bne June 2011 - Ukraine: the edge of darkness

Inside this issue: Caveat emptor in Russia EU funds slosh through Slovakia Turkey's canal dreams Food fight in the Balkans June 2011 www.businessneweurope.eu

Special Report: Hot Coals

THE EDGE OF DARKNESS Ukraine's politicians are losing legitimacy

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

Contents

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Inside this issue:

+7 9162903400

Caveat emptor in Russia EU funds slosh through Slovakia Turkey's canal dreams Food fight in the Balkans June 2011 www.businessneweurope.eu

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

Special Report: Hot Coals

THE EDGE OF DARKNESS Ukraine's politicians are losing legitimacy

Eastern Europe: Graham Stack (Kyiv) stack@businessneweurope.eu

+7 9266052742

Central Europe: Robert Smyth (Budapest) +36 19995200 rsmyth_hu@yahoo.com Jan Cienski (Warsaw) +48 604994850 jancienski@ft.pl Mike Collier (Riga) +37 129473192 balticfeatures@yahoo.co.uk Matthew Day (Warsaw) +48 607291187 mattday@businessneweurope.eu Tom Nicholson (Bratislava) +42 1907732736 tom.nicholson@sme.sk Kester Eddy (Budapest) +36 308665550 kester.eddy@gmail.com Steven Roman (Tallinn) +372 56665911 steven@online.ee Southeast Europe: Justin Vela (Istanbul) +90 5393614470 justinvela@bne.eu David O'Byrne (Istanbul) +90 5359210950 davidob@ttnet.net.tr Bernard Kennedy (Ankara) +90 535 7485120 bkennedy@superonline.com Ian Bancroft (Belgrade) ian.bancroft@transconflict.com Bogdan Preda (Bucharest) +40 722580137 bpreda@gmail.com Nadia Damon (Sofia) +359 885 849884 nadiadamon@gmail.com Andrew MacDowall (Sofia) andrew.macdowall@googlemail.com Eurasia: Bureau Chief: Clare Nuttall (Almaty) +7 7073011495 nuttall@businessneweurope.eu Molly Corso (Tbilisi) molly_corso@yahoo.com Oliver Belfitt-Nash (Ulaanbaatar) +97688113149 oliver@businessneweurope.eu International: Derek Brower (London) derekbrower@gmail.com

COVER STORY 6

The Insiders

8

The edge of darkness

12

Emerging euro-scepticism

14

Perspective

CENTRAL EUROPE 28

Structural funds slosh through Slovakia

29

Slovakia's shame as corruption besets EU funds

32

Hungary finds solution to forex loans elusive

34

Europe's diffusion of power

36

Poland's survival budget

37

Poles apart in search for shale gas

39

Warsaw cultural transformation sign of Poland's rise

EASTERN EUROPE 16

Caveat emptor in Russia

17

Travel insurance

19

Broadcast news in Russia

21

Too rich by half

22

What a state in Russian banking

23

Putin for president?

26

Looking under the hood of Ukrainian engineering

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bne June 2011

Contents

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EURASIA

42

Turkey's canal dreams

50

Life after depletion

43

An over-basted Turkey

51

Straight as an Aral

45

Bulgarian renewable energy law is no green light

52

Overdue changes come to Azerbaijan

47

A food fight in the Balkans

54

Georgia's debt to the world

49

Could Croatia be first to reject EU membership?

55

A youthful campaign

56

New credit cycle begins in Kazakhstan

57

End of the line

58

The power to attract

SPECIAL REPORT 62

The changing coal face of Central Europe

64

Mining in Mongolia

65

Raspadskaya looks east

66

Kazakhstan keeps faith with coal

68

CLASSIFIED

70

UPCOMING EVENTS

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6

I The Insiders

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What's the best time to invest? How about when you have money!

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Mobius. "We've been investing in copper mines all over the world."

But Mobius is also quick to point out the possible risks in the wake of the crisis. "The US, the Eurozone and Japan have been printing money and pumping it into the system – if that changes and they suddenly stop, that's a risk," he says.

In addition, he warns that regulation remains a huge problem, citing the failure of the Basel III accord to significantly reform banking regulation, the abandonment of mark-to-market accounting and the failure of the US to re-institute the GlassSteagall act, the absence of which has allowed retail banks to gamble depositors' money on risky derivatives deals.

David O'Byrne in Istanbul Mark Mobius

Emerging markets guru Mark Mobius talks to bne about why investors should forget the West and look east.

I

But it is the performance of emerging markets during and after the recent global economic crisis that Mobius says is most impressive.

Speaking at a recent conference on turning Istanbul into a global financial centre, Mobius proved that he is both never stuck for a response and can flip out one-liners pithy enough to send comedians reaching for a notebook and pen. "What's the best time to invest?" he asks, "How about when you have money!"

Catching up fast Having lagged the US in the value of IPOs in 2008-09, last year saw the total value of emerging market IPOs exceed $450bn, more than double the $190bn in the US – an important consideration for the head of an investment fund that invests in emerging market stocks.

n the unlikely event that the global financial system crashes, Mark Mobius – once dubbed "the pied piper of emerging markets" – is unlikely to be stuck for a new career.

A flip line perhaps, but one which neatly encapsulates wise advice within a wisecrack.

But then turning the arcane world of emerging market equities into a source of both comedy and good solid documentary fact is a rare skill and one that Dr Mobius performs with the same aplomb with which he has successfully piloted Franklin Templeton's emerging markets funds for the past 24 years.

Brushing over an incident where one unimpressed Scottish investor had – either by mistake or by jest, referred to him as "Dr Dubious", Mobius pulls out a wealth of statistics to back his assertion that emerging markets are where we should all be putting our money. "One of the key reasons we are in China, in Turkey and in other emerging markets is their incredible growth," he says, pointing out that most projections foresee emerging markets this year growing at three times the rate of developed countries, with China expected to grow 8.9% this year and India 8.6%.

That history of rapid growth, he explains, has seen the emerging markets percentage of global market capital grow from 10% in 2001 to 15% today, figures reflected in the percentage of global IPOs taking place in emerging markets, rising from 10-15% over the same period.

"Derivatives are what got us into this mess – they're the elephant in the room, and they still haven't properly been addressed" And that performance, says Mobius, won't recede any time soon. Emerging markets, he points out, have a combined population of 5.6bn, over four and a half times the population of the 1.2bn of the developed countries, but with GDP per capita which ranges down from a quarter of that of the developed West, and yet which grew by 87% between 2005 and 2010.

Digging deeper into his store of statistics, Mobius tells bne that those growing populations with their growing disposable incomes want the same goods as those in the West. Percentages of refrigerators and washing machines per household in rural China? Low but growing quickly – he explains, good news for anyone investing in manufacturing and commodities. "Commodities are on the up and will continue," says

According to Mobius, those derivatives remain the biggest risk to global financial stability. With a value of $600 trillion – 10 times that of the global economic output – the unchecked growth of the global derivatives market represents a huge systemic risk, and one which still has not been properly addressed. "That's what got us into this mess," he says. "It's the elephant in the room, and it still hasn't properly been addressed."

Talking Turkey But while he warns that improper or insufficient regulation threatens the stability of global markets, Mobius also advises that correct legislation holds the key to Istanbul's hopes of becoming an international financial centre (IFC) – identifying banking legislation and taxation as key issues needing to be addressed. "With banking confidentiality laws similar to those of other financial centres, it will be possible to attract funds from all over the region," he explains, adding that taxation rates for companies and individuals working in the IFCs would also need to be competitive.

EM money flows

Mobius also identifies increased public listing of companies as key to boosting foreign investment and hence Istanbul's chances of becoming a regional hub for investment. "We would like to see more state-owned companies becoming listed – this means privatisation of state-owned enterprises and activities should be accelerated," he says.

US$ mill 100,000 80,000 60,000 40,000

But while the Turkish government seems unwilling to overhaul a tax system that has supported the country's recent meteoric growth – despite its obvious inconsistencies – it has at least embraced privatisation, with sales of the last of the stateowned power distribution companies ongoing and sales of the state-owned power plants just commencing.

Which judging from the interest shown has been enough to satisfy local investors, but it still remains to be seen to what extent it can help fulfill the ambitions of making Istanbul an global financial centre.

20,000 0 © 2011 EPFR Global

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7/1/10

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All Emerging Markets-Bond-Flow Cum

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4/1/11

All Emerging Markets-Equity-Flow Cum

"One of the key reasons we are in China, in Turkey and in other emerging markets is their incredible growth"

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The edge of darkness Graham Stack in Kyiv

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W

hen on April 18 news came through that 46-year-old Mykola Lisin, a lawmaker from Ukraine's ruling Party of Regions, had died in a car crash while driving at over 100 miles an hour in his Lamborghini Diablo, even hardened Ukraine watchers were shocked at the wave of schadenfreude that swept through the blogosphere. Party colleagues suggested Lisin may have swerved to avoid a bunny; less generous spirits nodded to what they saw as the poetic justice of the millionaire oil trader-turned politician catapulting into a filling station price display – at a time when petrol prices are soaring across the country, piling more misery on already cash-strapped consumers.

The hardhearted reaction to Lisin's death points to the crisis of legitimacy that Ukraine's democracy finds itself facing, with officials and parliamentarians perceived as an elite caste rather than a political class. As the cost of living surges, the political elite, largely coterminous with the wealthy elite, seem to live extravagant lives outside the rule of law, while they call on the population to tighten their belts.

Lisin's spectacular accident hurt only himself, but there are other cases where national or regional deputies' or officials' belief in their impunity has caused casualties among the public. An MP from Yulia Tymoshenko's BYuT faction, Viktor Lozinsky, was sentenced to 15 years in jail on April 20 for premeditated murder after shooting dead a villager in 2009 when out hunting with a local head of police. But that was a rare instance of parliamentary immunity being lifted due to the publicity the case attracted.

The sense of impunity is coupled with the neglect of public interest. Tellingly, after nine years in parliament, Lisin left behind not a single political speech, legislative initiative or even an interview. But this is par for the course: MPs in Ukraine are not actually required to have an interest in public politics. Ukraine's parliament operates a closed party list system, meaning most MPs never have to campaign publicly for office. Nor do MPs have to actually attend sessions. Parliament operates de facto bloc voting in the chamber.

Cover Story I 9

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A well-tuned system of "piano playing" means a handful of MPs present can use the electronic voting cards of absent colleagues to vote for them: bizarrely, Lisin was registered as present to vote in the chamber on April 18, a day after he died.

This is not to say Lisin was an anonymous backbencher. Lisin was co-founder of Infoks fuel trading and refining holding, valued at $300m, according to its website, and was president of the holding from 1991 until entering parliament in 2002. This marks him out as one of many Ukrainian MPs and ministers who are multi-millionaires, in a country that has the fourth lowest per-capita income in Europe – only the frozen-conflict states of Bosnia-Herzegovina, Kosovo and Moldova are poorer, according to GDP per capita measured by purchasing power parity. The estimated assets of top officials, according to Focus maga-

"Officials and parliamentarians are perceived as an elite caste rather than a political class" zine's top 200 rich-list in February, totals roughly 20% of the country's annual GDP. Ukraine is the third largest consumer of the luxury Maybach cars in Europe after Germany and Russia, and has four Maybach dealerships compared with three in Germany, according to Nico Lange head of Konrad Adenauer Stiftung.

For such multi-millionaires, deputy status provides mainly wide-reaching immunity against prosecution in a country with an uncertain legal environment and widespread dubious business practices. At the same time, the single-chamber Verkhovna Rada and its committees are a key platform for rent-seeking. "Formally, MPs are barred from having professional activities outside their parliamentary duties, but in reality taking care of their personal interests is what many mainly do," says Valentin Korolko, president of the PR agency Mainstream Communications.

Ukraine's economy gets up off the floor

Graham Stack in Kyiv After the knockout of 2009, when Ukraine's GDP collapsed by 15%, the economy has got up off the floor and started to grow again, but it's still groggy and vulnerable to any further blows from international turbulence.

The economy recovered macroeconomic stability thanks to International Monetary Fund loans and managed 4.2% growth in 2010, according to preliminary estimates. Beyond stabilisation, growth was driven almost solely by the growth of export-oriented industries, fuelled by Chinese growth for the metals sector and Russian state spending for engineering.

Analysts are predicting a similar growth rate in 2011, which will keep the country ticking over, but won't do anything to make up for lost time. "Even 5% GDP growth is far below the kind of pace that would signify real economic progress," says Oleg Ivanets of ART Capital. "Ukraine needs to be growing 10% a year for seven to eight years to achieve GDP per capita levels of Romania, Bulgaria and Belarus, let alone Poland, Russia or Argentina."

Late 2010 saw a surge in consumer spending, up 10% on the year in December, giving hope for diversification of growth, but rising global food and energy prices in 2011 could kill that off, with an April GfK survey finding consumer confidence had collapsed to levels last seen during the crisis. Banks are still hardly lending to consumers, but have restarted corporate lending, which could support growth in 2011. But as Dragon Capital analysts point out, bank lending to corporates is still only a matter of working capital rather than investment. Companies have extremely restricted access to capital.

So where do we go from here? Reform is the only way forward, is the consensus, but easier said than done. Ukraine placed 145 on the World Bank's benchmark "Doing Business" survey in 2011, compared with Belarus at 58 and Russia at 120. In terms of ease of complying with tax legislation, Ukraine was 181 out of 183 in 2011. The World Economic Forum's Global Competitiveness Index places Ukraine at 89th spot, and Russia at 63rd. Given that neither Belarus nor Russia are investor heavens, it should be within Ukraine's capability to jump up the tables without having to turn itself inside out, argues ART Capital's Ivanets.

The current economic recovery, political stability and post-crisis sobriety offer a sterling chance for a coordinated legislative programme to improve the business climate. Brokerages such as Dragon Capital argue that there are signs the government knows what is needed, with some major recent moves to reduce red tape including a 60% decrease in types of business requiring permits, the number of state controlling bodies reduced by 60%, and talk about cutting the number of documents needed to start construction projects by 75%.

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And while off the radar screen in terms of public politics, Lisin was no political outsider. His business partner in Infoks, former college classmate and party colleague through changing affiliations, was none other than the current minister of environment and natural resources, Mykola Zlochevsky. Zlochevsky was vice-president of Infoks until, like Lisin, entering parliament in 2002. Zlochevsky drives a Rolls Royce Phantom, according to his statement of assets.

Fields of dreams Zlochevsky illustrates further issues that dog Ukraine's development. He has been connected over a number of years with a scandal surrounding the license for Ukraine's largest natural gas field. Now he is in charge of deciding who gets to access Ukraine's potentially strategically significant shale gas reserves.

A year after entering parliament, in 2003, Zlochevsky became head of the state committee for natural resources, at that time responsible for awarding mineral exploitation licenses. During his tenure, the committee transferred the license for Ukraine's biggest gasfield, the Sakhalinsk field in Kharkiv region, from a joint venture between Ukrainian stateowned companies and Poland's national gas company, to an unknown newly founded private company Ukrnaftoburennia. The move inevitably aroused suspicion that the company was linked to him, including public accusations from the Polish side to that effect. Zlochevsky has denied the allegations. The Sakhalinsk field has estimated reserves of 15bn cubic metres (cm) of gas, worth around $4bn at current international prices.

Following the change in presidential administration in January 2005, Zlochevsky was fired and the Sakhalinsk licence reverted to Ukraine's state-owned operator. But in July 2010, Zlochevsky returned to office as minister of environment and natural resources, and again became responsible for natural resource licensing. There was little surprise when in December one of his subordinates confirmed that Ukrnaftoburennia once again held the Sakhalinsk licence. There was considerably more surprise when on May 20 a lower-level court revoked

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the licence due to no tender having been held. Analysts connect the surprise decision to an April visit to Kyiv by Polish President Bronislaw Komorowski, who called for a renewal of the two countries' gas cooperation. Poland will assume the presidency of the European Council in the second half of the year, just as Ukraine is edging towards a landmark freetrade agreement with the EU.

of companies linked to Donetsk figures who are apparently benefiting exorbitantly from government decisions. Partly state-owned grain trading company Hlib Investbud has come from nowhere to take a lion's share of export quotas, with journalistic investigations linking the company to Party of Regions deputy, Donetsk man Yury Ivanyushenko. He has denied the links.

Ukrnaftoburennia has said it will appeal the decision, and its chances are good given the company's connections. Ukrnaftoburennia's ownership is hidden by Cyprus offshore companies. But bne has been able to establish that there exists another company, Evrokompleks, registered at the same address in Kyiv as Ukrnaftoburennia, with the same office telephone number, founded the same week in 2004, with its financial officer listed also as contact person for Ukrnaftoburennia.

Ukrnaftoburennia's twin, Evrokompleks, may have only seven employees, according to company filings, but it has a high-ranking supervisory board chairman: Party of Regions Deputy Oleksandr Kirichok. Kirichok entered parliament in June 2010 on the death of a sitting Party of Regions member.

With Ukraine's position as a significant player in global food security, such goings-on are prompting international concern. Similarly, the opaque awarding of contracts by the Ministry of Environment and Natural Resources casts a shadow over what could be Ukraine's brightest economic prospect outside of agriculture, and also a key to the international energy security issue: Ukraine's potential reserves of unconventional gas – hard-to-get-at deposits of tight and shale gas, as well as coal-bed methane.

According to his official biography, Kirichok, the man looking after Ukrnaftoburennia's twin, worked at major Donetsk-based metallurgical concern Ukrpodshipnik from 1997 through 2007, before becoming chairman of the board at Evrokompleks and parliamentary candidate for the Party of Regions, both in October 2007. Ukrpodshipnik is in turn the main industrial asset of Party of Regions magnates, the Klyuev brothers, Andriy and Sergiy. Andriy Klyuev is first deputy prime minister, with overall charge of the energy sector, and thus Zlochevsky's boss. Brother Serhiy is deputy head of the Party of Regions parliamentary faction. Both are close associates of President Viktor Yanukovych and at the heart of the "Donetsk group" in Ukraine's politics – those hailing from the large city in eastern Ukraine on the Kalmius river. Evrokompleks could not be reached for comment.

Ukrnaftoburennia's links to Party of Regions' upper echelons fits into a trend

Guesstimates from research centres put Ukraine's shale gas reserves at around 1 trillion cm, which would cover roughly 15 years of the country's gas needs.

Zlochevsky himself has spoken of 30 trillion cm of shale and coal-bed methane gas combined. Either way, international energy giants are queuing up to sign contracts. But all eyes are on the responsible Ukrainian officials to see what slice of the action they may seek for themselves in the highly politicised energy sector.

Authoritarianism rising The failure of the government to improve anyone's standard of living other than the deputies themselves is starting to count with the electorate, and the Party of Regions' honeymoon ratings of a year ago, following party leader Viktor Yanukovych's election as president, are almost all gone.

An April 28 poll by the Kyiv International Sociology Institute showed support for the Party of Regions crashing from 38.0% to 13.9% over 12 months.

The main opposition party of Bloc Yulia Tymoshenko (BYuT), which should have been the main beneficiary of Party of Regions' fall from grace, has also failed to improve its standing – BYuT's ratings have also crashed to 10.6%.

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Another poll conducted by the Razumkov Center in April found that 63.8% of respondents believe the situation in the country is heading in the wrong direction. 49.0% said they did not support Yanukovych, with only 10.6% saying they fully supported the president.

These results speak of a deep-seated disillusionment amongst the Ukrainian people. The irony is that the citizens of a country that could once boast to be the only true democracy in Eastern Europe now don't trust any of their politicians, with the opposition seen just as corrupt as those who hold the reigns of power.

The international community may be partly to blame. Analysts put much of the sharp drop in support for the Party of Regions on utility price hikes required by the International Monetary Fund (IMF) and the global surge in food and fuel prices unleashed by the second round of US quantitative easing. Media have calculated a 30% real increase in the basic cost of living over one year.

Like wind chill, this "felt inflation" is not reflected in official inflation statistics, which are in fact lower than they've been since Ukrainian independence.

But the spike in prices affects a few key consumer staples – monthly utility bills, food and fuel – with prices at the petrol pump approaching the UAH10 per litre, and fruit and vegetables at an all-time high. These prices have a direct knockon effect on poll ratings, and also for consumer confidence.

Some jiggery-pokery with numbers may also be going on, analysts surmise, since Ukraine also has inflation targets to meet for the IMF. Ukraine is no stranger to cooking the books; when Yulia Tymoshenko was prime minister in 2008 and negotiating with the IMF for a bailout loan, the government was caught lying about the size of the deficit on a massive scale: Tymoshenko promised the fund a zero budget deficit and ended the year with a deficit on the order of 13% of GDP. Wrong target Discontent is refocusing the broader public's attention on issues of corruption and legitimacy of the elite, just as

Cover story

elections start to loom in October 2012.

The government is claiming it has introduced key reforms such as a muchneeded new tax code. But among the population the tax code is associated with a higher tax take from "entrepreneurs," meaning Ukraine's vast army of shopkeepers and market sellers, and a drop in corporate profit tax helping the oligarchs. At the same time, pledges to change double tax treaties with Cyprus that leak the country's wealth to the West have quietly died.

Instead of taking on vested interests such as the oligarchs, the government has spent most of its time harassing the opposition. Criminal charges have been brought against former prime minister Tymoshenko and former interior minister Yury Lutsenko, the two most outspoken and charismatic opposition figures, on charges of exceeding their powers while in office. Even without a jail sentence, a conviction could bar them from political office and running for parliament next year. Government representatives point out that a far more serious case has in the meantime been bought against former president Leonid Kuchma, Yanukovych's mentor, in connection with the cause célèbre murder of critical journalist Georgiy Gongadze in 2000. But analysts remain sceptical about the Kuchma case, regarding it as

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January, and followed up with a report in April that warned of a "move towards greater centralisation and consolidation of power." Reporters Without Borders, the Index of Economic Freedoms and Transparency International have all also downgraded Ukraine in recent months, harming the country's image abroad and reducing its international clout.

Criminal charges against leading opposition figures is something not seen even in Russia, indicating that the Kremlin's "managed democracy" may be unattainable in Ukraine, due to the heavy-handedness of Donetsk gangland traditions and the commitment of the national opposition. A bne source from the last KGB generation of the USSR, now a Party of Regions member in Kyiv, is highly critical of what he calls "the Donetsk idiots' attempts to kill off or frighten opposition through physical contact". "You can't go after people physically, after all it's the 21st century. You have to do it like we did in the KGB, where only in one case out of 50,000 did we use physical contact. You have to know how to work with people without resorting to contact: pressure them over work, at the border, or over debts," the source says.

However, despite opinion polls showing an increase in members of the public prepared to take to the streets, the

"Formally, MPs are barred from having professional activities outside parliamentary duties, but in reality taking care of personal interests is what many mainly do"

a flanking manoeuvre against international criticism of the crackdown on the opposition. Meanwhile, Lutsenko, who has been detained, was by mid-May in the third week of a hunger strike.

The tightening screws in Ukraine have been well documented by international watchdogs. Freedom House downgraded Ukraine from "free" to "partly free" in

source sees little immediate prospect of protests among the wider public. "The people have already been settled down into 'regime-ness' well, and as an ex-KGB man I'm happy that's it's been possible to settle them down without using physical contact."

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ernising force – were in fact "invalid."

However, he noted it is impossible for Poland to stay outside forever. "The cost of foreign exchange trading and capital associated with having a separate currency is unsustainable."

Emerging euro-scepticism Nicholas Watson in Prague

T

here is a growing consensus among Central and Southeast Europeans that keeping sovereign currencies, rather than adopting the euro, offers the best route to prosperity for Emerging Europe.

The latest evidence that the lengthening list of Eurozone countries requiring a bailout and the muddled response from European governments to the crisis is having a deleterious effect on support for the euro in the region came on May 11 in a poll taken by the Warsaw School of Economics, which showed for the first time in many years more Poles were against the adoption of the euro than for it.

In the latest poll, 41.7% of respondents were against adopting the euro, an increase of 3.3% on last year, while the number of the euro's supporters has dropped from 42.2% to 40.8%. "For the first time in a long while we have observed a higher number of sceptics than supporters of the euro," says Piotr Bialowolski from the Warsaw School of Economics, which has been following the Polish public's mood on euro entry since 2006.

Public opposition to adopting the euro is even more marked in the Czech Republic, where fully 80% of respondents to a SANEP poll published in April said they were against adopting the euro, with support for the single currency at less than one in five people.

Speaking out The region's policymakers too are becoming noticeably more strident in

"The euro actually made it easier for countries to borrow like a thrifty German and spend like a profligate Greek" their criticism of the euro's flaws and outspoken in support of staying out.

On May 20, Marek Belka, head of the Polish central bank, said the crisis had shown the main benefits attached to the euro – access to cheap capital, a mod-

Mojmir Hampl, vice-governor of the Czech National Bank, rubbished the supposed virtues of the euro at a conference in Vienna hosted by Erste Bank in April.

"A typical journalist phrase in the past was: 'the country is safely within the Eutozone'. Well, exactly the opposite is true," he said. "There is a convergence trilemma: a country which is catching up can never have growth, low imbalances and fixed exchange rates at the same time. For converging countries it's not wise to hurry into the Eurozone, because the project was not designed for poorer economies aiming to catch up."

This is an argument picked up by Capital Economics in a May report entitled, "Does Emerging Europe need the euro?". In it, the consultancy notes that that while there is no clear-cut answer as to whether a country should fix its currency or not, "the fact that those economies in Emerging Europe with flexible exchange rates experienced a more moderate drop in output during the crisis – and a quicker recovery subsequently – suggests that flexible exchange rates offer the most secure route to future prosperity for the region."

So while there are clearly some benefits to fixing exchange rates – currency volatility is eliminated and transaction costs are reduced, and small developing nations may benefit from lower borrowing costs – Capital Economics argues the size of these benefits are overstated, "particularly now that the region has progressed from the very early stages of transition to a market economy."

The conclusion that irrevocably fixing exchange rates is not in the region's best interests is reinforced by the theory of "Optimum Currency Areas", Capital Economics says. This theory states that monetary union is likely to be appropriate if member states: a) accept free movement of capital and labour; b) are similar in structure; c) have flexible labour and

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Cover story

product markets and d) fully co-ordinate their fiscal policies. But "most economies within Emerging Europe fail all but the first of these criteria (the Baltic States are the exception by virtue of their greater flexibility)," it says. "Structural convergence has much farther to run, the region’s labour markets are still too rigid and fiscal co-ordination is, for the most part, a non-starter."

Hampl has also attacked the ideas the founding fathers used as the reason for creating the euro. One of these was that the euro would make the various economies more alike. In reality, the economies have not only remained different, but these discrepancies grew – a trend that was accentuated by the global crisis.

Another idea was that the euro would force those Eurozone members to push on with structural reforms. However, he says the euro actually made it easier for countries to "borrow like a thrifty German and spend like a profligate Greek."

Eva Zamrazilova, another member of the board of the Czech central bank, also picks up on this theme of structural reforms, though is ultimately less hostile to the euro than Hampl. Before the Czech Republic can join the euro, she insists that it needs tackle head on the consolidation of public finances and change the whole architecture of the country's public spending to deal with the demographic challenge of an aging population. "Countries need to sustainably meet the Maastricht criteria [on debt, budget deficits and inflation], not just for two or three or 10 years," she tells bne. "When that is finished, I don’t say 'no'."

Creating a drachma out of a crisis Experts say the popularity of the euro in Emerging Europe is only likely to get worse before it gets any better.

On May 17, Europe's top financial officials broke a taboo by acknowledging for the first time that Greece may

I 13

have to restructure its debt, a move which could deepen Europe's sovereign debt crisis. According to a Bloomberg poll in May, some 85% of international investors surveyed said Greece would probably default, with smaller majorities predicting Portugal and Ireland will do the same.

Such a scenario would have a big knock-on effect on Emerging Europe, even those outside the euro, since western banks hold much of Greece's debt and losses on this would inevitably curb lending and investment to the region, which has driven the recovery in the stock, bond and currency markets there. According to research from Bloomberg, the Hungarian forint is the top performing currency in 2011, rising 16.3%, followed by the Czech koruna up 15.5%, the Russian ruble up 12.0%, and the Polish zloty up 11.2%. The Polish stock market has risen about 25% over the past year.

OVERVIEW OF OPTIMUM CURRENCY AREA CRITERIA

Cyclical & Structural Convergence - Growth correlated with EZ? - GDP per capita - Structure of GDP - Structure of employment - Inflation - Interest rates - Credit market development - Trade integration Labour & Product Market Flexibility - Administered prices - Opening/closing a business - Wage/Employment flexibility

Bulgaria

Czech

Estonia

Hungary

Latvia

X

X

X

X

X

X

X

X

X

X

X X X X X X

X X X X

X

X X X X X X

X

X

X X X

X X X X X X

X X X

X X

X X X X X X

X

X X X X X X

X

X

X

X

X

X

X X

X X

X X

X X

X X

X X

X

X

X

X

X

X

X X

X

Lithuania Poland

Romania Slovakia

Croatia

Free Movement of Labour & Capital - Foreign Bank Ownership - Sources of FDI - Emigration/ Immigration Fiscal Union Source: Capital Economics

X

X

X

X

14

I Perspective

bne June 2011

Perspective I 15

bne June 2011

Give credit where credit is due Karol Chrystowski of Renaissance Asset Managers

"We can be heroes, just for one day...”

David Bowie

8

6 5.7 4

2

2.3 0.9

0

1.4

1.5

-1.5 -2

-2.5

Source: RAM research

Brazil

-3.5 -4

Turkey

Global emerging market (GEM) economies, on the other hand, start from a much lower base, as they haven’t had time to build up much of a reputation. They are constantly having to convince the financial markets that they are running their economies in a sufficiently prudent and sustainable way. GEMs have to act decisively to counter any problems: if inflation is running at 3-4%, then their central banks have to raise rates (see chart); if they are running a deficit, they have to produce a plan to reduce spending or raise revenues. In

Real interest rates (base rate minus CPI, in %)

In contrast to the developed markets, the GEMs are in a much stronger position in that their economies are still based on the utilisation of human and natural resources other than the “paper industry”. Unlike in the West, GEM economies are being driven by real rises in consumption, not just by falling interest rates. The Chinese and Russians love to shop.

Moreover, businesses and entrepreneurs that set up viable ventures using credit lines at high rates are likely to withstand future shocks to their revenue flows when those rates fall as their economies improve. And as funding in their home markets is not subsidised, debtors face much more rigorous credit assessments. All of this will set GEM economies apart from developed economies when, as any investor who’s been involved in emerging markets for long enough will tell you, economic reality prevails.

Hungary

Having a sterling reputation, built up through years of effort, is a colossal asset, since it can be relied on to help one through difficult times. However, it can only be stretched so far and can disintegrate rapidly, as the developed markets are finding.

investments undertaken by companies is derived primarily from the cost of debt and equity calculated against the baseline of sovereign benchmarks. However, if sovereign yield curves become a function of the speed a printing press can be made to work, then the economic argument for any investments will become divorced from reality too.

South Africa

The banks were the first “beneficiaries” of this policy, as they were nationalised, recapitalised or simply bailed out with “can’t lose loans”. Companies also “won,” as their balance sheets were cleared of bad debt. The problem was that these rescues did little to encourage sceptical populations to go back to the shops, the traditional rescue for the sluggish developed economies.

The upshot is that the credibility of what have been traditionally the safest assets in the world is now diminishing at a rate proportionate to the speed with which central banks are printing more money to use to buy government debt.

"GEMs are clearly being held accountable in a way that developed markets are not"

China

In the midst of the recent meltdown, the consensus view was that after decades of credit expanding way ahead of GDP growth in the developed world, it would take years of de-leveraging to reinstate an equilibrium, which would entail a long period of sluggish growth. But politicians were being asked to push through a set of policies tantamount to political suicide. Thus, the game quickly became how to shift the immediate pain away from the population. Companies were prevented from making cuts. Debt from corporate books was moved to national accounts. In effect, the whole problem was kicked down the road.

The disparity between developing and developed economies has tremendous implications for how the whole world goes about its business, since credit – corporate and retail – is priced off sovereign benchmarks. The economic viability of

There are two parts to pricing credit: the macro-fundamentals that underpin the real risk of default; and the issuer’s reputation based on the past ability to pay. The developed markets get a discount on a reputation that is being rapidly debased, whereas emerging markets pay a premium for their youth irrespective of their solid fundamentals. It’s time to give credit where credit is due.

Eurozone

The fix to this conundrum was to make central banks independent from government. It was a good arrangement that worked reasonably well in many countries, but the main consequence of the global crisis is that this divide between central banks and parliaments has been breached.

However, investors are now questioning the sustainability of this plan and demanding higher premiums on developedmarket debt. Increasingly backed into a corner, policymakers are running out of options and reaching for the traditional escape of last resort – the scapegoats. “Speculators,” say politicians, are to blame for Greece’s inability to service its debt and for the sky-high interest rates on sovereign bond issues, not the fact that many of these economies are now completely dysfunctional. But banning these “vultures” from dabbling in certain products and geographies would take time to implement, so in order to curb the higher interest rates that investors are demanding on developed-market debt, governments are attempting to artificially cap rates by buying their own debt.

short, GEMs are clearly being held accountable in a way that developed markets are not.

US

The perennial election cycle drives politicians to think only in the short term. These days, the term “statesman” could be applied to any politician willing to think beyond his/her reelection – and there are very few of them. However, economies don’t work in convenient four- or five-year cycles; they are a continuum where past mistakes can reverberate for years.

In lieu of consumption and in place of pushing crazy ideas like working more for less or facing up to the scale of the problem, another solution is being offered. This is to reduce the cost of servicing debt to an arithmetical minimum, and keep it there until shoppers feel a bit more cheerful.

UK

I

nvestors will take the dour charcoal-suited central banker over the immaculately coiffeured, smooth-talking politician any time when it comes to receiving reassurances. The former are grounded in the realities of the economy whereas the latter always have their eyes on the ballot box. But with developed market interest rates persistently and significantly below inflation levels, investors would be justified in wondering whether central bankers have become politicians.

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bne June 2011

over details of users of Yandex.Dengi, its money transfer system. Specifically, the successor to the KGB demanded details on donations to Rospil.ru – an anti-corruption website run by shareholder activist Alexei Navalny that targets state-controlled companies such as Rosneft. Yandex had already dedicated a significant portion of its IPO prospectus to warnings of political risks and the dangers of a takeover bid from oligarchs close to the authorities. "High-profile businesses in Russia, such as ours, can be particularly vulnerable to politically motivated actions," Yandex said in the prospectus.

That's an awful lot of Russia risk to attach to a company as it prepares to launch itself on the stock market, but analysts said the reason the admission didn't have a serious impact on the IPO was because Yandex is such a compelling story. One fund manager, who asked for anonymity, said: "Russia risk is always there, so most are used to it.

As long as the pricing and strategy are right, then appetite should remain."

Caveat emptor in Russia Tim Gosling in Moscow

R

ussia is a topsy-turvy place. Take IPOs: In the West, the game is to convince investors that you have the coolest product on the market and the sharpest management team. In Russia, it seems that the more dirt on yourself that you can squeeze into your prospectus, the more investors will be attracted to your company.

It worked for Wimm-Bill-Dann. When the company floated at the start of 2002, it admitted in its prospectus that the company's largest shareholder, Gavril Yushvayev, had served nine years in a Soviet labour camp after being convicted of a violent crime. The company also admitted that Yushvayev and another shareholder, David Yakobashvili, also owned Trinity Motors, which was one of the first companies to import American-made cars and was rumoured to have ties to organized crime. All these admissions were taken as a sign the company was serious about transparency, and investors didn't seem to care about whatever wrongdoing stood behind them.

The latest example of this was Yandex.

Just days before it was due to announce the indicative price range of the share sale in early May, "Russia's Google" raised a red flag on political risk attached to its business. However, given that investors hungry for exposure to Russia's booming internet sector have been waiting for Yandex to offer up its equity for close to three years, this didn't put too many off.

Yandex closed its listing on New York’s Nasdaq on May 24. The company delayed the sale by a day to raise the price and reopen the bid book after it was reported that the offer was oversubscribed by as much as 10 times.

Moving from an initial pricing range of $20-22 per share, “Russia’s Google”

ended up selling 52m shares at $25 each, to raise $1.3bn.

The last-minute price hike was largely driven by an accelerating wave of global sentiment for internet stocks. Demand for exposure rose dramatically through May on the back of hugely successful IPOs by Chinese social media site Renren and US company LinkedIn, as well as Microsoft’s $8.5bn purchase of Skype.

Even before that, however, appetite for Yandex was reported to be big, with investors believing that the specific risks were already discounted in the price.

Pressure from the top The company's admission on May 2 was that it had been forced by the Federal Security Service (FSB) to hand

"High-profile businesses in Russia, such as ours, can be particularly vulnerable to politically motivated actions"

Eastern Europe I 17

bne June 2011

Tom Mundy, chief strategist at Otkritie Financial, agrees that investors in Russia are less concerned about such issues than many might think. "We rarely speak to investors that are not already sceptical concerning Russia risk," he says, "whether that be political issues, corporate governance, corruption etc."

Alexander Vengranovich, a media and IT analyst at the same bank, picks up the theme. "The investors we've been speaking with aren't paying much attention to the political risk story. They're more interested in the Yandex growth story," he says.

Yandex says it accounts for 64% of all search traffic in Russia – compared with Google's 22% – and is the largest Russian-based internet company by revenue. That puts it at the top of a segment likely to develop swiftly as broadband is rolled out across the country and advertising spending grows on the back of accelerating economic recovery.

Konstantin Chernyshev of Uralsib says he expects the internet advertising segment to grow at 27% annually over the next five years, adding that

Travel insurance

bne VimpelCom's latest deal to expand further in Asia is another example of a Russian company looking to invest overseas as insurance against political risk. But analysts warn that if Russian companies continue to expand abroad rather than at home, it will be increasingly difficult to persuade foreign companies to invest in the modernisation of Russia's economy.

Russia's largest mobile phone company said in late April it had signed a deal to increase its stake in Vietnamese joint venture GTel Mobile to 49% from 40%. VimpelCom is due to invest a total of $500m in the development of the joint venture by 2013 before further increasing its stake to 65%.

Headline figures suggest foreign investors have been returning to Russia: foreign direct investment (FDI) rose to $41.2bn in 2010, still down from a peak of over $80bn in 2008. But only $9bn of this money was new foreign inbound investment – the rest was largely multinationals reinvesting profits – and was equal to less than half of Russia's $19.4bn outbound direct investment. "The huge difference between the two figures suggests that Russia has to focus on improving its investment climate, as it will be hard to attract more foreign investment while Russian business is actively investing abroad despite the huge need for domestic investment," says Natalia Orlova, chief economist at Alfa Bank.

After years of accumulating billions of dollars in reserves, the capital flight that plagued Russia in the 1990s has returned: $35.3bn left in 2010, with $22.7bn leaving in the last quarter of 2010 alone, despite the clearly improving macroeconomic situation. That was followed by another $21.3bn in the first quarter of this year. The government is putting on a brave face and expects zero capital outflow over the whole year, Andrei Klepach, deputy economic development minister, said in April. But clearly Russia's businessmen are nervous.

Investing abroad often makes good business sense. But since the state increased its share of the economy during the crisis and state-owned companies and banks have become more aggressive, holding assets overseas has also become an attractive form of insurance.

There have been too many cases of Russian entrepreneurs losing their companies to powerful officials or well-connected oligarchs. The most famous example is the de facto nationalisation of oil company Yukos and the jailing of its owner Mikhail Khodorkovsky. But Khodorkovsky is by no means alone in falling foul of the authorities.

Mikhail Gutseriev, owner of oil company Russneft, fled to London in 2007 claiming he was the victim of "unprecedented bullying from the state." In a carbon copy of the Yukos saga, the authorities launched a tax investigation into the company after Gutseriev allegedly interfered in presidential elections in the autonomous republic of Ingushetia in southern Russia.

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Yandex is the better bet for investors.

"Unlike Mail.ru, Yandex offers a clear investment story," he points out. "Mail. ru benefited from being the first to offer exposure to the sector, and the backdoor it offered to Facebook shares.

It looks like it will lose both of those advantages in the near future."

However, it's hard not to wonder what effect such risks might have had on companies in less attractive sectors of the Russian economy. Already this year, four planned IPOs have been pulled at the last minute due to demands for deeper discounts to global peers.

Not only is exposure to the internet sector attractive for the growth story, but as Chernyshev of Uralsib points out, "investors in the internet segment are very risk tolerant because the entry barriers are very low: it's cheap to set up a venture and success is driven by innovation. It's not like drilling for oil."

The lesson here appears to be that pricing remains the ultimate key to

bne June 2011

the success of Russian IPOs, and that issuers must still take Russia risk into consideration. Yandex priced its IPO at a significant discount to global peers, especially compared to Chinese peers.

The indicative price range put Yandex at a 2011 price/earnings ratio of 30-34x, whilst Chinese portals such as Baidu (56x) and Sina (69x) demand much higher prices. "The political risk for Yandex is already priced in via the more general Russian discount, which we factor at 37% to the [emerging market] aggregate," suggests Mundy. "Look at the risk-free rates on Russian corporate debt versus sovereign – the spread between the two suggests strongly that the market is pricing 'intangibles' for Russian corporates."

Blogger-in-chief The flare-up of political risk surrounding Yandex is only the latest in a growing debate around the internet in Russia, which is credited as the last bastion of independence in a media industry dominated by state ownership.

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Eastern Europe

That debate intensified in April when the FSB requested bans on Skype and Gmail, claiming they posed a serious security threat. The Kremlin dismissed the call, but the discussion appears to have opened a floodgate of sorts, with the sector front and centre in news flow since.

Yet the internet has a powerful champion in the form of President Dmitry Medvedev. Not only has Russia's "blogger-in-chief" repeatedly insisted that he will not allow censorship of the internet, but, as opposed to life-sciences or nanotechnology for instance, IT is also the only high-tech segment in which Russian companies have made significant strides. That's the kind of progress that Medvedev has demanded should form the core of his top project – the drive to modernise the economy.

Whether that success, and the attention it brings, is purely positive for the country's top portal is hard to say however, as has been illustrated this week.

I 19

that spans half the globe, sets in the front room remain the main source of news and entertainment for millions of Russians living in the far-flung regions and the only way that multinationals can cost-effectively sell their fastmoving-consumer-goods (FMCGs) to the entire 142m strong population. The upshot is that while TV advertising typically accounts for a third of the total ad spending in the West (in the UK online ad spending recently overtook that for TV), in Russia half of every ruble spent on advertising goes on TV ads.

Broadcast news in Russia

Russia's total ad spending in 2010 was $4.2bn – more than 10 times that of Ukraine's, the second largest in the region with a third of the population – and has been growing by 25-30% a year. The crisis took the edge off this ballistic growth, when the total ad spending in Russia fell 18% in ruble terms in 2008 and by more than 40% in dollar terms, but Kudryashov reckons it will have recovered all the ground lost by the end of this year.

Ben Aris in Moscow

I

n a sign of the growth potential of Russia's advertising market, Alfa Group has slapped a $1bn price tag on its stake in the country's largest commercial broadcaster CTC Media.

Russia's leading financial-industrial conglomerate Alfa said on April 28 that it's in talks to sell its 25.3% stake in CTC (pronounced “STS” – the company uses the Cyrillic version of its name in print) to Russia's National Media Group, but has first offered the stake to fellow shareholder Sweden's Modern Times Group, which is owner of 38.3% of CTC shares, at a price of just over $27 per share, or $1.07bn. That's almost double what the shares IPO'd at in the summer of 2006.

is not only the most successful commercial TV company in Russia, but the most profitable media company in the world, and it looks set to benefit from the surge in advertising spending over the coming years. "In terms of ad spend, Russia is already the ninth biggest market in the world, the fifth largest in Europe and, if current growth contin-

And there's still a lot of room for growth: in the West the total amount of GDP spent on ads is typically equivalent to 1.0-1.5%. Russia's spending hit a peak in 2008 of 0.7%, but fell back to 0.5% in 2010. "The Russian market is large in size, but still immature in nature," he says. "In the West, cars and financial services are amongst the top-five biggest spenders, but in Russia

"In terms of ad spend, Russia is already the ninth biggest market in the world, the fifth largest in Europe and, if current growth continues, it will be the largest in Europe as soon as 2013"

Modern Times had until May 25 to respond, though analysts say it's unlikely that the Swedish firm would acquire Alfa's stake because Russian legislation restricts the stake held by foreign investors in television companies at 50%.

ues, it will be the largest in Europe as soon as 2013," Kudryashov told bne in an interview just before the news broke that Alfa is looking to sell its stake.

these products only account for 2% of the total spend – of course this will be a major source of growth as these areas develop."

More's the pity for the Swedes, because CEO Anton Kudryashov claims that CTC

Television is by far the most important media channel in Russia. In a country

All this makes CTC a valuable proposition. Nadeem Moulvi, an equity

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bne June 2011

research analyst, picks CTC as one his top-10 growth stocks. He says the company should grow its profits at an annual rate of 60% compared with the 19% growth rate of the wider US broadcasting and cable TV industry. The company is debt free and has maintained a net profit margin of 24% during the past five years, he says.

Pure entertainment CTC began life as a small broadcaster in St Petersburg in 1994 and only went nationwide in 1996. Things started to move fast for the company when Modern Times bought out the founders in 1999 and then brought in Alfa in 2003. This investment cycle culminated in an IPO on Nasdaq in 2006 that raised $200m, which provided the funds for a rapid expansion and a string of acquisitions including two more broadcasters – Domashny, the only channel in Russia to specifically target women, and DTV, which specialises in reality TV – as well as some production companies to produce content in-house.

CTC focuses solely on entertainment, broadcasting a mix of domestically produced content – which makes up two-thirds of its programming – and international shows, targeting viewers aged 6–54, especially younger audiences. Kudryashov says the station made a conscious choice to carry no news or socially orientated programming.

"News is not dangerous, but it does require a lot of coordination with the supervising authorities," says Kudryashov. "News is expensive, as you need a big staff and the state can lose money on news production, we can't."

While it's hard to compete as a news broadcaster, it is easier to cater to the demand for pure entertainment. With its in-house production and extensive market research, this is where CTC has

"News is not dangerous, but it does require a lot of coordination with the supervising authorities"

bne June 2011

Eastern Europe

by signing free-trade deals, EU officials said. However, while Ukraine is lobbying hard for a free-trade agreement with the EU, Russia is primarily focused on building up its own trading bloc, the Customs Union, with Kazakhstan and Belarus that came into force last year.

a market advantage, which allows it to capture the advertising spending.

This is a crucial advantage in Russia's highly competitive TV market. There are 20 free-to-air channels, but the top five account for 68% of the audience share and 80% of the advertising revenues, says Kudryashov. By 2003, the broadcaster had built up an 11% audience share and taking into account its small channels CTC is the third or fourth largest channel in the country, reaching over 100m people and nine out of every 10 households in the country.

The main challenge has been to keep up with the changing tastes of Russia's viewing audience. A year after the Soviet Union collapsed, a wave of Brazilian and Mexican soap operas appeared on Russia's airwaves and were a smash hit; shows like Mexico's telenovelas "Simply Maria" and "The Rich Also Cry" could clear the streets of Moscow for a particularly dramatic instalment.

These days, tastes have become more sophisticated, says Kudryashov, and CTC either makes or buys two-thirds of its content domestically, with the rest being mostly Hollywood blockbusters. Many of the home-grown shows are adaptations of successful formulae developed overseas and transposed into a Russian cultural setting. For example, CTC bought a license to produce the sitcom "Born not pretty" based on the popular Colombian telenovela that is better known as "Ugly Betty" in the West. "Nowadays, there is more and more demand for original Russian produced content, but the problem is where to get it from. Production is not mature and there are not enough writers to create the content needed to meet the demand," says Kudryashov.

I 21

Too rich by half bne

R

ussia is no longer an emerging market according to the cashstrapped EU, which wants to get rid of the preferential trade terms implemented in the 1990s to support Russia and the other BRICS' transitions to freemarket economies. The proposal is the most concrete example yet that the world economic order is changing as the leading emerging markets begin to mature.

"Almost 40% of our current preferences benefit Russia, Brazil, China, India, and Thailand, which no longer need preferences to maintain and build upon their success," Trade Commissioner Karel De Gucht told reporters on May 10 following the annoucement by the European Commission that it plans to exclude middleincome countries such as Russia and Brazil from special rates under the EU's General System of Preferences (GSP).

The decision to cut benefits is viewed as the most significant revamp of the trade system since the preferential scheme was first introduced in 1971.

"Global economic balances have shifted tremendously," De Gucht said. "If we grant tariff preferences in this competitive environment, those countries most in need must reap the most benefits."

Currently 176 countries are entitled to the special tariffs that together account for 4% of total trade turnover. Under the proposals, the EU will cut about 80 countries from the list. "Trade preferences do not make much sense anymore for relatively well-off countries such as Russia, Malaysia, Saudi Arabia or Qatar," De Gucht said.

But the proposal might face challenges as it goes through negotiation with 26 other commissioners; at least 10 commissioners have already expressed their opposition to the proposal, which must be approved by the European Council and European Parliament.

Bear up The proposal is the most explicit acknowledgement by the EU of Russia's rising economic power. The EU is by far Russia's biggest trade partner and trade volumes have grown quickly over the last

Under the new EU scheme proposed by De Gucht, countries "not classified by the World Bank as high-income or uppermiddle income countries during three consecutive years" can enjoy the GSP benefits.

Russia's per-capita income has increased nearly 10-fold over the last decade to $15,900 at the end of 2010, according to the CIA Factbook, making Russia a "developed middle-income country" according to the most recent UN Human Development Index report.

Western European companies have responded to the spike in disposable income by flocking to Russia and capitalising on the fast-growing and increasingly wealthy consumer market.

Russia's TV ad spending is expected to become the biggest in Europe and in the top 10 globally as soon as 2013, accord-

"If we grant tariff preferences in this competitive environment, those countries most in need must reap the most benefits" decade. The EU accounted for 49.5% of Russia's trade turnover in 2010 after the total volume of business increased more than four-fold from $66.3bn in 2000 to $298.8bn in 2010, according to investment bank Renaissance Capital. GermanRussian trade turnover alone was up by just under a third in 2010 to $5bn – about as much as Russia's entire foreign trade turnover a decade and half ago.

A final list of countries that are to be excluded from the GSP has not been set yet and the Commission said it would like the new rules to be in place by January 1, 2014. The countries they eliminate will be offered the opportunity to secure alternative concessions

ing to media experts. Likewise, Russia is so far on track to become the largest car market in Europe in the next five years.

Even if the EU proposal is implemented, it would have only a moderate impact on Russia's external trade. Russia's exports are largely driven by natural resources, including oil, revenue from which rose 22% in the first quarter of this year to $112.8bn; this was due to higher than expected oil prices and unrest in the Middle East and Northern Africa. However, as the economy starts to recover, the value of Russia's imports, mostly manufactured products and retail goods, soared to $60.2bn, twice their level a year earlier.

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What a state in Russian banking

Moscow's stake in the bank. Borodin then found himself implicated in a $440m corruption investigation into the dodgy loans made to a property company controlled by Luzhkov's wife and the richest woman in Russia, Elena Baturina. When he was called in for questioning in April, he fled to London and checked into hospital for treatment. A week later he agreed to sell his stake at what analysts report was below market rates. "It is clear what actually happened," one banking source tells bne. "The old management were not happy with being pushed out of the bank and were holding out for a high price for their stake – a price VTB was not prepared to pay. So the management tried to play hardball, but bit off more than they could chew."

lready the second biggest bank in the country, Russian stateowned VTB Bank has improved its position further by taking over the Bank of Moscow, in a deal which some worry takes the state's share of Russia's banking sector to too high a level, but others say is part of a welcome bout of consolidation.

VTB was interested in buying the bank.

The state bank's VTB-24 retail operation is already a leader in providing consumer credits and mortgages, but adding Bank of Moscow 500-plus branches would put VTB into a league of its own behind its sister Sberbank, which has the lion's share of Russia's retail banking business.

Mission creep The VTB takeover significantly increases the state's share of the country's banking sector and follows on the heels of Sberbank's takeover of Russia's leading investment bank Troika Dialog in February. Both banks have become noticeably more aggressive in building up their business following the economic crisis. Several foreign banks have already pulled out because of the growing competition; the latest was HSBC, which announced on April 26 it was abandoning a two-year drive to build up a retail operation in Russia.

On April 27, VTB said it has no plans to increase the 46.48% stake in Bank of Moscow it acquired in February for a reputed $3.5bn, but has moved to consolidate its hold over the lender by installing VTB executive Mikhail Kuzovlyov as the bank's chief after a Moscow court in April removed the previous president and major shareholder Andrei Borodin from his position.

However, the deal didn't go smoothly.

At first the Bank of Moscow's management said they were willing to sell their 20.3% to VTB, but things got ugly when

According to Oleg Vyugin, CEO of the private MDM Bank and former head of the Federal Financial Markets Service, state banks are preventing the growth

Ben Aris in Moscow

A

Bank of Moscow, Russia's fifth largest commercial bank, was set up in the mid1990s as the pocket bank for Moscow's City government. However, following the ousting of Moscow mayor Yuri Luzhkov at the end of September the bank's future was thrown into uncertainty and the Kremlin made its move in November, with Deputy Prime Minister and Finance Minister Alexei Kudrin announcing that

"The state can't restrict Sberbank's place in the market, as how can we say to the minority shareholders there is a cap on the bank's ability to compete?" they brought a legal case in March to try to block VTB's purchase of a small stake in the bank from the US investment bank Goldman Sachs and then announced a rival bid for the City of

of private banks, which thanks to their quango-like status enjoy access to significantly lower borrowing costs than the privately owned banks. "The recession was tougher for foreign banks

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Eastern Europe

that have only operated on the Russian market for a few years than for foreign banks that had established themselves in the early 2000s during the period of rapid economic growth. Latecomer banks were hit hardest by the recession as they failed to sufficiently increase market share to weather the crisis," says Seija Lainela, an analyst with the Bank of Finland.

The Kremlin says that the increase in its share of the banking sector is temporary and that it is powerless to prevent it. "Technically, [the Bank of Moscow] deal has increased the state's share in the banking sector, but the plan is to sell the state's shares in [VTB and Sber-

bank] and increase the competition in the sector. The other side of the coin is the state can't restrict Sberbank's place in the market, as how can we say to the minority shareholders there is a cap on the bank's ability to compete?" Arkady Dvorkovich, economics aide to president Dmitry Medvedev, said in a recent interview with bne.

Indeed, the state has been busily selling shares in both banks. VTB raised $8bn with an IPO in May 2007 by selling a 22.5% stake and sold another 10% in February raising another $3bn.

The state has said that it wants to sell another 10% as soon as possible. Likewise, the government owns 60.25% of

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Sberbank and shortly after the purchase of Troika Dialog, Russia's National Banking Council signed off on a decision to sell another 7.58% to the public, probably later this year.

Some investors are happy to see both banks growing in size and power. "On the one hand, the state is making it more difficult for private banks to operate, but on the other we are starting to see the beginning of badly needed consolidation in the banking sector. Taking over banks that are clearly not run on commercial lines but for the benefit of their owners is, all said and done, a good thing," argues Roland Nash, chief investment officer at Verno Capital.

achievements that the government has overseen in the last decade and present his vision for a strong, resistant country that is not beholden to any "unjustified liberalism". A stab at President Dmitry Medvedev? More on this below.

http://premier.gov.ru/

MOSCOW BLOG:

Putin for president?

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ladimir Putin is coming back as president in the March 2012 elections – or so everyone is saying after he announced in May that he was forming a new electoral bloc, the AllRussian National Front. But I don't get it. While it's clear this bloc is desperately needed if the Kremlin is to stand any chance of winning even half the vote in the Duma elections in December, I don’t see why this necessarily means Putin will end up as president in the

March 2012 elections. That is one of the options open to him, but it's not a given nor even likely.

Putin gave two important speeches that set off a cacophony of comment that he has “shown his hand” and will “definitely” come back as president next year. The first was his annual report, as prime minister, to the Duma on April 20. He used this occasion as an excuse to showcase the many (real)

The second speech was at the regional conference of the ruling United Russia on May 6 (which Putin heads, despite not being a member) where he presented the idea of floating a new All-Russian National Front election platform, which would be an alliance of a range of trade unions, women's groups, social organisations and other semi-political organisations (that have all shown themselves to be pro-Kremlin in the past.) It was this idea that really convinced the pundirazzi that Putin has presidential ambitions.

The first thing to understand is that, despite all the criticism, Russia is half way towards becoming a democracy: party politics really matter, even if they are not as important as in the West where they are the only thing that matters.

Put it this way: even the Kremlin knows the ruling party can't claim to win 90% of the vote as happened in Kazakhstan and Belarus recently – the people wouldn't stand for it. If the Kremlin organised this sort of result (which it is completely capable of doing), you

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would quickly have at the least mass demonstrations – doubly so these days, as the dissatisfaction with the government is palpable. Moreover, the Kremlin has made it abundantly clear on several occasions it dare not stoke the popular dissent fire – remember how fast it backpeddled when it tried to make OAPs pay for their bus passes a few years ago?

Instead, in Russia's "managed democracy" citizens don't have a free choice, but they have some choice and the Kremlin needs to convince a large amount of them to vote for the government (it removed the "against all" option off ballot papers at the last general election). And after a decade of economic recovery and rising living standards, a significant number of people are actually willing to vote for the powers that be. All said and done, both Putin and Medvedev are genuinely popular.

The rub is exactly how many people you can fool all of the time, to paraphrase Abraham Lincoln, and that is what is behind Putin's speeches: the number of people willing to be fooled is falling fast.

Follow the money In business you can judge the success of corporate strategy by looking at the numbers; success is finely judged in terms of dollars, nickels and dimes, and as market forces mean that costs and demand are relatively stable and quantifiable, you can usually make extremely accurate forecasts of how a strategy will do.

Politics is a different matter. As the fundamental unit is not a dollar, but the whim of the voter on election day, the business of forecasting elections is a lot harder. Voters' decisions are one part rational (hiking pensions will win votes and so is predictable), and one part sentiment (climbing about in Siberia with your T-shirt off may win votes, but not necessarily). Politicians have to play on both these forces to get the job of their dreams.

And so do political commentators: a good op-ed will cover the rational aspects, but mix them up with the irrational elements and sprinkle in a

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good dose of old-fashioned rhetoric, wander off into ideology, paint character portraits and indulge in some mud raking. Politicians understand this and the great ones are masters of manipulating journalists' appetites to create an image they think they can sell to the public. That's why opinion polls and focus groups are so important in modern politics.

With its super majority in the Duma, the Kremlin has full control of the rational part of politics (pensions were hiked by 50% at the start of this year and teachers were the latest group to enjoy voting winnings pay rises). Moreover, with oil at over $100 a barrel, the government has plenty of money to buy lots of popularity.

The difficulty is that it has lost the sentimental part of the vote so completely that the government can't even ensure it will win a simple majority in December.

United Russia as a party is bankrupt.

Widely known as "the party of crooks and thieves", it no longer has any legitimacy with the masses. Indeed, according to bne sources in Nizhny Novgorod, United Russia came third in regional elections this March – not first as announced – and the election was actually won by the Communists. And this was after the ruling powers used every dirty trick in the book to push their cause. If the regional elections in March were a curtain raiser for December's poll, United Russia wouldn't even get a simple majority. In other words, the Kremlin is facing a political crisis of the first order.

The introduction of the All-Russian National Front is Putin's rescue plan.

The timing looks about right too: six months is enough time to build up a campaign based on hype into a crescendo, but not so long that you have to build anything of substance.

Depending on the Duma How important is it to the government to win not just a majority of seats in the Duma in December, but a constitutional majority – over 60% – that would allow the prime minister to change the constitution at whim? Based on the last Duma elections in 2007, it is of paramount importance.

United Russia easily won a large majority last time round (of course, by making full use of the gamut of administrative resources). However, it fell short of winning a constitutional majority by a few percentage points and statisticians convincingly showed that some 14m votes were stuffed into ballot boxes to take the party over the magic threshold. The Organization for Security and Cooperation in Europe (OSCE) said the elections were not up to international standards. Still, the fix was relatively small and so the elections passed off without incident.

That won't be the case this time round.

United Russia is a political zombie and the fix will have to be on a massive scale if it is to win the constitutional majority again on its own (the regional elections in March were clearly a travesty). And if the Kremlin attempts to pretend that United Russia has won a landslide, it will be taking a very big risk.

The Front is an aggressive move to fix this political problem. Everything will depend on the plan's success and there are several possible outcomes at voting time: 1. Kremlin's party proxies win a clear constitutional majority and ZAO Kremlin continues business as usual.

2. Kremlin's party proxies almost win a clear constitutional majority and there is some fixing, but it is small enough that no-one gets too upset.

3. Kremlin's party proxies win a simple majority and there is massive vote rigging to give them a constitutional majority. This may or may not end up in popular protests, but will certainly bring down more international condemnation and also raise political tensions.

4. Kremlin's party proxies win a simple majority and the Kremlin accepts it.

In this case, Russia takes a giant step towards real democracy and President Medvedev's vision of a modern Russia.

What will Putin do in each of these cases?

In the first scenario, there is no reason why Putin should not stay on as PM. He has control of the levers of real power in Russia and also of the day-to-day running

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of government. And same is true in the second case for the same reasons.

His choice is more difficult in the third case, as while he still controls all the reins of power, he will head essentially an illegitimate government. If the people rebel against the election, then Putin will be held personally responsible. This would destroy his personal popularity, which is the cornerstone of his hold on power, and hence he will also become vulnerable to attacks by the oligarchs and other Kremlin factions. The temptation to leave the PM's job and take back his old job as president would be high.

The dream scenario would be where the Kremlin accepts a simple majority and Putin stays on as PM, relying on his popular mandate to keep him in his job, rather than the constitution where he has the ability to strip the president of his powers if Medvedev tries to sack him.

Then the rest of the world should shout "Hosanna!", as Russia would have taken a giant step towards true democracy.

But the dream scenario is unlikely. The Kremlin has made it clear it will allow more political pluralism (that was the whole point of hiring Medvedev as president rather than Sergei Ivanov in 2008), but only when Russia becomes more prosperous. The Kremlin has also made it abundantly clear that it wants to make this transition slowly.

Both Medvedev and Putin have explicitly said they are afraid of repeating the mistake of perestroika , where Mikhail Gorbachev enacted political reform before economic reform, and when his mild economic reforms failed, the whole loosening process spun out of control. Putin's plan is to do the economic reforms first and when Russia is prosperous, then to start on the political changes.

The other half And what of Medvedev? The press is leaping on any contradictory comment the president makes as evidence of a "split" between the two men, speculating that Medvedev might mount a "real" challenge to Putin in the 2012 presidential race.

Commenting on Russian politics over most of the last two decades has all

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been about understanding the personalities. However, while the 1990s were all about raw power, the naughties were about policy; a lot more people are involved in running Russia these days and the debate they are having matters.

As party politics develop, pundits are having a difficult time of kicking old habits and seeing Russian politics as anything but a scrap between "bulldogs under the carpet."

It is not impossible that Medvedev has developed a taste for power, but it seems more likely that he has been carefully chosen to bolster the Kremlin's appeal to the electorate. Russian society is rapidly dividing into the those that yearn for the certainties of the past – the old and state employees – and those with their eyes on the future – the young, the entrepreneurs and

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but put someone else in as president – new Moscow Mayor Sergei Sobyanin has been mentioned as a candidate. But is this group a real threat? The liberal businessmen have by definition made their fortunes by not playing the government game. Given that Putin has successfully contained massive state interests like Rosneft and Gazprom, surely a collective of supermarket owners is not going to pose a threat? Moreover, their main ability to make mischief would be to persuade Medvedev to sack Putin, but it is widely assumed that Medvedev himself remains a member of Putin's group, not his own.

Medvedev opened his own election campaign with a similar big press conference on May 18, where he dodged the candidacy question but spent two hours laying out his position on Russian

"The Kremlin knows the ruling party can't claim to win 90% of the vote as happened in Kazakhstan and Belarus recently – the people wouldn't stand for it" the emerging middle class, some 100m people by some counts. Putin cannot appeal to both groups at once, but by setting up Medvedev as the modernist reformer, he gives the broadest sections of society a candidate they can believe in, while keeping the actual power within confines of the Kremlin's control.

However, it is possible that Medvedev could be ousted. Over the last four years, a liberal camp of businessmen and government officials has grown up around the president who want to go faster. With per-capita GDP at $15,900 at the end of 2010, according to the CIA Factbook, Russia is prosperous and the Kremlin could start easing its control now, but it appears Putin is not ready yet (and this may turn out to be his greatest political misjudgement).

In order to defang this alternative power centre, there are persistent rumours in Moscow that Putin will stay on as PM,

policy. Given that the two men are now following a very similar media campaign, with different but complimentary messages, the chances that things will remain as they are following the dual elections seem much higher.

Nevertheless, Russia's elite is clearly extremely nervous and the capital flight of 1990s has returned in the last six months. There was $9bn of real inbound foreign direct investment in (FDI) the first quarter of this year, but $19bn of outbound FDI – double the amount a year earlier – which strongly suggests Russia's top dogs are putting something aside just in case. Bottom line is that like the last election cycle, the Duma elections, not the presidential elections, will be the crucial event and everything hangs on how successful Putin is in persuading enough Russians to vote for this All-Russian National Front coalition to give it a fig leaf of legitimacy.

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Frunze leases its entire facilities from the Cyprus company. The Surkis brothers have said they will fight the move: "If [Hryhoryshin] wants to wage war, we will wage war back," Ihor Surkis told journalists.

Hryhoryshin could not be reached for comments. Sumy Frunze said it could not comment on a shareholder conflict.

Looking under the hood of Ukrainian engineering Graham Stack in Kyiv

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ith machinery exports booming, Ukrainian engineering stocks should be an interesting play for investors – were it not for these companies' horrible corporate governance.

Ukraine's machine-building output was up by a whopping 35% on the year in February, with exports playing a driving role. But exports still predominantly go to Russia, and for the sector to go global it urgently needs new capital and technologies. Yet a series of corporate governance scandals has recently afflicted Ukraine's engineering sector, crippling its attractiveness for investors just as it gains from currency devaluation and a commodity-led recovery in the Commonwealth of Independent States (CIS).

Political football is sometimes quite literally that in Ukraine's corporate world.

One traditional derby runs between Ukraine's football oligarchs, the Surkis brothers – who comprise Hrihory, president of the Football Federation of Ukraine, and Ihor, chairman of Dyamo Kyiv football club – and Konstantin Hryhoryshin, owner of the Energy Standard

group of power engineering companies.

The derby kicked off in 2004 when the Surkis brothers allegedly diluted Hryhoryshin's stake in Dynamo Kyiv. However, it seems Hryhoryshin has won the return leg, with the feud now spilling over into ownership of electricity companies.

According to the Surkis brothers, Hryhoryshin has now diluted their 13.5% stake in the engineering giant Sumy Frunze, the biggest producer of gas-pumping equipment and a key supplier to Russia's gas firm Gazprom.

Hryhoryshin owns 75% of the company.

According to analyst Oleksiy Andriychenko of ART Capital brokerage, Sumy Frunze received $81m from the Cyprus company for the transferred subsidiary, with payment to be completed within five years – but it is now paying roughly $20m in rent per quarter. The rent is equivalent to as much as 20% of Sumy Frunze's annual sales. "If we conclude that the Cyprus company is controlled by Energy Standard, the scheme now allows it to accumulate 100% of all earnings from Sumy Frunze's production at Energy Standard, bypassing [Surkis'] Prosceno Trading. Thus in effect, Prosceno is left with shares that entitle it to a company that is unable to generate any profits and therefore is worth nothing," says Andriychenko.

Dragon Capital analyst Taisia Shepetko agrees that, "Energy Standard is siphoning off profits from the company and accumulating them at the holding group level."

Fourth-quarter results announced on February 25 underscored the disastrous financial impact the changes are having, with the company showing a net loss of $10.4m in the quarter, and 2010 net profit down 35% on the crisis year

"If Hryhoryshin wants to wage war, we will wage war back" In October, Sumy Frunze announced it had divested a subsidiary to a new Cyprus offshore company that Hryhoryshin is believed to control – having first transferred Sumy Frunze's production facilities to the subsidiary. Now Sumy

of 2009. As a result of the manipulation, Sumy Frunze's share price has plummeted a stomach-churning 60% since October, even as the Ukrainian Exchange index has climbed 50% over the same period.

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More grist for the mill The jittery market is now wondering whether a similar story is repeating itself at Hryhoryshin's other major listed company in the Energy Standard group called Zaporizhtransformator, the largest producer of power transformers in the CIS, and one of the largest in the world.

There is no shareholder conflict at Zaporizhtransformator, but preliminary 2010 results dished up an unpleasant surprise with the company recording a three-fold drop in profits in 2010 relative to 2009, well below forecasts.

The jury is out on whether this is due to profits being accumulated on the level of the Cyprus holding company, or due to the after-effects of the 2009 crash on demand for investment goods in 2010.

The company says the latter. "We are now expecting 2011 to set a record in terms of orders," says the company's press secretary, Anna Tischenko.

Controversial restructuring moves are afoot at another of Ukraine's leading engineering holdings, rail car and industrial equipment producer Azovmash, which is controlled by its president

Eastern Europe

was completed at an April 6 shareholder meeting, possibly paving the way for the sale of a stake in the company. The Azovmash press service said it was not authorized to comment on the restructuring.

mash. According to Oleksiy Gorovyy of Millenium Capital, which acquired 10.8% in the company from the State Property Fund a year ago, "the lease means all cash flows will be transferred away from Mariupol Heavy Machinery."

With the group having a history of alleged transfer pricing in favour of non-listed companies, the pool of creditors demanded a concentration of profit at the holding's listed Azovzagalmash company, the largest producer of cisterns in the CIS, to support servicing of the subsidiary's roughly $150m shortterm debt. Creditors and investors were thus astonished on February 22 when Azovzagalmash announced that it had run up a preliminary net loss of $33m for 2010, compared with $25m of losses in the crisis year of 2009, far below forecasts. Some $27m of the $33m losses were incurred in the fourth quarter alone, due to a new surge in transfer pricing benefiting a non-listed group member, Azovzagalmash Trade House, which handles marketing. According to ART Capital's Andriychenko, in the last quarter of 2010, Azovzagalmash paid the trading house a whopping $19m in marketing expenses, compared

All this wrecked the investment case for the railcar producer, which up until now had had one of the biggest free floats on the market at around 25%. As a consequence, the company's share plummeted 48% from December 10 through the end of March. Then the announcement on March 31 of an upcoming 22-fold increase in the company' charter capital at a shareholders' meeting April 15 sent the stock plunging 40% from its endMarch level.

"A series of corporate governance scandals has recently afflicted Ukraine's engineering sector" Oleksandr Savchuk, a deputy of the ruling Party of Regions. In contrast to Hryhoryshin, Savchuk is wrestling not with minority shareholders, but with the company's creditors.

Total Azovmash debt is put at $500m-600m. Savchuk finally reached an agreement with a pool of creditors in July on restructuring the debt, including a reshaping of the way that the group does business. This restructuring so far has meant the transfer of Savchuk's stakes in the group members to a Cypriot offshore company, Wessanen, announced January, as well as the creation of a management company for the group in Ukraine. The restructuring

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with a previous maximum of $6m. The resulting losses now question whether Azovzagalmash will earn enough to service its debt. The group's new export orders in 2011 – including a massive $74m order from Russia's Brunswick Rail – are apparently being closed by the trading house, not the listed company.

There is no doubt that the restructuring has already savaged the group's second listed company, Mariupol Heavy Machinery. As part of the group restructuring, the company announced in December it would transfer its production facilities to Azovzagalmash and move to a lease relationship that would obviously transfer profits to Azovzagal-

There would also seem to be more turbulence up ahead at another key engineering plant – state-owned Turboatom, the largest CIS producer of power turbines. This time the story again involves Energy Standard owner Konstantin Hryhoryshin, but this time he is cast in the role of confrontational minority shareholder.

Hryhoryshin, who owns a 12% stake in the company through a Cyprus outfit Linfot, has aggressively pushed to increase his influence over the company, and has been bitterly opposed in this by the company's present management.

Former president Viktor Yushchenko banned the privatisation of the state's 75% stake as a protective measure for the national champion. Almost immediately on current President Viktor Yanukovych coming to power in February 2010, the three-year conflict erupted again at Turboatom, with political manoeuvring, accusations of corporate raiding, and dodgy court decisions causing a suspension in trading of the share in April 2010. In December, the Ukrainian parliament then removed Turboatom from the list of countries excluded from privatisation, and in February 2011 the Rada again voted to confirm this decision. But in March, the head of the State Property Fund Oleksandr Riabchenko spoke out against any privatisation of Turboatom. Watch this space.

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INTERVIEW:

Slovakia's shame as corruption besets EU funds

Tom Nicolson in Bratislava bne talked to Zuzana Polackova, head of the European Social Fund in Slovakia, about the murkiness surrounding the distribution of millions of euros in EU structural funds. bne: After eight months in the job, what is your view of how structural funds for the 2007-2013 have been used in Slovakia?

Structural funds slosh through Slovakia

ZP: On the one hand everyone knows there was an awful lot of corruption, and our project managers are always saying that they were under orders from above not to ask questions about the budgets of certain projects, even when they were clearly grossly overpriced. On the other hand, no one wants to testify. What I can say is that it [corruption] was highly sophisticated and difficult to prove.

Often reputable institutions and individuals were drawn into these practices because they needed funding and realised that in Slovakia there was no other way to get access to structural funds. That they had to accept the rules of the game and pay bribes. The result was a kind of public resignation that moral principles don't apply, because everyone is doing it. For me this has been the most difficult thing to handle, because I've come to realize that giving up on moral principles has become the norm in this country. And no-one is doing anything about it.

Tom Nicholson in Bratislava

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uropean structural fund lore is full of bold frauds. The Italian dentist who bought himself a Ferrari Testarossa and 55 other cars with money earmarked for a fictitious solar panel business; the Spanish mayor who built a brothel out of funds for a riding stable; oh, and the over €100m in staff allowances pocketed by European parliamentarians (MEPs) themselves. And yet little so far has been written about systemic fraud – about how entire operating programmes in EU countries could be hijacked by a small elite.

Zuzana Polackova took over as director of the European Social Fund (ESF) at Slovakia's Labour Ministry only eight months ago. As European Commission inspectors slog through already their second audit of how these ESF structural funds – which the EU says are designed

bne: How did this corrupt system work, through bribes? to "promote employment in the EU... [and] help member states make Europe's workforce and companies better equipped to face new, global challenges" – were used at her ministry, she says she

of corruption aren't immediately visible.

The publicly available list of structural fund recipients – mostly of money for training employees – tells you little.

Few have overt political connections,

"What we know so far is that corruption worked through procurement tenders – it was very sophisticated and it's difficult to prove" knows what they will find. "There was an awful lot of corruption," she tells bne in an exclusive interview.

Lucrative sub-contracts At Slovakia's division of the ESF, signs

while many have solid reputations in the business and NGO sectors. Moreover, the amounts awarded are small, with all but a few projects getting less than €500,000.

ZP: I don't think any cash actually changed hands. People aren't that stupid. What we have found so far is that everything worked through procurement tenders [held by structural fund recipients], especially for various studies and market analyses, where it is very difficult to set any universal quality standards. The fact that these analyses were almost always included in the first requests for funding tells us that the money was going towards the people who had arranged for the project to be approved.

Then there were educational services, which were horribly overpriced across the board. This has been confirmed by audits and is one of the European Commission's most common findings. They often laugh at the money we were approving for personnel costs or training courses. bne: Could it be argued that little of value was achieved with structural funds, even when we disregard the corruption involved? What is the benefit to society of teaching factory floor workers how to speak English, or truck drivers how to manage stress?

ZP: I have no problem with educating people. But the question is always what we teach them and how we do it. If we teach them in a systematic manner, I think that's fantastic. But when they only get a one-off course of 10 hours of English for which the company providing the service charges an exorbitant fee – that's a tragedy. The problem was that these calls for projects were made so broad that anyone could participate. In a civilized society this is a good thing, because if you relax the conditions you create room for more original project proposals. But in Slovakia these broad definitions were grossly abused. The worst problem was that the project selection process was totally incompetent. The people evaluating the projects often knew nothing about project management or about the field they were judging. This allowed worthless projects to be approved because they met the formal requirements, or because they had protection from someone higher-up. bne: How is it that until now no-one has known that structural funds corruption worked through procurement?

Why doesn't your internal IT system provide a picture of which companies were earning millions through these mini-tenders?

ZP: Because it wasn't in the interest of the people running the process that these things should be generally known. The IT system we have – ITMS – is supposed to be a cutting-edge technology providing a central database of all projects that have drawn money from structural funds, but we are unable to access information on other operating programmes, which means we can't verify whether applicants are drawing from more than one structural fund for the same project. It's common for a single person to be doing the same thing for a dozen projects in various operating programmes, under the heading of "services".

There is simply no public control over structural funds, meaning that regional and municipal authorities have no idea of what projects are taking place on their turf. And so it is that in a single village you could have the same work being performed by five, seven or nine various institutions of whom the mayor has never heard. bne: A high-level policeman told me recently that if the EU knew what had happened with structural funds in Slovakia, they would cut the country off. What is your opinion?

>

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ZP: My experience with European Social Fund auditors is that they know a great deal. They know the percentages involved in kickbacks; they know even more than the police. But cutting off a country from structural funds is easier said than done. Part of the problem is that the European Commission finds it difficult to take radical decisions. I don't mean to play down the extent of theft in Slovakia, but I think older EU member countries are better at cleaning up their messes at home and not getting the European Commission involved. We're still rookies at this. On the other hand, rather than admit our system is bad, we tend to try to defend it. We have a three-level control mechanism that is one of the most complicated in Europe, and people are still able to steal from the system.

The problem is that we verify paperwork and nothing else. bne: While writing this article, I received several suggestions to leave well enough alone, because Slovakia could lose millions in potential funding. What is your opinion?

ZP: At the moment I am a state employee, and the majority opinion in the state administration is that we should take care of this at home, not talk about it, and not let anyone find out because we would just be creating

To understand what really happened to the hundreds of millions of euros the ESF has handed out in Slovakia, however, you have to look beneath the surface – not at who officially received the money, but at the professional training companies they chose through tenders to school their staffs, in languages, personal skills, management or computers. "What we know so far is that it [corruption] worked through procurement tenders," Polackova says. "It was very sophisticated and it's difficult to prove."

A month-long bne investigation found that many of the training contracts that have been tendered since 2008 were for exorbitant amounts. Trainers regularly demanded €1,400 a day to teach courses on "communications skills" or "managing stress" with fewer than 10 students each. Another company of Bratislava, for example, wanted €2,380 to teach a 16-hour cooking course entitled "modeling chocolate" with one participant.

Yet another firm wanted €22,000 for a nine-hour course on "effective communication."

other problems for ourselves. Brussels has a very good press monitoring system, and after every article we get questioned. Questions could also arise in the European Parliament, which at the moment is deciding on budgets for the next programme period. There are a lot of risks attached, and I am beginning to understand my colleagues, even though for six months I completely rejected their point of view. It's just the way bureaucrats look at things. My own opinion – and I stress that this is my view as a citizen and not as the head of the ESF – is that this approach amounts to burying your head in the sand, and even though you don't worsen the situation you don't improve it either. It just prolongs the agony in this country, our resignation of any moral principles. I actually believe that the best thing that could happen to Slovakia is to be cut off from structural funds, so that people here would finally understand that stealing is wrong. I would have no problem going to the European Parliament and telling them what is going on with structural funds, and not just in Slovakia but in all EU member countries. I believe these things need to be said, because people have a right to this information. It's not just German taxpayers' money, it's ours as well. And if I were a German taxpayer, I wouldn't send another cent to Central Europe.

So why were these education costs so high, given that they were tendered?

Why was the competition for contracts not sufficient to keep prices down?

Problem #1 – Procurement Law Until this year, Slovakia's Public Procurement Act regarded education as a "non-priority service," which meant that contracts for training – even those worth millions of euros – could be awarded through a less transparent tender method. Tenders did not have to be widely advertised, for example, or their results published. As a result, it was easier to arrange to have tenders won by a pre-selected firm. With no real competition – and with European taxpayers paying the bill – prices exploded.

"Educational services [in Slovakia] were horribly overpriced across the board," says Polackova. "This has been confirmed by audits and is one of the European Commission's most common findings. They often laugh at the money we were approving for personnel costs or training courses."

According to Polackova, the ESF has so far awarded almost 70% of the €1.5bn it has available for "employment and social measures" for the 2007-2013 period. Of the 1,500 funding recipients, about one-third have already tendered out sub-contracts, with the rest soon to follow suit.

Certain companies seem to have cleaned up in the sub-contracting business. While dozens of training firms have won one or two tenders, the following have won 10 or more: Gestus Training House of Bratislava, the VAPC education centre of Kosice in the east of the country, and Anfemata from a small town near Zilina in the north. Centire of Bratislava remains the cash winner with over €5m in at least 15 sub-contracts from 2008 to 2010.

Of course, just because these companies were successful doesn't mean they were corrupt. However, they provide some useful clues as to why public procurement didn't provide cheaper services.

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Problem #2 – Ties between procurer and bidder Proving that a tender has been fixed is rarely easy, but there are certainly grounds for investigation when the procurer and the successful bidder are basically the same entity.

The clearest examples of this trend in Slovakia were when a non-profit organization that had been set up by a training company won a grant to train its volunteers – and then awarded the contract to its founder.

For example, the Futura non-profit organisation in Kosice sits at the same address as VAPC, which is not surprising given that it was founded by VAPC owner Jindrich Gazda. Future was awarded €160,000 by the ESF in March 2010, and then handed VAPC a €110,000 contract for training services. While other training companies requested tender documents, only VAPC submitted a bid.

Another €240,000 went to the Slovak Chamber of Language Education, which was also staffed by VAPC members and was located at VAPC headquarters. Not surprisingly, VAPC won the €150,000 training contract there as well.

Problem #3 – Ties between bidders The existence of ties between individual bidders for training contracts also creates grounds for further investigation.

Anfemata for example won a €110,000 training contract from the K-7 Canine Rescue Team last year to provide "professional canine rescue instruction."

The initial tender K-7 held attracted bids from Anfemata as well as from the Entrepreneurial Information Centre (ICP) and a company called Kompleksa Development. Anfemata won with an offer that was €5,000 cheaper than the others.

That would have been fine, except that Anfemata owner Zoja Zidekova also co-owns Kompleksa along with Peter Batory, chairman of the board of K-7, as well as with Juraj Malik of ICP. Zidekova's Anfemata eventually signed a €112,000 training contract with her business partner Batory as well as a €21,000 contract for "external manage-

Central Europe

ment" of the deal. Zidekova admits her business relationship with Batory, but said the contract with K-7 had been signed by her son Andrej.

Even where no such obvious business connections existed, many tenders showed signs of previous coordination between bidders. Anfemata won almost €2m through four training contracts signed on a single day – February 8, 2010 – with four different companies within the Central Slovak Energy (SSE) group. In each tender, Anfemata ran against the same two competitors, Eurex Slovakia and Meritum, a fact confirmed

by Anfemata. "Your information is correct," Zoja Zidekova of Anfemata confirms to bne .

Problem #4 – Political "background" Many of the top tender winners show clear political and inside connections.

Gestus, for example, won at least 11 tenders worth over €450,000. Among the training experts Gestus listed was Lucia Hutanova, who also served as a project manager in 2008 with the

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sented Jan Slota of the opposition Slovak National Party, and was a major player in Slovakia's worst eurofunds scandal to date, a €120m tender for advisory and marketing services that was "advertised" on a bulletin board behind a locked ministry door. Between 2007 and 2009, VAPC won almost €3m in training contracts from the Slovak Post Office, where Hatvany was chairman of the supervisory board from 2006 to 2010. For its part, Lenka Takacova of VAPC tells bne: "We have no knowledge of the existence of any relationship between the representatives of our company and the individual you have named [Juraj Hatvany]."

Police investigate While abuses of structural funds are likely to have occurred at other ministries as well, the Labour Ministry is the first to have come under wider investigation by the Slovak police since a new government came to power following June 2010 elections.

Peter Kovarik, head of the police AntiCorruption Unit, says he "couldn't dis-

"These procurements were generally handled in a highly sophisticated manner through advisory firms, and are now difficult to challenge from a legal point of view"

Slovak Implementation Agency, which is in charge of handing out ESF money. "I don't see any conflict of interest there," Hutanova says.

Another Gestus expert was Jan Pataky, a former member of parliament for the ruling SDKU party, who was charged last year with accepting a bribe in the reconstruction of a hospital. Pataky's daughter Adriana Sklibova owns Gestus.

Gestus did not return bne's calls.

VAPC's Gazda, meanwhile, is on the management of the Albatros L39 company along with Juraj Hatvany of the Avocat law firm. Avocat has repre-

agree" with ESF director Polackova's view that massive corruption had accompanied the use of structural funds. He warned, however, that putting the culprits in jail may prove difficult. "These procurements were generally handled in a highly sophisticated manner through advisory firms, and are now difficult to challenge from a legal point of view," he says. "If one company billed another for a service, and that contract was awarded through a standard tender, I have a serious problem proving that a crime occurred. It's not enough for me to say that it was exceedingly immoral."

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Hungary finds solution to forex loans elusive

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took hold in the second half of 2008, Hungary's manufacturing industries, the bastions of its economy, began to downsize rapidly. And as unemployment and short-time working rose, the forint slumped. Hungarians who could buy the Swiss franc for as little as HUF150 early in the year, faced a rate of HUF200 on their repayments only nine months later.

move off for better jobs," says Bernath.

The moratorium has introduced another problem – moral hazard. Janos Muller, spokesman for the Hungarian Banking Association (HBA), says that without the threat of eviction, those struggling with debts have less incentive to pay off mortgages. "We certainly have evidence of this; the number of non-performing debts has grown," he says.

As the stock of bad loans, and subsequent repossessions of homes by banks increased, so too did the public outcry, fuelled by TV reports of anguished families being turfed out onto the street. In an attempt to ease the pain, and facing a spring election, the Socialist-technocratic government led by Gordon Bajnai imposed a moratorium on evictions in early 2010. "The moratorium certainly calmed public fears, though in fact the number of evictions was limited; it is not an efficient way for the banks to recover money in a weak housing market, itself made weaker by the moratorium," says Bernath.

Bernath concurs: "The number of nonperforming household loans now totals some 110,000, or close to 11% of total, up from 3% in late 2008."

While a cause for concern, the National Bank of Hungary insists in its latest stability report that the non-performing household loans aren't a threat to the banking sector as a whole, which is well capitalised. Nonetheless, foreigncurrency loans still make up almost two-thirds of Hungary’s total household debt of just under HUF10 trillion (€37bn), according to central bank data. And with the Swiss franc now

I 33

"The moratorium certainly calmed public fears, though the number of evictions was limited"

trading around HUF213, the situation for debtors isn't easing.

The banks, meanwhile, are also feeling squeezed. Bank sector results have worsened significantly, partly due to the crisis tax. Returns on equity in the sector have come down from an average of 11% in 2007 to just 2-4% last year, when "four of the largest seven banks made losses," says PwC’s Bernath.

While both the government and the banking association expressed optimism in early May that an agreement on a package of measures was close, this appeared to be scuppered two weeks later when the media reported that the government had insisted on some last-minute, radical changes

to conditions, which the banks had rejected as highly unfavourable. (These included setting the exchange rate at HUF160 to the Swiss franc, instead of HUF190, for a period of four years.)

On May 18, HBA’s Muller insisted to bne that talks were continuing. "The media reports are not correct. There has been no final draft from the government.

Our goal is to come to a solution. This is very important, because the housing market is dead. Banks are unable to lend [without guaranteed collateral]."

But asked if government demands were making agreement less likely, he replied: "Do not let us be pessimistic."

Kester Eddy in Budapest

B

anks have been in (sometimes heated) talks with the Hungarian government over how to tackle the crushing foreign currency debts of Magyar households since February. And with a moratorium on home repossessions and evictions due to end on July 1, and the total amount of "delinquent" loans increasing, a solution is now regarded by all sides as a matter of urgency.

Tamas Bernath, for one, well remembers the Hungarian public's initial love affair with Swiss franc loans some eight years ago. "Local-currency housing loans in 2004 carried an interest rate of about 11%. Given that banks were simultaneously offering Swiss franc loans at 4-5%, it is little wonder that people were keen on forex-based credit, primarily in Swiss francs," he says.

By early 2008, that early enthusiasm had turned into a stampede; more than 90% of all new retail and housing loans, the vast majority using homes as collateral, were in Swiss francs, euros and even Japanese yen.

Bernath, a banking expert who now heads the Financial Sector Advisory of PriceWaterhouseCoopers in Budapest, says he and other professionals saw the risks from the very beginning, but the

New broom The incoming government of Prime Minister Viktor Orban in 2010, which had pledged to avoid evictions as part of its election campaign, extended the moratorium – first to April this year,

"The number of non-performing household loans now totals some 110,000, or close to 11% of total, up from 3% in late 2008" warnings – including notices from the central bank and Pszaf, the financial regulator – were largely ignored in the headlong rush for seemingly cheap credit. "Almost all the Hungarians taking forex-based loans were being paid in forint. Of course, there was a huge risk that if exchange rates moved against them, they would have trouble with repayments," he says.

And when it came, the trouble was very serious. As the world economic crisis

and later to July 1 – while it wrestled with the problem of how to live up to, and pay for, its campaign promises.

But while the extension eased the situation for those who could benefit from the limited economic recovery over the last year, the situation for others has deteriorated further. "Many of the debtors are family people living in small towns, where both housing market liquidity and employment chances are worse than average. They can’t just

[

] {

> h c r a

e s e eR

Ca

L O nd

www.candole.com

Critical analysis of New Europe's energy establishments

CEZ Unplugged

Good, bad and ugly sides to the Czech energy giant

Double Trouble

Romania aborts plans for two national champions

Кто Кого?

Why Bulgaria should abandon NPP Belene

Dinosaurs

The fossilisation of Czech district heating policy

Power Abuse

CEZ and the abuse of dominant market power

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I 35

competitors are unable to satisfy Czech demand. "In peak hours in winter, for example, CEZ’s competitors are able to cover only around 30% of demand. As a result, CEZ is the pivotal supplier in the Czech Republic and the potential for market abuse is high," it says.

The Commission's current investigation is centred on how any "suspected illegal conduct" could comprise excluding competitors and raising prices on the Czech wholesale electricity market. And Candole's report investigates whether CEZ makes use of its dominant position to create high profit margins through the use of margin squeeze and vertical foreclosure.

Europe's diffusion of power

VISEGRAD:

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y March of this year, EU governments were required to have adopted into national law two directives on gas and electricity contained in the bloc's "Third Internal Energy Market Package", which is designed to, among other things, make the trading of energy across borders easier and reduce transaction costs.

However, the Czech electricity market shows just how far from reality a truly integrated and competitive European power market is.

The giant Czech utility CEZ – which is nervously awaiting the European Commission's nearly two-year investigation into "suspected anti-competitive practices" on the Czech electricity market, expected within the next few months – holds about 80% of the domestic power generation market, a level most would agree isn't healthy for competition.

However, CEZ often loudly complains the relevant market to consider is not the domestic but the wider European

one, where its market share is around only 3-4%. So what is the relevant market to look at?

In a report released in May entitled "Power Abuse," the Prague-based advisory firm Candole Partners, which counts CEZ competitors amongst its clients, attempts to answer this question by examining two main elements

Photos: www.cez.cz

two countries is congested, then they must be different markets, not one "European" market.

Borderline similarities Looking at cross-border auctions for electricity capacity, Candole found that demand for capacity is always higher than the supply, mostly five times higher on average, meaning that interconnection capacity is not satisfactory to cover this flow of power between the two countries. "To create a European market, you'd have to expand these capacities by investing significantly," says Martin Bebiak of Candole, a coauthor of the report.

Following on from this, if the crossborder capacities are congested, then

"To create a European market, you have to expand interconnection capacities by investing significantly" of electricity markets: the price of electricity and the interconnectedness of the markets. The assumption is that if prices are different between the Czech Republic and next-door Germany, and if interconnected capacity between the

prices should be different. Looking at nominal prices of electricity over a time scale of, say, a month, there actually appears to be a high correlation between those of the Czech Republic and Germany, because prices on this

scale are both affected by the same factors – GDP developments, global crisis, prices of oil etc. – and so trend together.

However, Candole argues that this gives a distorted picture, because the difference in prices are lost in the large scale being used. "However, if you zoom in and look at hourly prices, then you get a completely different picture," says Jan Ondrich, co-author of the report.

"The base price of electricity is large [at around €60 per megawatt hour] but the differences are tiny but there, and the volatility of hourly prices is also large – there are a significant number of hours when Czech electricity prices are higher than in Germany, and there is also a significant number of hours when the prices are lower than in Germany."

When the data is "cleaned", what emerges is that there is very little correlation between the prices of electricity in the Czech Republic and Germany, with the correlation coefficient – a measure of the degree to which two variable's movements are associated – decreasing from about 0.9 to about 0.2, calculates Candole. In competition economics, if the correlation between two prices is 0.8 and higher, then it's likely those products exist in the same market. If the correlation is below this threshold of 0.8, then the markets are separate. "Electricity is a homogenous good and the correlation should be very

high at 0.95 – it should really be the same, and certainly not at 0.2," says Bebiak.

The European Commission has set a target to achieve complete electricity market coupling by 2015, gradually bringing prices in neighbouring countries closer together. Clearly, much more work needs to be done.

Concentrated If the appropriate market to consider is the Czech one, therefore, how concentrated is the Czech electricity market?

Employing the same methods that the European Competition Commission uses to determine market concentration, Candole found the Czech market to be one of the most concentrated in Europe – on a par with France and Belgium. One of those measures, the Residual Supply Index, shows the combined generation capacities of CEZ’s

Margin squeeze is where one company that is active in all levels of production increases its margins at one level to squeeze the margins in others. Candole argues CEZ makes use of its market power in the generation sector to minimise margins in the mining sector – in essence, taking the whole profit for itself. Candole also claims that CEZ is able to prevent new market entrants from entering the market – a practice called vertical foreclosure – because it is vertically integrated and so enjoys the dominant position on the most important market in the value chain, which is electricity generation.

By using its dominant market position, Candole calculates that CEZ's electricity mark-up is around 230%, significantly higher than in any other country in Europe. "German producers, who compete on an oligopolistic market, have price-cost mark-ups of around 50%."

CEZ had not replied to a list of questions by the time of publication.

"When the data is 'cleaned', what emerges is that there is very little correlation between the prices of electricity in the Czech Republic and Germany"

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Poland's survival budget Jan Cienski in Warsaw

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oland's draft budget for 2012 aims to finally bring the budget deficit below the EU's requirement of 3% of GDP. But with reports emerging on May 9 that the budget deficit likely hit PLN21.5bn-22.0bn in the January-April period, or 53.554.7% of the annual plan for 2011, the size of the problem shows how hard that ambitious goal will be to reach.

The goal is for the deficit to hit 2.9% of GDP in 2012, down from an expected 5.6% this year, and 7.9% in 2010. "We have embarked on a path of consolidation. Tightening and saving so as to reach safe levels of deficit and public debt for Poland," Donald Tusk, the prime minister, said as the budget project was announced earlier in May. However, Poland's government, which faces a parliamentary election later this year, has been unwilling to take the political risks in embarking on economic reforms of the type seen in countries that were hard hit by the crisis like the three Baltic states. Its most radical step was a controversial move to partially undo earlier pension reforms, shifting some of the money flowing into private pension funds back into the state system, which lessens budgetary pressure. Other steps include a temporary increase in the VAT, as well as restrictions on the growth of discretionary spending. "This is a breakthrough budget when it comes to the realisation of our goal, which is the liquidation of the overly large budget deficit," Jacek Rostowski, the finance minister, said when announcing the planned budget.

However, other issues like the separate and expensive (but politically very popular) pension programme for farmers, as well as reducing the stifling level of bureaucracy have made little progress.

And that makes analysts sceptical that Warsaw will hit its budgetary targets.

"In terms of fiscal deficits, Poland is now the worst positioned among the major economies in developing Europe – even after this year's pension changes," says Nicholas Spiro of Spiro Sovereign Strategy. "It is paying a price for having pursued accommodative policies prior to and during the financial crisis. While this may have cushioned the downturn, it has led to a significant deterioration in the country's public finances at a time where there remains little appetite for meaningful expenditure reform and non-resident holdings of public debt are growing, making Poland more vulnerable to an adverse shift in market sentiment."

The International Monetary Fund is also dubious. While praising Poland's

Markets have also been less than impressed. The zloty has continued to flounder against the euro despite an unexpected rate hike by the central bank, which brought the benchmark interest rate to 4.25%.

Stronger measures A stronger zloty coupled with robust GDP growth are key for Tusk's political

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fortunes. The rising deficit has pushed public debt to within a hair of 55% of GDP, which, if breached, imposes painful legal requirements to bring spending under control. As much of Poland's debt is in euros, a weak zloty increases the danger of passing that threshold.

Tusk's finance minister is under immense pressure to bring spending under control without stalling the economy. One measure, that has aroused the ire of mayors across the country, will limit the ability of local governments to incur debt, as a way of keeping public debt from rising too high. However, as a result dozens of projects such as improving local roads and building new sewerage plants are endangered, which could affect unemployment and economic growth.

Ryszard Petru, head of strategy for PKO BP, Poland's largest bank, says that the budget has been prepared with an eye towards the upcoming elections to ensure as little political turmoil as possible while Tusk tries for an unprecedented second term as prime minister.

"This is a survival budget," he says. "It's a budget which does not bring in any essential reforms to the Polish economy,

"In terms of fiscal deficits, Poland is now the worst positioned among the major economies in developing Europe" fiscal consolidation so far, its own estimates find that next year's deficit will come to 3.6% of GDP. The IMF recommends that Poland tighten its spending by an additional 1% of GDP.

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and is based on the idea that the Polish economy will only continue to grow."

The danger, Petru says, is that if the optimistic assumptions, which call for steep increases in the tax take as well as GDP growth in 2012 of 4% do not pan out, the fiscal projections will be unrealistic. "The fundamental problem is that, with any kind of an economic slowdown, there will be a repeat of what happened during the last crisis, namely that revenues will fall and spending will rise, increasing the deficit and the debt," he says.

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Poland has enough gas to cover its own domestic consumption for up to 300 years. With Poland generating 90% of its electricity from coal, domestic shale gas would also allow it to lower its greenhouse-gas emissions, but not at the expense of having to increase its reliance on Russia for gas. "Development of Poland’s large shale gas technically recoverable resource of 187 trillion cf could significantly increase the country’s natural gas reserves and internal gas production," the EIA report says.

Indeed, Polish Prime Minister Donald Tusk has said he's determined to see the "exploration and exploitation of shale gas in Poland become a fact."

Poles apart in search for shale gas

Unsurprisingly, international oil companies, fuelled by the huge rewards gained from developing US shale gas deposits, are arriving en masse to Poland and other European countries where shale gas is reckoned to exist in great enough quantities, such as next-door Ukraine. "Wherever you find hydrocarbons, there is the potential for shale gas," says Michael Borrell, senior vice president of Continental Europe and Central Asia at Total E&P.

Nicholas Watson in Prague

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o we now know it's less a question of whether Poland has large deposits of shale gas, but rather if these are commercially viable. For several reasons, that's still a big "if".

An April report by the US Energy Information Administration (EIA) on shale gas resources outside the US put Poland's technically recoverable shale gas resources at 187 trillion cubic feet (cf), making them the largest in Europe.

That compares with the 862 trillion cf of technically recoverable shale gas in the US, and sets it apart from other countries in Central Europe like Hungary, where the national oil and gas company Mol has been exploring for shale gas for several years but hasn't seen any results.

The ramifications of this could be huge for Poland. Technology such as horizontal drilling has allowed the US to commercially produce large amounts of unconventional gas – hard-to-get-at deposits of tight and shale gas, as well

as coal-bed methane – which turned the country into a gas exporter from being a big gas importer in a matter of years.

The EIA says that of the 577bn cf of gas consumed in Poland in 2009, 61% was imported, almost all of it from Russia. But with the shale gas reserves, Map of 48 major shale gas basins in 32 countries

Legend Assessed basins with resource estimate Assessed basins without resource estimate Countries within scope of report Countries outside scope of report

Recent significant developments include a deal between Marathon Oil and Nexen to jointly explore for shale gas in Poland, while reports say Poland's largest energy firm PKN Orlen is close to a deal to take a stake in a substantial US shale gas deposit in exchange for access to its own concessions at home.

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According to the local Rzeczpospolita newspaper on April 28, PKN is close to signing a deal with a US partner, but details of the partner and the shale gas deposit in question would remain undisclosed until after the deal is finalised, perhaps in June. "We've said for a long time that we're going to look for partners to search for and exploit shale gas deposits in Poland and we want a company with experience in this field.

Most of these companies are active in the US, which is the leader in shale gas production," Wieslaw Prugar, chief

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drilling in over 70 concessions around Poland.

20-year period" – something which has the environmental lobby up in arms.

However, experts warn that commercially developing the shale gas in Poland could run into the same problems that are preventing exploration from happening elsewhere in the world.

"Shale gas production involves considerable social and environmental costs.

They vary from place to place, and may not yet be institutionalised, but they are real. If it’s increased crime rates, split communities, water contamination, road degradation, industrialisation of places of rural tranquillity or natural beauty, these costs are real and will eventually be factored in," says Mark Olsthoorn, a climate and energy consultant.

Contaminated At a Washington forum on transAtlantic natural gas issues hosted by Johns Hopkins University's School of Advanced International Studies in May,

Shale gas production involves considerable social and environmental costs"

executive of PKN's upstream subsidiary, Orlen Upstream, told the daily.

The report said PKN has offered potential partners a 20-30% interest in Polish shale gas concessions in which it plans to remain the operator. In return, PKN gets the technology for the extraction process known as "fracking" or hydraulic fracturing.

The latest foreign player to be attracted

by Poland's potential is Canada's Nexen, which on April 26 said it had signed a deal with Marathon Oil to jointly explore the US firm's shale gas concessions in Poland. Marathon said Nexen will acquire a 40% working interest in 10 of its concessions in Poland's Paleozoic shale play, where the company has 2.3m acres. "This partnership provides not only financial risk mitigation, but combines the extensive unconventional drilling and completion experience of Marathon and Nexen to fully evaluate the potential of these concessions," Annell Bay, Marathon's vice-president worldwide exploration, said.

Nexen joins a collection of major oil companies such as Exxon Mobil and Chevron, as well as smaller players including Canada's BNK Petroleu,

Vaclav Bartuska, the Czech Republic's ambassador-at-large for energy security, told delegates that the fear of pollution from fracking, which involves the pressurised injection of water and chemicals into the earth to separate gas from rock layers, is too great to allow shale gas development. "The reason we are so cold about shale gas is that we have had 30 years of mining for uranium, which involved pumping millions of litres of sulphuric acid into the ground. That has been an ecological disaster. We stopped it in the 1990s, and we've been trying to clean it up ever since," Bartuska was reported as saying at the forum.

Indeed, a recent study by New York's Cornell University found that methane emissions from shale gas extraction "carry a greater carbon footprint than oil, coal and conventional gas over at least a

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Central Europe

for their strengths in their past or in the misty future, what is best in Warsaw is either happening before our eyes, or is going to happen any moment."

Warsaw is, indeed, wild and unpredictable, and has little physical past to display – but those may be among its greatest strengths as it seeks the European culture title to help transform itself by using culture for social change. This "Paris of the East" was reduced to rubble

by Nazi Germany during World War II, but rose again burdened by massive Soviet-style modernist public buildings, a dreary grid pattern of wide streets, and indistinguishable clumps of cheap apartment blocks. The Royal Castle and Old Town were lovingly recreated by Polish workers (aided by the detailed cityscapes of Italian artist Bernardo Bellotto), but most of its pre-war art and architecture was lost.

Olsthoorn cites a study by the Oxford Institute that estimates in Europe shale gas production costs would be three times higher than currently in the US, which to a large extent is due to the more demanding regulatory context.

And the EIA notes in its survey that while the Polish government has shown strong support for shale gas drilling by putting in place very attractive fiscal terms for gas development, "infrastructure and regulatory issues remain as barriers to efficient development."

For David Goldwyn, a former shale gas expert in the US State Department who now runs an independent consulting firm, none of this cuts much ice. He says what is certain is that commercially producing shale gas can take as long as a decade to fulfil, so these possible environmental problems are far off in the future, if at all. In the meantime, the uncertain global energy situation behoves governments to determine now whether they have reserves of shale gas or not. "These are the early days, and the time for Europe to act is now, in terms of looking at what is there," Goldwyn told AFP. "The potential is there, but the reality is, very little drilling has been done, except in Turkey. People should look first, before they worry about it."

"We've said for a long time that we're going to look for partners to search for and exploit shale gas deposits in Poland"

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Warsaw cultural transformation sign of Poland's rise Patricia Koza in Warsaw

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he campaigns are over and the wait begins for five Polish cities seeking the title of European Capital of Culture 2016. One Polish and one Spanish city will gain the honour, with the Polish winner to be announced on June 21.

Gdansk's application cites its role as cradle of the Solidarity movement that brought freedom to Eastern Europe.

Lublin points to its history of tolerance

and east-west cooperation. Katowice calls itself a "city of gardens" on which to base a new concept of urban living. Wroclaw highlights its diversity and its prestigious international music festivals. And then there's Warsaw. "Warsaw is a city of chaos, improvisation, unpredictable processes," wrote Sebastian Cichocki, chief curator at the six-year-old Museum of Modern Art (MoMa) Warsaw. "Warsaw is active, expansive, uninhibited. It is wild. While many other cities must look

The end of communism in 1989 unleashed a string of high-rise office and apartment buildings downtown, but Warsaw is a work in progress – and there's plenty of work to be done. "We are witnessing the creation of a new Warsaw – a Warsaw that is constantly under construction, where each and every one of us can be the constructor," says Mayor Hanna Gronkiewicz-Waltz.

Take Plac Defilad, the largest city square in Europe (at 24,000 square metres), once the site of propaganda rallies and then a disorderly giant marketplace. The central square is dominated by the gargantuan Palace of Culture and Science, the tallest building in Poland, which was Stalin's "gift" to the Poles. After years of public debate over whether to tear down the Soviet power symbol, Warsaw officials have developed an ambitious plan to revitalize the area around it, and the linchpin will be a new permanent home for MoMA Warsaw, construction of which is due to begin by late 2012/ early 2013.

Home sweet home The warehouse-like structure, designed

by Swiss architect Christian Kerez, will spread out directly in front of the Palace of Culture. At 35,000 sqm – almost exactly half the size of New York's

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MoMA (there is no direct connection) – it will consist of a vast glass-walled ground floor and an upper floor of open space covered by a canopy roof.

Estimated to cost PLN480m (€120m), it will have a theatre, two restaurants, a café and a bar, and a major bookstore – and 10 entrances to make it approachable day or night. Half the funding is already budgeted, and the city is applying for EU funds for the rest. Once completed – hopefully by 2016 if Warsaw wins the European cultural crown – the central government will take over operating it. The rest of the square will gradually be given over to commercial and housing projects, but always with an eye to keeping it attractive for pedestrians.

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The museum project is essential to reflect Poland's transformation into a modern society, says its deputy director, Marcel Andino Velez. "Polish history is full of traumas," he tells bne. "We find ourselves a counterbalance that presents the world as it is today, without looking back into history."

MoMA Warsaw was established in 2005 in temporary quarters just as many Polish artists were beginning to attract international attention. From its first days, it has been actively pursuing what Andino Velez calls "a debate about modernity."

This involves engaging local communities in cultural projects, especially since many inhabitants have moved to Warsaw for its career opportunities but have little emotional connection with the city.

Culture has never been lacking in Warsaw – per-capita spending on culture, which accounts for 4% of the city budget, is the highest in Poland – but the city is mainly seen as the venue for business and politics. "We were so busy making money and raising the standard of living that for the first 15 years, culture was not strengthened," says Grzegorz Piątek, artistic director for the Warsaw 2016 application. "Now one of our goals is to transform the city through culture."

Another goal is to increase the visibility of the commercial creative sector – advertising, film, graphic design, furniture making – which would help associate Warsaw with creativity. City authorities could commission poster designs, leaflets or even seek an inno-

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vative design for the city's ugly bus tickets, Piątek says.

Music to the ears of Poles Warsaw's second flagship project will be a €100m centre for the Sinfonia Varsovia Orchestra on the site of a former veterinary school in Praga, one of the poorer districts. It would be the first major cultural attraction on the city's right bank, and would draw the populations on both sides of the Vistula closer together. The centre, designed

by Austrian architect Thomas Pucher, will include an 1,800-seat terraced "vineyard" concert hall with world-class acoustics, several rehearsal halls, education and workshop facilities and a small hotel for artists in residence and music lovers on vacation.

Central Europe

The orchestra came into being by a combination of chance and quick thinking. Its predecessor, the Polish Chamber Orchestra, invited the legendary violinist Sir Yehudi Menuhin to Poland in 1984 to participate in a concert both as soloist and conductor. To accommodate the repertoire, the orchestra expanded its ranks to 40 members by recruiting talented musicians from all over the country. The concert, broadcast on radio and TV, was such an overwhelming success that the group immediately became a permanent ensemble consisting of 24 strings and a double wind section – with Yehudi Menuhin signing on as principal guest conductor. The orchestra has performed all over the world; of its 130 concerts last year, only 35% were in Poland.

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Its director, Janusz Marynowski, admits the group travels so much "because we are homeless." He said the centre would attract more international culture to Warsaw because the ensemble has been invited to perform with artists the world over, but cannot issue many invitations in return. The project still needs the approval of city officials.

Marynowski, Piątek and Andino Velez all worry about what might happen if the culture title goes to another contender. "We are in for an uncertain future," says Piątek. "That's why we need the title. The projects can be quite vulnerable, because of the scale of ambition and the costs."

"Warsaw is a city of chaos, improvisation, unpredictable processes"

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An over-basted Turkey bne Is the Turkish economy overheating? Data for March provide the strongest evidence yet that it is.

On May 11, Turkey's central bank released preliminary balance of payments data for March that showed a record monthly current account deficit, taking the annualised deficit over the $60bn mark, another record, and equivalent to 8.1% of GDP. "To give some perspective as to the pace of deterioration on the current account, the monthly deficit in March was not that far short of the full-year deficit posted in 2009 of $14bn," says Tim Ash of Royal Bank of Scotland.

Predictably, a large part of the deterioration on Turkey's current account reflected a worsening in the merchandise trade account, which also posted a record deficit of $8.3bn in March, more than double the year-earlier level of $3.7bn. While exports posted a robust 17% year-onyear increase, export growth was running at 45.4%.

All this strongly suggests that the Turkish central bank's unorthodox efforts to rein in domestic demand – which involve holding interest rates low, while tightening domestic liquidity by hiking reserve requirements on banks – aren't working, or at least not working rapidly enough. "The policy of holding policy rates low is supposed to cap hot money inflows, but the data for March suggest the policy is not working, or if it is, one only has to imagine the sheer weight of portfolio/hot money inflows had the policy not been in place," says Ash. In the International Monetary Fund's (IMF) latest table of "overheating indicators" in the G20 released in April,

Turkey's canal dreams

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new financial district is planned for Atasehir, a booming municipality on the Anatolian side of Istanbul, as part of a goal by the government to turn the city into a new global financial centre similar to New York or Shanghai. Domestic politics and practicalities threaten to intrude, however.

The $1bn development in Atasehir, which is expected to serve 20,000

people, will include 1,500 residential units, parks, a five-star hotel, and offices and conference facilities. Planned wind turbine technology and rainwater collection sites will make Atasehir one of the largest green developments in Turkey.

Numerous banks have bought land and are preparing to move their headquarters there, hoping to benefit from the new financial district through an effect

Turkey sat comfortably in the bottom half of the table with relatively low signs. These latest worrying numbers will no doubt focus attention on the Turkish economy's Achilles heel and lead to a less-favourable position on the IMF's table next time around.

Overheating Indicators – G20 Summary Output relative to trend

Output Unem- Inflation Fiscal Real interest gap ployment balance rate

Argentina Brazil Indonesia India China Korea Saudi Arabia Australia Germany South Africa Turkey United Kingdom Canada Japan Mexico Russia France Italy United States Sources: Haver Analytics; and IMF staff calculations.

David O'Byrne in Istanbul

known as clustering. "If you have all the big banks in one area, you will have all the professional services. Despite technology, somehow people still like to be located together," says Mark Yeandle of British consulting firm Z/Yen, which produces a survey of global financial centres every six months.

Turkey's Banking Regulation and Supervision Agency, Capital Markets Board,

"As a logistics engineer, I think the canal a great idea – but it will be very difficult to build and will cost a lot more than they predict"

and the Turkish Banks Association are also expected to move to Atasehir, along with the Istanbul Stock Exchange. The Islamist-rooted ruling Justice and Development Party (AKP) has even introduced a motion in parliament to amend a law stipulating the central bank be headquartered in Ankara, paving the way for its move to Istanbul.

Plans for the new financial district date

back to 2006. The global economic crisis intervened, but with the economy now booming, the AKP is seeking ways to expand Turkey's importance as an economic powerhouse, claiming it will be among the top-10 economies in the world by 2023.

Istanbul's growth appears unstoppable, driven by a rapidly growing, young population and directed by the

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Housing Development Administration (TOKI), which is directly connected to the prime minister's office. "In the last seven years, TOKI began building 483,287 dwelling units, 350,000 were completed, and the prime minister ordered TOKI to construct 500,000 more dwelling units by 2023, the 100th anniversary of the establishment of the Turkish Republic," says Tahire Erman, a professor of urban development and political science at Ankara’s Bilkent University.

Many are enthusiastic about the plans for Istanbul, yet some urban development experts such as Erman say the new financial district will overburden Istanbul. "It is already overgrown, and there are already many problems in the provision of infrastructure and municipal services to the city," she says.

There is certainly still much work to be done. Z/Yen's latest survey of global financial clusters ranks Istanbul at just 71 out of 75 global financial centres.

Yeandle explains the city is currently a "local diversified" financial centre, or one that serves nearby countries such as those in the Balkans, Middle East and Central Asia, as opposed to a truly global centre such as London or New York. "The infrastructure is not bad; access to the international market is not too bad; the availability of people – all those factors are good," he says. "[But] Istanbul needs to improve its business environment, the ease of doing business, and operational risk and corruption perception."

Talk of Istanbul elevating its status as a global financial centre and other sublime goals usually linked to the country's heady GDP growth also mask

"The same problem applies to a canal as to a pipeline – if one is free and one has a tariff, then there has to be a group agreement between oil shippers as to how much oil they send through each"

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Southeast Europe

Possible projects proliferated: it cost little to have a project up your sleeve and, if nothing else, it enhanced the value of the land on which it was to be sited. Figures reached surreal levels. Bulgaria's total installed capacity at present – nuclear, conventional, the lot – is around 11,500 megawatts (MW). And, hydroelectric power plants apart, existing renewable capacity comprises just 465 MW worth of wind and 21.4 MW of solar. But add up all the renewable-based projects that have been, in some sense, proposed and you get upwards of 14,000 MW. Even those for which preliminary or final grid contracts have been signed add up to more than 6,000 MW.

a fragile economic situation. The AKP might have won plaudits for the eight years of relative political stability and economic growth it has brought to Turkey, yet observers aren't convinced that enough has been done to counter the country's traditional boom-and-bust cycles. "Turkey's position as Emerging Europe's star performer is looking increasingly precarious," warns Neil Shearing of Capital Economics.

Empire dreams Stoking a growing polarisation in the country, the AKP's opponents are trying to undermine the idea of moving the central bank from Ankara with conspiratorial criticisms, such as alleging it would allow government supporters to be appointed to key financial positions.

"In ideological terms, the AKP wants Istanbul, which was the capital of the Ottoman Empire, to increase its domination and power over Ankara, which is the capital of the secular Turkish Republic," argues Bilkent University's Erman.

The Turkish daily Milliyet reported in November 2010 that draft legislation currently in parliament has the central bank moving within two years. However, Turkish opposition leader Kemal Kilicdaroglu of the People's Republican Party tells bne that this is unlikely, with the proposal moving slowly through parliament and modern technology making such a move unnecessary anyway. "There is no logic to the move," says Kilicdaroglu.

Unfortunately, logic, some would argue, is hardly equal to ideology for a government that is increasingly being accused of silencing critical voices and attacking press freedom. While still the market favourite, the AKP is dismaying some supporters with its increasingly autocratic signals, especially considering the party's intention to rewrite the constitution following the June 12 parliamentary elections that it's set to win by a wide margin.

Turkey returning to its Ottoman-era prominence, when Istanbul was a critical international hub, is a top priority for the AKP. Yet no-one misses the absolutism of the Sultanate.

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Bulgarian renewable energy law is no green light Sandy Gill in Sofia

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s Kermit the Frog once observed, it's not easy being green. Legislatively speaking, Bulgaria's decision-makers have been trying for the last 15 months. In that period, they've gone through draft after draft of a new Law on Renewable Energy Sources that's supposed to update the rules on green energy and bring them into line with the latest EU norms and policies.

The latest draft cleared parliament just before Easter and, it emerged on May 3, President Georgi Parvanov has chosen not to exercise his suspensory veto on it, as some thought he might. And if you believe industry representatives, it seems that Sofia's Kermits have come up with something guaranteed to horrify Brussels, not to mention also trample on the Bulgarian constitution and, incidentally, kill off a rather promising fledgling industry that promised to bring in several billion euros in foreign

direct investment. A destructive feat, one might say, that's worthy of Miss Piggy herself.

Wind in its sails There's a background. The new law replaces a 2006-vintage one which had, in some senses, rather overdone things. Those producing electricity on the basis of renewable energy sources, it said, were entitled not just to attractive (though annually adjustable) feed-in tariffs – a payment the state guarantees to pay for all the green electricity produced – but also, unconditionally, to grid connections immediately once their project was built. They could apply for such connections at an extremely early stage of project development and the grid operator – national power company NEK for big projects, the country's foreign-owned distribution companies (discos) for smaller ones – was legally bound to take notice.

Now, nobody thinks more than a fraction of what's proposed or even contracted will actually happen. But not knowing which fraction presents something of a grid planning problem for NEK and the discos. There's a geographical dimension, too: the windy northeast – Bulgaria's most aeolically fashionable neighbourhood by far – is also home to one of its least developed grids.

There's also the question of how much capacity from renewables Bulgaria actually needs. According to its EU commitments, the country must meet 16% of its final energy consumption from renewables by 2020. That, says energy minister Traicho Traikov, means generating around 21% of electricity from renewable sources, compared with 15% now (which is mostly down to the country's well-established large hydro sector).

For this, say sceptics, around 2,000 MW worth of wind, solar and biomass capacity is needed: more would be wasteful because renewable-based power is expensive, though green investors say otherwise. "Even in Bulgaria, the EU nation with the lowest retail price, the wind energy tariff matches retail prices," says Sebastian Noethlichs, executive director of the Bulgarian Wind Energy Association (BGWEA). "So if there is any effect at all on prices, it should be a positive one. While fuel prices continue to rise and the real costs of nuclear multiply, [renewables] is the one power source that's bucking the trend by getting cheaper every year."

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Assorted other viewpoints and interests have fed into the political equation.

Earlier lax environmental regulation produced a crop of ornithologically doubtful wind permits that got current Environment Minister Nona Karadzhova into hot water with Brussels, making her something of an renewables-sceptic.

Agriculture officials – and those with an interest in containing land rents – have raised the (arithmetically implausible) spectre of Bulgaria's best farmland being gobbled up en masse by wind turbines.

Arguments about the supposedly cheap power offered by the controversial Belene nuclear project have formed a backdrop to the debate. NEK has certainly been concerned about grid investment costs, not just grid planning.

And some pretty scary drafts came up last year: one, for instance, envisaged precisely the sort of grid capacity tender system that ruined Hungary's wind prospects.

cost-based element couldn't drop by more than 5% in any given year). With solar technology costs expected to fall radically in the next few years, early solar investors thus stood to lose out badly. The draft put that right, applying the same tariff to a given project throughout its feed-in period – the tariff in force when capacity was allocated.

All in all, however, what had emerged

by March this year was a draft law that investors could work with. A system combining hefty advance payments for grid connections and annual regional quotas for grid capacity seemed to be a rough-and-ready way of weeding out projects that weren't serious and averting potential grid problems. The periods for which feed-in tariffs were available – 25 years for solar, 15 for wind – were retained.

And then, unluckily for said investors, came April 13.

And one tariff concern of solar investors was met: hitherto, annual adjustments applied to all capacity of a given category (for instance, wind turbines operating more than 2,250 hours a year, or photovoltaic modules of more than 5 kW), regardless of vintage. Those adjustments depended partly on general power prices (expected to rise), but partly also on costs (subject to the qualification that the

Admittedly, the draft also removed that 5% limitation for adjustments and made the price-based element 70% rather than 80% of average power prices.

Admittedly, too, this wasn't particularly welcome for wind developers, whose capital costs are lower than solar and unlikely to fall much over time, and who had been looking to a price-based upside… But overall, says Noethlichs, while the draft was "sufficiently unpleasant to stop all but the most determined – and hopefully capable – developers and investors, it was at least still workable."

Amendments Possibly emboldened by disparaging remarks on pricey renewables a week earlier by tough-talking premier Boiko Borisov, the relevant parliamentary commission introduced last-minute amendments that were promptly passed

by MPs on April 21.

Three points in particular have peeved green investors. First, feed-in tariff periods have been cut for wind and photovoltaic projects, to 12 and 20 years respectively (though currently fashionable biomass has been favoured with a 20-year period, up from 15). Second, a project's feed-in tariff is to be reckoned from, effectively, the date on which its construction is completed. That, the investors say, will make projects unbank-

"With this law we will see the destruction of years of work, future investment and jobs along with trust in Bulgaria as an investment destination"

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able: income flows just won't be predictable at the stage in the investment process when banks need to participate.

And third, projects already operating will be subject not to the existing tariffadjustment procedure, but to the new system of flat tariffs, which could be very bad news for them if they are wind projects. "As a sector we could have lived with the initial, restrictive regime," laments Noethlichs. "This final version, however, goes far beyond this in being outright prohibitive and destructive.

With this law we will see the destruction of years of work, future investment and jobs along with trust in Bulgaria as an investment destination."

And those EU obligations? "No way will they get 2,000 MW with this law," he says. "In fact, they'll probably get nothing beyond what's already in place and what's almost built. So they'll be lucky to reach 800 MW." Noethlichs and his friends still have a trick or two up their sleeves, however.

They had hoped for a suspensory veto from the president – who had seemed sympathetic – though this hasn't materialised. Positioning himself for politics after he leaves office this autumn, Parvanov may not be too keen to champion the less-than-populist cause of renewables.

But there's also Brussels. The law in its present form violates all manner of EU principles to which Bulgaria is committed, argue the green investors: that renewable-based power should have priority access to the grid, for instance; that there should be no unnecessary hindrances to grid access; and that power regulation should be of a "proportionate level." All this will be pointed out to the European Commission.

There's also the national constitution.

That forbids retroactive and discriminatory legislation. And this law is both, argues BGWEA. True, appeal to the Constitutional Court is possible only by the president (who seems to have declined) or a minimum of 40 MPs, and Noethlichs isn't too optimistic about those. But you never know. As any princess will tell you, frogs can sometimes come good in the end.

A food fight in the Balkans

Photos: www.agrokor.hr

Guy Norton in Zagreb

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obody could ever accuse Ivica Todoric, owner of Croatia's biggest private company Agrokor, of being a quitter. In recent years, he's tried to snap up supermarkets in Russia, Serbia, Turkey and most recently Slovenia, in an attempt to catapult his food and drink empire from being a big fish in the small but profitable Croatian retailing pond, to one with true international scale and reach. But on each occasion he's failed to land his acquisition target, leaving him increasingly vulnerable to competition from major global retailers that have either already entered or are considering entering the retail arena in Southeast Europe.

Todoric's latest setback came with the news on May 4 that Slovenian brewer Pivovarno Lasko Group had declined its offer to buy the 23% stake in Slovenia's leading supermarket chain Mercator Poslovni Sistem that it holds. If Agrokor's bid had been accepted, it would have netted Pivovarno Lasko nearly €200m and enabled it to make substantial progress in cutting its €450m debt mountain down to size.

Much to Todoric's frustration, however, the Slovenian competition regulator put the kibosh on the deal when it slapped an injunction on any sale of Mercator shares by Pivovarna Lasko and a number of Slovenian and inter-

Not Mr Right While few questioned the financial attractiveness of Agrokor's bid – it represented a roughly 25% premium to where Mercator's shares were trading on the Ljubljana Stock Exchange at the

"During the last few years, the region has experienced a retail revolution" national banks. Todoric had previously been favourite to land the stake put up for sale by Pivovarna Lasko after it trumped offers by private equity players Mid-Europa Partners and Warburg Pincus, with Agrokor bidding €221 per share. Although the Croatian tycoon's pitch was the most generous, it quickly unleashed a wave of protests in Slovenia from farmers, trade unions and politicians that made the takeover bid front-page news for weeks on end in March and April.

time – the main point of contention was whether Todoric's Agrokor would be a suitable owner of Mercator, which many Slovenian regard as a national treasure.

Among the first to voice concerns about Agrokor's intentions was Slovenian Agriculture Minister Dejan Zidan, who feared for the future of Slovenia's food industry if Agrokor's bid was successful. Agriculture and food production employs roughly 100,000 of Slovenia's 1.9m population and Mercator alone buys around 40% of all the food produced in the country. Agrokor not only owns Konzum, Croatia's biggest

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supermarket chain, but is also a major food producer in its own right. Zidan expressed fears that Slovenian products would be forced off Mercator's shelves if Agrokor managed to eventually wrest control of the retailer. "It is certainly a legitimate interest of the Slovenian government to support our food producers and to have a company [Mercator] that will continue to expand and develop on other markets in the region as an independent company," Zidan told Slovenian business news portal Finance.si.

Another politician to weigh into the debate on the rights and wrongs of selling Mercator to Agrokor was former economy minister Matej Lahovnik, who while conceding that Pivovarna Lasko needs to offload its stake in Mercator to help clear its debts, questioned the wisdom of selling the highly profitable Mercator to the highly indebted Agrokor. In 2010, Mercator's net profit surged 44% to €30.4m, making it an attractive source of cash flow for Agrokor, which has to pay off a €550m high yield bond in 2016 on which it's paying a hefty 10% annual coupon.

Commenting on Agrokor's bid for Mercator, Lahovnik said: "It looks like a sick tiger wants to eat a healthy tiger so that he can become powerful again."

Todoric did at least enjoy the support of his own government though, with Croatia's agriculture minister, Petar Cobankovic, telling Croatian daily Jutarnji List: "All those who want to invest in Croatia are welcome, and we expect the same treatment for our businesses who want to invest abroad, including Agrokor."

With the Slovenian competition authorities having at least temporarily frustrated Todoric's advances, the question now is where both Agrokor and Mercator go from here.

"All those who want to invest in Croatia are welcome, and we expect the same treatment for our businesses who want to invest abroad, including Agrokor"

In Slovenia, the favoured option is that Pivovarna Lasko and Mercator's Slovenian bank creditors pool their more than 50% holding in Mercator and offer it for sale in a new public tender later in the year, in the hope of attracting an offer from a cash-rich major global retailer. On May 10, Finance Minister Franc Krizanic told the Delo newspaper that Pivovarna Lasko and the other owners of Mercator would probably organise another sale of the retailer by the end of the year, and that Mercator should be bought by a "strong and strategic" company. Lahovnik has called for any future bid for Mercator to preclude it being bought by Mercator's direct rivals in Southeast Europe.

Meanwhile, Todoric it seems has not given up hope of securing at least a slice of Mercator. According to Croatian weekly Vjesnik Agrokor, Todoric is considering building up a position in Mercator through the purchase of shares on the Ljubljana Stock Exchange. Agrokor believes a tie-up of its retail chain Konzum and Mercator "would create the most successful retail company in the region."

Through this merger, Agrokor would go some way to bolstering its business against the influx of retail giants that are entering the region, attracted by its 28m aspiring consumers. "During the last few years, the region has experienced a 'retail revolution'," says GFA Consulting Group. "Supermarkets and hypermarkets have been opened, and consumption has strongly shifted from smaller shops and groceries to supermarkets.

This trend seems to have been accelerated during the food price crisis in 2008 and the financial crisis in 2009."

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Could Croatia be first to reject EU membership?

Guy Norton in Zagreb

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hock and awe. Originally conceived as a military doctrine by a couple of geeks at the US National Defense University to describe the tactics applied to the attack on Iraq in 2003, this phrase could just as well apply to the reaction of the Croatian public in the wake of the International Criminal Tribunal for the Former Yugoslavia (ICTY) verdicts on a brace of Croatian officials recently sentenced to long prison sentences for their roles in the endgame of the break-up of the former Yugoslavia.

After yet another lengthy trial – seemingly a speciality of the ICTY even though it always claims its goal is to deliver speedy justice – Generals Ante Gotovina and Mladen Markac received initial verdicts of 24 and 18 years imprisonment respectively. For those living outside the former war zone, the verdicts seem like merely the latest in a series of decisions that have served to reinforce international prejudices about the tribal nature of conflicts in what erroneously or not is termed the Balkans.

In August 1995, Croatia's Operation Storm – named with more than a nod to 1991's Desert Storm attack on Iraq – seemed to have provided a convenient, if bloody, end to the battle of wills between a secessionist Croatia seeking to break away from the dominance of the Serbian authorities in the former Yugoslavia. An undisputed military triumph that dashed any hopes of Serbian hegemony in Croatia, Operation Storm also ultimately represented a public relations disaster for Croatia, which had long held to the maxim that it was fighting the good fight to establish once and for all its adherence to Western European liberalism. In the course of a few days, Croatian forces brushed aside feeble military resistance by the supporters of Serbian demagogue Slobodan Milosevic and effectively ended any dreams of a Greater Serbia.

But at the same time, the killing of over 300 civilians and the expulsion of at least a further 150,000 individuals – as always in the Balkans the numbers are the subject of fierce dispute – created yet another historical bone of contention in the region, whereby Croatia was seen as employing the same brutal tactics at the end of the conflict that Serbia had used at its start.

The ICTY's decision, likely to be appealed in the next couple of months, to declare that Gotovina and Markac had been culpable of crimes against humanity unleashed a veritable tsunami of outrage in the Croatian capital Zagreb, where TV screens on the city's main square, Trg

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has promised that the government will hold a public referendum on EU entry later this year. According to the latest polls, however, it's conceivable that Croatia could become the first country in Emerging Europe to reject the offer of EU membership, a development that could have serious repercussions for Croatia's economic future.

Economic fallout Based on projected EU entry in 2013, Croatia stands to gain roughly €1.7bn a year in funding from the EU, which would give a vital boost to an economy that has yet to emerge fully from a twoyear recession. GDP this year is expected to be in positive territory – forecasts are that GDP will expand by 1-1.5%. However, that would be insufficient to have any positive effect on unemployment levels in Croatia, with the jobless rate running at 19%, or over 300,000 people. While many of its regional peers have cut public spending, with an eye on the elections scheduled for the end of this year the Croatian government has maintained a

"Latest polls suggest that support for entry into Europe's elite politico-economic club has hit a record low" Bana Jelacica, transmitted the damning verdict to a disbelieving public. With Croatia's cooperation with the ICTY regarded as a prerequisite for the country's accession to the EU, the verdict has had a dramatic effect on public opinion regarding EU membership. Latest polls suggest that support for entry into Europe's elite politico-economic club has hit a record low, with just 23% of the population currently in favour of Croatia becoming the 28th member of the EU. That presents a real headache for the ruling right-wing coalition headed by Prime Minister Jadranka Kosor, who has staked her political future on completing EU accession negotiations this summer. Subsequent to the successful completion of the negotiations that have dragged on for seven years, Kosor

high level of support for the unemployed, alongside pensioners and war veterans.

Collectively, those three social groups now outnumber those in work.

All this has put pressure on the country's finances, with the budget deficit expected to continue to grow, albeit at a slower pace than previously, rising to 5% of GDP from 4.6% last year, the highest level since 2003.

Any delay to or even rejection of EU membership is likely to have a major negative effect on sentiment towards Croatia, which is struggling to retain investors' attention. Last year, for example, foreign direct investment was just €1.3bn, almost half the €2.21bn figure for 2009.

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KMG EP deputy general director, who started his 40-year career at Uzen.

"When a field is close to 50 years old, there are also many difficulties."

Although salaries are relatively high for Kazakhstan – averaging KZT240,000290,000 a month ($1,600-$2,000) for an operator – life is also tough in nearby Zhanaozen, a one-time workers camp that has now grown into a town of 120,000 people. Due to the town's isolation, food prices are well above average. Crops only grow in irrigated areas, and workers in the fields have to bandage their faces with scarves to stop the sun scorching their skin.

Like Kazakhstan's other oil towns, Zhanaozen sees periodic strikes over pay and conditions. One KMG EP official claims these are being secretly funded by ex-BTA chief and billionaire opposition supporter Mukhtar Ablyazov, who is now in exile in London.

Life after depletion Clare Nuttall in Aktau, Kazakhstan

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azMunaiGas Exploration Production is making a big push to acquire new oil and gas prospects both in Kazakhstan and abroad in order to maintain production levels as its main fields mature.

One of those major ageing assets of KMG EP, the London-listed subsidiary of state-owned NC KazMunaiGas, is the Uzen mega-field in the western Mangystau region. Drillers first struck oil there back in 1960, long before international consortia arrived in Kazakhstan to develop the massive offshore Tengiz and Kashagan oilfields, and the field has been producing ever since.

Conditions are tough at the field, where some 6,000 nodding donkey wells, 3,400 currently in operation, are spread across 60 square kilometres of desert. Temperatures soar to 60°Celsius in summer and fall to -30°C in winter, when oil has to be heated to stop it from solidifying. Since fresh water is scarce in this part of west Kazakhstan, the Soviets decided to extract oil using sea water pumped from the Caspian, which adds to the complexity of the process.

"This is a complicated oilfield and lifting costs are high compared to other fields.

In Soviet times, Uzen engineers were in high demand because of their experience here," says Vladimir Miroshnikov,

What happens uzen?

But by far the biggest fear in Zhanozen is what will happen when the Uzen oilfield is exhausted. Although the Kazakh government is trying to turn Mangystau into a logistics hub, with the construction of the Kazakhstan-Turkmenistan-Iran railway (which runs to Zhanaozen and is due to open later this year) and the Kenderly resort and special economic zone on the Turkmen border, the region is still heavily dependent on the oil industry.

Production at Uzen has fallen somewhat since 2008, and KMG EP says that it is investing into new seismic monitoring technologies that will allow it to detect new wells, extending the life of the field and raising - or at least maintaining - production. Miroshnikov describes the field, which has recoverable reserves of 150m barrels, as still "quite prospective". The company has also bought up neighbouring blocks for exploration work. "Even within Kazakhstan, we are competing with multinational companies, so we can't rest on our laurels, we must maintain our production level and market position," chairman of KMG EP's management board, Askar Balzhanov, told journalists on May 18. "Our 10-year strategy is to become one of the top-30 largest oil and gas companies in the world."

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In 2010, KMG EP formulated a strategy through to 2020 that aims to reduce the average maturity of its assets through exploration and new acquisitions both at home and abroad. It is aiming for at least a 120% average annual reserves replacement ratio. In February, the firm said that its reserves replacement ratio for the five years since the IPO reached 178%.

KMG EP has acquired several new exploration assets within Kazakhstan, most recently the Fydorovskiy block through its purchase of 50% in Ural Group on April 19. A week earlier, the company bought up four exploration contracts.

However, according to Dastan Abdulgafarav, managing director for new business development, there are limited acquisitions prospects onshore in Kazakhstan.

"Our assets are mostly mature and we need to bring down the maturity of our assets because investors are not interested in stakes in a company whose productivity level is decreasing," Abdulgafarav says. "We need to increase our level of reserves. We have high hopes of offshore, and are also looking at exploration and production assets abroad."

KMG EP denies the company, which raised over $2bn through its IPO, will be used to fund parent company NC KazMunaiGas's acquisition agenda.

"KMG EP is publicly traded, and is not a cash cow for anybody," Balzhanov said.

Internationally, KMG EP is looking for acquisitions in the $500m to $1bn range. However, though it has looked at 30-40 potential targets in Russia, it hasn't so far found a suitable one to buy. "We have been looking for four years, but so far have not been able to bring a single deal to fruition. The specifics of the Russian market make it difficult to invest there for the time being.

If we go into Russia in the future, we would form a joint venture to minimise the risks," Balzhanov told journalists.

KMG EP has also been unsuccessful in Turkmenistan, another potential market, but one where the onshore blocks are reserved for domestic state-owned companies. Offshore, the most promising areas lie in areas of the Caspian Sea that are disputed with Azerbaijan.

Eurasia

KMG EP said its deal with the Iraqi authorities over the Akkas gasfield fell through in May mainly because the terms offered by the Iraqi side were unacceptable. Balzhanov said KMG EP's decision to withdraw from negotiations was not political, but added that "the political realities do determine the willingness of any company to invest in Iraq."

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"The events in the Middle East did not tend to make Iraq more attractive," he said. "For us, one condition for going into Iraq was that we would be able to export via Syria, as Akkas is near the Syrian border. With Syria now in upheaval, even if we could produce gas, selling it would be difficult."

Straight as an Aral

Clare Nuttall in Astana The Aral Sea basin is possibly the second most prospective area for oil and gas in Central Asia after the Caspian basin, according to Askar Balzhanov, general director and chairman of the management board of KazMunaiGas Exploration Production (KMG EP).

So far, drilling in the Aral region of Kazakhstan by KMG EP, the Londonlisted subsidiary of state-owned NC KazMunaiGas, hasn't yielded substantial results. "Two wells have been drilled since 2005 – the outcome wasn't negative, but it was hard to decipher because of big faults in the area," Balzhanov told journalists and analysts. "However, the Aral Sea area is promising for exploration and production."

Tethys Petroleum is already operating in the North Ustyurt basin to the west of the Aral Sea. On the Uzbek side of the Aral basin, exploration work is more advanced. An international consortium comprising state-owned Uzbekneftefas, Russia's Lukoil, Malaysia's Petronas, Korean National Oil Consortium and China National Petroleum (CNPC) signed an agreement to explore and develop fields in the region in 2005. Five years later, in June 2010, the consortium announced it had discovered a gasfield at the West Aral structure.

Speaking at the KMG EP investor day on May 17, Balzhanov said that the firm was in talks with two companies involved on the Uzbek side, who "are possibly interested in the Kazakh side too. In the fullness of time, we expect to begin operations." Balzhanov did not name the companies.

The Aral Sea, which has dried up to a fraction of its original size as the rivers that feed it have been diverted for irrigation, is one of the world's worst ecological disasters. The sea's surface area fell from 68,000 square kilometres in the early 1960s to just 17,160 square kilometres by 2004, and split into two smaller seas. Efforts to revive the smaller Aral Sea, which is mainly located in Kazakhstan, by building a dam to stop waters from the Syr Darya river flowing into the larger Aral Sea have had some success.

Balzhanov acknowledged that the Aral region was "probably on a par with the Caspian in terms of environmental vulnerability" and said the company would "comply 100%" with any directives from the Ministry of Environmental Protection if it starts work there.

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Observers say that the anti-corruption campaign is proving to be more than just empty rhetoric. "The initial reaction was scepticism, but we have seen some progress already at lower levels of government," says Clemente Cappello, CEO of Caucasus and Central Asia-focused Sturgeon Capital. "President Aliyev has since taken a stand against the monopolies within the Azeri economy. It's not yet clear whether there will be real action in this area, but acknowledging the problem is the first step."

Overdue changes come to Azerbaijan Clare Nuttall in Almaty

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fter a long wait, foreign investors in Azerbaijan are reporting signs of a new political will to reform two key areas, fighting corruption and developing the local capital markets – both of which should help the oil-rich economy to diversify. The financial sector remains the easiest way for foreign investors to access the market, but other sectors including IT, tourism and agriculture also look promising.

One of the most important weaknesses that the government is trying to address is corruption, which has been a major limiting factor on both domestic and foreign investment. Transparency International put the country in 134th place on its ranking of 178 countries in October.

On January 27, officials announced a no-tolerance policy for graft and several local investigations were launched, leading to dozens of state employees being fired, ranging from the head of Azerbaijan’s penitentiary service to several officials from the powerful Ministry for State Emergencies.

Clearly, the launch of the new anticorruption initiative was in response to the wave of protests in the Middle East and North Africa, and the fear in government circles that revolution-

A second area that has long been of concern to investors is Azerbaijan's stock market. The domestic capital market is under-developed and, aside from the bond market, is lacking in activity. The technical changes that need to be made are relatively straightforward, and include changing some laws and removing the capital gains tax, but until recently the political will for reform had been lacking.

Now this too has changed. The World Bank on March 17 approved a $12m loan to support the Capital Markets Modernisation Project in Azerbaijan. This is intended to improve access to finance and contribute to faster economic growth of the non-oil economy. "The government is currently going through its internal approval process. We hope the agreement will be signed in May and the project will become effective soon

"President Aliyev has taken a stand against the monopolies within the economy. It's not clear whether there will be real action, but acknowledging the problem is the first step." ary fever could also sweep through Azerbaijan. The Azeri opposition has tried to emulate these efforts but so far with little success. Two recent protests organised via social networking sites were broken up almost as soon as they started, while a third, planned for April 16, was thwarted from the outset by the police and security forces.

after that," World Bank spokesperson Saida Bagirli tells bne.

Observers say these changes will undoubtedly help diversify the oil and gas-dominated economy, but even before that Azerbaijan was experiencing increasingly strong growth outside its energy sector.

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Model country The fastest-growing economy in the world in the mid-2000s, Azerbaijan was never going to sustain such growth, stemming as it did from such a low base.

Even so, Azerbaijan managed to maintain steady growth throughout the crisis, and GDP was up by a healthy 5% in 2010. This is expected to decline to 2.8% in 2011 and 2.5% in 2012, according to the International Monetary Fund.

The latest IMF report from Azerbaijan points out that, "Non-oil economic growth was strong in 2010, largely spurred by high public investment spending." The European Bank for Reconstruction and Development (EBRD) also reports the potential of sectors outside of natural resources, forecasting 12-14% growth in the nonoil sector this year.

However, Azerbaijan remains an oil and gas related economy and is likely to remain so for the near future, says Cappello. "A lot of the growth in the coming years will come from gas projects. The country will be fine following this model for the next five to ten years; after that it is harder to say," he says. "The big question is whether Azerbaijan will become another Kazakhstan, or follow the Gulf state model. We are getting mixed messages at the moment."

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ease'. Azerbaijan is richly endowed with natural resources, but also has great potential for agriculture and tourism, the IT sector is growing, and manufacturing is picking up recently."

The financial sector is already the best way for international investors to get exposure to the Azeri market, according Sturgeon Capital's Cappello. The sector remains relatively untapped, apart from commitments by a couple of investment funds and international financial institutions such as the EBRD and the International Finance Corporation. Nor has the sector seen an influx of international banks, although more are expected. "The financial sector is a good place to get exposure to the Azeri market. It is an investor friendly sector, and as yet the level of external financing is low. There are good prospects for the sector, although with 42 banks in a small economy, some consolidation is expected," says Cappello.

Azerbaijan's financial sector compares favourably with that of Kazakhstan, which suffered terribly during the crisis.

While Kazakh banks had rushed to borrow on international credit markets, exposing them to the crisis, their Azeri counterparts remained quietly dependent on local funding. This has resulted in a sector that is still relatively small

compared with the size of the economy – the ratio of bank assets/GDP is just 26% – but without the overhang of bad debts that other countries' banking sectors are still struggling with. Texnikabank's Huseynov says that the proportion of foreign borrowing by Azerbaijan banks was only at 17-18% as of the end of last year. However, this situation is set to change in 2011, with several banks including Texnikabank, International Bank of Azerbaijan (IBA) and Pasha Bank considering tapping international capital markets.

Huseynov says there is considerable scope for expansion. "For Azerbaijani banks, there are two drivers for growth. First, the expansion of banks' funding bases, allowing them to increase lending. Second, the government strategies to encourage cashless transactions," he says.

Texnikabank has declared 2011 as the year of plastic cards, and is concentrating on projects for Visa and Mastercard.

Meanwhile, Azerbaijan's largest bank, IBA, announced in April that it has launched a new scheme to allow drivers to pay their traffic fines by card through POS terminals being set up in State Traffic Police checkpoints and vehicles.

IBA substantially expanded its electronic banking channels in 2010.

Statistics also show some success in diversification. For example information and communications technology, or ICT, is being vaunted as the hot new sector, having grown an average of 30-35% a year during the last seven years. The sector attracted $1.5bn of investment over the last six years, 21% of which was from abroad, Azerbaijan's Deputy Minister of Communication and Information Technologies Elmar Valizadeh told a recent investment summit in Baku, APA reported.

"The government has launched a number of measures to promote the non-oil sector of the economy, including launching a fund to support banks' lending to SMEs," Samir Huseynov, chairman of the board at Texnikabank, tells bne. "We need to achieve growth outside the oil sector in order to avoid the 'Dutch Dis-

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"The big question is whether Azerbaijan will become another Kazakhstan, or follow the Gulf state model"

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Kobalia told Reuters on May 5 that she expects foreign investment to double to $1bn this year, with the energy and tourism sectors leading the way.

Exports also remain a problem; Georgia's highest export is the re-export of new and used cars, followed by ferroalloys and scrap metal.

By Narmania's estimates, at the end of 2011, 47% of Georgia's GDP – an estimated GEL9bn – will be in foreign debt. The economy is forecasted to grow 5.5% this year. "Honestly, [the second Eurobond] is not that bad of a step – but also not that great," Narmania says, noting that the debt has been postponed, not eliminated.

Georgia's debt to the world Molly Corso in Tbilisi

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ound fiscal planning is helping Georgia battle double-digit inflation and manage its large foreign debt, according to a May report by the International Monetary Fund (IMF). But critics maintain the high level of debt is compounding deep-rooted problems in the economy.

Over the past three years, concerns over a looming principal payment for a Eurobond due 2013 have stalked Georgia's government, especially since the bond was set to mature during a presidential election year, traditionally a period of high state spending.

In April, however, the Georgian government neatly circumvented the issue by selling a second $500m Eurobond.

The proceeds were used to pay off the 2008 issue, postponing the real cost to the country until 2021. The government initially raised funds off a $500m, five-year, 7.5% Eurobond in 2008 in the months before the August war with Russia and the global financial crisis.

The decision to refinance the first Eurobond with a second offer – with a longer maturity period (10 years) and lower interest rate (6.79%) – was a coup for the government, Vakhtang Lejava, a chief advisor to Prime Minister Nika Gilauri, tells bne. He stresses that interest from investors in the second Eurobond was high. "The trust was there, I think that matters. Plus I think it is very prudent," Lejava says.

But critics like economist Davit Narmania argue that while conditions for the second Eurobond were good, that doesn't change the fact that the economy is not growing fast enough to support the weight of its foreign debt.

Weighed down The economy, which registered 6.4% growth last year, has not fully recovered from its 2% contraction in 2009.

Foreign investment in 2010, $553m, was a fraction of the $2bn the country received prior to the crisis in 2007.

Georgian Economy Minister Vera

He notes that with the country's jagged growth history, poor investment inflows, high trade deficit and doubledigit inflation, the economy has not rebounded enough to support a large foreign debt. "We have growth in the economy, but that is not sustainable growth… We have, very often, shocks to the economy and due to that there is economic growth but not stable growth."

But Lejava shrugs off concerns about the size of the debt. "Of course, if we are in the ideal world we can judge that you have to repay your debt and have zero debt," he says. "But business does not work like that. They need to be leveraged and governments also don't work like that."

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Gardner notes that a debt level of around 40% of GDP is not "inordinately high" and the second Eurobond is a "one for one" – basically a refinancing mechanism. Rolling over Eurobonds, he adds, is common for governments.

"I don't think there is any concern with this level of debt as long as there is a process to bring it down very slowly over time," he says. "What I think the government is looking at and talking to us about is a fiscal plan over the next couple of years that insures that the debt does not continue growing over time, but starts going down."

Inflation, officially reported at 13.5% in April, should go down this year, he says, since it is due to international high food and fuel prices, not bad fiscal policy.

Narmania, however, stresses that better debt management is imperative to turn the newest Eurobond liability into a mechanism to create sustainable growth, not just refinance the country's debt burden. "The government needs to prepare a good public debt payment system – when they need pay, how much and [steps], so they don't take on more debt," he says. "When they take some, they need to use it to pay for those things that stimulate growth in the economy."

A youthful campaign

Molly Corso in Tbilisi After two years of falling foreign investment, the Georgian government is betting on a team of business students to reenergise its push to attract investors.

With annual foreign direct investment (FDI) down 16% in 2010 – dropping from $658.4m to $553.1m – the government is looking for new ideas, Deputy Economic Minister Irakli Matkava tells bne. "We understand that today competition for FDI is tough," he says. "There is a noise screen we have to break through. In that sense, it is very important to have a very clear message, to have the right differentiation strategy, to stand out, to attract attention."

Attracting investment is a key priority for the government, and Tbilisi – through a startling number of economic ministers and investment gurus – has created a dizzying history of efforts to entice investors to choose Georgia, ranging from large-scale privatisation to radical market liberalisation and a presidential push for surf-ski tour packages. Past attempts at promotion – Georgia as the birthplace of wine, the heart of the Silk Road, the paragon of liberalisation – fell flat in the face of the global recession and the increased competition for fewer investment dollars.

The latest wheeze is to pay MBA students from the Haas School of Business at the University of California at Berkley a mere $30,000 to zero in on the country's strengths that will strike a chord with investors and push them to pick Georgia. Matkava, the former head of Georgia's National Investment Agency, says the government is working on the same thing, but hopes the students will bring fresh insight for policymakers.

Matkava says the idea to hire the students came from a meeting between representatives from the school and Economic Minister Vera Kobalia during a conference in California last year. "The major value we see in this [is a] group of people who can take a look from outside, who can see things in a new light, a fresh light, who can find things unexpected to us, which is quite important," he says. "We are working toward strengthening certain things, working toward certain aims. So it might happen that we don't see some of the new things that might be out there."

Lejava adds that the government's policy of economic openness and flexibility has "saved it" from the worst of the financial crisis and post-war shocks.

And, he says, the country's foreign debt is financed at a low annual rate, at an average of just 2.3%.

Edward Gardner, the head of the IMF mission to Tbilisi, tells bne that Georgia's current account deficit remains a concern, but not an immediate one.

Fitch estimates that the current account deficit came in at 10.5% of GDP in 2010, down from 11.3% in 2009 and an average of 19.2% during 2006-08.

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The students, who are arriving in Georgia in May to conduct interviews on the ground, are expected to compare how other countries are analysing their own strengths and weaknesses, and how that impacts their marketing techniques.

"The second Eurobond is not that bad of a step – but also not that great"

Georgia has advertised, with mixed success, on CNN and other large media outlets. Now the focus is on "direct contact" with businesses to target decision makers and ease the influence of lingering images of the country at war in 2008 – an event Matkava delicately refers to as the "Russian issue". "Especially with the Russian issue two years ago etc., the perception problem should reasonably be there in certain parts in the world and among certain groups of people," he says.

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loans, while many businesses in other sectors took on too much debt before the crisis and are still deleveraging.

Banks have until recently been unwilling to take on new risks while non-performing loans continue to rise. However, corporate lending was flat or rising versus the month before in the second half of 2010, and the sector posted 1.2%

"Overall the market is very attractive – there is a sense that people want to make things better for the future"

New credit cycle begins in Kazakhstan Clare Nuttall in Almaty

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he economic recovery in Kazakhstan, driven by strong commodities prices, helped pull the country's troubled banking sector out of the crisis. And lending, which started to resume in late 2010, is expected to pick up as Kazakhstan enters a new credit cycle.

Kazakhstan's banks are recovering more slowly than their Russian peers, even though the Kazakh economy was one of the first to exit the crisis. In its report, "Kazakh Banks: A Steppe in the Right Direction", Uralsib forecasts that positive momentum within the sector will become clearly evident in the second half of this year as the government introduces new regulations. "We see banks' balance sheets being cleaned out, provisions releases, and demand for loans returning," says the report.

"Signs of lending growth are still not

as evident in Kazakhstan as in Russia, though we would bet on the second half of 2011 when the state is to support the sector and growth."

The Kazakhstani economy was already outperforming Russia's in both 2009 and 2010, and the government expects the economy to expand by around 3% in 2011-12. "Overall the market is very attractive. There is a sense that people want to make things better for the future," says Simen Munter, CEO of HSBC Bank Kazakhstan. "We are seeing optimism in business and new investment projects being started."

But while commodity-related industries have grown strongly, other sectors, including banking, were slower to follow suit. Enterprises in the commodityrelated sectors typically have access to cheaper sources of funding than bank

year-on-year growth in December after almost a year of decline. Banking debt has also halved since its peak in 2007.

"We are counting on a turnaround in the second half of 2011, as we believe long-awaited regulatory changes will be finally introduced," says Uralsib. "This should trigger a new stage of the credit cycle with the release of provisions supporting both lending growth and profitability – as we currently see in the Russian banking sector."

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the bank's deputy chairman, Rauan Daukenov, points out that, "Although some difficulties connected to the global crisis are behind us now, there are still a number of post-crisis matters we as well as most our peers have to deal with, such as deterioration of the loan book and asset quality."

The Uralsib report notes that asset quality remains one of the major risks for the Kazakh banking sector, as banks have so far preferred not to write off bad loans in the "absence of a proper mechanism."

The share of non-performing loans has remained above 30% since June 2009, though it had fallen to 33% in February after peaking at 36.5% in December 2009 (see graph 3). "The banking sector is head and shoulders better than a year ago, but there's still a long way to go," says Eggleton. "Although there has been incredible change, and the risk of a sectoral failure is pretty much gone, that doesn't mean that all banks are good.

For the next one to five years, some banks will be spending a lot of time dealing with the problems of the past rather than focusing on the opportunities of the future."

End of the line

Clare Nuttall in Almaty Almaty's metro has become known locally as the "golden metro" because of the amount of money sunk into the project over the last two decades.

After many false starts, trains are now being tested, and the latest date for its opening is December 2011.

Construction of the metro started back in 1988, before the break-up of the Soviet Union. Construction continued with stops and starts through the cash-strapped 1990s and the pace was stepped up a little in the 2000s. Despite a push by the government and the Almaty city authorities to get the metro ready by February for when Kazakhstan hosted the Asian Winter Games, the deadline was missed yet again.

One western engineer, examining the metro, said it looked like "a museum of technologies of the last 20 years." To the layperson, it is more like a miniature version of the Moscow metro, but with each station themed to illustrate a different aspect of Kazakhstan.

Independence day The launch is now scheduled for December 16, the 20th anniversary of Kazakhstan's independence. The first line will have seven stations, and seven trains supplied by South Korea's Hyundai will initially operate on the line, with a capacity of around 300,000 passengers a day.

Speaking during an inspection of the second section of the first line, Almaty akim (mayor) Akhmetzhan Yessimov said that the government was providing an additional KZT2.5bn ($17m) of funding for construction of the metro's second line.

Customer is king Several Kazakh banks are looking to boost their presence in the retail segment of the business. "We see 10–12% year-on-year lending growth as entirely possible this year on the back of a recovery in demand, while in 2012-13 the sector may achieve 20% year-on-year growth," predicts the Uralsib report.

To tap into this market, Eurasian Bank in February took over one of Kazakhstan's largest consumer finance companies, ProstoCredit. The bank's chairman, Michael Eggleton, forecasts that the majority of the bank's growth this year will be from the retail sector.

Meanwhile, Nurbank, which launched a new long-term strategy after a change of ownership in 2010, plans to boost the share of small business and retail loans in its portfolio by 50%. However,

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The city authorities hope that when the metro opens it will ease congestion on Almaty's increasingly traffic-clogged streets and reduce air pollution. In a city originally designed for a million people, there's now double that number and more than 500,000 registered vehicles, with an additional 200,000 or more cars commuting daily to the city. "Almaty is Kazakhstan's largest metropolis, but as the city grows so does the load on the environment. More than 80% of emissions in Almaty are from transport.

The launch of the metro will help to solve this problem," Yessimov told a recent environmental forum in Almaty.

"The banking sector is head and shoulders better than a year ago, but there's still a long way to go"

In addition to the metro, there are also plans to convert both buses and private cars to environmentally friendly compressed natural gas (CNG), in a bid to improve air quality. Some 50 CNG buses have already been purchased, and the city authorities are planning to increase that number to 200. Almaty authorities plan to give preferences to companies operating CNG buses and is setting up a micro-crediting company that will offer loans to citizens willing to convert their cars to CNG. "We would like to switch the entire Almaty transport system to CNG," Yessimov said.

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82.6bn kWh to 103.5bn kWh by 2015.

Kazakhstan is currently investing in new capacity across the board – from coal and nuclear to renewable energy. Major projects include the expansion of the Ekibastuz Gres-2 coal power station and the construction of a new thermal power station near Lake Balkash, as well as the Moinak Hydropower plants in south-east Kazakhstan.

The country is also expected to get its first nuclear power plant, to be built in cooperation with Russia in the western Mangystau region. However, this is still at the early planning stages and a date for construction hasn’t been decided.

The power to attract

Clare Nuttall in Almaty

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azakhstan needs more power, so is pushing ahead with plans to create a wholesale electricity market in a bid to attract more investment to the generation sector.

Legislation paving the way for the new market has been drawn up by national grid operator Kegoc and approved by Kazakhstan’s economic policy board, headed by Karim Massimov, the prime minister. It is due to go before parliament in the near future.

“The [wholesale] capacity market mechanism will make it possible to return investments, including on renewable resources. We expect that when the capacity market is established, it will completely solve problems connected to the construction of generating plants,” Almassadam Satkaliyev, chairman of Kegoc’s management board, tells bne.

Investment in Kazakhstan’s electricity generation and transmission sector has been a matter of urgency since the

economy started to take off in the mid2000s. The slowdown in economic activity during the recent crisis gave a brief respite but demand is now expected to accelerate as the economy expands and the government pushes ahead with its

The development of the wholesale market will help bring in more investors like Malaysia’s CapAsia, a private equity fund set up by CIMB Group and Standard Bank Group, which on April 25 said they had agreed to provide $50m in equity capital to Central Asian Power and Energy Company (Capec) in Kazakhstan through its Islamic Infrastructure Fund (IIF).

“We see Kazakhstan as a primary market for IIF because of the government’s commitment to furthering private sector involvement in the provision and financing of infrastructure,” CapAsia’s CEO, Dr Johan Bastin, said in a statement.

Capec is a power generation and transport company, which is also the control-

"We expect that when the capacity market is established, it will completely solve problems connected to the construction of generating plants” industrialisation plans. Domestic consumption is also rising as the population grows and becomes more affluent.

ling shareholder in Eximbank Kazakhstan and the APF Amanat Kazakhstan pension fund.

According to Kazakhstan’s ministry of industry and new technologies, electricity consumption is set to reach 100.5bn kWh by 2015, while generation will increase from its 2010 level of

New sources Kegoc itself has already approved a longterm investment strategy under which a total of KZT530bn ($3.6bn) will be invested by 2025. It has embarked upon

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several projects, including rehabilitation of substations, transmission lines and other equipment, building a new substation near Almaty, and power lines to the Moinak power plant. Kegoc is now considering building a new 500 kilovolt north-south power line and new transmission lines to connect the west Kazakhstan regions of Uralsk, Atyrau and Mangystau to the national grid.

Interest in alternative energy has increased since the adoption of legislation on renewable energy in 2009. The share of alternative energy sources in the total electricity mix is expected to increase from 0.48% in 2010 to 1.54%

in 2015, according to Kazakhstan’s Ministry of Industry and New Technologies. “There is a good dynamic for introducing small hydropower plants in the south of Kazakhstan. Several projects to build wind farms have also been initiated recently,” Satkaliyev says.

“As the system operator, Kegoc will give maximum support.”

Some 30 per cent of Kegoc’s investment programme is expected to be funded either directly from the Kazakh government or through state holding company Samruk-Kazyna, which owns 100% of Kegoc. The electricity company is one of those earmarked for participation in

the “People’s IPO” programme, under which state companies will list around 10% of their shares on the domestic stock exchange. President Nursultan Nazarbayev has ordered that the IPOs take place before the end of this year, but a government working group is still working on the parameters.

“The IPO is a good chance for alternative direct investments for our projects, rather than receiving funds from the state budget. It is really what we need and a very necessary process,” Satkaliyev says. “It is an opportunity for us to join the stock market as a transparent company.”

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Special Report: Hot Coals

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The main problem, as with most failed takeovers, was differing views on valuations – something that promises to plague future M&A takeover in the industry, reckon analysts. NWR said its offer, which valued Bogdanka at a price/ earnings multiple of 18.1x and on a cash flow basis about 8.0x Ebitda, compared favourably with comparable transactions and trading multiples in the mining sector internationally, and so it refused to lift its bid. The Polish shareholders of Bogdanka, however, took a different line, especially over the mine's "Stefanow" expansion project, which is predicted to double capacity and to increase Bogdanka's share of the Polish hard coal market to 12% by the year 2014. "I'm sure that in some shape or form, this will happen," says Jelinek. "But will it happen on time and on budget? We assign a certain probability to that happening, while other people assign a 100% probability to it happening, and that's where the disagreement existed."

The changing coal face of Central Europe

Nicholas Watson in Prague

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he long-awaited consolidation of Central Europe's coal industry has yet to materialise, a fact exemplified by last year's failure of Czech coal mining group New World Resources (NWR) to acquire the Polish miner Lubelski Wegiel Bogdanka. Even so, industry experts say the driving forces behind any consolidation are still there and it's only a matter of time before this process kicks off.

That NWR was the first to make a move surprised no-one – after all, being a consolidator of the region's fragmented coal industry was a stated goal of financier Zdenek Bakala when he took his first step toward creating NWR in 2004 with the leveraged buyout of Czech coal group Karbon Invest, which owned the country's largest mine Ostravsko Karvinske Doly (OKD). In 2007, NWR was formed to house a collection of coal mining and coking operations, which today employs over 18,000 people.

Since then, a successful IPO on the London, Prague and Warsaw stock exchanges in 2008 that raised $2.2bn plus a far-

ranging modernisation programme to improve the efficiency and profitability of NWR makes it stand out from the region's other smaller, ossified, inefficient, uniondominated and often loss-making mines, especially those in the Silesian coal basin which straddles the Czech Republic and Poland. "Everybody in the Silesian coal mining industry needs to go through a significant restructuring process – we are in great position because we have gone through the process and many of the

poration [in the UK], which makes us the best positioned in the region with good access to the capital needed to drive this consolidation process."

On October 5, NWR launched a daring €857m hostile bid for Poland's only listed coal mine, Bogdanka. The offer was attractive on several measures: a 13% premium to the pre-announcement closing stock price and a 43% premium to the price the government charged Pol-

"If you look at the Silesian mining industry, I just don't see why it should be as fragmented as it is today" things we've learned could be directly applied to any other Silesian coalminer," Marek Jelinek, chief financial officer of NWR, tells bne. "Another key reason is that we are listed on three stock exchanges and hopefully soon to join one of the FTSE indices on the back of our reincor-

ish pension funds for a stake earlier that year. However, by the end of the following month the offer was allowed to lapse amid a degree of acrimony after NWR failed to get anywhere near the 75% of shareholder votes needed.

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However, price tells only half the story.

This first ever hostile takeover attempt of a Polish company did not go down well in a country where nationalistic tendencies bubble under the surface.

Bogdanka's management fought the takeover tooth and nail from the outset, enlisting the help of politicians glad to appeal to their constituents' less savoury views about rapacious foreign capitalists. Given that the Polish state views the country's private sector Open Pension Funds, which are big shareholders in Bogdanka, as quasi-public institutions, it was easy to apply the necessary pressure to see off the bid. "The majority of these shareholders are pension funds, which depend on good relations with the Treasury in order to gain access to other privatisation deals, which in the near future will include coal producer, Jastrzebska Spolka Weglowa. Hence the fact that the Polish government – which retained 2.3% in Bogdanka after its privatisation in 2009 – opposed the sale of the Polish mining group to a Czech entity was critical in directing the pension funds to reject the bid," says IHS Global Insight.

As one banker in the region summed it up: "The price wasn't right, and the politics wasn't right."

Merger pressure For all that, the pressures forcing the region's coal mines toward consolidation haven't gone away – a fact that's been all but acknowledged by the Polish government, which appears to be trying to put the financially weak, but politically powerful, industry in as strong a position as possible before this M&A process kicks off in earnest.

During communist times, Silesian coal mines were a valuable source of scarce foreign currency and the miners a cosseted class of worker. But in the market economy, the mines have struggled to compete and the number of pits was cut from over 80 to around 30, while employment fell from more than 400,000 to about 100,000 today. Even so, the mines are too small to exist in an industry that's desperate for finance to modernise. The Financial Times quoted a mining analyst as estimating the Polish coal industry needs an infusion of about PLN20bn (€5bn) to modernise properly.

"If you look at the Silesian mining industry, I just don't see why it should be as fragmented as it is today," says Jelinek.

"Clearly, there are real synergies that can be created by combining the Silesian mining companies."

To prepare for the endgame, Polish media reported in April that the government is preparing to bulk up the mines through mergers and then float these on the Warsaw Stock Exchange. However, recent experience suggests this is unlikely to go smoothly.

The government is currently trying to privatise Jastrzebska Spolka Weglowa (JSW) in southern Poland – a stateowned company that owns five mines and employs more than 22,000 people.

JSW is supposed to make its debut on the Warsaw Stock Exchange on June 30, but even though the government has promised to retain a majority stake, the unions are still up in arms and have launched a series of strikes in protest, arguing the privatisation plans would lead to a loss of jobs and benefits.

DnB Nord Securities analyst Mikolaj Saj says such shenanigans will only ultimately have a negative impact on the valuation of JSW – something that will please miners like NWR that are looking to buy up assets in Poland. "I wouldn't rule out at all a possible repeat of our [takeover] effort at some point in the future. I think, though, that it's very, very unlikley it would happen within 12 months or so," says Jelinek.

Present in a region with 110 billion tonnes of total coal resources

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Mining in Mongolia Oliver Belfitt-Nash in Ulaanbaatar

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en years ago, the average Mongolian herder looked at coal as just a convenient, ubiquitous fuel used to heat the tent and brew tea.

Today, however, noorse (the Mongolian word for coal) is heard on the lips of hairdressers, students and investment bankers alike. Coal is now big business in Mongolia.

The Minerals Authority estimates the country's coal reserves at a staggering 163.3bn tonnes spread over 300 proven deposits, split into 172 mining licenses in the hands of 123 companies. This would rank the country second in terms of reserves, behind the US with 237bn tonnes; in per-capita terms, Mongolia is far out in front.

The development of the Tavan Tolgoi coal deposit, one of the world's biggest untapped coal deposits, exemplifies this.

Claiming 6bn tonnes of reserves, the area was split into 12 licenses, of which half remain in government hands. The bidding for the remaining 3bn tonnes has again been divided. The western block will be sold to a strategic investor, short listed as one or more of six mining giants: ArcelorMittal, Vale, Xstrats, Peabody, a consortium of Chinese energy firm Shenhua and Japan's Mitsui, or a consortium of Japanese, South Korean and Russian firms. The eastern half, however, will be held by state-owned Erdenes Tavan Tolgoi and the plan for this block is to sell a 30% stake on an international stock exchange, 10% to Mongolian companies, and dish out another 10% between each and every citizen. "The company will produce 1m-2m tonnes of coal in 2011 and not less than 10m tonnes in the long term," says Jalbasuren Batzandan, who sits on the board of Erdenes Tavan Tolgoi. "We will improve infrastructure and build a

power plant, a coal-washing plant and a chemical coking plant."

Shared hopes If you are Mongolian, getting your hands on a piece of this asset is easy – and free of charge. A quick registration with any broker or notary office entitles a Mongolian to 538 shares of their coal giant, roughly calculated at $0.33 per share from the state's expectations, or $175 total. This hasn't stopped rumours on the street about the value of the stake, ranging from $0.10 to $2.00, and Goldman Sachs and Deutsche Bank, lead managers of the IPO, may want to

ment decisions over it that are crucial to a newly developing economy like Mongolia's. Optimistic investors tell this story as a sign of a healthy democracy with citizens airing their grievances now rather than later in an uprising. With each citizen a shareholder, it's hoped Tavan Tolgoi will be a flagship project that helps the country safely navigate through the treacherous waters of development. "Tavan Tolgoi will open a new chapter for the lives of Mongolians," argues Batzandan. "8,000-10,000 new jobs will be created. If Mongolia successfully capitalises on the strategic deposits of the country, the GDP will reach $100bn in 10-15 years. Poverty and unemployment will be left written only in history books."

Judging from the performance of listed coalmining companies already operating in Mongolia, hopes are high for Erdenes Tavan Tolgoi. The share prices of Australian-listed Guildford Coal and Hunnu Coal, Hong Kong-listed Mongolian Mining, and local-listed Sharyn Gol have

"The average Mongolian will be a millionaire by 2014" re-look at the valuation of the company if the government will let them.

To some, the plan is a throwback to the government-issued "coloured tickets" in 1991 that entitled owners to buy newly privatised assets. Others see it as the government's latest "bribe" to buy votes – a repetition of last year's $1,000 "gift" promised to each citizen for successfully signing the investment agreement for Oyu Tolgoi, the world's largest untapped copper and gold resource, but one that no-one received. Despite the government's efforts to placate voters, an ongoing protest in the city centre demands the impossible: the disbandment of the government and annulment of the Oyu Tolgoi investment agreement.

The share distribution plan has sparked a heated debate over the country's natural resource wealth and the govern-

all shot up over the past year. On April 20, C @ Limited announced the acquisition of a Mongolian coal asset and over the following two days its share price on the Australian Securities Exchange spiked 100%. "The average Mongolian will be a millionaire by 2014," says Chris Devonshire-Ellis, a business consultant in the region. "Reform is happening at a frantic pace."

That said, many caution that coal mining is not an unalloyed good. "We need to learn how to offset ramifications of mining on the economy and society. We cannot forget that mining is the most harmful sector in the business world.

Mongolians love the motherland, and mining operations will be on a whole different level when the paved roads and railways are built," says Batzandan.

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INTERVIEW:

Raspadskaya looks east Rachel Morarjee in Moscow

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year after a mining disaster that killed 90, Russian coal giant Raspadskaya is setting its sights on the Chinese market and working to raise transparency at the company.

Raspadskaya hit the headlines in May 2010 when a methane gas blast ripped through an underground mine in the coal-rich Kuzbass, followed hours later by a stronger blast that wrecked the mine's main ventilation shaft and badly damaged buildings on the surface.

Prime Minister Vladimir Putin said repairs at Raspadskaya's largest mine would cost RUB10bn ($320m) – a price tag that will be borne largely by stakeholders and owners of the mine.

Deputy General Director Alexandr Andreev tells bne that the coalminer, which holds 10% of the Russian coking coal market, will need some months before it is working at full capacity in the wake of the 2010 methane leak.

For 2011, the main mine will produce 2.5m tonnes of coal, well below full capacity, while repairs are ongoing. He did not give further details about the technical repairs on the damaged mine.

The company aims to produce 8.5m tonnes of coal across all of its operations this year. "The coal industry needs to pay attention to efficient equipment, human skills, to use its reserves efficiently and have good communication with clients," says Andreev.

Over the last five years, the company has made great strides in becoming more open and changing its corporate culture to respond to institutional investors who bought its bond and stock issues. Raspadskaya was the first Russian coal company to IPO, listing on the Russian stock exchange in November 2006. "After this process, we had to keep much better stan-

© 2010 Raspadskaya

dards of corporate governance because our employees began to understand the importance of investor relations," says Andreev. "Our top management put a lot of effort into becoming more transparent, because we had institutional investors from the UK, the US, Scandinavia and other European countries. We had to invest a lot in communications."

New markets Before the mining disaster, the global economic crisis proved a wake-up call for the company, signalling the critical importance of exploring new markets and breaking the company's traditional reliance on the Russian and Ukrainian markets. Raspadskaya is one of the leading suppliers to the largest Russian metallurgic plants, including NLMK (Novolipetsk Steel), MMK (Magnitogorsk Iron & Steel Works) and NTMK (Nizhniy Tagil Iron & Steel Works) and Kemerovo Koks.

However, the downturn in the Russian economy made it clear to top management that the company had to look overseas for new markets. "We changed

2009. In 2010, 30% of Raspadskaya's sales were export sales. "We changed our direction, decreased Ukrainian market and increased significantly our Chinese market sales. In 2010, 62% of our all our export sales went to China, versus only 10% in 2009," Andreev says. "We would like to increase exports sales in the coming months, but after the incident in our main mine it will take time to build up capacity again. We would like to keep the share of exports at not less than 35%, and hopefully more."

However, bottlenecks in the seaports of the Russian Far East remain a problem and could stymie further growth. At present, there is only one year-round border crossing over the Amur river that divides Russia from China on the TransSiberian railway, although there are plans to build a new rail link at Birobidzhan to connect the iron mines of the Jewish Autonomous Region with the steel mills in north-east China. "For stable clients of Raspadskaya, we see that we need to find capacity in sea ports, to deliver coal in long-term contracts, so we need to keep our own

"Our top management put a lot of effort into becoming more transparent" our strategy in the middle of 2009. It was not easy to make the transition and find new customers, when we found the Russian and Ukrainian market could no longer absorb our production capacity," says Andreev.

China has become a key market for the company. In 2010, Chinese coal exports from Russia stood at 4.5m tonnes in 2010, compared with just 2m tonnes in

capacity in the sea ports for future export contracts and we need to work with port operators to clear bottlenecks," says Andreev.

For Raspadskaya, the future means looking east. Although the concerns of western investors remain a key consideration for Raspadskaya's management, it is Chinese clients who will provide the foundation for future growth.

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When Kazakhstan was part of the Soviet Union, it produced around 140m tonnes a year (t/y), the bulk of it burnt in the Ekibastuz power plants or exported to the industrial cities of Siberia and the Urals. Today, Kazakhstan has a pressing need to expand and modernise its

"We don't expect Kazakhstan to get its first nuclear power plant before 2020 at the earliest, and renewables contributed under 1% of total energy in 2010"

Kazakhstan keeps faith with coal Clare Nuttall in Almaty

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he Kazakhstan government has been flirting with ideas to introduce nuclear and renewable energy, but due to the country's abundant reserves, coal remains the primary source of energy. As Kazakhstan seeks to ramp up electricity production to feed growing industrial demand, expanding coal generation capacity is the cheapest and quickest way to achieve this.

The Ekibastuz coal basin in the north of the country has reserves of around 10bn tonnes of coal, and boasts the world's third-largest open pit mine, Bogatyr. With another massive coal basin near Karaganda, in the centre of the country, and numerous other smaller deposits, Kazakhstan has recoverable coal reserves of around 34bn tonnes, putting it among the world's top-10 producers.

power generation sector. The country enjoyed a brief respite during the recent economic crisis when power consumption fell slightly, but as the economy is now growing rapidly again, demand for electricity is also rising. The Ministry of Industry and New Technologies (MINT) forecasts that electricity generation will increase from 82.6bn kilowatt hours (kWh) in 2010 to 103.5bn kWh by 2015, slightly ahead of consumption, which is expected to reach 100.5bn kWh by 2015.

Kazakhstan plans to invest over KZT2.3 trillion ($15.6bn) into the power sector by 2015, including KZT235.91bn for the coal mining sector.

Several of the power projects in Kazakhstan are for new coal-based generation capacity. Major projects include the expansion of the Ekibastuz GRES-2 power plant, and plans to upgrade Ekibastuz-1 and build a new coal-fired power station near Lake Balkhash.

Small coal-fired thermal power plants and CHP (combined heat-and-power) plants are also being rebuilt. "Kazakhstan has significant reserves of highquality coal and low production costs.

Therefore, the coal power plants account for 60-70% of total electricity produced in Kazakhstan," says Evgeny

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Vinokurov, director of the Eurasian Development Bank's centre of integration studies. "In the coming years, a significant change in the share of coal-fired power plants in Kazakhstan's energy mix is not expected."

Leila Kulbayeva, director of mining sector research at Visor Capital, agrees that coal will remain the major power source, as building coal-fired plants is the cheapest way to increase generation capacity. "We don't expect Kazakhstan to get its first nuclear power plant before 2020 at the earliest, and renewables contributed under 1% of total energy in 2010," she points out.

Producing the goods Coal production is expected to reach 134m t/y by 2015 and 151m t/y by 2020, according to the MINT. All the country's major producers say they are planning to increase output. "Several of Kazakhstan's big listed mining companies produce coal, and they are planning to increase output. The biggest production increase will be from Bogatyr, a joint venture between Samruk-Energo and Rusal," explains Kulbayeva.

Bogatyr Coal is planning to deliver around 38m tonnes of the coal to its customers in 2010, the company said in a press release. Production is expected to almost double to around 55m t/y by 2020.

Kazakhstan's largest metals companies are also active in the coal sector.

The energy division of ENRC is one of the largest producers of electricity and coal in Kazakhstan. The company has steadily increased coal production to reach 20.1m tonnes in 2010.

Kazakhmys Power has a 50% interest in Kazakhstan's largest coal fired power plant Ekibastuz GRES-1. It also owns the Maikuben West coal mine.

ArcelorMittal, which has eight coal mines in the region of Karaganda providing the Temirtau steel plant with captive coal, plans to increase production from 10.8m tonnes in 2010 to 13m t/y from 2015. "This added capacity in coal will support the planned expan-

sion of the steel plant's capacity from 4m to 6m t/y of liquid steel," spokesman Roman Ilto tells bne. "The expansion is subject to favourable market conditions, of course." ArcelorMittal plans to invest around $300m into the expansion of its coal capacity between 2011 and 2015.

While most of the coal produced in Kazakhstan is used either to generate electricity or is coking coal for the metallurgical industry, there are also plans to increase exports from their current level of 20m-22m t/y, to 32m t/y in 2014. "As coal is abundant and cheaply available in Kazakhstan, demand for coal is fully satisfied from domestic production," says Zaurbek Zhunisov, an analyst with investment bank Troika Dialog. "Furthermore, we export around 30-35% of total production, primarily to Russia. Given the fact that a number of thermal power capacity expansion initiatives are underway in both Kazakhstan and Russia, the coal producers will also be ramping up output, for which they have the resources."

While renewable energy is expected to only account for a small share of the energy mix for the foreseeable future, both the Kazakh government and private companies are paying greater attention to the environmental impact

"Coal power plants account for 60-70% of total electricity produced in Kazakhstan" of coal production and power generation. Several of the major generation companies have installed state-ofthe-art filtering systems, and both the government and international financial institutions, including the Eurasian Development Bank and European Bank for Reconstruction and Development, are supporting clean-coal investments with funding.

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