.

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Damning statistics Statistics already show the inevitable economic collapse resulting from the conflict. Ukraine's industrial output declined 12.1% in July year on year. Donetsk saw a 28.5% drop in output, while there was an astonishing 56% collapse in the Luhansk region, according to the State Statistics Service. Among the worst affected sectors were the Donbass staples of mining and metallurgy, machine-building and chemicals. That collapse is only deepening in August. Rail freight in Donbass fell 2.4 times in the first half of the month compared to June, according to Ukraine Railways. That illustrates another major problem for those companies still working, how to move output. The drop was due not only to falling production, but also disruption of the railway network. Luhansk's railroads have largely ground to a halt and the westward connection from Donetsk to

Dnipropetrovsk and onwards is also disrupted. In the context of a civil war the collapse is not surprising and could easily have been worse, but the hurt is multiplied because of the key economic role played by Donbass. The area – which groups the Donetsk and Luhansk regions - accounts for over a quarter of Ukraine's $70bn annual exports. Its real share may be even higher, according to economists, since many trading companies for Donbass producers are registered in other regions. This means the local economic collapse will directly and swiftly impact the hard currency revenues Ukraine needs to shore up its economy. “Export is already falling, and it’s mainly due to war. Export from Donbass may fall 2-2.5 times [during] these crisis months," says Concorde Capital's Aleksandr Paraschiy. “Cities such as Donetsk, Gorlivka, Luhansk, and Stakhanov – as well as the

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coal-producing districts of the southern Luhansk region – have no access to the outside world, which is being reflected in the weakened local currency." Kyiv authorities, troubled by the ongoing slide in the value of the hryvna, are aware of the problem. "The industrial potential of Donbass is being almost totally destroyed," President Petro Poroshenko told his security council on August 18, blaming the Russian-backed rebels. “They destroy infrastructure, substations, bridges, facilities. The terrorists and their foreign backers are guilty," he said. The president called for new tactics to minimise the damage to the economy, but many are sceptical about the wisdom of such a move. "Unfortunately this would simply give the rebels more leverage over Ukrainian authorities," believes Dmitry Tymchuk, director of the Centre of Military-Political Studies.

What you need to know

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Civilians pay price for fighting in east Ukraine

COMMENT:

Vera Graziadei "The lawgivers and founders of mankind, starting from the most ancient and going on to the Lycurguses, the Solons, the Muhammads, the Napoleons, and so forth, that all of them to a man were criminals, from the fact alone that in giving a new law, they thereby violated the old one, held sacred by society and passed down from their fathers, and they certainly did not stop at shedding blood either, if it happened that blood (sometimes quite innocent and shed valiantly for the ancient law) could help them." â&#x20AC;&#x201D; Fyodor Dostoyevsky, Crime and Punishment

n the 5th August 2014 the UNâ&#x20AC;&#x2122;s Security Council issued a briefing about the humanitarian situation in Ukraine, where the government has been fighting anti-government rebels, who are now occupying the cities of Lugansk and Donetsk; 3.9m people live in areas directly affected by violence, with significant damage to infrastructure, limited water and power supply, reduced access to medical care and basic services. There are 117,910 people registered as internally displaced throughout Ukraine and 168,677 Ukrainians are registered as having crossed into the Russian Federation as refugees. For those that remain in Donetsk and Lugansk, the problems of daily survival are exacerbated not only by threat of abductions and tortures, as reported by Amnesty International in their June

report Abductions and Torture in east Ukraine, but also by a very direct risk of being killed. Since the beginning of the anti-terrorist operation in mid-April, at least 2,086 have been killed and nearly 5,000 wounded. (Reuters 13/08/14). As Human Rights Watch investigator Ole Solevang explains in one of his reports: "One reason why so many civilians are getting injured and killed is the use of unguided rockets in populated areas." Both sides deny responsibility, but in four attacks against populated areas that Human Rights Watch investigated in Donetsk, the evidence strongly indicates that "Ukrainian government forces were responsible," the report said. The use of indiscriminate rockets in populated areas is extremely dangerous as they are imprecise and cannot be relied upon to accurately strike military targets. However, it appears that civilian homes and public buildings are hit not because of imprecision and accident, but as a result of intentional shelling.

and public buildings and just shells them repeatedly. The latest HRW report supports this testimony: "Explosive weapons such as artillery shells and unguided rockets have struck at least five hospitals in eastern Ukraine since June 2014, killing at least two medical staff ... circumstances of the attacks, most of which took place in insurgent-controlled areas under attack from government forces, suggest that government forces were responsibleâ&#x20AC;Ś Often no warning siren is used and shelling lasts for a long time, between 10 minutes and hours, with patients having to stay in cellars up to two days in a row. As HRW warns: "The use of Grads in populated areas is a violation of the laws of war, and repeated attacks like those we documented could amount to war crimes." Now that the Red Cross has made a confidential legal assessment that Ukraine is officially in a war, according

"Since the beginning of the anti-terrorist operation, at least 2,086 have been killed" Back in June, when I interviewed an independent American witness in Kramatorsk, he attested that the Ukrainian Army targets residential

to a Reuters report, "both sides become combatants with equal liability for war crimes." However, Ukraine's supporters in Washington, Brussels, and elsewhere

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in Europe are in no hurry to demand that Kyiv's government stops using Grad rockets. Any concern for international humanitarian law seems to be out of the question when it does not support Western interests. While the press was busy bashing Russia as potentially

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reports their use was explained on CNN as "Ukraine using its right to defend itself." The Western press has ignored this use of ballistic missiles almost entirely, even though in the past deposed Libyan leader Coronel Gadaffi was condemned for using them against his own people. Has our conscience in the West shifted so much that even the

use of heavy ballistic weapons against urban areas still populated by civilians is now totally acceptable when done by our ally, Ukraine?

As crimes against humanity committed by the Ukrainian army on the population of east Ukraine are underreported and not condemned by any of Ukraine's supporters in Washington, London and Brussels, Kyiv effectively has been given the green light to continue its brutal repressive campaign. This moral failure is something that the West will not be able to undo or atone for easily, but with the public comfortably acclimatised to indiscriminate violence as long as it's used against those whose political views are perceived to be un-Western, it's likely that there will be no need for atonement anyway, at least for those who are comfortably navigating only the Western view of this war.

At the time of writing this article, the killing of civilians is so accepted and normalised, the argument mulled over in the press is not whether they should be killed or not, but rather whether those who remain standing should or shouldn't be helped. Russia has sent a convoy with humanitarian aid, but Ukraine tried to prevent it entering the country, promising instead to pack up its own convoy - one hand kills, while another feeds. The press is busy thinking up ulterior motives for Russia's offer of help, rather than acknowledging that east Ukraine is now

As long as there is an implicit understanding that the war in Ukraine is fought to establish a new unspoken law, which will prevent Russia from exerting influence over its neighbours, thereby weakening its global power, east Ukrainian bloodshed, regardless of the final number of casualties, will be inherently justified in the West. It will be ignored that at least half of those people dying actually want to keep close links to Russia - the West chooses democracy only if the desired outcome is guaranteed, otherwise it's the rule of the gun that still reigns in our "enlightened" world.

"The West chooses democracy only if the desired outcome is guaranteed" responsible for the downing of MH17 (something for which no concrete evidence has been provided yet â&#x20AC;&#x201C; the MH17 Inquiry results will only be published early September, Kyiv not only didn't halt their use of Grads, they ratcheted it up. As UN human rights spokeswoman Cecile Pouilly told Reuters, if up until July on average 60 people a day have been killed or wounded daily, the figure rose to at least 70 people in the first week of August. And the UN reported on August 13 that the death toll in Ukraine had doubled in the previous two weeks. When in July Kyiv used OTR-21 Tochka ballistic missiles, also known as SS-21 â&#x20AC;&#x153;Scarabs,â&#x20AC;? in eastern Ukraine according to Russian government-backed media

in humanitarian crisis and civilians are in need of urgent help.

Photo: Oleg Pchelov

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association deal with the EU. Ukranian pipe companies were landed with paying 19.7% customs levies. Ivan Dzvinka, an analyst at Eavex Capital in Kyiv, says the group failed to anticipate the problems in Russia and diversify its operations. "It was only a matter of time for problems to arise with Russia. They have little chance of solving the diversification issue," Dzvinka says.

Investors fear time running out for Interpipe

Interpipe in the report claims to be exploring new geographical markets for its pipe products, including pipes used for oil and gas, machinery, and construction. Analysts doubt that sales to the rest of the world, including the US, the Middle East and Asia, which amounted to 19% of Interpipe's sales last year, can offset growing losses in its main markets. Around a third of the company's total exports go to Russia and the curbs on imports by the Russian government are, according to Dzvinka, a "big problem."

Nick Kochan in London

he release of the full 2013 financial statement of Interpipe Group, the Ukrainian steel pipe maker owned by oligarch Victor Pinchuk, was delayed by a board dispute, as some board members apparently sought to prevent full disclosure. When the financials were finally signed off by the auditors on June 30 and then leaked on July 29 (Interpipe has yet to publish them on its website), the reason for the reticence became clear: Interpipe, according to its auditors, is in severe difficulties. Ernst & Young, Interpipe's auditors, calculate that, "the Group's current liabilities exceed its current assets by $649.1 million." That amount, the auditors warn, is a "material uncertainty that may cast significant doubt about the Group's ability to continue as a going concern." The delay in publishing the financials was closely watched by Philipp Thomas, a Luxembourg lawyer who acts for an Interpipe bondholder. "They did procrastinate in handling them over," he says of the audited

results. "Initially, there were only eight pages of figures. Then some of the creditors insisted on seeing the whole story and not something deliberately edited. The full story is much more negative. Apparently, there was some internal row within Interpipe in that management didn't want these accounts to leak out." Indeed, an eight-page "consolidated statement" of Interpipe's financial position for the year to December 31, 2013 (dated June 17) was published by the company in the middle of July. Then two weeks later, a 55-page "consolidated financial statement" and "independent auditor report" (dated June 30) were leaked to a website. Problems in Russia The group's difficulties arise from Russia's withdrawal of a quota to the company for pipe imports last July, together with the raising of customs duties. This increase was not directed at Interpipe or Pinchuk so much as a punitive response to Ukraine’s decision to reject the Russia-led Customs Union in favour of signing a free trade and

The company accounts say that in 2013, the group generated approximately 27% of its revenues from Russian customers: “The dispute over Crimea and Eastern regions of Ukraine and the resulting deterioration in political relations between Ukraine and the Russian Federation may have a considerable negative impact on the trade conditions between the two states and, therefore, may affect the ability of the Group to maintain the historical level of sale revenues from Russian customers.” Security issues are less of a concern for Interpipe and are not mentioned in the financial report. The company is based in Dniepropetrovsk, some way from the troubled Donbass region, and its assets are not said to be in physical danger. Keeping schtum The difficulty in getting the true picture of Interpipe's finances comes as no surprise to Dzvinka. "The company is highly non-transparent in terms of providing information and updates. They have not reported publicly their annual report for 2013. It is quite complicated to understand the situation. They used to keep silent when there were problems," he says.

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Thomas puts it more forcefully. "They didn't want to face the entire truth. How long is it going to take them to go under?" he wonders. Dzvinka reckons that Pinchuk is in a position to step in and save the business. "Pinchuk is a rich guy and I guess if it is his intention to keep the group operating in the future as a going concern, he is able to do this," he says. Bondholders are watching developments eagerly. Dzvinka fears that given the recent figures disclosed, there will need to be further restructurings of the outstanding debt. The accounts show financial liabilities as of December 31 totalling $1.255bn. "I doubt that he [Pinchuk] is ready to repay or make regular repayments on his debt. This was the case in the past. He could definitely default once again on several of his loans, given the political and economic situation," Thomas says. "It is very difficult to see how Interpipe is going to be in a position to service those bonds. Time will tell."

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Negotiations are currently in progress with lenders to restructure borrowing facilities and debt, which the auditors say has been in default since October 2013. The group incurred a net loss of $73.5m in 2013 with current liabilities exceeding $649m. But a legal dispute between Interpipe and the Ukrainian state energy firm Naftogaz over unpaid bills for gas is another cloud hanging over Interpipe. Under pressure from the International Monetary Fund to pursue outstanding debts, Naftogaz has stepped up its attempts to recover more than $70m for past deliveries. Interpipe has negotiated a reduction by bartering pipes the state company requires for its operations, but Interpipe executives have acknowledged to bondholders that the current cash obligation to Naftogaz still stands at about $40m. Thomas says that if this matter is not resolved, "the gas supplies could be disrupted and it would have to stop producing for a while. It is quite a mess."

In spite of the poor results, Interpipe's directors and managers are trying to remain optimistic, writing in the accounts: "Nevertheless, having assessed the situation, the directors and management believe that a mutually acceptable restructuring agreement with the lenders will be reached during 2014 and the Group will be able to continue its operations for the foreseeable future in the normal course of business. For these reasons, they continue to adopt the going concern basis of accounting in preparing the annual financial statements." Longer term, Interpipe says it is counting on the devaluation of the hyrvnia, the new free trade and association deal between Ukraine and the EU, and the IMF's $17bn assistance programme to strengthen the company's financial position. The issue for bondholders and analysts, though, is whether Interpipe can last that long.

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a dramatic shift in Russia's grand strategy; from cautious integration with the West to full-scale rejection. It seems like a lifetime ago, but Russia's 2012 entry into the WTO was the culmination of a multi-decade effort to bring it into the institutions of the US-led international order. Russia's instrumental role in the creation of a bank specifically intended to operate outside of that order is an eloquent statement to how rapidly and cardinally Russia has shifted its focus.

The BRICS bank and the Great Schism

COMMENT:

Mark Adomanis in Philadelphia The five BRICS nations agreed in August to set up a development bank. The project is the embodiment of what could now be dubbed "the Great Schism" developing between the emerging and developed world.

Development Bank" (NDB) - surely the least exciting name ever given to a paradigm-shifting international organization) is clearly a very big deal.

When analyzing the BRICS bank it is important to keep in mind the distinction between its short-term political significance and longterm economic impact. The first is unambiguous and widely accepted; the second a source of serious debate.

Rise of the rest Founded during the most acrimonious period of relations between Russia and the West in the past 25 years, the NDB is a living, breathing rejection of the idea that Russia is "isolated." No matter how frequently the US state department's press office states otherwise, the simple fact is that Russia is not in any way isolated from the international community, and actually enjoys productive diplomatic and economic relations with the world's most populous and dynamic countries. As the foundation of the NDB underscores, relations between Russia and the other BRICS are on a positive trajectory, and seem likely to further strengthen.

In terms of politics, the BRICS Bank (technically called the "New

The political significance of the NDB then is twofold. First of all, it highlights

Brazil, Russia, India, China and South Africa will set up the BRICS bank with $100bn capitalization in a bid to break their dependence on the G7-dominated International Monetary Fund (IMF) and World Bank. The emerging market giants are uncomfortable with relying on the West for badly needed support during transition.

Outside Russia, the NDB further underscores the continuation of a long process of multi-polarization. The NDB is perhaps the single most concrete example of the "rise of the rest" and the concomitant breakdown in the West's privileged position in the international system. Economically the "developing world" now accounts for over 50% of global GDP, and it is starting to catch up in terms of its institutions. Mind the gap Economically things are a quite a bit murkier. The World Bank has conservatively estimated the developing world's "infrastructure gap" at about $1 trillion a year. This is a gap that neither the World Bank nor the IMF have proven particularly adept at closing. Over the long-term the only way that this gap will ever be diminished is if developing countries themselves take more aggressive and coordinated action. The developed world is too focused on its own serious economic problems (including unsustainable pension systems and sclerotic labour markets) to be bothered with fostering infrastructure development in SubSaharan Africa, Southeast Asia, and other capital hungry regions of the world. The NDB could conceivably play a leading role in meeting this challenge. It will need serious resources in order to do so. Stephany Griffith-Jones, a professor at Columbia University, made some back of the envelope calculations about the potential role that the NDB could play. They are revealing.

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If one assumes a total capital endowment of $100bn (which matches what the BRICS themselves have been describing in their public statements) annual lending could reach $34bn in the next 20 years. When private contributions are taken into consideration - BRICS leaders have talked constantly about the importance of public-private partnerships - projects worth up to $100bn per year could be possible. If Griffith-Jones' estimates pan out, the NDB would, within a mere two decades, become a more significant international lender than the World Bank, though its total financial resources would still pale in comparison. The problem, however is that lending to the countries where infrastructure development is most urgently necessary is a very risky and uncertain proposition (if it was both easy and profitable, someone would already have done it). Writing in the Washington Post, Georgetown University professors Raj Desai and James Vreeland astutely noted that there are reasons for scepticism about the economic influence that the NDB can realistically wield. Cheques and balances In order to lend on a scale comparable to either of the two most important International Financial Institutions (IFIs), the NDB will have to develop a rigorous and transparent process for scrutinizing loan applications. If the NDB's standards are too loose and permissive, then the quality of its loan portfolio will suffer accordingly, and it will require ongoing support from its founding members. Asking Chinese or Indian taxpayers to continually subsidize risky loans in Laos or Bangladesh is, to put it mildly, a politically dubious proposition. A development bank that needs ongoing support is one that will not last very long. On the other hand, the NDB can't be too conservative. If it's too scared to loan money to high-risk developing countries, then it will come to

resemble the shambolic BancoSur, another developing-world-led IFI which - despite quite a lot of fanfare accompanying its 2009 launch - has yet to make a single actual loan. The NDB has serious political and financial support, but one should not underestimate the difficulty of the task it faces: it's very easy to say that the new bank's leaders should simply "find a middle ground" but exactly where this middle ground should lie is extremely contentious. And with the NDB, the emerging markets are setting out to find that middle ground on their own. The NDB is an example of extremely important and ongoing structural changes in the nature of the world economy, particularly the West's swift loss of economic prominence and the rapid rise of China. Politically, it is an important testament to the developing world's ambition to work together without western involvement. Economically, it has the potential to play a very significant role in driving growth and development, but it will need substantial coordination among its member states that will likely prove difficult due to their enormous political and economic differences. While opinions differ on precisely what kind of an impact the NDB will have, what is clear is this: the old system, in which the United States and its close European allies made all of the important decisions, is breaking down. Exactly what will replace it is not yet known, but we will see more and more organizations that look like the NDB, organizations of developing countries, run by developing countries, that help developing countries.

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Sanctions take aim at Russia's Arctic push Joe Parson

S and EU sanctions are threatening to derail a monster exploration and production project in the Russian Arctic between state-owned Rosneft and US oil major ExxonMobil. The threat is not that Washington will pressure US companies to pull out of Russian deals. Rather, the latest round of sanctions includes bans on the transfer of technology vital to the future development of Russia's increasingly hard-to-get-at oil and gas deposits. Rosneft and ExxonMobil opened an Arctic Research Center in June 2013, in order to prioritize technology-sharing adaptable to the challenging Kara Sea. ExxonMobil likely contributed the first $200m in order to give the project a quick boost, and since the pair has jointly contributed an additional $250m. By funding research and development costs up front, the companies may have provided a buffer against short-term sanctions impact. On top of that, Rosneft and ExxonMobil have a long partnership. They've been

working together since launching development of fields on the Far-East island of Sakhalin over fifteen years ago. That suggests knee-jerk political pressure will need significant substance to disrupt relations.

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Ukraine - initially targeted only specific individuals, they have now grown to include many state-owned banks - specifically banks used by the stateowned energy companies – as well as other companies. Another round of sanctions restricted access to European and American financial resources. By and large, several Russian companies have sought to mitigate this threat through non-dollar financing from East Asian partners. Gazprom even listed on the Singapore stock exchange in June. The most recent sanctions, unveiled in late July, will restrict the export of technologies patented in the US, as well as prevent investment in Russian Arctic projects. If alternatives are not found, this could have a substantial impact. However, for the time being, sanctions apply only to new contracts. In other words, should ExxonMobil and Rosneft seek to expand their cooperation to new deposits, then problems may occur. Notwithstanding, Schlumberger the world's largest oilfield services company – says it will begin adapting to the sanctions in order to continue operations in Russia and "mitigate predicted short-term impacts on operational costs and efficiency". At the same time, Schlumberger CEO

"Rosneft and ExxonMobil have a long partnership" At the same time, Exxon is not invulnerable. Shareholders have been increasingly concerned over the US giant's recent financial juggling in preparation to acquire US shale producer XTO for $41bn. That threatens to limit ExxonMobil’s ability to weather a political storm should relations between the West and Russia continue to deteriorate.

Paal Kibsgaard claims that for now, the Russian energy sector is "business as usual". The Sea of Kara project has already sidestepped one obstacle, moving swiftly to purchase six drilling rigs from Norway-based North Atlantic Drilling on July 31. Norway was late getting onboard the EU sanction initiatives.

Impact Although the US sanctions – a bid to persuade Moscow to cease what Washington says is its support for pro-Russian separatists in east

Rosneft and Exxonmobil could potentially continue to avoid the technology clampdown by claiming to be searching for natural gas – which is specifically not covered in the

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sanctions. The distinction is essentially meaningless in practical terms, as both oil and gas utilize similar, and often identical, exploration and production methods. The targeting of oil technologies specifically is a passive financial attack on Russia; the oil sector makes up the vast majority of budgetary revenues. The exclusion of gas from technology sanctions is likely due to Europe’s heavy reliance on it for energy consumption. Expertise Elsewhere in Russia, energy firms may have difficulty acquiring necessary technologies adapted to oil exploration. At many of Russia’s conventional fields, much oil remains, but is located in disparate sections that are difficult to target with horizontal drilling without highly accurate reservoir modeling. If later sanctions decide to include natural gas, it will impact the entire upstream sector in Russia. However, any sanctions in this area would test the ability of Russia to provide Europe and China with contracted levels of gas in the medium term. The Arctic is the prime region from which Russia seeks to supplement declining production rates from its long maturing Western Siberian fields. Russian companies, with little experience with such challenging off-shore drilling, have launched projects with significant financial and crucially technical - support from Western companies. Chinese and South American competitors lack the expertise needed, and are unlikely to substitute any exit of US or European firms. This is likely at least partly mitigated for the meantime as many Western players maintain active cooperation with Russian research universities and institutions. This will probably lead to a rebalancing of the relationship between Russia and international companies. Sanctions impacting Russia’s ability to directly purchase Western technologies for Arctic and shale projects will require them to rely on already existing partners to sidestep them, or funnel

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expertise through existing joint institutions. Along those lines, further pressure from governments will likely only result in the reduction of new Western service companies entering Russia. This may decrease Russia’s bargaining power in future projects, although at the same time the ability of Russia’s regulatory structures to support national companies shouldn’t be discounted. In the event that oil and gas companies begin acquiring financial capital from regions outside of the EU and the US it will likely reduce the West's ability to influence international energy relations. The recent actions by Norway to support new sanctions are possibly an attempt to slow down Russia’s rapid advance into the Arctic shelf. This is also likely given the failure of Norway’s Statoil to make any discoveries this past summer in the Arctic area of the Barents Sea, despite its worldrenowned offshore experience.

"Chinese and South American competitors lack the expertise needed"

Eastern Europe I 27 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

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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. 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

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Slower growth and lower inflation mean that Poland's central bank is increasingly likely to cut its record low 2.5% benchmark rate later this year. “We are taking part in an economic war and we'll see who holds out longer,” said Marek Sawicki, Poland's agriculture minister.

Feeling the pinch in Central Europe Jan Cienski in Warsaw

oscow's former Central European empire is feeling the effects of tit-for-tat sanctions against Russia for its intervention in eastern Ukraine, with the countries that pushed hardest for sanctions likely to suffer most of the economic pain. The region's response to Vladimir Putin and his attempts to upend Europe's postCold War order varies widely. Countries like Hungary, the Czech Republic and Slovakia have been the most dovish, while Poland and the three small Baltic states have been among the most vociferous advocates of strong EU action against Russia. The EU's imposition of bans on trade in arms and arms-related goods, as well as restrictions on financing Russian debt, led to Moscow's retaliation, banning many food imports from the EU and other sanctions-adopting countries. Poland, the largest country in the region and the leader of the anti-Putin bloc, was the first to feel Moscow's anger. Russian health officials banned the import of many Polish fruits and vegetables, most significantly apples. In response, a Polish newspaper editor dreamed up a campaign dubbed “Resist Putin, eat apples and drink cider,” which produced a national outpouring of apple

eaters, hoping to lessen the impact of a loss in Russian apple sales. Poland is the world's leading apple exporter, selling 1.2m tonnes a year, of which 677 tonnes go to Russia. Despite the PR success of the "eat apples" campaign, it is unrealistic to expect Poles to each gobble up over 100 apples over the next year to make up for the loss in Russian sales.

Baltic bans Poland's closest allies in sending a sharp message to Moscow were the three small Baltic countries, which also look to be affected by the sanctions against Russia. All of them do significant trade with Russia, and also transship products from the rest of the EU to Russia. Lithuania is the EU's third largest exporter of milk and milk products to Russia, selling ¤160m a year. In all, 2.7% of Lithuania's GDP is tied to agricultural exports to Russia, according to Polityka Insight, the highest level of any EU country. About 20% of Lithuania's exports are sent to Russia, about half of which could be affected by the various embargoes and sanctions. Neighbouring Latvia and Estonia are not as endangered, with food trade with Russia accounting for 0.3% and 0.4% of GDP respectively. Nomura, the investment bank, estimates Latvia and Lithuania will each see a downward revision

"If EU countries cannot export their goods to Russia, then these goods will create overpressure in the EU market" Polityka Insight, an analysis firm, expects average Polish apple prices to drop by 70% because of the embargo. That will be a blow to Poland's apple growers, but will also push down Poland's already very low inflation rate, currently running at only an annual 0.3%. With Moscow's retaliatory sanctions affecting about 10% of all of Poland's exports to Russia, Polish growth could drop by 0.6 to 1%, according to Marek Ignaszak, chief economist for mBank, a unit of Germany's Commerzbank.

on GDP growth of 0.3% in 2014 because of the embargo, and a similar reduction in 2015. However, all three countries have long experience of Russia using trade as a weapon to influence their policies, and all of them are strongly backing EU and Nato solidarity to change Moscow's behaviour in Ukraine. “There should be no concessions made to an aggressor, who continues an open war and supplies arms to terrorists, and it poses a threat not only to Ukraine, but also to entire

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Europe, including the Baltic region, and we should not concede, neither fear the aggressor, as then he would never stop,” Dalia Grybauskaite, Lithuania's president, said in a radio interview. Elsewhere in Central Europe, some countries were affected by the EU's sanctions, particularly the Czech Republic, whose industry sells some weapons and dual-use equipment to Russia; future contracts are now in jeopardy. Although Russia accounts for only about 6% of the Czech Republic's agricultural exports, the country could also be hurt by knock-on effects from Russia's response. Larger producers like Poland will be frantically looking to get rid of unsold production, driving down prices and hurting Czech producers. “If European Union countries cannot export their goods to Russia, then these goods will create overpressure in the EU market and there may be a significant drop in the prices of some commodities,” Czech Agriculture Minister Marian Jurecka told Czech Television. Going Hungary Russia is Hungary's largest non-EU trading partner, one of the reasons that Budapest has been one of the EU's most lukewarm members on imposing sanctions against Russia. Hungary also signed a ¤10bn deal with Russia's Rosatom to expand its Paks nuclear power plant. Viktor Orban, Hungary's prime minister, in July denounced the EU's drive to impose sanctions against Russia, complaining that they ran counter to Hungary's interests. Although EU members in Central and Eastern Europe are likely to feel most of the impact of sanctions, countries from the region that are not in the EU, such as Serbia, may even see some benefit as Russia shifts its purchases away from the bloc. “Non-EU/US economies with agro-food sector potential should benefit,” writes Timothy Ash of Standard Bank, pointing out that Serbia and Belarus in particular could see an economic boost.

Tax and shale in Poland

Wojciech Kosc in Warsaw Poland's infant shale gas industry can sit down and work with some solid numbers after the Polish parliament on July 25 finally passed new taxation rules governing the production of hydrocarbons. Not that Industry complain. In practical terms, the law will apply to companies hoping to find gas along Poland's "shale gas belt," which stretches from Gdansk in the north to Lublin in the east. The new law introduces a special tax on hydrocarbons production that will have a flexible rate of anything between zero and 25%, depending on costs such as drilling and production revenue. The law will also have shale gas companies pay a new royalty rate of 1.5% on the value of extracted resources. Including corporate tax, real estate tax and local fees etc., shale gas producers will bear an overall tax burden of around 40%, according to the finance ministry, which drew up the new regulations. The legislation now passes to the Senate, after which the president needs to sign it into law. The new rules will officially enter into force from 2016, but in practice they will be delayed until 2020 so as to give companies an incentive to invest and intensify exploratory drilling. The shale gas industry, however, remains sceptical. "It's much too early for introduction of a new taxation regime," insists Marcin Zieba at Polish oil and gas industry lobbyist OPPPW. "The exploration phase is still going on and will for the next few years before we will be able to say that there's enough gas in Polish shales to justify commercial production." OPPPW claims that the overall tax burden will not be 40% as the government claims, but much higher at 60-70%. However, Grzegorz Kus, attorney-at-law and tax expert at consulting firm PWC, says neither the government nor the industry is particularly credible in terms of how much tax they claim will be levied. Neither side has made the models on which they calculated their results public. "It's true, though, that the finance ministry disregarded some burdens in their model, such as mining usufruct [a permit authorizing the use of mining deposits] fees, which may not be taxes technically, but are still paid to the treasury," says Kus. The consultant also suggests the new regime could have unintended consequences for a government hoping to speed up shale gas exploration and production. "Companies will certainly start modelling their revenue based on the new law, and if they see that the tax burden is unacceptable, they will quit, even if the calculations might prove inaccurate eventually," he says. That risks further hindering a drilling rate that's already slow. Only around 64 exploration wells have been drilled in Poland, despite suggestions from Warsaw that they're set to mushroom. The most promising are set in northern Poland, west of Gdansk, where companies like ConocoPhillips, BNK Petroleum and San Leon Energy have been drilling. The latter pair claims they could even see commercial flows by the end of 2014.

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response forces. And unfortunately, the Russian actions in Ukraine don't make us feel more secure, but less secure,” he told CNN recently. Tusk tried to reset relations with Russia not long after winning power in 2007, but Poland is now returning to its more normal role of being one of Europe's most reliably Russophobic countries. The hawk camp Warsaw heads a camp that also includes the three Baltic states and Romania. All of them have promised to increase their defence spending. Poland was already one of the highest spenders in the region, with a commitment to spend 1.95% of GDP on the military. It has agreed to raise spending to 2%, Nato's target, but a goal reached by very few alliance members.

Photo: photo.ua

Lithuania, which until recently spend on 0.8% of its GDP on defence, is now pledging to also increase that to 1% by next year, and then to work towards 2%.

Ukraine crisis exposes sharp divisions in CEE

Romania is particularly concerned about Russia's actions in Ukraine, worrying about a spillover to neighbouring Moldova, largely populated with ethnic Romanians. Russian troops are stationed in the eastern breakaway region of Transnistria.

Jan Cienski in Warsaw

All of those countries have also been strong advocates of imposing sanctions against Russia, despite their close economic ties with their eastern neighbour. “Russia is unpredictable and aggressive,” said Estonian president Toomas Hendrik Ilves, while his Lithuanian counterpart Dalia Grybauskaite compares “great Russia chauvinism” to the Nazi threat of the 1930s.

Moscow ruled from the Baltics to the Balkans, but the region's response to Russia's annexation of Crimea and now to its fairly overt support for separatist fighters in eastern Ukraine is sharply dividing Central and Eastern Europe. The division is in part based on trading ties with Russia; those countries with large and lucrative Russian deals are warier of angering Moscow. But it also down to very different perceptions of the historical experience of being part of the Soviet empire. The hawks are led by Poland, which under the leadership of Prime Minister Donald Tusk and Foreign Minister Radoslaw Sikorski has been one of the strongest voices in the EU for sanctions

against Russia and support for Ukraine. Poland is also lobbying hard for Nato to shift its footprint, permanently deploying troops to Poland and other frontline states. Sikorski has called for the Atlantic alliance to send two heavy brigades –

"Russia is unpredictable and aggressive" about 10,000 troops – to be stationed in his country. “We do and we want prepositioning of equipment. We want a standing defence plans. We want bigger

All of the countries are also scrambling to lower their dependency on Russia, which is the main energy supplier to the region. Poland is completing a liquefied

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natural gas terminal on the Baltic, due to come online net year, while Lithuania is building a floating LNG terminal allowing it to import gas from international markets. More dovish By contrast, the core of Central Europe is much more ambivalent both about the Russian threat and the need for a firm response, as well as much more skittish about increasing Nato's presence in the region.

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¤1.9bn to ¤2.4bn over the same period. Russia's Rosatom also signed a ¤10bn deal to expand the Paks nuclear power plant. The Czech Republic has also seen the economic relationship with Russia become significantly more important, part of a post-crisis push to diversify away from the EU. Exports jumped from ¤2.4bn in 2010 to ¤4.2bn in 2012. In one example, Skoda, the Czech-based subsidiary of Volkswagen, has two car

"The Russian actions in Ukraine don't make us feel more secure, but less secure"

Slovakian PM Robert Fico said he could not imagine Nato trrops being stationed in his country, saying Slovakia had been scarred by the presence of Soviet troops in Czechoslovakia and by the 1968 Soviet invasion to crush an attempt at liberalising communist rule. Bohuslav Sobotka, his Czech counterpart, has been similarly reluctant, both about Nato moving its forces into Central Europe and any involvement in the fighting in Ukraine. “I do not think that Nato should send its units to Ukraine. Nato should only launch a military reaction if a Nato member state were attacked, or based on a decision by the United Nations Security Council,” he told the CTK news agency. Hungary's Viktor Orban, despite his domestic anti-communist credentials, has also been wary of annoying Moscow. His major contribution to the debate over what to do about Ukraine was to play the ethnic Hungarian card, calling earlier this year for “autonomy” for Hungarians living in western Ukraine. Russia is Hungary's most important non-EU trade partner, and the relationship has become tighter in recent years. Imports, mainly oil and gas, have jumped from ¤5.7bn in 2010 to ¤7.0bn last year, while exports have risen from

plants in Russia, one of its most important markets. Both Hungary and the Czech Republic and Slovakia suffered through Soviet invasions during the Cold War, but all three countries are much less suspicious of Russia than their northern neighbours. The Czechs and Slovaks are currently both ruled by centre-left parties, more interested in domestic policies than in foreign issues. Hungary's Orban was an anti-communist activist in his youth, but in recent years has played on Hungarian nationalism, concerned with the fate of millions of ethnic Hungarians living in neighbouring countries. His prickly relationship with Brussels and his nationalism also make him a comfortable partner for Russia's Vladimir Putin. Poland's trading relationship with Russia is also important – total trade in 2009 was ¤12.8bn while in 2013 it was ¤27bn. But Poland's vision of itself as a regional leader has pushed it to oppose Russia. As well, Polish politics are now dominated with parties with historical roots in the Solidarity labour union, which led the opposition to communist rule in the 1980s. That leaves little domestic space for a pro-Moscow political line.

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for his new Hungary is, as he put it, to create a “a new Hungarian state which is capable of making our political community competitive in the great global running race in a ten-year horizon”? Difficult times For many business sectors – most notably the banks, telecommunications, retail and utilities – the past four years under Orban's Fidesz party has proved hectic, if not ruinous.

Photo: EPP

When Orban talks, business shudders of significantly remodelling themselves,” he said.

That, at least, was the hope. “There is absolutely no sign of consolidation,” says Szabolcs Kerek-Barczy, a board member of the Democratic Coalition, a small centrist opposition party led by former prime minister Ferenc Gyurcsany.

Given that a deadly conflict was underway in neighbouring Ukraine involving one of these supposed model nations even as Orban spoke, it was little wonder that the initial media attention focused on the political ramifications of his address. After all, critics asked, should the EU, which advocates democratic pluralism, continue funding a member state

Kerek-Barczy points to the pressure put on the banks and non-governmental organisations (NGOs) almost immediately after the elections. The banks certainly face enormous costs – estimated at up to ¤3bn – due to government measures forcing them to repay customers for charges now deemed “unfair” on retail loan contracts.

Kester Eddy in Budapest

iktor Orban has grabbed the headlines once again: his extraordinary declaration late in July that China, Russia and Turkey were better models for Hungary to follow than the “failed” liberal West sent shockwaves throughout the US and Hungary's EU partners. Hungary's mercurial prime minister was speaking at an annual ethnic Hungarian gathering in the Carpathian mountains, central Romania. According to Orban, the 2008 economic crisis had exposed the fallacy of western capitalism, with the result that “the hottest intellectual topic today is the comprehension of systems which are non-western, nonliberal... perhaps which are not even democracies, and they still make some nations successful.” To survive in the new, competitive world, Hungary should look to the likes of China and Russia, he continued. “Societies built on the principles of liberal democracies will not be able to maintain their global competitiveness in the next decades; rather, they will be forced to retreat unless they are capable

Yet for some months prior to the elections in April, the prime minister and government officials had indicated that the worst was over. Extreme measures had been needed for an extreme situation in 2010 – or so the argument went – and a win for Orban in 2014 would usher in a calmer period of “consolidation.”

"It is not an exaggeration that private property in this country can be taken away any time"

whose leader openly not only advocates autocracy, but whose moves in the past four years have systematically removed or circumvented the checks and balances on political power? But what are the implications for business, given that Orban's core rational

As even Sandor Csanyi, chief executive of OTP, Hungary's largest bank (and someone with political sympathies somewhat akin to the prime minister) noted, these costs will “severely damage” the economy, because banks will be unable to provide loans as a result of their weakened capital base.

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But ruining the banking sector's profitability dovetails with Orban's declared plan of raising Hungarian ownership within the sector to a minimum of 50%. As BayernLB, the owner of MKB, Hungary's fourth largest bank, proved in July, any foreign owner that decides to cut its losses will find a ready buyer in the Hungarian state – albeit it at a beaten-down price. The government has championed the renationalisation of MKB – a move which has been declared of strategic importance, thereby bypassing the scrutiny of the competition office – as a great achievement for the nation, and also promised to re-privatise MKB at some future date. Opposition groups are highly sceptical. “The government always refer to national interests, that they want to keep profits in the country and stop what they call 'extra profits' leaving the country. But this is a lie. The intention is to hand over newly acquired

companies to friends of the government,” says Kerek-Barczy. Indeed, Kerek-Barczy, who worked with the very first Orban administration for a year in 1998, is particularly scathing of his former employer. “No business is safe in Hungary at the moment. It is not an exaggeration that private property in this country can be taken away any time and foreign investors can be called rogue agents if they do not collaborate unconditionally with Orban's government,” he tells bne. Not all are so pessimistic, not least in the real economy, where a clutch of foreign investors has announced expansions in their Hungarian operations in the last month, most notably Wanhua Industries of China, which is going ahead with a new ¤84m hydrochloric acid plant at its BorsodChem plant in north-east Hungary.

William Jackson, emerging markets specialist with London-based Capital Economics. And while the negative influence of the Ukraine crisis on the region makes it difficult to know the extent to which Orban's speech alone has damaged businesses confidence, it “adds to the series of events which have hurt Hungary’s business environment, heightened uncertainty for firms and eroded the quality of governance in the country,” he says. Further, with Orban enjoying a strong mandate following April’s election, there seems to be little reason to think that things will change, Jackson argues. “The most recent talk of forcing banks to convert household foreign-currency loans into forint has spooked investors – the forint is the worst performing [emerging market] currency since mid-May. And looking ahead, Hungarian equities and the forint are likely to continue performing poorly,” he says.

But the global investment community is taking note of Orban's moves, says

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

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ing other direct investments of his own on the continent. One effort to return to big Polish deals flamed out in 2010, when the treasury ministry backed out of a transaction to sell him a controlling stake in Enea, one of the country's largest power companies. Kulczyk had been hoping to use Enea as the linchpin for creating a large private utility. Back home But Kulczyk now seems to be taking a renewed interest in Poland. One of his companies, KI Chemistry, recently took a majority stake in Ciech, a leading chemicals company, after the treasury ministry agreed to sell him its 38% share. Kulczyk was appointed to the company's board, along with several of his lieutenants.

A polarising Pole returns to the fray Jan Cienski in Warsaw

an Kulczyk is back. After years of keeping a very low profile in his home country, Poland's richest man is again cutting deals and spooking politicians after becoming embroiled in the bugging scandal. Kulczyk, 64, became a billionaire by cutting extremely lucrative deals during the country's massive privatisations in the 1990s. His formula was to use his contacts with the top levels of politics and business to make himself a crucial middle man in several enormous transactions. But his run of luck ended at the turn of the millennium, when his efforts at playing a leading role in PKN Orlen, the state-controlled refiner, blew up amid allegations that he had been in touch with former Russian spies interested in grabbing a share of Poland's energy market. Although nothing was ever proven

against him, the embarrassing spectacle of being forced to testify before a hostile parliamentary commission convinced Kulczyk to shift most of his business

Ciech was an easier morsel for Kulczyk to swallow than a company like Enea, which was in the politically sensitive energy sector; chemicals arouse fewer populist hackles. Ciech has also been restructured and a cost-cutting programme has made it profitable. It posted a net profit of PLN49m (¤12m) on revenues of PLN3.5bn in 2013, after posting a net loss of PLN431m a year earlier. Unfortunately, Kulczyk's return to striking deals with the treasury ministry coincided with his reappearance in the country's scandal sheets.

"Kulczyk's return to striking deals with the treasury ministry coincided with his reappearance in the country's scandal sheets" interests outside of Poland. Instead of hobnobbing with Polish politicians, Kulczyk instead turned his formidable social skills to his fellow London-based billionaires. Rather than invest in Poland, he began to take an interest in Africa, piggybacking on some energy investments led by Indian steel magnate Lakshmi Mittal, and undertak-

When in June the Wprost news weekly broke its first stories based on recordings obtained from private dinner conversations of top political and business figures – dubbed “Waitergate” thanks to the likely originators of the recordings – the magazine also said that there were recordings of meetings with Kulczyk.

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Those have not yet been released, but one was apparently with Pawel Gras, former spokesman for prime minister Donald Tusk, and reportedly concerned the privatisation of Ciech.

while living in Germany by trading with Poland's communist regime in the 1960s and 1970s. Giertych was apparently proposing to pay as much as PLN400,000 for the book not to appear.

Kulczyk also met with the head of Poland's official watchdog agency to complain about economic misdeeds of which he was aware.

Topic of discussion The recordings plus the Ciech deal have again made Kulczyk a Warsaw talking point. In recent years he had largely contented himself with appearing at conferences and promoting his charities. His economic activity in Poland was low profile, largely the completion of part of Poland's A2 east-west highway, as well as an investment in renewable energy.

Another of the recordings, this one made three years ago by a journalist and published in July, was with Roman Giertych, a right-wing politician turned lawyer. Apparently, Giertych was working on behalf of a â&#x20AC;&#x153;friend of Kulczyk'sâ&#x20AC;? and was trying to negotiate a deal with the journalist, Piotr Nisztor, who was writing a book about Kulczyk. Giertych was concerned that the book would cast an unfavourable light on Kulczyk's father, Henryk Kulczyk, who had become rich

He had also become anathema to most working politicians. Although Aleksander Kwasniewski, a former president, is one of his advisers, meetings between him and top officials had become something of a rarity. When Tusk flew

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to Nigeria last year as part of an effort to boost Poland's economic contacts with Africa, the lead commercial presence on the trip was not Kulczyk but his son Sebastian, who accompanied the Polish leader. Politicians' wariness was linked to the fear that Jan Kulczyk would quickly cause them problems with voters. And they were right to worry. The Ciech transaction has already been criticised by the opposition Law and Justice party as being overly favourable to Kulczyk, creating problems for the ailing Civic Platform government as it heads into parliamentary elections next year. Kulczyk's touch may be golden when it comes to making a fortune out of complex transactions, but it has more of a leper's touch to any officials seen to be too close to him.

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elect a Social Democrat-led government unwilling to pursue the venture of the previous conservative government in its present form. With hopes for a revival in the town's fortunes fading, there are fears that growing anti-EU and pro-Moscow sentiment among the disaffected population could set off a chain of events similar to that which led to Crimea seceding from Ukraine.

Lithuanian town says sayonara to nuclear saviour Linas Jegelevicius in Vilnius

uring Soviet times, Visaginas – an “atomic” town in northeastern Lithuania with a 65% ethnic Russian population – prospered, and unsurprisngly sentiment for the Soviet era remains high. But the town has since fallen into decay with unemployment near the country’s highest at 15% and the emigration rate of young people exceeding 25%, after the Lithuanian government in 2004, complying with promises it had given to the EU, closed down the Soviet-built Ignalina nuclear power plant for which Visaginas had provided the skilled workforce. Hopes were high just a couple of years ago that Visaginas would see a recovery

with the arrival of the Japanese firm Hitachi and its US partner General Electric, whom Lithuania has entrusted with construction of a new ¤5bn, 1358-megawatt (MW) nuclear plant

Postponing the inevitable A decision on the fate of the project has been postponed over a dozen times, though Lithuanian Prime Minister Algirdas Butkevicius denies suspicions he wants the project to wither and die, and insists he wants to see an improved project underway. “We are still resolved to build the Visaginas nuclear power plant, but we want the project partners – Latvia, Estonia and Lithuania – and their respective energy companies to find an optimal solution on the plant’s capacity, price tag and contribution,” he said. A new date for announcing the decision on the fate of Visaginas has been set for the autumn. But some Lithuanian lawmakers, like Linas Balsys, an MP and chairman of the Green Party, are convinced the prime minister made up his mind on the project some time ago. “As Butkevicius tries to please President Dalia Grybauskaite, a staunch supporter of a nuclear power plant, and the Japanese and American lobbyists in the country, he simply doesn’t want to exasperate her with what he really thinks of it. Hence the numerous postponements,” Balsys says.

"No one here believes that the nuclear project will ever get off the ground" to replace Ignalina. But a national non-binding referendum on the need for the plant that was held in 2012 together with a parliamentary election saw 63% of voters reject the plan and

The citizens of Visaginas themselves are under no illusions about the government's stance. “Supposed ongoing talks among the project partners are a

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sheer bluff. Even Visaginas pensioners call them a big baloney. No one here believes that the nuclear project will ever get off the ground,” says Larisa Chrechkova, a teacher at the Draugyste school in Visaginas. Such pessimism stands in stark contrast to the euphoria of 2011 when the town

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undermine Lithuania’s energy security goals and national interests,” Sekmokas says. "It seems to me the government is seeking ways how to nicely end the project." The Green Party's Balsys says ultimately the Social Democrats won't defy public opinion, the economic reality and

"It seems to me the government is seeking ways how to nicely end the project" began gearing up to welcome the Japanese. “We have 49 nationalities in the town, so learning some Japanese would have not been a daunting task,” says Dalia Straupaite, mayor of Visaginas. The construction of the plant would have brought in a few thousand Japanese industry specialists, who planned to build a Japanese settlement complete with kindergarten, school and recreational facility. “We were and are still ready for that,” the mayor says. The positive impact on Visaginas' infrastructure would have been wider, as Hitachi was aiming to turn Visaginas into a high-tech “smart” town with a “smart” power grid, new communications infrastructure and even a Japanese bank. “If the investor had come, much of that would have been done. There would have been a high added value from other investments into the region,” says Arvydas Sekmokas, a former energy minister in the conservative government and staunch supporter of the nuclear venture. Most importantly, the Visaginas project would have ensured Lithuania’s energy security and significantly enhanced its geopolitical “weight” in the region, supporters say. Indeed, with the shutdown of Ignalina, Lithuania went from being a major power exporter to an importer, with most of that (63% in 2012) coming from Russia. "I don’t believe the Social Democrat-led government will pursue the project [and] that will

the position of the project's partners. According to him, Lithuania's Baltic neighbours have set their eyes on the launching of power interconnectors NordBalt and LitPol, which are expected to cut power prices for the countries on the NPS Exchange to ¤0.03 per kilowatt hour from the current ¤0.08 kWh – a lower price than a new Visaginas nuclear power plant could provide. “As a member of the Baltic Assembly’s Energy Committee, who is well aware of the behind-the-stage debates, I’m sure the Estonians and Latvians won’t ever approve the project, which for them is just too expensive,” Balsys says. With the Lithuanian government still sticking to the idea that a nuclear project with smaller parameters is still an option, Hitachi has refrained from making any public comments, but behind closed doors has made its displeasure at the situation plain. Dark future For the people of Visaginas, the fate of the town without a new nuclear power plant is clear. “The town has no future now. When in 1977 the town started popping up, thousands of people from all over the Soviet Union came for the construction and work at the new nuclear plant. All thrived here. The European Union has destroyed the town with the closure of the plant,” says Viktor Jelisejev, a once respected engineer at the plant, now a retiree who is supplementing his meagre pension of ¤200 by selling vintage books and coins at a local market.

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The number of schoolchildren at the school where the teacher Chrechkova works has shrunk from 600 to 400 over the last two years and an estimated onethird of Visaginas residents have left the town since 2004. The number of people living on welfare has soared three-fold. Chrechkova says she will stay in Visaginas “no matter what,” but laments that a recent meeting with former co-workers who over the last two years have left Visaginas for the West and Russia highlighted what the town has lost. “Their sentiment for the once hustling and bustling 'atomic' town has remained so strong that they came over here for a nice 'get-together' from as far away as Russia, Germany, Switzerland and UK. I wept seeing all of them here again,” she recalls. But beyond the sadness there lurks darker fears about the longer-term social effects of the cancellation of the project on the region. Anti-EU and proRussia sentiment is being stoked by the issue, and some political experts fear this could be Lithuania’s “ticking time bomb” capable of setting off a chain of events similar to those that ended in the Crimean peninsula's secession from Ukraine and its joining the Russian Federation. "Luckily for the Lithuanian government, there's no pro-Russian political movement or party in Visaginas trying to capitalize on the social tensions," says a Visaginas councilman, speaking on condition of anonymity. "With many young people left for a better life abroad, the town's seniors disdain politics." Upon hearing that, Mayor Straupaite hastens to point out that an “absolute majority” of Visaginas people “dream of Japanese nuclear reactors, not Russian tanks”. “Visaginas yearns for a nuclear power plant. It would mean a revival of the town. It would stop the massive exodus of youth and bring back those young people who have left the town,” Straupaite insists. “We just don’t have other options besides it,” she adds forlornly.

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in a tender a contractor who designs the installation, procures the necessary materials and builds the project in return for a fixed price. Lack of finance The Temelin tender's ignominious end was put down to many project-specific factors, such as CEZ's legally suicidal decision in 2012 to eject France's Areva from the tender. But more generally, observers say the problems afflicting the nuclear industry, namely those related to the cost of financing and new competition rules in EU energy markets, have forced governments into reconsidering the open EPC contract, whose predetermined nature foists most of the cost increases onto the contractor.

Nuclear in CEE – too tender by half Nicholas Watson in Prague

A similar story was seen in Bulgaria with the ¤5bn Belene nuclear project, where an EPC contract was signed with Russia's Atomstroyexport (a division of Rosatom), but not the financing package. Parliament under a previous centreright government officially terminated the Belene project in March 2012. "The main issue the nuclear industry is facing is the combination of the difficulty to finance these projects – due to the huge initial investment and the long development and construction period – and the liberalization model that the EU and third energy liberalization package has imposed on the industry. So avoiding open tenders is rather a reaction of the host governments and the nuclear industry in CEE to the range of difficul-

he Czech Republic's decision in April to scrap a tender to build nuclear reactors ended not merely that process, but has also perhaps sounded the death knell for the use of such open tenders in Central and Eastern Europe (CEE) for these hugely expensive and complex projects.

published on May 30, Industry and Trade Minister Jan Mladek said nuclear remained the best option for the country and together with Finance Minister Andrej Babis he would produce a draft plan by the end of the year under which

Five years before CEZ announced the cancelation of the ¤8bn-10bn expansion of the Temelin nuclear power plant on April 10, the state utility had announced to great fanfare the start of what it claimed would be the Czech Republic's "most transparent" tender ever. But on the back of worsening economics and decisions of questionable legality, the process had degenerated into a fiasco by the time it was put out of its misery.

"Choosing the technology is too difficult without lots of experience"

That's not to say the Czech Republic has given up on expanding nuclear generation. In an interview with local media

nuclear would replace coal-fired power plants by around 2030. But analysts say the Czech Republic will probably join others in the region – like Hungary, Poland and Turkey – in avoiding the use of traditional "engineering, procurement and construction" (EPC) contracts, whereby the state chooses

ties that the industry is facing," says Kostadin Sirleshtov, who heads the electricity practice in CEE for CMS Cameron McKenna in Sofia. An industry insider in the region, who wishes to remain anonymous, says Poland's "integrated procedure," which combines the key elements of the nucle-

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ar power plant construction project, is perhaps better suited to today's market. "Choosing the technology is too difficult without lots of experience, so it might be better to choose a strategic partner that would cover investment, the contract, a technology partner – this integrates the whole view," says the insider. PGE EJ1, a unit of state utility PGE set up to build and operate Poland's first nuclear power plant, is currently looking for long-term technology and financial partners for the ¤10bn-14bn project, after the Polish government at the end of January adopted a national programme to build two 3,000-megawatt (MW) nuclear power plants in Poland, as well as put together a regulatory and organizational framework for the industry. The site of the first plant – two locations, Choczewo and Zarnowiec, both close to the Baltic coast have been shortlisted – will be decided by 2016, with construction beginning in 2019 and ending in 2024. The programme includes plans to build a second plant by 2035. Two Polish energy firms, Enea Group and Tauron, and the country’s copper producer KGHM have been cited as possible partners, while two French energy companies, Areva and EDF, have inked initial deals with Polish construction firms over collaborating on the construction of any future nuclear plant. CMS Cameron McKenna's Sirleshtov acknowledges that, "the Polish approach provides the best value-for-money alternative for the government, guarantees enough business for the ones involved in the model and builds on the fact that Poland enjoys a sufficient number of very experienced experts in energy contracts who could be of assistance in this project." However, while the integrated approach has its advantages, he is less convinced that a country like Poland in desperate need of nuclear power but with no experience in the sector should take this option. "Such a country needs to make a strategic decision on the technology and move forward with a turnkey EPC contract, which in theory will make the project more expensive, but which skips many of the hurdles," he says.

Central Europe

Hungary has gone down the bilateral route, signing a state-to-state deal with Russia in January for Rosatom to build and finance two new 1,200MW reactors. In June, the Hungarian parliament, where the governing Fidesz party has a majority of two-thirds, approved a loan agreement worth up to ¤10bn with the Russian state nuclear holding Rosatom. With no open tender, the EU hasn't approved project. The European Commission has indicated it is examining it to see whether it abides by public procurement rules. For the Czech Republic, Finance Minister Andrej Babis, who together with President Milos Zeman appears to be leading the charge for trying again to build two more nuclear reactors in the country, began fleshing out the details of how a

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ated. In July, the Commission approved this model for general use in the electricity generation sector, though it is still investigating on a case-by-case basis to see whether the scheme conforms to rules over state aid when applied to the new £16bn nuclear power station that will be built by a consortium led by France's EDF Energy at Hinkley Point in Somerset. For that project, the British government and EDF agreed a "strike price" of £92.50 for every megawatt hour of energy Hinkley C generates, almost twice the current wholesale cost of electricity. The Commission has yet to decide if CfD would count as illegal state aid for Hinckley, but in February issued a critical preliminary verdict on the plans. However, as the industry source, who

"The UK model is providing one alternative solution, which Brussels will find it hard to reject as a whole" new tender might be structured in an interview with business weekly Ekonom published on July 17. In it, he suggested a public-private partnership (PPP) could be the way to go. Another option would be for the project to be a joint investment with a private investor. Of the bidders in the last tender, only Russian state nuclear agency Rosatom said it was ready to put up money for the project, while the two private contractors, the Japanese-US Westinghouse and France's Areva, would not be in a position to do so. South Korean state utility Kepco is strongly linked with joining any new tender; like Rosatom, it too could offer financing. New model army There are alternatives being explored elsewhere in Europe that could be emulated, most notably in the UK. There, the government intends to employ its "contracts for difference" (CfD) scheme, which provides a guaranteed "strike price" for each unit of electricity gener-

has previously worked at the Commission, tells bne: "In this report the Commission is just doing its job, in 70 pages or so asking relevant questions and points that must be addressed. They are really looking for extra information." Sirleshtov agrees, warning that it will take some time for Brussels to fully assess and come back with either an approval for the model or a revised draft of it. "The UK model is providing one alternative solution, which Brussels will find it hard to reject as a whole. The model is a complicated one and there might be elements in it… which might be subject to adjustment." Ultimately, Sirleshtov says, there is a sense of relief in the nuclear industry that the EU appears to have arrived at a point where the seriousness over the lack of new electricity capacity in Europe is accepted, and that "a new market model is being developed that could easily be the ground for reshaping the EU approach to the electricity markets."

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the border in Slovakia and Poland, and pledging to invest ¤96m by 2017. "To win this new major investment, the Czech side has had to fight until the last moment against a competing Polish offer," Trade and Industry Minister Jan Mladek said of the Nexen deal on June 16, reported The Wall Street Journal. "Therefore we have chosen a mix of several incentives such as subsidies for creating new jobs, subsidies for strategic investments, tax breaks and a partial compensation for the local administration to buy [an] additional building plot [to be used by Nexen]."

Crisis triggers Czech job hunt Tim Gosling in Prague

he Czech Republic has fought hard to seal a pair of large investments from South Korea in 2014 that will bring much-needed jobs. Those deals illustrate how hard the crisis has hit a country that just ten years ago refrained from chasing simple manufacturers. The country's success through the 1990s and early years of this century allowed Prague more room to choose which investments it would chase. High-tech and high added-value operations, which tend to form deeper roots in the host country, would be given a helping hand; simple manufacturing projects leveraging cheap labour that could easily jump further east as the EU expanded were also welcome, but not worthy of costly incentives. Even as late as 2011, PwC described "a move away from reliance on [FDI] in low-cost labour production toward strategic FDI, emphasising high-quality labour forces, excellent infrastructure and technological support." The Czech

Republic, PwC noted in the report, "has been building on its traditional strength in engineering and applied science, placing emphasis on the development of new capacities in sectors such as nanotechnology and aeronautics." Fast forward to June this year and the Czech government was boasting of the

The Czech site, 90 kilometres northwest of Prague in Zatec, got the final nod after a tense runoff with a Polish competitor just across the border. Both are close to auto plants run by Hyundai, Kia and Skoda in the Czech Republic and Slovakia that Nexen will supply. Meanwhile, Mladek explained that Mobis will also be able to claim incentives, mostly through tax breaks and subsidies for job training. On the eve of the deal, South Korean Foreign Minister Yoon Byung-Se traveled to Prague to ask for further tax breaks, according to The Korea Times. Total incentives are reported at over CZK500m. Back to basics The tussle across the Visegrad region for these investments is reminiscent of the 2005 race to land another South Korean tyre producer, Hankook. However, back

"To win this new major investment, the Czech side has had to fight until the last moment against a competing Polish offer"

"fight" it won to persuade South Korean tyre maker Nexen to invest CZK23bn (¤827m) in a new plant in the country. Nexen's compatriot Hyundai Mobis followed suit in July, electing to manufacture headlights near Ostrava rather than at competing sites just over

then, Czech officials said – off-record at least – that Prague refused to offer investment incentives. Yet with the crisis having pulled the rug from under the country's formerly successful drive for investment, the new government has made foreign investment a top priority.

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Hungary eventually fought off Poland and Slovakia for the Hankook plant. In March, the European Commission gave approval to ¤58m in investment aid from Budapest to the company, which is planning a third phase expansion of its Hungarian facilities. That kind of approach is back in vogue in the Czech Republic. The strategy changed when the Petr Necas' centreright government was replaced by an interim administration in mid-2013, suggests Ondrej Votruba, head of investment agency CzechInvest, although he doubts that official policy would have ruled out offering incentives to Hankook. "We started to feel stronger political support," he tells bne of the effort to stave off competition from as many as seven CEE states for the Nexen deal. That support appeared to increase when the centre-left coalition took power in January. "The top priority is jobs," Votruba continues. "Unemployment figures this year set a new record. While we also want to raise the tech level of Czech industry, we can't focus solely on high added-value projects. Those that employ mass workforces are rarely working in that sphere." Mladek told reporters on July 17 that Prague handed incentives to 84 foreign companies, and 54 of their domestic peers, in the first half of this year. Overall, the minister claimed the country would see up to 14,000 new jobs created. While relatively low in a European context, the Czech unemployment rate peaked at 8.6% in January following the country's longest ever recession in 2013. And joblessness reaches 12% in the worst hit regions of the country, such as around the former industrial hub Usti nad Labem in the northwest. The 1,000 jobs or so that Nexen will bring to the area will be hugely welcome. Meanwhile, on a national level improving the job market is vital to help the economy in its steady but sluggish recovery. The traditionally conservative Czech consumer all but disappeared during the crisis, leaving exports as the only meaningful driver of the economy.

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Look east The effort to get domestic economic forces back on their feet reflects another issue exposed by the crisis – the need to diversify trade and investment. The Czech Republic's huge dependence on Eurozone demand for exports saw it hit particularly hard when the single currency area succumbed to the sovereign debt crisis. Even if they do extend the country's over-reliance on the auto sector, the twin arrivals from South Korea are still a boon. The feeling is mutual; delegations from Seoul have clocked up a lot of air miles travelling to Visegrad recently. Slovak Foreign Minister Miroslav Lajcak credited South Korea with being his country's "most important non-European investor" as he received a visiting party in July. Meanwhile, Seoul has been highly vocal about its plan to submit a bid on the roughly ¤10bn project to expand the Temelin nuclear power plant, even though Czech utility CEZ hasn't yet officially announced plans to resurrect the tender that it aborted in April. The new Czech government has also spent the year pushing to deepen ties with China, even stating that economic concerns trump those of human rights. The signs are promising, although Beijing is notoriously slow in matching talk of investment with hard cash. The Czech-Chinese Chamber of Cooperation said in July that Chinese pharmaceuticals are eyeing the Czech Republic as a potential base for their EU operations. The same month, state-owned China Railway Signal & Communication Corporation signed a deal to buy 51% percent in tram builder Inekon Group – a deal that should set it up to participate in rapid development of public transport in the giant Asian market. "Limited resources" at CzechInvest, means those countries already covered by its office network are the top targets says Votruba. While that includes stalwarts Germany, the US, UK and Japan, China also features on the list. "We plan to open a new office in South Korea in 2015," he adds.

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Pitiful presents from Poland Poland's current irritation with the US appears to extend to the gifts it gives its supposedly closest ally, if a US newspaper is to be believed. In June, Polish Foreign Minister Radoslaw Sikorski was revealed in leaked tape recordings to have referred to his country's ties with the US as "worthless", and worried that "we’re going to think that everything is great because we gave the Americans a blowjob. Suckers. Total suckers." Then in August the Washington Post ranked 274 presents given by foreign states between 2009 to 2012 to President Barack Obama and listed by the White House’s Protocol Gift’s Unit, putting Poland's "swag bag" for the computer game "Witcher 2" in last place. According to the paper, the bag contained: the DVD "Best of the Witcher 2", "Witcher 2" gift box set, three golden "Witcher 2" coins, a "Witcher 2" book, "Witcher 2" stickers and an ivory-coloured bust of "Witcher 2" character Gwynbleioo. This compares unfavourably with what the paper deemed the most impressive gift: a five-inch Aztec calendar in silver, given by Mexico in 2012. During Obama’s visit to Warsaw earlier this year, the US president admitted that he hadn’t played the much-praised video game. “I confess, I'm not very good at video games, but I've been told that it is a great example of Poland's place in the new global economy,” Obama said tactfully.

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Turkish voters hand Erdogan the presidency David O'Byrne in Istanbul

urkish voters went to the polls on August 10 to elect Recep Tayyip Erdogan the country's twelfth president. Victory was widely expected, but although he avoided a run-off, the current prime minister took less of the vote than forecast. Erdogan won 51.8% of what was Turkey's first ever direct election for the presidency. That was enough to beat off opposition candidates Ekmeleddin Ihsanoglu - standing as a candidate for the two main opposition parties - and Selahattin Demirtas, standing for the mainly Kurdish People's Democracy Party. With over 50% of the vote, Erdogan won the election outright, removing the need for a run off on August 24th. However,

his margin of victory was lower than that suggested by opinion polls, which had indicated Erdogan would take as much as 57%. Analysts suggest the low turnout - just 73% of Turkey's 56m voters cast their ballot - is likely behind the drop. Erdogan will take over from the incumbent, Abdullah Gul, on August 28th and will serve a five year term. Having indicated on numerous occasions that he intends to be an "active" president and wants constitutional changes to give the presidency greater powers, many were expecting Erdogan's victory speech to see him lay out a route map for his presidency. In the event, addressing his supporters from a balcony in Ankara, Erdogan

offered a more conciliatory tone. "Today we are closing an old and opening a new era," he said, calling on Turks to leave behind the "old Turkey" and "the politics of polarisation and divisiveness". How serious the PM is on that score, given his central role in the mass unrest and political scandals of the last 18 months or so, remains to be seen. Observers noted that while his speech was simultaneously translated into English and Arabic, was not offered in any of the Kurdish dialects spoken by between 10-15m Turks. Erdogan also declared his win a victory not only for Turks, but also for the citizens of neighbouring, predominantly Muslim, countries. "Today, not only

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Turkey, but Beirut, Sarajevo, Skopje, Damascus, Aleppo, Jerusalem are the winners of this election," he claimed, echoing a tone set during the election campaign, in which events in Gaza and Iraq often appeared to be of more significance to candidates than domestic Turkish politics. No laughing matter This was a campaign in which reconciliation and celebration of Turkey's political, ethnic and religious diversity had often seemed far from the agenda. Only two weeks before the poll, deputy Prime Minister Bulent Arinc declared that women who laugh in public are "unchaste". Erdogan meanwhile offered off-colour comments about the ethnicity of more than one opposition figure. Even more oddly, the PM launched repeated attacks on Economist correspondent and popular Turkish columnist Amberin Zaman, labelling her "a shameless militant woman disguised under the name of a journalist." Given the apparent certainty of victory, the need for such rhetoric from the Erdogan camp is unclear. According to some, it was in part an attempt to rally Turkey's more nationalist voters in an effort to prevent a low turnout as occurred in the early polling of the 2.8 million Turks resident abroad, only 8% of whom bothered to vote. Others question whether Erdogan's intentions were as divisive as has been claimed. "In fact he hasn't changed his position or his attitude," says Oral Calislar, a columnist for the left-wing Turkish daily Radikal, pointing out that his comments on ethnic and religious minorities have been widely misinterpreted. "He was actually trying to say something positive about ethnic diversity, but he just doesn't have the ability to explain himself well, " he suggests, adding though that Erdogan's attack on Zaman was unacceptable. With the final result closer than expected, Erdogan's victory has been followed by numerous claims of electoral malpractice, albeit fewer than asserted in local elections in March. At that time,

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Turkey eyes up the neighbours David O'Byrne in Istanbul The ongoing ISIS insurgency in Iraq and the occupation of the oil-rich Kirkuk region by Kurdish Peshmergas has presented Turkey with a serious dilemma. On the one hand is the potential for oil and gas; on the other an independent Kurdistan and what that means for its own restive Kurdish population. With the central government in Baghdad unable to deliver on promises of gas or increased crude exports through Turkey, the past five years has seen Ankara grow increasingly close to the Kurdistan Regional Government (KRG) administration in Erbil. Last year saw two major gas deals, followed by the commencement of exports of crude from the region via the Kirkuk-Ceyhan pipeline â&#x20AC;&#x201C; albeit opposed by Baghdad, which has threatened legal action. For Turkey, oil and gas flows from Erbil appear impossible to turn down. "They [Ankara] have put their chips in with the Kurds and in the short term it may work, but there are many uncertainties and risks," says Emre Deliveli, economic columnist for Hurriyet Daily News. Chief among these is the ongoing ISIS insurgency in northwest Iraq. While it has allowed Peshmerga forces of the KRG to occupy the oil-rich Kirkuk region, ISIS has cut the Kirkuk-Ceyhan export route to Turkey. Schwann Zulal, CEO of Carducci Consulting explains that the KRG is close to completing a 40km section of pipeline that will allow crude from Kirkuk's Khurmala fields to flow through its own network, and on to Turkey's Mediterranean export hub at Ceyhan. The KRG is waiting to get the go-ahead to export the oil, though such a move is opposed by both Baghdad and the US. However, this could all change if the KRG pushes ahead with plans for a referendum on full independence, and claim full rights to export its oil reserves and the region's estimated 6 trillion cubic metres (cm) of gas. That could include Kirkuk's fields, believed to hold between 5bn-6bn barrels of crude. The KRG's occupation of Kirkuk has an appearance of permanency. Having been part of the original Kurdistan region until the1960s, and with Kurds still believed to be the largest ethnic group, Kirkuk has been long claimed by the KRG as part of its territory. "Kirkuk can easily produce 350,000 barrels a day, which means if they can sell the oil, the KRG could be exporting up to 500,000 b/d by the end of the year," says Zulal. Turkey is also looking for cheap gas to meet growing demand and pressure existing suppliers Russia and Iran for more competitive prices. "They have a plan to send 6bn cm/y of gas to Turkey by 2016, but 2017-18 would be more realistic," says Zulal, pointing to the need for considerable infrastructure investment to allow exports to start. The question remains, though, whether cheap gas will be sufficient incentive for Turkey to accept an independent Kurdistan on its borders, which could in turn act as incentive for Turkey's own fractious Kurds to push for greater autonomy.

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power cuts at polling stations interrupted vote counting and led to allegations of manipulation. This time out Turkey's energy regulator EPDK warned power distributors to postpone maintenance work and maintain full staffing levels to deal with unplanned outages. Ahead of the election, the Organization for Security and Co-operation in Europe (OSCE) questioned why 18m extra ballot papers were printed, and warned of other problems. "There is no

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to promote Erdogan's campaign. It's a criticism that has been echoed by the opposition candidates, with Ekmeleddin Ihsanoglu describing the election code adopted for the polls as "absurd". "It paves the way for the ruling party to use public funds to support its campaign. This would not happen even in third world countries," he said. An Erdogan presidency However, arguments over the election are par for the course. Many are

"Not only Turkey, but Beirut, Sarajevo, Skopje, Damascus, Aleppo, Jerusalem are the winners of this election" clear separation between government activities and election campaigning on the side of the government," said Ambassador Geert-Hinrich Ahrens of the Limited Election Observation Mission (LEOM), pointing to the recent opening of the Ankara-Istanbul high-speed rail line as a government activity being used

instead already looking ahead to what an Erdogan presidency will mean for the economy. "An Erdogan victory has already been priced in by the markets so it should have little impact, " says Inan Demir, chief economist at Turkey's Finansbank,

explaining that the big question is who will replace Erdogan as prime minister and what sort of cabinet he will preside over; questions which won't be answered until after August 28, when Erdogan would be sworn in. Although President Abdullah Gul has been mentioned as a possible candidate to return to the post, Demir points out that such a move would require a byelection, which would require Erdogan's assent. "It would require his cooperation, and I'm not sure that cooperation is there," says Demir. More likely candidates, he suggests, are Erdogan loyalists such as former deputy PM and speaker Mehmet Ali Sahin, former transport minister Binali Yildirim or Foreign Minister Ahmet Davutoglu. "Given the extent to which Erdogan regards foreign policy as being as important as domestic policy, perhaps Davutoglu is the obvious choice," he suggests. Another key question is how the new government will deal with the central bank, which has been repeatedly criticised by Erdogan for not reducing interest rates as fast as he would like.

Southeast Europe I 45 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

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What you need to know

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Photo: Dusan Milenkovic

Western Balkans count cost of floods Clare Nuttall in Bucharest

he cost of catastrophic floods in Bosnia-Herzegovina and Serbia this spring is still being tallied, with the latest estimates putting the total at ¤3.5bn. Beyond the immediate human cost and the need to rebuild essential infrastructure, the economies of the two countries – and to a lesser extent Croatia and Bulgaria, which were also hit by floods this spring – have been set back by the disaster. The worst floods since records began engulfed large parts of Bosnia, Serbia and Croatia in mid-May, resulting in the deaths of at least 77 people, 57 of them in Serbia. In neighbouring Bosnia, almost 40% of the population, over 1.5m people, either lost their homes or were without electricity and running water. This was followed in June by another wave of deadly floods in Bulgaria. Serbian Deputy Prime Minister Zorana Mihajlovic said July 7 that the Belgrade

government’s first official estimate was around ¤1.5bn, while an international expert group put the economic impact on Bosnia at BAM3.98bn (¤2bn), according to a July 9 statement from the EU delegation in Bosnia. In addition to the homes destroyed, this includes damage

economy is expected to shrink by 1.1% this year, rather than growing by the 2.2% previously forecast. The Serbian government also expects GDP to drop in 2014. On August 1, preliminary data from Serbia’s statistical office showed the economy shrank by 1.1% on year in

"With the flood losses and the preceding threeyear drought, Bosnia's agricultural sector is in dire condition" to roads, railways and other infrastructure, and power stations. In both countries, the agricultural sector was particularly badly hit. As a result, 2014 growth forecasts are being revised downwards, despite promises of aid from both international organisations and country donors. Bosnia’s

the second quarter, following a 0.1% rise in the first quarter. In June, Bulgaria too was hit by flooding, resulting in at least 12 deaths in Varna and Dobrich, the worst affected areas. Sofia is still counting the cost of repairing roads and other infrastructure, but the damage was not as serious as in

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the Western Balkans. Lyubomir Peshev, analyst at Sofia-based Elana Trading, tells bne that he does “not expect serious impact of heavy rains on the country’s economy,” which is expected to sustain more damage from the ongoing political instability in Bulgaria. Elana has maintained its 2014 growth forecast at 1.8%. Despite earlier fears, tourism, which accounts for over 13% of GDP, is not expected to suffer, according to the Bulgarian Association of Travel Agents. In a pickle Across the region, the agricultural sector was badly affected. In Serbia, where agriculture accounts for 10% of GDP, wheat production is expected to be 19.6% lower than previously forecast at around 2.16m tonnes, the state statistics agency said June 30, according to local press reports. A report from the United States Department of Agriculture (USDA) estimates damage caused by the flooding to Bosnia’s agricultural sector at $271m, including crop damage, livestock deaths and infrastructure. “Normally, domestic agricultural and food production only covers approximately 30% of BiH’s needs. With the flood losses and the preceding three-year drought, BiH’s agricultural sector is in dire condition,” the report warns. Bulgaria, which had been expecting a bumper harvest in 2014, has also had its projections cut after hailstorms followed flooding in northwest Bulgaria, the main grain-producing region. The agriculture ministry has cut its forecast from 5.5m tonnes of wheat to 4.6m-4.8m tonnes, though this is still close to the average of the last five years. “The harvest season of Bulgaria is [at] its peak and the producers are facing a lot of problems... Still, it is a little bit too early to speak with certainty for this year's production in terms of quantity and quality,” a spokesperson from Bulgaria's National Grain Producers Association tells bne. Politically, governments across the region have come in for increased scrutiny for their preparedness – or lack thereof – and handling of the disasters. In Serbia, the expected dip in GDP may

force the new government under Prime Minister Aleksandar Vucic to put some of its ambitious reform plans on hold. Serbian Finance Minister Lazar Krstic resigned July 12 after Vucic refused to implement the radical austerity measures he had advocated. Talks with the International Monetary Fund (IMF) on a much-needed loan agreement have also been postponed while the government revises its budget, and are unlikely to take place before the autumn.

As governments in the region struggle with the aftermath of this year’s floods, preparing for future catastrophes is becoming more important. Far from an isolated incident, flooding on this scale is likely to become ever more frequent, according to a report published by London-based Nature Climate Change in March. Economic losses from flooding within the EU alone are expected to increase by as much as 500% by 2050, which would mean an increase from an average ¤4.9bn to as high as ¤23.5bn a year.

Meanwhile, the Serbian government has come under fire from both local activists and the European Commission after reports that articles critical of the government’s handling of the floods had been removed from the internet. Sarajevo, the capital of the Bosnian Federation where the country's central authorities sit, has also come in for criticism over its response to the disaster, in particular in Republika Srpska, the Serb entity of the divided country, which was worst hit by the flooding. With parliamentary and local elections coming up in October, frustration with the authorities’ lack of progress could result in Milorad Dodik, president of Republika

"The government’s negligence in responding to the floods has further undermined public confidence in the political elite" Srpska since 2010, and the Alliance of Independent Social Democrats being ousted from office. “[The] government’s negligence in responding to the flood has further undermined public confidence in the political elite, which had already been very low, and public dissatisfaction is vast in both parts of BiH,” writes Marta Szpala, senior fellow at Centre for Eastern Studies (OSW), although she adds that, “It is difficult at present to predict whether this frustration will bring about any deeper changes in the political elite.”

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world. In the communist era the most famous Georgian grapes, Saperavi, were exported to Albania too. And Georgia has been successful in exporting its best wines, Saperavi and Mukuzani, which it is starting to market internationally. Albania is also home to several grapes that are grown nowhere else, of which Kallmet and Shesh are the best, says Dashamir Elezi, president of Albania's sommelier association. Trained in Italy, Elezi is one of only 19 sommeliers in Albania and serves regularly on jury panels in France, Italy and elsewhere.

Albania struggles to develop its vintage wine industry Ben Aris in Tirana

lbania has arguably been making wine longer than any other country in Europe, but its domestic wine industry is only just starting to find its feet. Fragmented land ownership makes Albania's vineyards mostly small family-run affairs, and a total lack of marketing means their unique wines from grapes grown nowhere else in the world remain virtually unknown to anyone outside the country. But that is starting to change. Albanian wine used to be well known in the ancient world. The Roman diarist Pliny described vintages from what is today Albania as "very sweet or luscious", and refers to them as "[taking] the third rank among all the wines". But the area was making wine long

before the Romans arrived on the scene. An archaeological dig outside the capital Tirana found amphorae with traces of tannic acid (the bitter taste in wine)

"Kallmet is one of the country's unique grapes from the Lezhe district in northwest Albania," he says, pouring a glass of the deep ruby red wine Kallmet into a glass and swirling it before testing its nose. "In communist times, all the best wine was exported, but following the collapse of communism domestic wine production more-or-less collapsed. It is only in the last few years that wine production has begun to grow again." The wine is delicious. "The deep ruby colour shows the wine has aged well. It is very clear and the density is good," Elezi says, swirling the wine in the glass to demonstrate its 'legs' â&#x20AC;&#x201C; the length of the trail of wine left on the side of the glass. "It has long legs so it has a good equilibrium, spicy and fresh." Lack of scale Despite the quality of the wines, developing the industry is proving hard. The main problem is that land ownership is

"It is only in the last few years that wine production has begun to grow again" that date back 6,000 years â&#x20AC;&#x201C; a full 1,000 years older than Georgia's claim to a 5,000-year-old viniculture. Most of the famous strains of grape grow well such as Cabernet Sauvignon, Riesling and Merlot, which actually originated in the region in ancient times before being exported to the rest of the

fragmented, so it is impossible to create a vineyard that is big enough to attract commercial investors â&#x20AC;&#x201C; a problem the country's entire agricultural sector faces. "Only a few years ago the wine producers were selling their wine in bottles without labels. It is only recently they have begun to think about marketing

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their wines," says Elezi, who owns the Etnik restaurant that, unusually for a leading eatery in Tirana, carries almost exclusively domestic wines.

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"The diaspora miss home and will be happy to have a little piece of it in a glass"

Production of wine over the last two years has doubled to reach 12m bottles in 2013, but this is still only a third of the amount of foreign wines that the country imports each year. Virtually all the domestically produced wine is drunk domestically. "Before we can attract investment and grow the domestic wine production, we first need to re-conquer our own market," says Elezi.

The first battle in building up the business has been to stabilise the quality of the wine production, which has improved enormously over the last few years. Elezi and his fellow sommeliers have been cooperating with the wine producers to encourage them to invest in new equipment from France and Italy, and package and label their wines more attractively.

Another famous Albanian wine is Shesh, which comes in both white and red varieties and has a heavier, fruiter flavour with earthy undertones, so the sommelier says.

The government is also interested in promoting the domestic viniculture and Elezi arrives at our lunch directly from meeting the deputy minister of agriculture. The state is offering grants

to farmers who plant domestic varieties of grape, but it is still a long way from launching a formal effort to help sell Albanian wines on the international market like the Georgians have done. "The plan is that when the production is ready, we will take and promote Albanian wines in those countries where there are large Albanian populations living, such as Italy, France, Germany and America. The diaspora miss home and will be happy to have a little piece of it in a glass," says Elezi. "We can build on that foundation."

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limestone quarry near the town of Orhei. At the same time, the company sticks to Moldovan traditions, including harvesting its grapes by hand. New markets Like other Moldovan wineries, Chateau Vartely recorded an increase in sales to European markets after the lifting of technical barriers to trade at the start of this year. A further opening of EU markets to Moldovan producers is expected after Chisinau signed its EU free trade and association agreement on June 27. While a dramatic overnight change is not expected, Gogu forecasts a steady increase in sales.

Moldova uncorks new markets after Russian wine ban Clare Nuttall in Bucharest

he largest market for Moldovan wines has traditionally been Russia and other former Soviet republics, but repeated closures of the Russian market combined with the opening of EU markets to Moldovan producers have caused a shift in the export strategy of local wineries. Chateau Vartely's general director, Ludmila Gogu, has to refer to a world map to show the farthest flung market for the company’s wines. The company, which has vineyards in central and southern Moldova, recently shipped its first container of Cabernet Sauvignon to the Pacific island of New Caledonia, following a chance encounter made at Moldova’s annual wine festival. A medium-sized player on the Moldovan market, Chateau Vartely has 250 hectares of vineyards where it grows both European grape varieties and indigenous grapes such as feteasca alba and neagra, and rara neagra. Europe now accounts for more than half the company’s sales,

with the remainder divided between the local market, the Commonwealth of Independent States (CIS), and other

This should help to offset the hit that Moldovan wineries took when Russia banned imports of wine and spirits in September, in response to Moldovan plans to initial the EU deal at the Vilnius Summit two months later. The head of Russian consumer health watchdog Rospotrebnadzor, Gennady Onishchenko, claimed the ban was due to concerns over quality control, telling Rossiya 24 news channel, “We have a feeling that the state has absolutely no control over the country’s major industry.” As a result of the closure of the Russian market, Chateau Vartely’s total

"The rules of the shelf are that if your product is absent for more than one month, your place will be occupied by others" countries in north America, Africa and the Far East. Gogu, who comes from a sales background, says she is constantly pushing to open up new markets. As a relative newcomer that produced its first vintage in 2004, Chateau Vartely does not benefit from the name recognition enjoyed by Moldova’s older and larger wineries – in particular the legendary Cricova. However, its recent launch means it does have the advantage of modern facilities and equipment, located in the cool depths of a former

production is set to fall from 3.5m-3.6m bottles to around 2.6m-2.8m this year, despite the expected increase in exports to Europe. The ban, which follows an earlier closure of the Russian market in 2006, is also expected to have long-term consequences, with Gogu saying it is unlikely Chateau Vartely will return to the Russian market even if the ban is lifted. “The rules of the shelf are that if your product is absent for more than one month, your place will be occupied by others. Russian politicians carried out very bad PR around Moldovan wine,

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and people who don’t understand the politics behind the ban will still have the impression that it is poor quality and dangerous,” she says. While the ban has not extended to the other countries of the Russia-led Customs Union, in both Belarus and Kazakhstan sales are also down, due to

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reports that when attending international wine fairs and meeting with international buyers, she often encounters a sceptical reaction – despite there being evidence of viticulture in Moldova from over 4,000 years ago. Moldovan wines are now struggling for shelf space against bottles from better-known wine regions.

"If you look at examples like Chile, they demonstrate that you need time, money and effort before your wine is present everywhere" a combination of stricter certification rules within the bloc, which have created new barriers to trade with Moldova, and the depreciations of both countries’ currencies. Meanwhile, in Ukraine, usually another major buyer of Moldovan wine, the ongoing conflict has hit trade with Moldovan exporters. This has forced Moldovan wineries to look to other export markets, where the country and its wines lack the same level of recognition as within the CIS. Gogu

State aid To overcome this, Gogu believes a concentrated effort from the industry and the government is needed. A recent positive development has been the launch of the National Office of Vine and Wine, a government initiative to promote the industry outside Moldova. “In selling wine you are not selling just the product. You are selling the terroir of the wine: the history, the legend, the vineyard, the soil, the weather – everything that goes into creating the quality of the wine,”

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Gogu says. “If you look at examples like Chile, they demonstrate that you need time, money and effort before your wine is present everywhere.” At the same time, she stresses the importance of growing on the domestic market. While Chateau Vartely only sells around 250,000 bottles a year on the domestic market – about 7% of its total production – the company's sales within Moldova are growing by around 10% a year. A large part of this increase is the transition from drinking wines from so-called “garage wineries” to professionally produced wine sold in shops. “It’s traditional to grow grapes and make wine in Moldova. Almost every farmer produces their own wine and has their own cellar, so we have to work very intensively to develop a culture of wine consumption from the bottle, not from the barrel,” says Gogu. This includes organising wine tastings and promotions, and working with the local hotel, restaurant and catering sector. “From year to year it is becoming more difficult to play on this market because the number of wineries, including small wineries, is increasing. Many of them offer very good quality wines, so competition is becoming very tough.”

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Macedonia buses in investment Kester Eddy in Budapest

n May, Nikola Gruevski, the Macedonian prime minister, snipped the ribbon at the official inauguration of the country's newest (and only) coach-building plant. Located in a so-called “Free Zone” business park a few miles to the east of Skopje, the gleaming new factory represents a ¤25m investment – and a business lifeline – to Van Hool, a Belgian bus maker. Van Hool could hold its own when it came to making the more profitable, specialist, bespoke designs of buses. But it saw production shrink from 1,700 vehicles in 2000 to around 1,000 in 2012 as cheaper competitors won orders for standard, off-the-shelf models, causing problems with cash flow, procurement discounts and simply paying for overheads, Filip van Hool, the company's chief executive, tells bne in an interview. “We face a lot of competition. There has been a lot of production transfer from Western Europe to countries like Poland, Czech and Turkey: now 85% of new

[bus and coach] registrations in Western Europe are coming from these countries,” van Hool says. Hence the search began for a cheaper, offshore production location, with Turkey and Serbia topping the provisional list. “At the time, we were not even thinking of Macedonia, it just wasn't known,” says van Hool. But through the grapevine, the Macedonians heard of the opportunity, and every six months, Vele Samak,

seriously. All the information that we requested we felt they gave answers to. They were very helpful; they made a lot of effort,” he recalls. Impressed by Skopje's pitch, van Hool made a careful evaluation of the locations, finally opting for Macedonia, which offers a ten-year holiday on corporate and personal income taxes in its Free Zones. “There was a good incentive package, and less bureaucracy. We also had and have direct contact with the government – that's important,” he says.

"At the time, we were not even thinking of Macedonia, it just wasn't known" then minister for foreign investment, would phone up van Hool and lobby for his country. And van Hool listened. “It meant to us that the government takes [foreign direct investment] very

It also helped that in the very labourintensive, coach-building business, Macedonian wage costs average a mere ¤3 per hour, far below the rates at home in Belgium.

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First buses Work began on the site in July 2012, and within 12 months initial production had begun. “We had only just completed the first part of the factory. It was very hectic, and it really was 'just in time' – production was pushing the construction company [to complete space],” van Hool recalls. In July, the 200th coach will roll out of the Skopje plant, all part of a 300-unit order for the US. And by September, the bus maker will employ 600 at its Skopje plant, who will build 450 vehicles in 2015, and 450-500 each year after that. So far, van Hool is well-pleased with his choice. The Macedonian government and local suppliers have been “very responsive,” and while there has been a “big effort in training,” there is – bar the odd exception – a definite “will to learn and perform very well,” he says. There is, however, a hint that more than one management recruit has expected an easy-going white collar job behind a desk. “We are a company with a horizontal structure, so everyone has to work and take responsibility. No one can hide, you know what I mean?” he says, admitting – after a pause – that he's had to part ways with some management appointees. "Of course, I have this problem in Belgium and our US company,” he adds, “I would just say [here], it's an extra challenge.”

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Prime attraction

bne Nikola Gruevski, the Macedonian prime minister, scores poorly among domestic political opposition. Critics accuse the 44-year-old economist, who won a third successive term in elections in April, of paying scant heed to the rules of democracy, citing, for example, the lack of consultations in his controversial and very expensive drive to beautify Skopje with statues of Macedonian national heroes. But there is little doubt that his programme to attract foreign investment and create jobs for an otherwise struggling economy is paying dividends – as illustrated by the Van Hool bus plant. The Belgian company is actually just one of a dozen high-profile investors that have settled in Macedonia in the past five to six years – and there are more on the way, insists Viktor Mizo, chief executive of the Free Zones Authority, which administers the business parks where most foreign businesses locate. “Companies like Van Hool, Johnson Matthey [a UK precious metals specialist], Johnson Controls [a US engineering company] and Draxlmaier [a German automotive supplier] are our best ambassadors. Many of them have expanded their operations here already,” says Mizo. Four more deals were signed this spring with US, German and Italian companies, which together are worth an initial ¤50m in investment and should create up to 2,800 jobs. A fifth, with the Turkish Weibo Group, involves an initial $180m investment in what promises to be Europe’s largest integrated textile and clothing zone, which will eventually employ a workforce of up to 5,000.

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Last year, on the back of around 9.5m overnight stays generated by 1.5m tourists, the WTTC reported that the total direct and indirect contribution of tourism netted Montenegro around ¤715m, equivalent to around 20% of GDP. Looking ahead, the WTTC forecasts that tourist revenues will rise by 13.2% this year and by an average rate of 8.8% over the next decade, with the result that by 2024 tourism could account for as much as 37.2% of Montenegro’s annual GDP. According to the WTTC, tourism could directly help to create 25,000 new jobs in Montenegro over the next decade, while the indirect contribution account for over 60,000 fresh positions, equivalent to around a third of total employment in the country.

Ukraine crisis casts shadow over Montenegro Guy Norton in Zagreb

asting a shadow over the tourist-dependent countries of Southeast Europe is the fallout from the crisis in Ukraine, which threatens to upset the best laid plans of countries in the region to attract the growing legions of cash-rich visitors from Russia and other ex-Soviet states, as well as the much-needed investment necessary to ensure their tourist industries remain lucrative cash cows over the long term. None more so than Montenegro, which with just 650,000 inhabitants may be a global midget in population terms, but which has proved to be a relative giant on the global tourism stage, thanks to it being a firm favourite with tourists from the former Soviet Union ever since it voted to dissolve its union with Serbia and opt for independence in 2006.

Revenues from tourism and associated infrastructure and investment projects have formed a key part of Montenegro’s

With visitors from Russia and other former Soviet states such as Ukraine accounting for roughly 40% of the country’s total tourist numbers and as much as 80% of residential property sales in the tourist parts of the country, concerns about the potential economic fallout from any potential drop-off in tourism and investment levels from there are understandable. Over-reliance on rubles The latest available tourism data though makes for relatively comforting reading for the authorities in Podgorica. According to the Montenegrin statistics agency,

"Visitors from Russia and other former Soviet states account for roughly 40% of the country’s total tourist numbers" credit story. And according to the latest research published by the World Travel and Tourism Council (WTTC), Montenegro is forecast to remain a global leader in terms of tourism growth over the coming decade, which will further increase the importance of the travel industry’s already major contribution to the economy.

Monstat, in the first four months of this year overnight stays increased by 5.8% versus the same period last year to reach 336,750, with the number of visitors from both Russia and Ukraine showing strong increases – up 23.3% and 124% respectively. If anything like those numbers is repeated in the key high season months of July and August, then

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concerns about Montenegro’s heavy dependency on Russia/ex-USSR-related tourists will abate. Nevertheless, there have been criticisms voiced in the local media in Montenegro that the authorities have pursued a short-sighted strategy when it comes to marketing itself as a tourist destination, favouring reliance on traditional visitors from Russia and other parts of the Soviet Union, rather than cultivating new visitors from Western Europe, the US and Asia. Montenegrin daily Vijesti recently quoted local businessman Zarko Rakcevic as claiming that official and unofficial revenues generated by tourists and property buyers from Russia and Ukraine could be worth as much as ¤350m-400m a year to Montenegro. “Political and economic events and trends in these countries will certainly have a negative impact on the tourist industry and the trade balance of

Montenegro," Rakcevic told Vijesti. The paper also quoted a leading restaurant owner in the tourist hotspot of Petrovac as claiming that pre-season revenues in bars, cafes and restaurants this year were 80% down on 2013. On a more optimistic note, Danilo Kalezic, public relations manager for luxury marina and apartment resort Porto Montenegro, told Vijesti that arrivals at the elite destination developed by Canadian billionaire Peter Munk – which is the only place in the region able to accommodate the largest super-yachts so favoured by mega-rich Russians and Ukrainians – were at least 10% up on last year. Porto Montenegro, developed on the site of a former naval base at Tivat on the Bay of Kotor, is soon set to be joined by a number of other luxury developments that could see the Kotor area attract as much as ¤2.5bn in tourism-related

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

investments over the next five years, according to the Financial Times. Projects in the pipeline include the ¤1bn Lustica Bay resort being managed by Swiss-Egyptian outfit Orascom Development, in cooperation with the Montenegrin government, which has a 10% stake in the tourist complex. This development should open its doors to its first guests in 2015. Meanwhile, in June Azmont Investments, a subsidiary of Azerbaijan’s state-owned oil company Socar, received the final sign-off to begin construction on its ¤500m Portonovi hotel and marina complex in Kumbor, which is due to be completed in 2016. No doubt that by the time both those two projects are up and running, the developers will be hoping normal service will have been resumed and that Russians and Ukrainians will be fighting to get the best places on Montenegrin beaches rather than each other.

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Putin plays peacemaker in South Caucasus Clare Nuttall in Bucharest

hile the world’s attention is focused on the fighting in Iraq and Ukraine, a threatened resurgence of the long frozen conflict over Nagorno-Karabakh looks to have been averted. Following several smallscale clashes around the separatist republic in recent weeks, the presidents of Armenia and Azerbaijan agreed at a meeting hosted by Russian President Vladimir Putin on August 10 to resolve the situation peacefully. The meeting in Sochi was planned before tensions around NagornoKarabakh suddenly escalated in late July. Renewed hostilities broke out along the line of contact between Azerbaijani and Armenian forces on July 29-August 1.

Estimates of the death toll vary; the selfdeclared Nagorno-Karabakh Republic’s defence ministry claims that 25 Azeris and five of its own soldiers have been killed since late July, while Baku says it has lost only 12 soldiers. Both sides were also reported to be building up their military presence on the de-facto border separating Azerbaijan from the breakaway republic. The new outbreak of violence in the South Caucasus raised concerns that the already tense situation could escalate into all out war. However, after individual meetings with both Armenian President Serzh Sargsyan and Azerbaijan’s Ilham Aliyev on August 9, Putin announced at the meeting the following day that there was “good will”

on both sides to resolve the situation on August 10. "I state with pleasure that the president of Azerbaijan has pointed out the need to solve the problem peacefully, and you [Sargsyan] have said the same just now. This is really of the [upmost] importance, because there is no greater tragedy than the death of people," Putin said, according to a transcript published on the Kremlin’s website. The calm in Sochi was at odds with earlier statements out of Baku, with Aliyev using his Twitter feed on August 7 to threaten to recover control of Nagorno-Karabakh by force. “We will restore our sovereignty. The flag of Azerbaijan will fly in all the occupied

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territories, including Shusha and Khankandi,” Aliyev wrote, referring to the capital of the self-declared republic (known as Stepanakert by Armenians) and another major town. The sabre rattling came a day after the president visited the front line manned by Azeri and Armenian forces. “We will restore our territorial integrity either by peaceful or military means," Aliyev continued. "We are ready for both options... Just as we have beaten the Armenians on the political and economic fronts, we are able to defeat them on the battlefield.”

sporadically flared up, but both sides have so far avoided allowing escalation into all-out war. Resumed hostilities would be particularly damaging for Azerbaijan, which has successfully built up its economy over the last decade. Baku’s huge investment into developing its oil and gas sector means it now has ambition to become a major gas supplier to Europe by the end of the decade. It will not want to risk disrupting that plan. At the same time, the spike in energy revenue has allowed Azeri military spending to spiral to around

“We will restore our sovereignty. The flag of Azerbaijan will fly in all the occupied territories."

That bluster came in the wake of a statement from the Armenian defence ministry blaming Azerbaijan for the flare up. “Azerbaijani Armed Forces continue making recurrent attempts to infiltrate into positions of Armenian Armed Forces and carry out subversive reconnaissance activities, and keep on opening fire on civilian population...” it claimed.

$3.7bn a year – more than 25 times higher than a decade ago.

Frozen conflict War broke out in Nagorno-Karabakh after the region - which has an ethnic Armenian majority - declared its independence from Azerbaijan in December 1991. When Baku tried to regain control by force, Karabak militia supported by the Armenian army - drove out the Azeri forces.

However, Moscow’s role in the Ukraine crisis has the potential to alter the status quo in other parts of the former Soviet space. Moscow's recognition of the independence of Crimea from Ukraine – albeit during a very brief pause ahead of annexation in March - has emboldened other separatists in the region, in particular those in Nagorno-Karabakh, alongside the pro-Russian "authorities" in Transnistria in Moldova. This has naturally alarmed Azerbaijan.

Around 30,000 died before a ceasefire agreement signed in May 1994 brought the bloody three-year war to a halt. However, Armenia and Azerbaijan have never signed a peace settlement. Under international law the tiny republic remains part of Azerbaijan, although it is de facto independent and has become increasingly integrated with Armenia. In the two decades since the ceasefire the frozen conflict has

Armenia has been unable to keep up financially, but a strong Russian military presence is insurance against an attack. Russia maintains a base at Gyumri and has troops stationed on the borders with Iran and Turkey.

Meanwhile, Armenia is hopeful of more rewards from Moscow in return for dropping plans to sign a pact with the EU to enter the Russian-led Customs Union instead. While Putin has already extended financial and economic support, Yerevan is also hoping for greater political support. However, although a key member of the

Minsk Group - set up to find a peaceful settlement to the Nagorno-Karabakh conflict - Russia has also at times used its position as the major power in the region to play the two sides off against each other for its own benefit. Peacemaker As fighting continues to rage in eastern Ukraine, and the sanctions war between Russia and the West escalates, helping to avert a new crisis in Nagorno-Karabakh could provide a rare piece of positive press for Putin internationally. “For Russia, all this has been 'opportune' to say the least, as it can confirm its importance for ensuring peace and stability in the region – and countering an image set that it has been stirring separatist unrest in the Donbas,” writes Timothy Ash of Standard Bank in an August 6 note. “And how better for President Putin to sell himself as a 'peacemaker' than to pull an AzeriArmenian ceasefire out of the hat, just as things were beginning to look decidedly worrying.” Ash does, however, add that “a longer-term solution is much more tricky.” In addition to Putin, the EU and other international organisations have also called on Azerbaijan and Armenia to avoid escalating the conflict. “The deteriorating security conditions and the current escalation in and around Nagorno-Karabakh demonstrate once again that the world cannot accept a conflict that remains ‘frozen’ for more than 20 years,” said Joao Soares, the Organisation for Security and Cooperation in Europe (OSCE) Parliamentary Assembly’s special representative on the South Caucasus, in an August 5 statement. Since Aliyev came to power in Azerbaijan and Sargsyan in Armenia, the two presidents have met several times – both presidents being more willing to negotiate than their predecessors. The meetings have, however, produced few concrete results. As a result, despite the progress on easing the current crisis, there is no serious expectation that the latest meeting will see a breakthrough towards a long-term solution.

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The situation in Kazakhstan is further complicated by the problems in its oil and gas sector, which is struggling to maintain oil output at last year's 82m tonnes: the continuing delays in getting production from the giant Kashagan oilfield in the Caspian Sea, which was halted last autumn due to the need to replace pipelines linking the field with onshore facilities, means the expected significant increases in output will not happen until Kashagan restarts production, which is not expected before late 2015. As a result, the Kazakh economy posted growth of only 3.8% in the first quarter of 2014, well below the government target of 6% for the whole year.

Kazakhstan rethinks its foreign policy

Gulf in understanding Given the unpredictable consequences of the sanctions for the Kazakh economy, Astana has drafted a "separate package of measures," which is going to be implemented in September, National Economy Minister Yerbolat Dossayev told a government meeting on August 6.

Naubet Bisenov in Almaty

No details of the plan have been made public, but Kazakhstan will likely have to rethink and diversify its trade relations, while managing to maintain good relations with the US and EU despite the sanctions. In a June paper entitled "Foreign Policy in Kazakhstan: Looking Outwards

azakhstan's foreign policy is facing one of its stiffest tests since the country gained independence from the Soviet Union in 1991.

EU sanctions against Moscow are hurting Russia's economy. This in turn is depressing demand for Kazakh

Despite the declared "multi-vector" foreign policy, Astana has been caught in the midst of tit-for-tat trade wars between its closest ally and major trading partner Russia and the West over the crisis in Ukraine. For the moment, though, Astana has managed to secure its national interests by persuading Moscow that as members of the Russian-led Customs Union, Kazakhstan and Belarus should not be drawn into these wars.

"Kazakhstan is not a Kremlin puppet"

Russia's confrontation with the West following its annexation of Crimea and support for separatists in eastern Ukraine presents a number of challenges to Kazakhstan. US and

imports, which in the first five months of 2014 were down about 20% from the year-earlier period. Experts predict that the trade restrictions imposed on Russia could lead to a depreciation of its currency and higher inflation, which is likely to impact the Kazakh economy because Russia is Kazakhstan's largest supplier. In addition, Kazakhstan, Russia and Belarus have agreed to deepen their integration by transforming the Customs Union into the Eurasian Economic Union (EEU) in January 2015.

and Moving Forwards," the Kazakh Foreign Ministry-funded think-tank the Eurasian Council on Foreign Affairs (ECFA) acknowledges that "Russia has always been a close partner with Kazakhstan" due to "deep and historic ties" between the countries, but insists that Kazakhstan is not a "Kremlin puppet." One of the regions that Kazakhstan could expand its trade with is the Gulf Cooperation Council countries â&#x20AC;&#x201C; Bahrain, Kuwait, Oman, Qatar, Saudi

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Arabia and the United Arab Emirates (UAE). Kazakhstan's trade with these countries totalled $210m in 2012, or less than 0.2% of the country's total exports. Expanding Kazakhstan's trade with these countries has "significant prospects," Almaty-based political analyst Rasul Zhumaly tells bne. "One the one hand, they are an important region; on the other, given Kazakhstan's multi-vector foreign policy, they are one of the few alternatives we can use to conduct a balanced foreign policy." Kazakhstan and Gulf countries are close in many ways – geographically, culturally and in terms of nomadic past and Islamic heritage. Furthermore, they also have economic compatibility that derives from the similar structure of their economies, which is mostly based on the oil and gas industry, says Luca Anceschi, lecturer in Central Asian Studies at the University of Glasgow. "Despite these similarities, Kazakhstan and the Gulf countries do not interact, and the relations between them are not developed as they should be and not as what many people would have thought they would develop in the 1990s," he says in an interview with bne. There are two reasons for the poor development of relations between Kazakhstan and Gulf Arab countries. Since both have lop-sided economies with a big emphasis on oil and gas, they are not particularly interested in investing in one another. The second reason is political, namely an Islam practised in the Gulf which the Kazakh government regards as a danger. "In my opinion, for economic and political reasons compatibility has transformed into incompatibility and that's why Kazakhstan is not interacting with the Gulf countries as it should be," Anceschi explains. Historically, Kazakh people practised the Hanafi school of Islam, whereas Gulf Arabs mostly practise the Salafi (aka Wahhabi) school of Islam. Anceschi believes that the problem is not in differences between these schools of Islam, but it is about what the Kazakh government wants Islam to be in Kazakhstan. "The Kazakh

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Kazakhstan re-jigs government Naubet Bisenov in Almaty Kazakh President Nursultan Nazarbayev announced a major government reshuffle on August 6 as part of attempts to revive economic growth, which has slowed due to stagnant oil production and falling exports. Nazarbayev said the changes were aimed at reducing the bloated bureaucracy. In the new slimmed-down government, the number of ministries will be cut from 17 to 12. Nine agencies have been abolished and committees reduced from 54 to around 30. "We now need to create an efficient system of government and we need a compact government. We don't need to bloat bureaucracy more than is necessary," Nazarbayev said, adding that the civil service has grown by over 8,500 to more than 90,000 people over the past decade. Prime Minister Karim Massimov retained his job in the reshuffle – though he will now have only two deputies, instead of four – as did Deputy Prime Minister Bakytzhan Sagintayev, who is handling Kazakhstan's negotiations on the Eurasian Economic Union with Russia and Belarus. The plan is that a more effective government will help to boost growth. Economic growth has fallen below target due to the stagnant oil and gas production sector – mainly because of delayed production at the giant Kashagan field in the Caspian – and falling exports to Russia and Ukraine. GDP expanded by just 3.8% in the first quarter of this year, well below the government's 6% target for the whole year. Meanwhile, the delay in production at Kashagan, which was halted last autumn over technical issues just as it finally started producing oil, means the country's output will see no significant rise until late 2015 at the earliest. Telling officials that the country's energy sector is in a "mess," Nazarbayev announced the creation of a giant new energy ministry, to be headed by the former chief of the state nuclear company, Vladimir Shkolnik. In a move apparently without intended irony, the enlarged ministry will also encompass the duties of the disbanded environment ministry. Two other ministries to be expanded are the national economy ministry and the investment and development ministry. Analysts met the government re-jig with a lack of enthusiasm. "I don't expect the reshuffle itself to change Kazakhstan's investment climate because, as far as the announcement goes, the reshuffle does not entail any changes in economic policies," Sabit Khakimzhanov at Halyk Finance tells bne. "By default, we expect the policies to remain largely unchanged. That does not mean that the policy is not changing or that the investment climate is not improving - it is; but not because of the reshuffle." Noting that on the surface the reduction of bureaucracy makes sense, Eurasianet suggests the realities in Kazakhstan mean it's likely to drag on efforts to improve growth, as officials fight over a redirected and reduced power and rent flows. "One shake-up likely to spark a round of infighting... is the abolition of the financial police, replaced by an anti-corruption agency," it writes, noting "cynics may see as just another re-division of lucrative spoils in the war on graft."

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government is instrumental in making this gap to be more substantive than it is," he says. In order to prevent the penetration of what authorities describe as alien versions of Islam into Kazakhstan, the government has reduced its links with Saudi Arabia because the promotion of Islam is a central part of its foreign policy. This has been done through cutting the number of Kazakhs performing the annual pilgrimage to Mecca, limiting the number of students studying at Saudi Islamic educational

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Fly Emirates Out of all the Gulf countries, Kazakhstan has the closest relationship with the UAE, which accounted for over 80% of the country's trade with the region in 2012. According to Anceschi, this is down to the close personal relationship between President Nursultan Nazarbayev and UAE President Sheikh Khalifa, the emir of Abu Dhabi.

In addition to opening up the Gulf countries as export markets for Kazakh products, Kazakhstan could also learn from these countries' experience in developing their oil and gas sectors. "At one point they also ceded their oilfields to global oil giants to develop them... and the Arabs have managed in a civilised way to return them and now own them 100%," the analyst Zhumaly says.

The Emirates are popular not only with President Nazarbayev, who visits the country a few times a year in both an

Zhumaly also cites Dubai's experience in diversifying its formerly oil-based economy after it ran out of oil for export in the early 2000s. The Kazakh government has made diversifying the country's economy to reduce its dependence on the oil and gas industry a top priority. "Despite losing such a powerful springboard, this emirate is developing very well. In a very short time, some 20 years, it has managed to create a strong alternative â&#x20AC;&#x201C; a hi-tech, diversified economy based on property, manufacturing, tourism, services and re-exports," Zhumaly says.

"Despite similarities, Kazakhstan and the Gulf countries do not interact" establishments and imposing restrictions on independent mosques that operate outside the semi-official Spiritual Directorate of Kazakhstan's Muslims. "The insulation of Islam practised in Kazakhstan has created an Islam which is more coherent with the regime and tame," Anceschi notes.

official and unofficial capacity, but also with ordinary Kazakhs: 10,000 Kazakhs are believed to permanently reside there and about 1,000 Kazakh students study there. The UAE is the third most popular destination for Kazakh travellers after Moscow and Istanbul.

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and in order to supply gas to consumers in southern regions and export it to China the country has built the 1,143-km Beyneu-Bozoy-Shymkent route, which will supply 5bn cm inside Kazakhstan with the remainder heading for export. For the meantime, the south consumes mostly Uzbek gas.

Kazakh plans for gas face obstacles Naubet Bisenov in Almaty The Kazakh government has adopted a programme to develop the gas sector with the aim of increasing domestic consumption, but market players believe heavy regulation and an approach that sees gas as simply an auxillary to oil discourages investment. The government adopted a scheme to expand gas supply networks in Kazakhstan until 2030, in June. Just two months later, one investor told bne that the plan makes little sense unless Astana does more to encourage development of smaller scale gas deposits. According to the scheme, domestic gas consumption should go up from the current 11bn cubic metres (cm) to 18bn cm a year in 2030. Former Oil and Gas Minister Uzakbai Karabalin said the programme aims to increase the number of settlements supplied with gas from the current 988 to 1,621, covering 12m people, or 56% of the projected population in 2030. The policy envisages building new gas pipelines, doubling the total length of

the network to 57,500km. That will require investment worth KZT656bn ($3.6bn) Karabalin suggests. All of which of course means more gas will need to be pumped into the pipes. Overall, the scheme will demand that the output of marketable gas must rocket from 21bn cm to 60bn cm annually. The government believes that the Turkmenistan-Uzbekistan-Kazakhstan-

Best option However, Astana could struggle to persuade private investors to contribute to the scheme. A tightly regulated market, combined with excessive red tape, is a hurdle for investors because Kazakhstan is not "a cheap place" to operate, says David Robson, executive chairman of Tethys Petroleum. That will change only if the government liberalises the gas market, says the investor, whose company is developing the Kyzyloi and Akkulka gas fields in the Aral Sea region. The gas sector in Kazakhstan is regulated by legislation that grants the government a pre-emptive right to acquire gas assets. Producers must also sell all gas output at regulated prices, which allow a maximum profit margin of 10%, to national utility KazTransGas. While that only applies to associated gas, that actually constitutes the vast bulk of the country's current output. The government considers it little more than a "by-product" of oil production. Meanwhile, deposits of dry gas are small, meaning large investors show little interest, preferring the muchprized oil fields. The smaller investors that might take the gas reserves on are however put off by the tight control.

"Producers must sell all gas output at regulated prices, which allow a maximum profit margin of 10%, to national utility KazTransGas" China gas pipeline - with a capacity of 55bn cm of gas a year - should help improve gas supply in the country's south. Kazakhstan's major hydrocarbons fields are located in its western regions,

"Kazakhstan should be following freemarket principles, and one of the most important is a free market in energy," Robson tells bne. "While you have a market which is controlled it discourages

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investment, because you can't derive a true price for your products." The British oil executive suggests having just a single, state-controlled gas purchaser is "not the best option". In addition to the regulated pricing, which is currently around $85 per 1,000 cm, the state's pre-emptive rights - as well as the bureaucracy oil and gas companies face â&#x20AC;&#x201C; is another obstacle for investment in smaller fields, he claims. The pre-emptive right is triggered even when a stake of as little as 0.1% in minor gas assets changes hands, Robson complains, insisting that it should be limited to "big, strategic projects" such

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is still awaiting a green light from the government for the deal. "Legislation relating to the transfer of assets is so cumbersome that it will take you at least a year to get the necessary consents to be able to bring in a partner, and not everyone is willing to wait a year," Robson laments. Export route However, Tethys doesn't appear too discouraged. The Chinese investment will open the way to more exploration, says Robson, describing his company as a "good explorer". He says Tethys is the first to discover commercial oil in the northwest

"Companies involved in small projects should be able to buy and sell assets "quickly and simply" as the giant Kashagan oil field in the Caspian Sea. Companies involved in small projects should be able to buy and sell assets "quickly and simply," he says. Illustrating the point, Tethys sold a 50% stake in its Kazakh assets to the Beijingbased SinoHan Oil and Gas Investment for $75m plus bonuses in November. It

Aral Sea area. That has encouraged others, such as the French supermajor Total, to move into the area, he adds. The company plans to invest around $170m into new exploration over the next two to three years, with revenue to lead in providing the funds. Tethys expects to produce about 800,000 cm

of gas per day by the end of the year, and 1m cm next year. It also anticipates oil output to rise. Tethys turned over around $36m last year. The central point in that investment drive however is that the Beyneu-BozoyShymkent pipeline will allow Tethys to export to China. The regulated prices on the domestic market "are not good enough for us to invest more," Robson insists. That means Tethys will not be contributing to the gasification scheme. "Despite what might be said, we are not bound by the gas law because we produce dry gas," he explains. "Our contract allows us to export, but we will pay an increased mineral usage tax. We'll also pay profit tax, plus excess profit tax, so Astana will get cash. If the price in Kazakhstan were competitive with export prices, then, of course, I would prefer to sell domestically. Red tape is another obstacle to potential investment, the executive claims. While he says Kazakhstan "is not as corrupt place today as it was reputed to be a few years back," he says that has only seen bureaucracy spike. "The rules which have been put in place to prevent corruption means everything takes a long time. It's very difficult to operate efficiently because of bureaucracy," he complains.

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Mongolians fear being railroaded by China Jacopo Dettoni in Ulaanbaatar

t may be a difference of less than 10 centimetres, but it's proving enough to revive Mongolians' darkest feelings of suspicion about their giant southern neighbour China. The difference in question is the 85mm between Mongolia's 1,520mm rail gauge – a legacy from the Soviet era, and called the "Russian gauge" – and China's narrower 1,435mm gauge, a more widely used track width across the globe that's known as the "Standard gauge." This minor detail represents a huge technical barrier between the two countries, since each train crossing the border is forced to make long stops to change the wheels. But while

Mongolia's growing army of mining companies consider it a logistics bottleneck, Mongolians themeslves see it as a matter of national sovereignty

it has become front-page news again after the government's recent attempt to pursue the construction of a standard gauge railway stretching from Tavan Tolgoi, the country's largest coal mine, to

"Is Mongolia the next Crimea?"

– a necessary shield protecting their sparsely populated homeland and its vast mineral resources from the everpresent “Chinese threat.”

the Chinese border turned into a political quarrel fuelled by the powerful and controversial politician, businessman and judo hero, Khaltmaa Battulga.

The Mongolian authorities have debated the issue for years, all to no avail. But

“Tanks can easily penetrate into Mongolia in no time if we build a

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railway with a [narrower] gauge track, the same used in China,” a TV show produced by Battulga claimed a few days ahead of a key parliamentary discussion on the project in June. The TV show triggered a wave of antiChinese sentiment right at a time when the Mongolian government is trying to increase commercial ties with China. In an attempt to rebut the criticism, the government labelled the televised content as “damaging to national security, economic sovereignty, and diplomatic relations with China.” President Tsakhiagiin Elbegdorj himself summoned Battulga and accused him of “wrecking a good culture being formed and shaped in politics.” Even so, the deliberations over the bill for the railway project was delayed until the fall session. Godfather politics Battulga is one of the most controversial figures in Mongolia's political and business arena. A former judo champion with the nickname Genco, recalling a character from Martin Scorsese's "The Godfather,"

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May in protest at a bill prohibiting the simultaneous holding of offices as a minister and a member of parliament. Battulga has continued his dark warnings about supposed threats to national security. “The war and conquest of any country starts with transportation, banking system and communications,” Battulga said during a TV show. “We have to protect these fields – some nations fight for it, die for it, but unfortunately Mongolians just give away these fields.” If it is arguable that a railway to China, or a TV show against it, represent a threat to Mongolia's national security, there is little doubt that the country's logistics bottlenecks are a much more concrete threat to its economic ambitions. The present cost of trucking coal across the 20-kilometre border is $10 per tonne. This will come down to $0.1 once the coal is moved by rail, with transportation times reduced to three hours from three days and the

"Tanks can easily penetrate into Mongolia in no time if we build a railway with a gauge track the same as used in China"

Battulga started off trading electronic appliances with China in the 1990s and ended up building an empire ranging from meat processing to land development. His political career has been as successful as his business ventures. After serving as roads, transportation, construction and urban development minister in the previous government, he became industry and agriculture minister and was even touted to be close to replacing Prime Minister Norovyn Altankhuyag in April. Instead, he ended up leaving the government in

overall transport capacity increased to 50m tonnes a year from 20m tonnes, according to government figures. If such estimates materialize, the narrower gauge railway project will improve the competitiveness of Mongolia's coal, which often gets outpriced by China's other coal suppliers like Australia. Mongolia exported to China 18.2m tonnes of coal in 2013 and this is planned to reach 50m tonnes by 2015. On the other hand, the railway will also increase Mongolia's economic dependence on China, which is already

the only buyer of its coal, raising concerns over the country's economic and political sovereignty. Those same concerns had already emerged in 2012, when China’s state-owned Aluminium Corporation of China (Chalco) was about to acquire a coal mine operator, SouthGobi Resources, from a Canadian company. Ulaanbaatar reacted by passing a new law requiring government approval for foreign investment in strategic industries. More recently, a Chinese blogger caused outrage in Mongolia when he redrew a map of China and asked: “Is Mongolia the next Crimea?” China's poor track record in dealing with border disputes and neighbouring countries proves to be fertile ground for such worries to proliferate. Nonetheless, Mongolia's government has little room to pursue other alternatives to feed its slowing economic growth. Despite recurring announcements, work has yet to kick off at the Sainshand industrial park project, a multi-billion project aimed to process locally Mongolian minerals and connected via railway to Russian ports. On the other hand, Chinese state firm Shenhua Group has already agreed to bear 70% of the cost of the 267km railway connecting Tavan Tolgoi and the Chinese border, making it a more realistic short-term option. Besides, the government hopes it can gain access to third markets through Chinese ports, giving Mongolia the chance to become the “Panama” of Eurasian transit trade, to put it in the words of local columnist Dambadarjaa Jargalsaikhan. “By making use of a mere difference of 85mm, we can turn Mongolia into a big player in terms of international trade,” Jargalsaikhan wrote in 2013, referring to the country's chance to become a regional hub for goods in transit towards China. However, for as long as Mongolia's relationship with China remains one of ambivalence, such ambitions remain vulnerable to sudden bursts of antiChinese sentiment and, ultimately, will not be fulfilled.

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Astana starts preparations for Expo 2017 Naubet Bisenov in Almaty Kazakhstan's glitzy capital Astana has started preparations to host the Expo 2017 international fair. The organisers believe the project, which includes construction of all facilities from scratch, will be completed in time to allow participants to start setting up their exhibits in January 2017, despite the tight deadline. When in 2010 Kazakhstan announced its intention, and in 2011 it submitted its bid, to host the exhibition, proponents hailed it as a chance to showcase the country's achievements, as well as its young capital, which will turn 20 the year of the exhibition. Supporters also claim the fair will give an impetus to innovative development and infrastructure. However, for sceptics, Expo 2017 is another vanity project on which the Kazakh authorities - emboldened by successful events such as the recent chairmanship of the OSCE or 2011 Asian Winter Games - will splurge public funds. Kazakhstan is also set to host the 28th Winter Universiade in Almaty in 2017. The country's biggest city is also competing against Beijing and Oslo to host the XXIV Winter Olympic Games in 2022. Critics argue such grand-scale events do little to promote the country. They add that the billions planned to be spent would be better used to solve social problems, as well as support the economy's struggle to return to dynamic growth. The International Exhibitions Bureau chose Astana over the Belgian town of LiĂ¨ge in November, and officially recognised Astana as the host city of Expo 2017 in June, presenting Kazakhstan with the flag of the exhibition. This marked the official start of preparations for the exhibition.

According to the fair rules, the host city cannot start the preparations before official recognition, but Astana had been granted an exemption because of the long, harsh winter that shortens the construction season. As a result, work kicked off in April. Talgat Yermegiyayev, chairman of Astana Expo 2017 â&#x20AC;&#x201C; the state company responsible for organisation - says that all the necessary legislation for building facilities for the event was passed last year. Even so, efficient use of the two and a half years remaining for completion is "critical," he says. Building the 1m square metres planned will be "very difficult â&#x20AC;Ś almost unrealistic" in such short time, he says, before insisting that the schedule will be met "100%". More power to green energy The theme of the Astana Expo will be green energy, and organisers say they hope it will draw attention to sustainable development, renewable energy, and energy efficiency in Central Asia and the CIS. Kazakh power companies intend to dot the city with 100 wind turbines to make a "contribution to the inimitable look of the capital." A solid waste-recycling plant, facilities to process rainwater and sewage, and a $100m solar power station with a capacity of 50 MW are also planned. The Expo tsar admits that a price tag of $3bn is high, and accepts there is criticism, but rejects claims the project will not be profitable and the money could be used wisely for "more important" purposes. "Talk that

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the exhibition will not pay off is just groundless insinuations. I guarantee the project will be profitable," he asserts. At the same time, he notes that the return on investment into the fair shouldn't be measured only in monetary terms. "Future generations will remember Expo 2017 as a "project with social, educational and, finally, spiritual meaning," he says. The government hopes that the private sector will invest at least $500m in building residential and commercial properties, as well as leisure and shopping centres for the exhibition. In order to entice local businesses to get involved in the project, the government has simplified customs procedures for goods imported from outside the Customs Union, and exempted them from duties. Taking into account the problem of white elephants left by previous fairs around the world, authorities are placing particular stress on the use of facilities after the exhibition: hotels and other residential buildings will be converted into apartments, while pavilions and other commercial facilities will be turned into offices. "Our task is to think about the future use of all these buildings after the Expo," President Nursultan Nazarbayev said during his inspection of the Expo campus, which will cover an area of over 170 hectares, in July. "All residential properties which will serve as hotels should then be used as flats. Everything should be used." The organisers also hope to recover some of the costs directly, via the boost that the local economy will receive from domestic and foreign tourism during the event. Over 2m people are expected to visit the fair during its three month run from June to September 2017, of whom 15% will be foreigners.

"Future generations will remember Expo 2017 as a project with social, educational and, finally, spiritual meaning"

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Too little, too late in Mongolia Terrence Edwards in Ulaanbaatar

Mongolia's lawmakers were betting investors would rejoice at new watershed legislation for the country's mining sector. However, investors are more concerned with the problems of today than promises for the future. Mongolia's parliament passed legislation crucial to its mining sector on July 1, the last day before lawmakers headed off for their summer break. Those following Mongolia's copper and coal mining investments had their focus squarely on an amendment to the Minerals Law, and reactions have been mixed, with miners complaining that the legislation does not fix corrupt licencing practices. That's not the feedback the government was hoping to hear. Foreign investment

sank to a new low in the first half of 2014 â&#x20AC;&#x201C; 70% less than the same period last year â&#x20AC;&#x201C; thanks to what investors say is a hostile business environment. Political instability, aggravated by tides of resource nationalism, are also an issue. A soft market for key export commodity

The flagging economy has put great pressure on Prime Minister Norov Altankhuyag to kick start investment flows, and the passage of the new legislation was part of a 100-day economic stimulus initiative. However, for many, the poorly received legislation is just more evidence

"The introduction of a competitive process for licence tenders is missing"

coal has not helped either, with Mongolia's earnings from coal exports falling 17% during the first half of the year.

backing the US embassy's opinion that Mongolia's support of foreign investment is more â&#x20AC;&#x153;aspiration than reality".

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Mixed Bag The good news is the passage of the amendment to the Minerals Law lifted a moratorium for new exploration licencing that has been in place since 2010. In addition, the duration of new licences was extended from nine to twelve years. The law also makes it a bit harder for the government to revoke licences. What it's missing, as law firm Minter Ellison pointed out in an overview, is the introduction of a competitive process for licence tenders. Instead, the current “first-come-first-served" basis for applications is retained. The largest outcry, meanwhile, came from the miners who say they can't find the “win-win” solution the government had privately promised them to resolve a dispute over licences revoked late last year. In November, a judge voided at

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According to the government's tender resolution meant to settle the matter, which was passed on the same day as the amendment to the Minerals Law, companies will now have to compete for the licences once again. “The government realizes that the court made the wrong decision, but still stands by the decision. It's been made very clear by this tender resolution,” said Tumurkhuu Batbayar, who heads an association representing the former licence holders. Batbayar says he and and the other original licence holders had privately been promised the return of their licences along with preferential rights from Mongolia's Mining Ministry. Batbayar had only his 15-years' experience as a career geologist to identify lucrative licences by sifting through government archives rather

"The government realizes that the court made the wrong decision, but still stands by the decision." least 106 licences that had been issued during the tenure of a senior bureacrat at the Mineral Resources Authority who was found guilt of corruption.

than deep pockets. He said that he was worried about the prospect of having to compete with bidders with government connections or the cash to outbid him.

Mongolia-focused Kincora Copper, which saw a C$7m write off last year due to lost licences, is one of 27 companies affected. It argues it attained the licences legally, and that the court had no grounds to revoke them.

“We're not expecting the tendering to be done in a fair and open manner,” he said.

“At no time did the court offer specific evidence proving that these licences, among the hundred granted during the official’s term, were improperly granted,” reads the US embassy report. The document adds that Mongolian courts lack authority to make administrative decisions: “In effect, investors have had their economic rights expropriated by judiciary acting outside its jurisdiction, without any opportunity to appeal these losses to a proper authority.”

Tax Dispute However, the long squabble with the country's biggest investor remains Mongolia's largest obstacle to getting investment flows going again. Mongolia has tried to show that relations have warmed with Rio Tinto, the private investor in the $6.5bn Oyu Tolgoi copper and gold mine, since the international miner put the breaks on construction of an underground mineshaft. That halt came after Mongolia balked at what it said were overblown costs. Rio Tinto owns 66% of the mine indirectly through majority

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ownership of Turquoise Hill Resources; the government owns the remaining 34%. Now, a tax dispute could be the catalyst for new problems. Turquoise Hill, in a statement on June 25, reported that it had submitted a notice of dispute. That followed receipt of a letter from Mongolia's General Tax Authority claiming the company owes $130m in taxes for 2010- 2012, plus interest and penalties. The notice filed by Turquoise Hill grants 60 days for resolution. “If the parties are unable to reach a resolution during this period, the dispute can be referred to international arbitration,” reads the statement. Tax Authority Commissioner Tunrev Batmagnai told bne he could not go into detail about the case because tax payment is confidential. “If the taxpayer confirms the conclusion, then that's the final word,” said Batmagnai. “If not then we have the dispute council [to refer to]... Right now Oyu Tolgoi and the government of Mongolia are at this point.” The Tax Council, he says, is an alreadyexisting panel of figureheads from various areas of government, and is independent of the General Tax Authority. It has 30 days to rule on the dispute, but that will only leave 30 days of potential negotiation for the dispute filings between the government and Oyu Tolgo. “They've created too much pressure for both sides,” Batmagnai suggests. He also laments that Oyu Tolgoi had caused the audit to drag on because it did not have all of the relevant documents in Mongolia, as specified by Mongolian law. “They're going against the law, how they've handled this,” he said, adding that punitive measures would be taken for any violations. Maybe so, but investors will likely be more interested in the outcome of the tax dispute than claims against Rio's paperwork management.

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STOLYPIN:

Russia not invading, nor yet backing down

Mark Galeotti of New York University

oward the end of August, reports surfaced of an armoured Russian incursion into Ukraine, but how close is Russia to invading?It will take more than a few APCs to invade Ukraine. Amidst the contradictory reports of an armoured Russian incursion, met and repulsed by Ukrainian artillery, it is inevitable that the talk is of Moscow moving to a new level; of the inevitability of war - or that it has already started. Ukrainian President Petro Poroshenko has accused Moscow of planning a "direct invasion." NATO Secretary General Anders Fogh Rasmussen claimed a "high probability" of such an intervention. Military logic would suggest that Russia is neither invading nor wants to, though. The questions become: how far is logic in the driving seat? And if this is no prelude for invasion, does it mean the conflict is nearing an end? British journalists on the ground saw a force of 23 armoured personnel carriers (APCs) and their logistical support vehicles cross the Ukrainian border near the M4 highway which leads to rebel-held Lugansk and Donetsk. This is not the stuff invasions are made of. Russian mechanized forces blend tanks, infantry in APCs, artillery and air-defense elements to combine offensive punch and defensive strength. On their own, APCs are vulnerable, little more than lightly-armoured trucks. If the Russians ever come genuinely to invade, then it will come as a thunderbolt, with massed airstrikes and artillery bombardments intended to shatter the command structures, supply lines, morale and cohesion of the Ukrainian forces. Moscow would use its overwhelming air superiority to strike deep into Ukraine, not least to prevent quick reinforcement of the frontline forces, cratering runways to prevent aircraft taking off and landing, blasting bridges and ripping railway

lines. Meanwhile, its special forces, the infamous Spetsnaz, would spread chaos as they have been trained to do, with sabotage, assassination and misdirection, supported by a massive cyberattack intended to shut down Ukrainian communications. The reason for this "shock and awe" approach is not only because it is envisaged by Russian doctrine, but also reflects the way that Russia's tactical advantage has steadily been eroded over recent months. August is one of the ideal times for

"If the Russians ever come genuinely to invade, then it will come as a thunderbolt" Russia to launch military adventures, because its spring cohort of conscripts are now fully trained, fit and deployed to their units, but not yet so close to demobilization that discipline and readiness have begun to suffer. However, while Russia still has perhaps 40,000 troops on the border, Ukraine's security forces have regained much of their operational capacity after the near-crippling collapse of the chain of command following the fall of Yanukovych. Three mobilizations have seen reservists called back into the ranks, and nationalists have been encouraged to volunteer for the National Guard, a force which has borne the brunt of much recent fighting. While the National Guards - who range from convinced patriots through to avowed neo-Nazis - have in the main

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received only the most basic of training and in many cases suffer from problems with discipline and restraint, nonetheless they represent an extra force of some 35,000 fighters. Furthermore, the country has 77,000 regular troops and 35,000 Interior Ministry security troops. In this context, should Moscow be contemplating direct military intervention, then unless it is willing to strip forces from its other commands and borders - something which would be expensive and impossible to conceal from spy satellites and social media photographers alike - it would have to rely on the 'force multipliers' of technological superiority, surprise and disruption to have any hope of victory. Any hope is not the same as much hope, though. Such an invasion would not only galvanize Ukraine's resistance (and there are still thousands more reservists to muster if need be), it would trigger an unprecedented Western reaction. While there is no real prospect of NATO personnel intervening, everything from direct transfers of hardware through to extensive intelligence and electronic support would be forthcoming, along with a sanctions regime designed to do everything possible to cripple the Russian economy. Whatever the success of the initial onslaught, Russian advances would likely be met with resistance by the Ukrainian units on the ground. Even if fighting piecemeal, with no common strategy, they would likely inflict serious losses on the attackers. Putin would thus be denied his preferred tactic, a rapid and unexpected revision of the truths on the ground, presenting the West with a fait accompli (think Crimea, think Georgia). He would also know that very soon Russians would start to notice the costs of this war, from a flow of 'Cargo 200s' - the Russian designation for fatal casualties - to serious economic costs. Of course, one could respond that this is a logic that might not resonate with the new-model Putin of his third presidential term, a man increasingly clearly driven by a sense of a nationalist mission. Or, indeed, that he may not even be aware of these stark realities. It is certainly clear that he now listens to a much smaller circle of allies and confidants, none of whom are in the military. One could look back to the fateful decision to invade Afghanistan in 1979, when the prescient and urgent concerns of the General Staff were never conveyed to the Soviet leadership by a defence minister who valued his relationship with General Secretary Brezhnev over his professional duties. Nonetheless, despite German Chancellor Merkel's claim that Putin is in "another world," there is little reason to think that the Kremlin is at all eager for a military adventure that promises massive risks and minimal chances of a quick and easy victory. Indeed, behind the rattling sabres, the Russians appear to have stepped up their efforts to reach some diplomatic resolution.

Opinion

Russian foreign minister Sergei Lavrov met his Ukrainian counterpart Pavlo Klimkin in Berlin on August 17, following a meeting between presidential chiefs of staff Sergei Ivanov and Borys Lozhkin. Ivanov is a close Putin ally and generally considered a hawk, so his participation was especially significant. Rather than gearing up for an invasion, Moscow is hoping rather to be able to negotiate its way to some face-saving formula which would allow Putin to abandon the increasinglyexpensive political liability that is Novorossiya while claiming it as a success. And that Russian "invasion force"? That was probably just one more consignment of military materiel intended to help the rebels hold the line long enough for Putin to get his deal. After all, according to Aleksandr Zakharchenko, new head of the Donetsk People's Republic, they have already received at least 30 tanks and 120 APCs, and this is likely a distinct understatement. But even if Russia does not plan or want an invasion, that hardly means it cannot continue to cause serious, even critical trouble for Ukraine. Indeed, even the fall off Lugansk and Donetsk, which would effectively end any coordinated insurrection, would not necessarily bring peace. After all, the essence of Russia's new doctrine of "non-linear war" means using everything from economic leverage to subversion and sabotage to pressurize countries to making the desired concessions. Take out the rebellion and still the Kremlin has a wealth of weapons in its arsenal, from gas shutoffs and intelligence operations, through economic penetration backing friendly politicians, to empowering criminals and strategic leaks and rumors. So, the military aspect of Russia's campaign looks unlikely to be about to escalate. But without some political settlement between Moscow and Kiev, it is likely simply to be succeeded by a more covert but equally destructive phase of underground subversion. Mark Galeotti is Professor of Global Affairs at the SCPS Center for Global Affairs, New York University, who writes the blog In Moscow's Shadows (http://inmoscowsshadows.wordpress.com).

"Behind the rattling sabres, the Russians appear to have stepped up their efforts to reach some diplomatic resolution"

Opinion

bne September 2014

INVISIBLE HAND:

The East-West trade war kicks off Liam Halligan in London

fter three rounds of US-inspired sanctions against Russia, Moscow has retaliated. We stand on the brink of a full-blown East-West trade war.

Since March, the West has imposed successive travel bans and asset freezes on various lawmakers and other prominent individuals - the most wide-ranging restrictions on Russian commerce since the Soviet era. In late July, the screw was turned even tighter, as the US and then the EU limited Russian state-owned banks’ access to international capital markets. President Vladimir Putin snapped. A 12-month ban on food imports from the US, EU, Australia, Canada and Norway was imposed in early August, and there’s talk of stronger measures to come. Diplomacy having failed - having barely been attempted - the economic gloves are now off. Will tit-for-tat sanctions between Russia and the West escalate, worsening the commercial and political damage? While Russia has so far avoided recession this year, recording a 1.1% GDP expansion during the first six months of 2014, growth over the second half will surely be lower - if not due to the direct impact of sanctions, then their effect on the broader business climate. A weaker ruble, though, is helping manufacturers, partly compensating for lower consumer spending. Russia’s fiscal surplus remains strong at 1.5% of GDP, there’s miniscule government debt and vast stashed sovereign wealth. The Kremlin, if need be, can turn the spigot on more infrastructure and budget spending should sanctions weigh too heavily on the domestic economy. Inflation, though, is a problem. Already 7.8% in July, price pressures are likely to be aggravated by the agricultural import ban - not least because Russians spend around a third of household income on food. The Central Bank of Russia has hiked borrowing costs three times in the last five months, pushing the main refinance rate to 8%, in a bid to contain inflation; further rate rises threaten to curtail bank lending and growth. Stalling Ironically, though, the West - in particular, Europe – may

be suffering more. The Eurozone was always going to bear the brunt of the sanctions against Russia, given its $460bn annual cross-border commerce with its eastern neighbour, twelve times more than the US. The sanctions have contributed to the stalling of the Eurozone economy's recovery, with region-wide growth flat between March and June. Germany looks to have been hit hardest. In June, factory orders in the Eurozone’s largest economy dropped the most in more than two and a half years, with the German government citing geopolitical tensions as a major reason. The following month, in the aftermath of the downing of MH-17 over territory held by anti-Kiev fighters in eastern Ukraine, the bellwether ZEW indicator of economic sentiment plunged to a two-year low, down for the third straight month. Germany is by some margin Russia’s biggest EU trading partner. The country’s manufacturing thoroughbreds have sunk hundreds of billions of euros into Russian production facilities. VW, for instance, now has several full-cycle Russian

"Russian inflation is likely to be aggravated"

plants and is the middle-class brand of choice in what will soon be Europe’s largest car market. Siemens is central to the upgrade of Russia’s vast rail network and Liebherr has a big presence too. Beyond these household names, numerous firms from the “Mittelstand” - the medium-sized enterprises that account for over half the German economy - have built lucrative tradinglinks with Russian counterparts over the last 20 years. Many have set up shop across Russia’s far-flung regions, making everything from machine tools to plasterboard.

bne September 2014

Such companies are now feeling the pinch, their Russian customers canceling orders as the geopolitical tensions rise and sanctions bite. These trends help explain why, having grown 0.8% during the first three months of the year, German GDP contracted 0.2% in the second quarter. The implications for the broader Eurozone are obvious. Italy, another large West European economy with big trading ties to Russia, just tipped back into recession. There’s now a very real danger that heightened geopolitical tensions, aggravated by sanctions, could mean the same fate befalls the entire Eurozone. I’m hopeful, though, that East-West sanctions will remain relatively limited, at least from the Western side, given the existence of powerful business lobbies that will help keep gung-ho governments in check. While the Kremlin’s choice of a targeted food import ban seems strange given the domestic inflationary pressures, it may be smarter than it looks. There are, after all, few interest groups European politicians fear more than the farm lobby. With EU farmers complaining of $16bn of lost commerce and warning of domestic price falls given the resulting food glut, Brussels is now under intense pressure to negotiate a reversal of Russia’s import ban or, at the very least, make sure it’s limited to a single year. Russia’s fast-growing food market is extremely attractive and, with foreign competitors looming and domestic producers finding their feet, Western Europe’s food industry doesn’t want to lose out. A potential beneficiary of the Kremlin sanctions is Brazil Russia’s peer in the Brics group of leading emerging markets. Since the ban was imposed Brazil has moved quickly, authorizing the immediate export of chicken, beef and pork to Russia from almost 100 meat plants. This will seriously annoy European farmers, as will the fact that while Russia accounts for a chunky 10% of EU food exports, it takes just 1% of the food the US sells aborad. Few Russian sanctions will more effectively split the US and Europe. The EU itself is also deeply split, of course, with Britain talking tough about further sanctions, while France and Germany, despite some occasionally fiery rhetoric, remain more cautious. French farmers and German manufacturers could now combine to push the debate their way - not least as the UK, petrified of jeopardizing the City’s Russia-related business, is looking for an excuse to back down. Even in the US, while Russia accounts for just 3% of total trade, there is now a considerable group of powerful corporations that have ploughed serious foreign direct investment into the country. The likes of Ford, GM, Boeing, Procter & Gamble, Pepsi and John Deere have between them built a myriad of Russia-based production facilities, keen to tap into what will soon be Europe’s largest consumer market. As have several US oil majors, of course.

Opinion

Defence industry lobbyists will forever play up the “Russia threat”. That will never stop. But any US President now has a growing corporate lobby in the other ear, stressing the “Russia opportunity” and the importance of protecting existing investments. No halt to politics Commercial imperatives won’t, however, stop the political posturing and rhetorical finger-pointing on both sides. But they should help keep sanctions within reasonable limits. Another reason the West may avoid further turning the screw is that the event that provoked the latest crackdown - the downing of MH-17 - may start to lose political significance. This disastrous crash, in which almost 300 civilians perished, was clearly a horrific tragedy. Of that, there can be no doubt. Yet while Western politicians were quick to blame Russia in the immediate aftermath the accusations have lately gone quiet - not least as US intelligence officials have quietly admitted they have no evidence of Russia’s involvement. It is entirely possible, of course, that anti-Kiev fighters used a Russian-supplied surface-to-air missile, either purposely or inadvertently, to shoot down MH-17. But in the absence of compelling proof, which America seems not to possess, that narrative will become harder to sustain. Mainstream media outlets, in continental Europe at least, are now voicing doubts, pointing out that the Ukrainian army also uses Russian-made missiles, while highlighting conflicting evidence suggesting MH-17 was shot down by a second plane, which the rebels don’t have. This plane crash, with its ghastly human impact, was a turning point. After MH-17, the EU toed the line, immediately agreeing to much tougher sanctions. That provoked Moscow’s response, putting us in a tit-for-tat that could now escalate. But the longer question marks remain regarding Russia’s involvement in the MH-17 incident, and the more food sanctions hit Europe but not the US, the more nuanced the EU’s views could become. If Ukraine’s civil war spreads, or Russia becomes extremely belligerent, then obviously all bets are off. But the base case is that sanctions have reached their high point, even if the rhetoric continues to spiral.

"The sanctions have contributed to the stalling of the Eurozone economy's recovery"

Special Report: Fund Survey 2014

bne 2013 bne September May 2008

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FUND SURVEY 2014:

Unloved and underinvested Nicholas Watson in Vienna

rdoganisation, Orbanisation, Italianisation – the last year has thrown up many new terms. However, it was, for the most part, yet another disappointing year for funds invested in Central and Eastern Europe/Commonwealth of Independent States (CEE/CIS). Though tough, this year was at least a bit better than the previous one, as evidenced by funds' largely positive returns. Last year was blighted by a sea of negative returns, which led to big outflows of investor cash (most this year look distinctly smaller than they were last year). Some funds have even disappeared altogether; in March, Swedbank merged its long-struggling 'Swedbank Central Asia Equity Fund' with its 'Swedbank Russian Equity Fund", explaining that investor interest in such a fund had faded and it did not see any chance of this situation changing. "The capital markets in Emerging Europe – unlike Asia and Latin America

– are facing strong geopolitical headwinds due to conflict in Ukraine with Russia as well as in the Middle East," says Alexandre Dimitrov, head of CEE equity fund management at Erste Asset Management. It's not hard to see why the region is unloved and underinvested: the bad news has continued to come in waves, beginning for the purposes of bne's survey period – the year from July 1, 2013 to June 30, 2014 – with the riots in Turkey and ending with the conflict in Ukraine and sanctions on Russia for the role it's playing in that. Fund managers describe it as a politically driven, top-down market – the bottom of which has yet to be reached. And it's characterised by a worrying structural conservatism, where the aforementioned "-isations" are standard features, as well as so-called "reforms" such as the renationalisation of pension assets. "We are returning to a structural conservatism," says Peter Svoboda, senior fund manager of Erste Asset

Management's 'Bond Danubia Fund'. "It's amazing to see this come back again. This pessimism of 25 years ago is very unfortunate." Wider EM problems In fact, the poor performance of CEE/ CIS funds is part of the wider underperformance of emerging market funds over the past few years. "The previous years have not been great for emerging markets in general," says Petr Zajic, senior fund manager at Pioneer Investments. "Since 2010, emerging markets are underperforming developed markets pretty significantly – the underperformance is around 45-50%." Part of this is due to the slowing economic growth in emerging markets. Some of the slowdown is seen as just a hiccup, but many economists also believe that emerging markets will have difficulty sustaining the kind of high growth rates of the 2000s over the next three to four years. Thus, some of this slowdown reflects lower potential growth and so is probably more perma-

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nent in nature. "Estimates of potential growth rates in emerging markets for the next 3-4 years, at 3½ percent, suggest that growth would be on average 1¼ percentage points lower than so far in the 2000s, though the magnitude of the impact varies by country," the International Monetary Fund economists, Evridiki Tsounta and Kalpana Kochhar, wrote in June. However, Marcus Svedberg, chief economist of East Capital, argues that investors are being too negative on CEE growth. Furthermore, while investors are often tempted to look at GDP growth as an indicator of future stock returns, research has shown that a more effective approach is to do the exact opposite. "The Turkish, Russian, Romanian and Polish markets have gained 30%, 25%, 10% and 5% respectively over the past three months," Svedberg wrote in July. "So if stock market performance is an indicator of economic growth assumptions, then the market is clearly too negative on Eastern European growth." Inevitably, this has been reflected in money flowing out of CEE/CIS regional funds. In bne's annual survey period (July 1, 2013 to June 30, 2014), figures from fund tracker EPFR show the cumulative outflow from Emerging European equity funds totalled $3.1bn. Russian equity funds lost a total of $2.2bn. In fixed income, EPFR data

bnebne September 2013 May 2008

making something of a comeback since March, following $14bn of outflows in 2013.

tively affected by Turkey; and for the future everything depends on how the situation in Ukraine will develop."

Sell Russia, buy Turkey This year has been a mixed picture for the region's equity markets. According to EPFR, the Emerging Europe regional equity funds that it tracks were down around 5% in the first six months of this year, while Russian equity funds were down about 13%.

So it should come as no surprise that the winner of the "bne Best Equity Fund 2014" is one that features Turkey, the 'East Capital Balkan Fund', which invests in companies in Romania, Croatia, Serbia, Turkey, Slovenia and Bulgaria. For the year period to June 30, the fund was up almost 26%.

"The markets have actually been incredibly relaxed for what is almost a full war scenario. The Russian market is only down about 10%. Could you imagine what might have happened or what could happen?" says Dimitrov. "In risk management, you try to limit the damage. I have difficulty telling you what is going to happen in three months from now."

Says Tim Umberger, senior advisor at East Capital: “Our long-term view that the Balkan markets offer attractive investment opportunities continued to materialise over the past 12 months. Most of the economies started to show significantly better growth numbers, which together with relatively low valuations formed good conditions for stock markets to perform. At the same time, an overall better sentiment spurred a new wave of larger transactions and deals, both on mergers and acquisitions as well as on privatisation fronts. In certain cases, East Capital’s involvement was crucial for deals to go through, while at the same time it allowed us to build new positions at attractive prices, which in turn helped generating solid returns for our investors. We continue to be very active in some of our key holdings, pushing for better corporate governance and higher dividends."

The standout performer in the region was Turkey (and Greece, now considered again an emerging market), which over the past year is up almost 5% and year-to-date up 29%. "For this year it's been a typical Russia-Turkey switch," says Zajic. "I don't think people are really bullish on Turkey, but part of this solid performance is part of this selling Russia, buying Turkey move." This is vividly illustrated by the performances of the 'East Capital Turkish Fund' and 'East Capital Russian Fund';

"The previous years have not been great for emerging markets in general" show that Emerging European bond funds lost a total $158m in the year, while Russian bond funds lost $418m. This was reflected in the wider emerging market universe. By the end of June, year-to-date outflows from emerging equity funds were around $25bn, well above outflows of $14bn in 2013. Bond funds' losses were about $2bn in the red to the end of June after

as of August 7, the former was up 25% so far this year, while the latter was down 16%. It also illustrates the volatility of the market, notes Erste's Dimitrov: Turkey moved from being minus 20% in February to 40%-plus in early August. As Zajic sums up: "This year the overall picture has been negatively driven by the performance of Russia; it was posi-

Other notable equity funds this year were the 'East Capital Baltic Fund' up 14.7%; the 'ELANA High Yield Fund' up 14.99%; and the 'VTB Equity Local Fund' up 12.7%. Bad start for bonds In fixed income, the year got off to a bad start when in May 2013 the US Federal Reserve began talking about "tapering" its bond-buying programme, causing emerging market bond prices and local currencies to drop sharply. "In 2013 we had this big drop as rates increased quickly in the US and so June, July and mid-August were really very disappointing months. For global Emerging Markets generally, and Central and Eastern Europe specifically, we had a lot of outflows until the end of

bne 2013 bne September May 2008

last year, though these outflows started to rebound at the beginning of the second half of this year," says Margarete Strasser, senior portfolio manager at Pioneer Investments. Erste's Svoboda says the main story this year has been CEE corporate bonds, which have seen the highest issuance in more than 10 years, in both euro and local currency. "They are taking advantage of low rates and lengthening maturities – it’s a very positive sign that corporates have dared to test the market," he says. Indeed, Erste lead managed a ¤710m three-tranche bond issue for the Czech gas transmission system operator Net4Gas, whose CZK7bn tranche (¤250m) was the largest corporate korunadenominated bond issue in the last decade. Tomas Cerny, head of CEE debt capital markets at Erste, says demand for the issue was around ¤1.5bn, implying that investors are hungry for any pickup in yield. Thus, selling debt into this market is a matter of price, rather than the capacity of the market to absorb such debt. The winner of the "bne Best FixedIncome Fund 2014" is the 'Pioneer Funds Austria - Bond Opportunities 6/2019' with a return during the year to June 30 of 9.79%. Says Pioneer's Strasser: "The good performance of PIA Bond Opportunities 6/2019 was due to the high exposure to Central & Eastern European EUR and USD hedged denominated sovereign and corporate bonds and the low portion of Russian and Turkish local currency instruments. In this period disappointing economic dynamics in Europe paired with low inflation supported central banks in Europe, Poland and Hungary to decrease interest rates several times. Bond yields decreased to all-time lows. Although the maturity of the instruments in the fund terminates 2019 or 2020, a big portion of performance gathered through duration. Additional performance contributed by spread tightening in Slovenia (500bp to 135bp), Hungary (430bp to 200bp), Romania (330bp to 190bp) as the market searched for yield." Other fixed-income funds that per-

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"In risk management, you try to limit the damage. I have difficulty telling you what is going to happen in three months from now"

formed well were VTB Capital Investment Management's 'VTB Treasury Fund' with a return of 6.19% and last year's winner, Erste Asset Management's 'ESPA Bond Danubia', up 5.41%. The winner of the "bne Best Balanced Fund 2014" is Sturgeon Capital's 'Sturgeon Central Asia Balanced Fund' with a return of 15.9%, edging out the 'ELANA Balanced EUR Fund' at up 15.6%. Says Clemente Cappello, CIO and CEO of Sturgeon Capital: "The performance of the 'Sturgeon Central Asia Balanced Fund' was generated both by allocation decisions between equities, debt securities and cash, and by its security selection process. As a result our Fund outperformed regional benchmarks and its peers, even where markets were not easy (eg. Kazakh Tenge devaluation, Russia turmoil etc). Although the Fund was established in 2007, we at Sturgeon Capital became its investment manager only in December 2012 and worked hard on better positioning the fund. This included implementing our holistic risk approach and using our in-depth knowledge of the investment universe honed over seven years focusing solely on Central Asia. "Our current focus on the resurgence of the Kazakh and Georgian banking sector, high dividend yielding stocks and cheap natural resource stocks may result to a further significant re-rating of the debt and equity securities in its portfolio in the next 12-24 months. In addition, the strong economic growth in the region, coupled with low valuations, may of course be a further potential boost to performance." The winner of the "bne Best Alternative Fund 2014" is Prosperity Capital Management's 'Prosperity Quest Fund' with a return of 20.5%.

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CEE and CIS funds

Fund manager

Name of fund

Type of fund

Geographic allocation

Citadele

Citadele Eastern Europe Bond Fund â&#x20AC;&#x201C; EUR

Fixed income

CEE

Citadele

Citadele Russian Equity Fund

Equity

Russia

Citadele

Citadele Baltic Sea Equity Fund

Equity

Baltic Sea

Citadele

Citadele Caspian Sea Equity Fund

Equity

Central Asia/Caspian

Citadele

Citadele Ukrainian Equity Fund

Equity

Ukraine

DWS

DWS Russia

Equity

Russia

DWS

DWS Osteuropa

Equity

CEE