bne July 2012 From here to modernity by Ben Aris

Inside this issue: A Latvian bank's Ukrainian connection A new energy in Poland Taxing times in Turkey A bloc like the EU, but better July 2012 www.businessneweurope.eu

Special Report: The Grexit effect

FROM HERE TO MODERNITY

How to invest in Eastern Europe and China

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bne July 2012

Contents

Editor-in-chief: Ben Aris (Moscow)

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Managing editor: Nicholas Watson (Prague)

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News editor: Tim Gosling (Prague)

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Eastern Europe: Graham Stack (Kyiv)

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23 COVER STORY 6 The Insiders

30 Poland's banks buck European trend

14 Perspective

31 A new energy in Poland 32 Unconventional in Europe

EASTERN EUROPE 16 A Latvian bank's Ukrainian connection 19 Has Belarus passed bottom?

22 Private equity bets on e-procurement

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28 CEE pensions accelerating at a brick wall

12 A lack of integrity

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CENTRAL EUROPE

8 From here to modernity

21 Russian businessmen take stand against graft

Please direct comments, letters, press releases and other editorial enquires to editor@bne.eu

33 Cutting carbon with the EBRD 34 Lithuania pans Russian nuclear plans 35 "Hungary: Between Democracy and Authoritarianism" 36 Warehouse rising

23 Faces of the new Russia – Alyona Popova 24 Russians getting richer faster 26 Potemkin village football

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Contents

SOUTHEAST EUROPE 38

A blast from the past in Serbia

Serbia's public finance imperative

42 43

EURASIA 47

A bloc like the EU, but better

Georgia's Persian partners

A frozen conflict heats up

Taxing times in Turkey

A Kazakh sukuk

Macedonia's ethnic fragmentation

A sea change in Caspian relations

Croatia's conundrum â&#x20AC;&#x201C; spending or rating cuts?

Not a LOT for Turkish Airlines

SPECIAL REPORT 61

Czech-Slovak split offers Greece history lesson

Bear up well

A bullseye on the Balkans

A plucky Turkey

Eurasia's Eurozone resilience

UPCOMING EVENTS

TANAP on tap

OPINION 55

The Baltic banking bust

Sbrioka Monologue and Velvet Tithes Bank squash competition

Gorillas in the Tatra mist

I The Insiders

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Forecasting the future in St Petersburg

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ussia held its annual Kremlin-sponsored investment jamboree on June 21-23 in the northern capital of St Petersburg. It is now the premier event on the Russian calendar and attendance by everyone who is anyone is mandatory. bne vox popped delegates to Russia’s ultimate insider gabfest on what the future holds. In general the mood was upbeat. The main event was President Vladimir Putin's speech, which set the tone for the coming year with a message of stability. “Naturally, everything that we say is easier said than done,” Putin said as he started on the obligatory ruminations dealing with reform, before adding: “I would like therefore to emphasise once again that macroeconomic stability has always been our special priority.” The emphasis on stability was perhaps disappointing to many observers who had been hoping for more details on the reform programme and hints that their pace will accelerate. It was only last year that then-President, now Prime Minister, Dmitry Medvedev outlined his ambitious privatisation programme – a significant step up in reform efforts. Whilst Putin repeated his commitment to privatisation, it was not a central point in his speech. Still, at least he promised a clean process. “I want to emphasise straight away that [this round of privatisation] must be a fundamentally different privatisation, one that has nothing to do with the practice of loans-for-shares auctions and other dubious deals that were widely used in the 1990s, when state-owned assets created by the previous generations of our people were acquired in corrupt deals, which involved the abuse of power and markedly lower prices – often simultaneously – and with the use of the state's own funds,” the president stated. Putin clearly outlined his concerns in the first part of the speech, highlighting the fact that the world remains in a volatile state, on top of which he has increasingly unhappy relations with the traditional powers in the west. By way of contrast, from his perspective things at home are going very well. Inflation is at 20-year lows as is unemployment. Economic growth is a respectable 3%-4% and lending and consumption

are rising. The only danger is a crash in Europe, over which he has no control; hence the emphasis on stability.

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sky, President and founder of IBS Group, the biggest software development company in Europe. Karachinsky set up IBS in 1987 when the communists first permitted private business and has grown the company into a European leader with 10,000 employees and $650m turnover last year, writing software for pretty much every major corporation in Europe and Russia. “There are always crises in Russia,” says the bearded and ebullient Karachinsky, who rattles off crisis years as if they were wine vintages. “1998 was a very tough year, but then so were 1996 and also 1993. But 2004 was okay and 20062007 was a good time like 1997 which was also a great year -- before 2008 of course or the struggle in 2009. When there is a boom everyone forgets the last crisis, but I know if there is a boom this year then there will be a crisis next year – it's always the case.”

"I know if there is a boom this year then there will be a crisis next year"

Unsurprisingly, business people dependent on the domestic economy march in step with the president. Dennis Ludkovskiy is the CEO of Svyaznoy, Russia’s second largest phone retailer and has more recently been setting up a bank. “The European crisis has barely touched the mobile phone market in Russia," he beams. "At the peak in 2009, sales went down by only 10% but quickly rebounded. Since then sales have continued to grow by about 30%, and the rate of profit growth has been even faster.” Svyaznoy is clearly in an advantageous position for the moment, like many companies facing a domestic market apparently full of consumer confidence and rising credit. “We feel the European crisis but it is muted as our business has almost zero dependence on the West. The only way a real crisis could transmit itself to Russia is through falling oil prices,” he says.

"We feel the European crisis but it is muted as our business has almost zero dependence on the West " Yet the Russian banking sector is in the front line and has been hit far harder than the real economy. Todd Berman, Head of Investment Banking at Troika Dialog, said: “The original problems were caused by excessive leverage, but it has become a crisis of confidence. Now I think we are close to the bottom but it will not be a smooth recovery from here; we are going to bounce along the bottom and there will be more ripples or waves to come. Still, the hard part is behind us.” However, the man with the longest perspective on the crisis that bne spoke with in St Petersburg was Anatoly Karachin-

St Petersburg, Russia. June 21, 2012. Russia's president Vladimir Putin addresses a plenary session at the 16th St Petersburg International Economic Forum. (Photo ITAR-TASS / Alexei Nikolsky)

I Cover story

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he "#hello 1937" Twitter hashtag suddenly went viral on June 12 when Russian police swooped on prominent opposition leaders, just as thousands were gathering in central Moscow for the latest street protest against the Kremlin.

From here to modernity Ben Aris in Moscow

Cover Story I 9

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The hashtag is a reference to the start of Stalin's Terror of the late 1930s, when the secret police arrested and shot hundreds of thousands of people. No one was shot this time, but just a few days after the new harsh law giving the police sweeping powers to arrest and prevent public protests (that contradicts article 31 of the Russian constitution guaranteeing the right of public assembly), the authorities raided the homes of most of the movementâ&#x20AC;&#x2122;s high-profile leaders and called them into the state investigation committee, ensuring few could appear at the rally of June 12. One-time "It Girl" and increasingly respected Kremlin critic, Ksenia Sobchak, tweeted that she didn't even have time to get dressed before police forced their way into her apartment. Popular blogger and the face of the opposition so far, Alexei Navalny, said that police smashed his door down in their eagerness to enter his apartment. "There is a search going on in my home," Navalny wrote on Twitter shortly after 8:00am local time, in a message that instantly went global. "They almost split the door in two." In a feeble excuse for the politically motivated raids, police said they were conducting an investigation into the violence that broke out between riot police and protesters at the last opposition demonstration on May 6, the day before Vladimir Putin's presidential inauguration. Since Russia's political conscience awoke from its apathy in December with the first street demonstrations, the Kremlin is responding with a mixture of the carrot and the stick. Dmitry Medvedev re-introduced the popular elections for regional governors as one of his last acts as president last year, but this stands in stark contrast to this new, restrictive law on demonstrations.

The Kremlin is clearly trying to find a balance between placating the rising dissatisfaction with the government, and making sure it stays in control of the situation. In doing so, what minor democratic advances that have been made in Russia over the past decade are now being rolled back. And this is being played out not just in Russia â&#x20AC;&#x201C; other countries in Central and Eastern Europe and the Commonwealth of Independent States (CEE/CIS) are also seeing governments roll back freedoms in the name of stability and in doing so are becoming increasingly autocratic and authoritarian. This prompts the question: is this a theme that threatens to play out across the region or will it be restricted to a few isolated cases? The answer is neither simple nor conclusive. But the fact the question is even being asked is in itself significant.

ish the single currency and even cause the economic bloc to disintegrate. The pain of the crisis has certainly led to some of the more progressive countries in the region going backwards rapidly in the search for stability. Hungary and Ukraine were singled out as particularly bad in a June report by the non-governmental organisation Freedom House. "In an alarmingly short period of time, the [President Viktor] Yanukovych government in Ukraine has closed the democratic space that was opened after the Orange Revolution of late 2004," Freedom House wrote in its annual report "Nations in Transit 2012", adding that the country has gone backwards in five of the eight categories it uses to measure democracy in just the last year.

The golden years In the years since the fall of the Iron Curtain and break-up of the Soviet Union over 20 years ago, few have questioned the path that these countries in transition have been on. They have developed market-oriented economies and introduced legislation, often drafted by the EU, to create liberal democracies.

The situation in Hungary is not much better. Since taking office in 2010, Prime Minister Viktor Orban has taken it from one of the most democratic counties in Freedom House's ranking to one of the worst. "Hungary's precipitous descent is the most glaring example among the newer European Union members. Its deterioration over the past five years has affected institutions that form the bedrock of democratically accountable systems, including independent courts and media," says Sylvana HabdankKoĹ&#x201A;aczkowska, project director for "Nations in Transit".

But everything has changed since 2008. First the financial crisis struck, bringing down huge financial institutions and rocking the very foundations of capitalism. This then turned into an economic

In journalist Paul Lendvai's recent book, "Hungary: Between Democracy and Authoritarianism", Hungary is described as "no longer a western-style democracy. It is an illiberal or managed democracy,

"In an alarmingly short period of time, the government in Ukraine has closed the democratic space that was opened after the Orange Revolution" crisis, bringing recession, economic hardship, unemployment and austerity. Today, this has morphed into a crisis of the EU itself, which threatens to demol-

in the sense that all important decisions are made by Orban." The author details how Orban uses powerful friends in the world of business to build up a loyal and

I Cover story

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sophisticated media network to provide unswerving support, while continually playing a dangerous game with neighbouring states that contain ethnic Hungarian minorities to keep national emotions running high. In addition to Hungary, Freedom House identifies another five countries that have also reined in their independent media: Bulgaria, the Czech Republic, Lithuania, Romania and Slovakia. Declines in judicial independence were the most widespread problem, and there have been mass arrests in Azerbaijan, Belarus, Kazakhstan, Russia and Ukraine in the last year. Even the well-liked countries amongst international investors have suffered from this backsliding. Marcus Svedberg, chief economist at East Capital, points out that Turkey, "democratic yet increasingly intolerant," has weathered the crisis well. According to the Organisation for Security and Cooperation in Europe, Turkey has more than 100 journalists behind bars, meaning it jails more than China or Iran. "But this isn't just about the

"Hungary is no longer a western-style democracy – it is an illiberal or managed democracy" press – students, academics, artists and opposition MPs have all recently been targeted for daring to speak out against the government of Recep Tayyip Erdogan and his mildly Islamist Justice and Development Party, or AKP," writes Mehdi Hasan in The Guardian, who describes "a new climate of fear in Istanbul." Some famously undemocratic countries have also dealt well with the crisis in the last two years (although they have also had their share of protests and riots). The economies of Russia, Kazakhstan and Belarus are still on track to grow this year, yet they all count amongst the least democratic in the world. And at the extreme end of the scale is China, which is still going gangbusters but doesn't even pretend to be democratic.

The key to success, it seems, is a combination of prudent policy pre-crisis, coupled with the ability to act decisively once the storm breaks. However, another clear factor - particularly in less open political systems - is the quality of a country's leader. Russia’s Putin has proven to be an adroit manager with a strong team in charge of the nation’s finances; Ukraine’s Yanukovych looks a man beholden to his business backers whose ham fisted policy initiatives are unlikely to push the country forward. This reliance on personalities is itself a disappointment: after two decades of transition the political systems built up are still almost entirely dependent on the individual presidents and prime ministers leading the change. Winston Churchill famously pointed out: "Democracy is the worst form of government, except for all those other forms that have been tried from time to time." The trials of the crisis are illustrating that some of those other forms are able to cope perhaps better than the western style democracies. Yet at the same time, others are lagging badly. The trivial notion that the stability an authoritarian regime can impose will automatically lead to better performance in times of crisis doesn't work either. A handful of the most successful countries in weathering the maelstrom are also amongst the most democratic. Poland stands out as arguably the only country that has dealt with the crisis well at the same time as advancing democracy. The only EU country that avoided recession in 2009, Poland also posted the greatest net improvement in Freedom House's survey. In October, for the first time in Poland's post-communist history, the incumbent government was re-elected, "signalling a more stable and mature political system," says Freedom House. Perhaps the most impressive of all have been the scrappy democracies of the tiny Baltic states, which achieved "the impossible" by forcing down wages and engineering internal devaluations that led to a strong bounce. How did these states manage to achieve what Greece

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and other EU states on the periphery are so manifestly failing to do? Maybe the chaos and poverty of the 1990s is still so fresh in people's minds that governments there were given a freer hand to take drastic action. "Undertaking the necessary austerity measures at an early stage had a triple beneficial effect. First, it allowed the Baltics to benefit from positive confidence effects. Second, it allowed Latvia to return to the financial markets well ahead of schedule. Third, it allowed growth to bounce back after exceptionally severe output contractions. In 2011, the Baltic countries were the three best performers in the EU in terms of GDP growth. At a time when all euro area policymakers urgently sought ways to re-launch growth, this is a remarkable achievement," P O Neill wrote on A Fist Full of Euros in June. J curve Ian Bremmer, founder of the Eurasia Group, in his book The J Curve, showed that in the long-run democracies produce more prosperity, but at the price of

Cover story

less stability. Authoritarian regimes are more stable, but the level of prosperity is capped at a relatively low level. And Bremmer says not all countries make the transition from one system to the other – the bloody war in Yugoslavia being a poignant example. Plamen Monovski, chief investment officer of Renaissance Asset Managers, and others have persuasively argued that the so-called "Washington Consensus" has failed, but no real alternative has emerged. China is experimenting with its "one party, two systems" model and Russia is doing something similar with its "sovereign democracy". Both these approaches put more emphasis on the state than the more traditional personal liberties that are at the core of representative democracies of the West, and neither are committed to the idea of democracy or civil liberties as a political philosophy. These countries are at a time of unprecedented crisis in the world feeling their way towards a

I 11

more workable system of control – and erring on the side of limiting personal freedoms and curtailing civil society. "Russia is half awake and will not slide back into slumber," an extremely heavy hitting team of political analysts of Dmitri Trenin, Maria Lipman, Alexey Malashenko and Nikolay Petrov from Carnegie Endowment for International Peace wrote in an excellent paper recently, "Russia on the Move", which calls on the West to engage Russia, not reject it. "But the real nature of the change is murky. How and from where change will come, when it will happen, or what forces, and in what proportion, will be the primary beneficiaries of the change remain uncertain. Bumpy and haphazard – rather than gradual – evolution toward a more open political system remains the best but not the only scenario," the Carnegie team concludes. Ironically this analysis applies not just Russia, but to most countries in the world at the moment.

I Cover story

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Cover story I 13 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

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indeed Bulgaria and Romania that continue to be the greatest cause for concern regarding the anti-corruption framework," TI says. "A plethora of laws have been passed in both countries, under the watchful eye of the EU institutions, but this flurry of legislative activity has not been accompanied by the widespread adoption of ethical norms, actions and behaviour."

A lack of integrity

Estonia, Lithuania, Poland and Slovenia were singled out for praise for having strengthened their integrity systems considerably in recent years, but "they still suffer from a number of important flaws that require attention to ensure that the fight against corruption is consolidated." Latvia, by contrast, is said to outperform its neighbours and "exhibits a generally strong integrity system."

What you need to know

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Within Emerging Europe, TI found that Bulgaria and Romania suffer the most serious integrity deficits, while the rest have made at best mixed progress in the fight against corruption. "It is

Parliaments in Europe are not living up to transparency, accountability and integrity standards, with TI finding that only three out of 24 national parliaments in the survey have appropriate and well-functioning integrity mechanisms for their MPs. This has led to a notable fall in public confidence in their parliaments, especially in countries like the Czech Republic and Bulgaria where scandals have flared.

HOW DO INSTITUTIONS IN EUROPE MEASURE UP?* Supreme audit institution Electoral management body

strongest

However, in its June report entitled "Money, power and politics: corruption risks in Europe", TI drew a direct link between serious deficits in public sector accountability and deep-rooted problems of inefficiency, malpractice and corruption in Greece, Italy, Portugal and Spain and the ongoing crisis in these countries, while also citing growing concerns that some parts of Emerging Europe – particularly the Czech Republic, Hungary and Slovakia – have "rolled back" the progress they were making in the fight against corruption since joining the EU in 2004. "In Hungary, recent constitutional changes highlight the risks of abuse of power by a strong executive and a parliament in which the opposition has little oversight of the ruling majority," it says. "In Slovakia, a failure to effectively regulate

political financing and continued widespread political corruption have meant that trust in politics and parliament is at an all-time low."

Ombudsman Judiciary Executive (government) Law enforcement agencies

*Institutions in order of strength based on the quantitative information presented in the National Integrity System assessments of 24 countries. An aggregate score for each institution was calculated by averaging each of the country scores for that institution/sector. Green represents an aggregate score of 71 or above out of 100, amber 61 to 70, and red 60 or less.

Legislature (parliament) Media Civil society Political parties Public sector Business Anti-corruption agencies**

weakest

t should come as no surprise that countries with weaker democracies tend also to suffer from what the anti-graft agency Transparency International (TI) calls weaker "integrity systems" – the institutions that are designed to prevent and fight corruption. "A well-functioning national integrity system provides effective safeguards against corruption as part of the larger struggle against abuse of power, malfeasance and misappropriation," the NGO explains.

**Note that only 12 out of the 24 integrity assessments included an anti-corruption agency, so the aggregate categorisation should be treated with caution.

bne’s veteran team of journalists have more than 100 years of collective experience of reporting on this dynamically growing region and can explain the “why” of “what” is going on. Eastern Europe Russia Belarus Ukraine Central Europe Estonia Latvia Lithuania Poland Czech Slovakia Hungary Southeast Europe Slovenia Croatia Serbia Romania Bulgaria Turkey Moldova Albania Bosnia Croatia Macedonia Montenegro Kosovo Eurasia Kazakhstan Georgia Uzbekistan Kyrgyzstan Turkmenistan Tajikistan Azerbaijan Armenia Mongolia

I Perspective

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Perspective I 15

monwealth of Independent States (Baku, Donetsk, Ekaterinburg, Kazan, Minsk, Yerevan, to name a few), the air of the bars and cafes filled with Russian and cigarette smoke. The same can be said of the cargo destinations. Six out of 10 are now in the east, with China featuring heavily. Emirates Airlines' daughter company Emirates SkyCargo, one of the world's top 10 air freight companies, now has capacity out of Prague for 20 tonnes a day, including for specialised cargo such as refrigerated medical supplies as well as flowers and fruit. Emirates' choice in 2010 to begin a passenger/cargo route to Prague is instructive. One of the largest airlines in the world and one of the best (it was voted by Air Transport World "Airline of the Year" for 2011), it has already upgraded the daily flight from an Airbus 330 to a Boeing 777, which has an extra 86 seats to take the total to 364. "The Czech Republic was oriented toward western countries, but there is an increasing interest in business and travel to the east and we're part of that," says Borivoj Trejbal, Emirates country manager for the Czech Republic. Of course, the majority of passengers from Prague don't end their trip in Emirates' hub of Dubai, but 70% transit to other destinations: for holidays, places such as the Maldives and the Seychelles; for business, places like China, Hong Kong, South Korea and Australia/New Zealand. Although Emirates is cautious in its outlook given the unfolding European crisis, Trejbal stresses he has seen no signs of any drop-off in its "more than satisfying load" factor on its daily flights, with prices staying stable. "In the Czech Republic, I can only see a bright future and there's no signals of any decline."

Eastward, ho! bne

hen this correspondent first arrived in Prague on a balmy summer's day in 2002, the airport was full of passengers disembarking from planes that had originated in Western Europe and North America, many of whom were intent on doing business in what was then still very much emerging Europe. The subsequent decade has seen lots of changes at Prague Airport, not least the swanky new second terminal that helped lift the total number of passengers arriving in 2009 to 11.6m, making it the busiest airport among the new EU member states. But it's not only the amount of passengers that's changed, it's also the direction they are coming from and going to. In 2002, the airport's destination list totalled 78 places, about 30% of which could be considered the emerging Eastern European and Asian states. The subsequent decade has seen some notable westward routes drop off. For this correspondent, the Czech Airlines flights to Edinburgh and Glasgow were sadly first to go; then shockingly, after 72 years Czech Airlines dropped all its flights into the UK in 2010. At the time, the airline, which operates about 60% of the flights to/from the airport, said it had cut its UK flights as part of a global restructuring, which had led it to reduce services on less profitable routes and increased those on more profitable ones.

For example, the number of scheduled passengers carried by CSA to/from the former Soviet Union grew from 425,000, or 9% of total scheduled passengers, in 2006 to 568,000, or 12%, in 2008. This "re-orientation" of Czech Airlines is mirrored in the airport as a whole. While in 2002 just 30% of the destinations were to the "emerging east", by 2012 this had grown to over 40% of the now 98 passenger destinations. The airport has got bigger, but is now also increasingly turning to the east. It is noticeable that in the evenings, once all the tourists from

"In the evenings, Prague airport resembles its old Soviet self, with numerous flights to the CIS and the air of the bars and cafes filled with Russian and cigarette smoke." Western Europe have passed through and are thronging the city centre, the airport again more resembles its old Soviet self, with numerous flights to Russia and the rest of the Com-

For those who look at global trade flows, none of this should come as much of a surprise. International trade has mushroomed as a result of globalisation, rising from the equivalent of 39% of global GDP in 1990 to 61% in 2010, and is expected to top 84% by 2030, according to a 2011 report by Citigroup. But since the global crisis hit in 2008, there's clearly been a trend of emerging markets trading more between themselves and less with developed markets. China, for example, has already become Brazilâ&#x20AC;&#x2122;s biggest consumer of raw materials, and will soon be the biggest for Africa too. "We expect world trade to expand at an average rate of 7.1% per annum between 2010 and 2030 (measured in constant 2010 dollars) and to expand by 4.7% a year between 2030 and 2050," Citigroup's Ebrahim Rahbari and Willem Buiter predicted last year. "What will be new is the prominence of todayâ&#x20AC;&#x2122;s emerging market economies in world trade. We expect intra-emerging market trade to overtake trade within the advanced economies by 2015 and to exceed trade between advanced economies and emerging markets by 2030." For Prague, geographically situated right in the centre of Europe, this pivoting to the east is a sign of and a reaction to this trend. And given the Czech government's previous attempts to privatise the airport, few would bet against an eastern investor acquiring it when the airport is finally sold, completing its eastward turn.

"We expect intra-emerging market trade to overtake trade within the advanced economies by 2015 and to exceed trade between advanced economies and emerging markets by 2030."

I Eastern Europe

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by assets, according to the tender documents and ensuing contract as seen by bne. Distrusting Trasta Remarkably, or perhaps not, the tender documents that have been viewed by bne showed not only that the winner (Highway Investment) in the drilling rig tender had its bank account at Trasta Komercbanka, but that the runner-up in the same tender (New Zealand-registered Falcona Systems) also had a bank account at Trasta Komercbanka. Falcona was runner-up in a parallel tender for supply vessels as well. Ukrainian legislation requires a minimum of two bidders.

A Latvian bank's Ukrainian connection Graham Stack in Kyiv

uestions are growing over the role played by Latvia's Trasta Komercbanka in controversial Ukrainian state tenders in 2011 allegedly involving the embezzlement of hundreds of millions of dollars. According to bne enquiries and the tender documents viewed by bne, companies participating in the tenders were mere creatures of the Latvian bank, which has links to Ukrainian Minister of Energy Yury Boiko. As bne previously reported, in March 2011 a UK shell company called Highway Investment Processing won a tender to supply a drilling rig for $400m to Chornomornaftogaz, which is a fully-owned subsidiary of national gas company Naftogaz Ukrainy. Norway's offshore drilling giant Seadrill later confirmed that it originally supplied the

rig to Highway but for only $248.5m, raising questions about the size of the intermediary's mark-up, and who was the lucky beneficial owner of Highway. In two parallel tenders in March 2011, a UK shell company registered at the same address as Highway Investment, Verylux Company, also with unknown beneficiaries, won contracts totalling over $150m to provide supply ships to the same Naftogaz subsidiary Chornomornaftogaz. Market analysts pointed to nearly 100% mark-ups for those deals. Naftogaz has disputed any irregularities in the tenders. Adding to suspicions that the Naftogaz tenders were rigged, journalist investigations and tender documents show that all shell companies involved in the tenders – both winners and losers –

had been set up by the same company service provider, International Overseas Services (IOS). A Ukrainian court, approving a police request to search IOS Kyiv offices in September 2011 in connection with a different money-laundering case, noted that IOS: "specializes in creating offshore companies registered under fictive persons for the purpose of tax minimization and transferring funds to offshore banks." According to the investigation cited, IOS is run for and by Latvia's boutique banks – banks that mainly service clients from the former Soviet countries incorporated as offshore companies in the West. Thus, it was no surprise to discover that the winning company in the $400m tender for the drilling rig, Highway Investment, has its bank account at Latvia's Trasta Komercbanka, the country's 12th largest

Eastern Europe I 17

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bne's examination of the tender documents shows that Trasta Komercbanka's involvement runs even deeper. The Falcona Systems tender documents specify that power of attorney over the company was held by a certain Raisa Mykolaivna Dziuba, with passport details provided. bne located and talked to Dziuba, who confirmed her passport details. But far from being an energy industry executive, Dziuba is a real estate agent in Kyiv employed by a minor player AESI International Development. She is currently trying to sell an office and parking space in the downtown "Diplomat Hall" development, as well as a suburban detached villa. Asked about her connection with Falcona Systems, as evidenced by the tender documents, Dziuba answered simply: "I work for Trasta Komercbanka, I have a contract with them." Dziuba confirmed in the framework of her relationship with Trasta Komercbanka she formally holds power of attorney for a number of companies established by Trasta Komercbanka clients. Dziuba, who does not speak English, showed no knowledge of Falcona Systems operations, nor of the Naftogaz tender bid, despite being named in the tender documents. bne established independently one other company for which Dziuba apparently holds power of attorney: Panama-registered Fondberg Trading Inc. The company is listed on the website of a Kyiv travel agent Magic Travel as its "foreign

partner", with Dziuba as its director, and a bank account at Trasta Komercbanka. Dziuba said she had never heard of the company and had nothing to do with the tourism branch – except for frequent trips to Riga. The findings may point to Dziuba's power of attorney for Falcona Systems being fictive and organized by Trasta Komercbanka, which suggests that Falcona Systems is a creature of the bank itself. The ultimate beneficiaries of companies that have nominee directors and shareholders, such as Highway Investment and Falcona, exercise ownership through their power of attorney. This document is crucial for banks and counterparties to establish the real beneficiaries of a company in order to comply with know-your-customer legislation. A fictive power of attorney is thus often a sign of foul play afoot. "Of course it is an illegal action," Anna Dravniece, adviser to the chairman of Latvia's Financial and Capital Market Commission, tells bne, referring to the creation of a fictive

Dvulichanskii. None of the contracting parties with Highway Investment questioned by bne have ever reported dealings with anyone of that name. Lacking passport details, bne was not able to establish the identity of Dvulichanksii, who has no public profile, despite being technically responsible for deals measuring hundreds of millions of dollars. Trasta Komercbanka said it could not comment on clients' arrangements, but assured that the bank played no part in the Naftogaz tenders and connected deals. Highway Investment could not be reached under their advertised telephone number. The Ukrainian connection Trasta Komercbanka's role in the controversial Chornomornaftogaz tenders is sensitive not just because of questions raised about the bank's probity, but because of the strong links between Trasta Komercbanka and Ukraine's energy minister, Yury Boiko, who masterminded the Naftogaz 2011 spending spree.

"Trasta Komercbanka's links to Boiko, combined with its involvement in the controversial March 2011 Naftogaz tenders he masterminded, reflect badly on the energy minister" power of attorney. Even if it was solely the company's initiative – doubtful in this case – the bank is obligated under anti-money laundering legislation to verify the data provided by customers, according to Dravniece. The apparent inclusion of a fictive power of attorney in the Falcona tender documents could put into question the results of the tender in Ukraine – and all the more if the power of attorney specified for the $400m winning company, Highway Investment, was also shown to be fictive. According to the tender documents, power of attorney for Highway Investment was held by a certain Pavel

According to the Trasta Komercbanka website, owner of 43.2% of the bank and chairman of the board is Igors Buimisters, a native of the Ukrainian city of Kharkiv. According to his resume, Buimisters in the first half of the last decade worked in Ukraine as consultant to the management of Naftogaz, which was headed at that time by none other than Yury Boiko. British citizen Charles Treherne, who holds a 9.3% stake in Trasta Komercbanka, according to the bank's website, and sits on the supervisory board, also has links to energy minister Boiko via Ukrainian gas oligarch Dmitro Firtash. Treherne was deputy chairman of the

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supervisory board of Firtash's Viennaregistered Centragas AG. Centragas is the ownership vehicle for Firtash' 45% stake in the scandal-tainted gas trader Rosukrenergo. Rosukrenergo until 2009 was Ukraine's dominant private gas trader earning

"It was no surprise to discover the winning company in the $400m tender for the drilling rig has its bank account at Trasta Komercbanka" billions of dollars by supplying cheap gas from Turkmenistan to Ukraine, an arrangement established in 2004 when Boiko was head of Naftogaz. Leaked minutes of a Rosukrenergo shareholders meeting from 2004 appear to show Boiko nominated by Centragas to a founding Rosukrenergo shareholders' meeting. Boiko has in the past denied ties to Rosukrenergo. The cosy Rosukrenergo arrangement ended as a result of the January 2009 gas agreements between Naftogaz and Russia's Gazprom, for which former prime minister Yulia Tymoshenko is currently serving a seven-year jail sentence for signing. Ivan Fursin, with 5% in Rosukrenergo Firtash's junior partner, has a 20-33% stake in Trasta Komercbanka, according to information at the Latvian financial regulator's website. Trasta Komercbanka's links to Boiko, combined with its involvement in the controversial March 2011 Naftogaz tenders he masterminded, where journalists and opposition allege that

over $200m went missing, reflect badly on the energy minister. But while questions have been raised in Ukraine over the conduct of the tenders, given the current constellation of power in Ukraine no law enforcement action is likely. In Latvia, however, question marks continue to accumulate around Trasta Komercbanka. Apart from its involvement with the controversial Naftogaz tenders, at least two other cases raised eyebrows last year. In September 2011, asset retrieval proceedings by Kazakhstan's BTA bank against its former owner Mukhtar Ablyazov at the High Court of London found that Ablyazov had diverted $1.5bn of BTA assets via offshore companies to accounts at Trasta Komercbanka, with a Belarusian farmer holding an apparently fictive power of attorney for the offshores involved. And a Ukrainian court in September 2011 found a small Dnipropetrovsk bank had shifted a total of $2bn out of the country via IOS-established companies to accounts at Trasta Komercbanka. "The bank controls all clients operations carefully in compliance with Anti Money Laundering Law. If the bank suspects or finds out that a client acts unlawfully, according to the law it notifies the national authority," Trasta Komercbanka assured bne. Latvia's banking sector is still reeling from the 2011 collapse amid hundreds of millions of missing euros of the country's 9th largest bank, Latvijas Krajbanka, and its Lithuanian parent bank Snoras, as a result of allegedly illegal activities of its owner Vladimir Antonov. The Krajbanka debacle raised urgent questions about whether Latvia's regulators are up to the job of handling Russian and Ukrainian oligarchs' shenanigans. Latvia can illafford a repeat performance.

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Has Belarus passed bottom? INTERVIEW:

Ben Aris in London Anton Kudasov, Deputy Minister of Economy

rises don't come much worse than the one Belarus has just been through. The currency was devalued three times in the space of a year and lost three-quarters of its value, inflation reached hyper levels, and bank runs drained the country of much of its hard currency reserves. But in the depths of a meltdown running an authoritarian regime has its advantages: bank withdrawals were banned, a dual-exchange rate introduced and fixed prices imposed on basic goods so no one starved â&#x20AC;&#x201C; all moves unimaginable in the West. The consequences were obvious and shop shelves quickly cleared of goods as people were forced back temporarily to the primitive system of barter that was prevalent in the first years after the break-up of the Soviet Union in the early 1990s. This was bitter medicine to swallow, yet while austerity has spawned riots in the capitals of Athens, Paris, London and elsewhere, the oppressed residents of Minsk had no choice except to hold their noses and swallow. However, a year on and the medicine is starting to work. Over the first quarter of this year economic growth resumed, driven largely by consumption and a recovery in foreign investment. Wages have begun to rise again and the state has clawed back some of the hard currency reserves that fled in the worst of the turmoil. "The country has been through a horrible crisis, but we are on the way to recovery now," claims Anton Kudasov, deputy minister of economy, in an exclu-

sive interview with bne. "We depreciated the currency three times all in all last year and dealt with hyper inflation, but most importantly the currency reserves have already reached two months of import cover and we will go on liberalising and relaxing the currency regime." The economy is not out of the woods yet and the threat of a second wave of the crisis as Greece exits the Eurozone was already making itself felt by the end of May. That two months of import cover is still less than the three months economists take as a minimum necessary to ensure the stability of a currency. Still, Kudasov says once the economy is a bit steadier, the liberalisation programme can be accelerated. "It is a strategic choice to continue to open the economy. There were several measures taken in the pricing policy to protect the population, because with inflation

some positive moves from external sources of funding. On June 8, the council of the Eurasian Economic Community's (EurAsEc) "Anti-Crisis Fund" approved the allocation of a third $440m tranche of a total $3bn loan for Belarus that was approved last year by the community, which is a regional economic grouping of ex-Soviet republics led by Russia. The first $800m tranche was disbursed in June 2011, the second $44m tranche in December. In May, the International Monetary Fund (IMF) issued a mission statement following its visit to Minsk in which it acknowledged "the authoritiesâ&#x20AC;&#x2122; commendable adjustment policies" that have "restored foreign exchange markets, reduced inflation and the current account deficit, and helped increase

"The country has been through a horrible crisis, but we are on the way to recovery now" at 108% last year we have to have price controls on basic foodstuffs. But it was a temporary measure and we will free the prices either second half of this year or start of next year," says Kudasov. Positive signs The government's policies to steady the economy have been rewarded with

reserves," but made clear its frustration with the slow pace of change. The IMF warned that the risk of an inflation spike goes up if the government focuses too much on boosting growth by substantially increasing public wages. Despite the IMF's natural skittishness, so far inflation has been contained:

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Money is time for Putin Call it Watchgate. The Russian press have been having a lot of fun with the wrist wear of senior Russian public figures and comparing them to their official income. And the latest victim to be caught out is none other than President Vladimir Putin, who declared an income of RUB3.6m ($112,000) last year, but owns watches worth six times as much, reports the Moscow Times. What the media does is search the press archives for photos of leaders to identify their watches and then look up the value of the timepieces. Putin has been photographed wearing a Patek Philippe Perpetual Calendar that retails for a hefty $60,000. He has also been photographed wearing a Leman Aqua Lung Grande Date by Blancpain worth $10,500, and a jewel-encrusted A. Lange & Söhne Tourbograph worth up to half a million dollars, the paper said. Russian Orthodox Church head Patriarch Kirill was caught out in the same way only two months ago sporting an expensive Breguet. The watch had been airbrushed out of the photo by the church, but they forgot to also erase the reflection of the watch on the shiny tabletop. Very embarrassing. Russian daily Vedomosti has done the most extensive report on the topic with a piece in 2009 that lists the watches of nearly two dozen politicians and their watches, most of which were worth hundreds of thousands of dollars.

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inflation in April was a moderate 1.7%, up slightly from the 1.5% recorded in both February and March, but well down on the 109% 12-month inflation rate hit in the first quarter of 2011. The government is in the tricky position of trying to phase out price controls introduced during the crisis while at

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to wilt in April. Economic growth slowed to 2.9% over the first four months and both retail sales and industrial production growth slowed to 6.8% from 11.5% and to 5.1% from 12.3%, respectively. How the republic fares over the rest of the year will depend heavily on what happens next in the Eurozone saga.

"It is not like show business where you 'perform' strategy to change" the same time boost salaries to fuel consumption-led growth, all without unleashing recovery-killing inflation. The sunny spot in the economy is that devaluation has worked its magic and exports were surging in the first quarter, up by 49% on year, while the weak Belarusian ruble means that imports have yet to return to pre-crisis levels, rising only 4% in the same period. A healthy balance of payments means the government can start the long task of rebuilding its hard currency reserves and the National Bank of Belarus reported the 11th straight month of rises in April. At the same time, the central bank is slowly cutting its refinancing interest rates from their still high 34%. Ironically, the biggest challenge Belarus has to face is not of its own making and beyond its control. Fears of a new wave of crisis stemming from the Eurozone caused all the major economic indicators

Europe is also causing Belarus political problems. It remains the butt of political opprobrium in Brussels, which slapped travel bans on senior officials and imposed limited sanctions after riots and a nasty crackdown in the aftermath of the rigged December 2010 presidential elections. Kudasov is clearly frustrated and says that changes are happening, but the Belarusians don't like being told what to do – they had enough of that under the Soviets – and will continue to go at their own pace. "It is not like show business where you 'perform' strategy to change," he says. "Sanctions like Europe has imposed are not helpful. If you have 20 countries subject to sanctions, eventually you lose yourself. We will continue the dialogue at the levels we can do to explain how we see the development of the political system. It is not stuck, it is changing."

Russian businessmen take stand against graft

Roman Borisovich, vice president of Rosgosstrakh

Ben Aris in Moscow

group of leading Russian businessmen have put their necks on the line with a public stand against the government's failures to deal with corruption.

University and went on to have a successful career as a banker before returning in 2007 because he felt Russia had matured. "I convinced my family it was a good idea to return," he says.

Eleven prominent business leaders and public figures have contributed RUB300,000 ($10,000) each to a fund managed by opposition firebrand and famous blogger Alexei Navalny to finance an organisation that exposes corruption in state procurement. "Corruption is a national tragedy and it could be getting into a downward spiral that would end in catastrophe," believes Roman Borisovich, vice president of Rosgosstrakh, Russia's biggest private insurance company. "Corruption is eroding our society so that it is not an economic problem any more; it is becoming morally acceptable."

But now he is worried. "Corruption is out of hand. I used to be optimistic about the future of Russia, but now I am not so sure."

Borisovich is typical of the contributors. He is not an oligarch nor does his business depend on connections with the state for success; rather, he is a senior member of the business community running a strategically important company that relies on Russia's general prosperity for success. Born in Russia, Borisovich's family left in 1992 during the chaos that followed the collapse of Soviet Union to live in both the UK and US. He studied at Columbia

Leaving Russia is rapidly becoming a normal country. The consumer market is growing fast and quality of life is rising steadily. But cutting down on corruption is not keeping pace with the transformation of everything else.

Russians increasingly don't want their children to grow up in this environment and immigration is increasingly being driven by the desire of parents to get their kids out of Russia," says Borisovich. "It's like the Jewish emigration in the 1970s and 1980s – they left for the sake of the kids and it is starting to happen again." An obvious example of the high-level corruption was the recent revelation that the wife of First Deputy Prime Minister Igor Shuvalov earned millions of dollars trading Gazprom shares in 2004 just before the "ring fence" that excluded foreigners from buying the stock was dismantled – a decision her husband was privy to. She is

"Corruption is out of hand. I used to be optimistic about the future of Russia, but now I am not so sure" Ivan Tchakarov, chief economist with Renaissance Capital, argues that the level of corruption in Russia is on a par with its income bracket, and Russia has moved up from 154th place on Transparency International's Corruption Perceptions Index to its current 143rd place, yet it is still near the bottom of the table of 182 countries. "What really worries me is

also a big landowner around Skolkovo, the region where the government is investing over a $1bn to build a high tech park. Shuvalov has breezily admitted to the trading and land holdings – an admission that would have at the very least lost him his job in the West and possibly landed him in jail. But rather than being

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Private equity bets on e-procurement

Nicholas Watson in Prague In yet another example of foreign investment finding its way into Russia's promising e-commerce market, a group of private equity firms tells bne that they have struck a deal to invest $45m to take a minority stake in Russia's largest online procurement player B2B Center. ALPHA Associates, a Swiss-based private equity fund manager with more than $2bn invested directly in CEE, has teamed up with New York-based Insight Capital Partners and Russian players Da Vinci Capital Partners and Runa Capital to take an unspecified minority stake with several board seats in B2B Center, Russia's largest e-procurement player with a 50% share of a market estimated to be worth around $45m a year - and growing fast. "E-procurement in Russia is growing at triple-digit growth rates," says Richard Seewald, a partner at ALPHA. "This was a chance to buy into a company that is cash-flow generative, is feeding its own growth and is very scalable with low fixed costs." Established in 2002 by local entrepreneurs Alexander Boiko and Andrey Boiko – and with Mail.ru a current shareholder – B2B Center is benefiting from three major trends in Russia and elsewhere. First, the Russian government, keen to cut costs, is copying e-procurement initiatives implemented by public sector bodies in places like the UK, the US, Australia and EU as a way to increase efficiency and cost-savings in government procurement. It has also passed legislation to this effect, requiring from January 1 more government procurement to be carried out over the internet. The anti-graft agency Transparency International highlighted to the European Commission in 2011 that e-procurement is not only a tool for bringing efficiency savings, but one that can help ensure transparency and integrity in EU public procurement, which is estimated to be worth approximately 16% of the bloc's $16 trillion economy in 2010. "E-procurement is a fantastic tool for reducing corruption and increasing integrity in public procurement systems," says John Warnes of Transparency International. Second, companies across the globe have been looking to slash costs since the crash in 2008. By paying just a flat annual subscription of a few thousand dollars to e-procurement companies like B2B Center, customer firms have access to thousands of suppliers who submit bids for goods and services in confidence. The customer can then choose the best supplier based on the strict criteria of the tender, thus helping to eliminate cost-raising factors like cronyism. "B2B Centre is already hosting billiondollar transactions," notes Seewald. Third, the crisis is forcing many western companies to look outside their own markets for growth, to Russia and the other emerging markets. E-procurement offers these firms a way to sell into those markets at little extra cost. "It's not just Russian suppliers that are on B2B Center," says Seewald, "but international suppliers looking to expand into the Russian market."

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fountain on Pushkin square together with her more famous peers Left Front leader Sergei Udaltsov, firebrand blogger Alexei Navalny, activist Ilya Yashin and her partner, and State Duma deputy Ilya Ponomaryov.

punished he was promoted in President Vladimir Putin's new government in May and is now the third most powerful man in Russia, acting as Putin's "go-to" man in PM Dmitry Medvedev's cabinet. In general, anecdotal evidence suggests that Russian companies spend about a third of their cash flow on paying bribes. In the West, executives pay bribes to win more business, but have the option of remaining honest; in Russia, businesses pay bribes simply to stop problems being artificially created and can't be honest if they wanted to – this is what the contributors to the new fund complain about. The fund will be used to pay for lawyers working on uncovering corruption as part of anti-corruption campaigner Navalny's RosPil initiative, the website of which collects information on obvious violations within the state procurement system. RosPil is a badly needed mechanism to expose corrupt practices and hold officials to account – something the government has failed to do. Borisovich, like many contributors, says that the fund is not a political statement; rather, it is an expression of frustration with the lack of progress the government has made tackling the corruption issue. "The last government came in with lots promises to do something about corruption, but next to nothing has happened," says Borisovich, who believes the Kremlin will not attack the businesses of the contributors. "If you listen to the complaints of the members of the group, they are identical to what Russian Prime Minister Dmitry Medvedev has been talking about. This is not political in the sense we are talking about the same thing as the government." Still, the contributors are taking a risk by sticking their heads so publicly above the parapet. Everyone is conscious that the Kremlin could choose to take issue with group. The minimum size of the contributions was set to be meaningful, but small enough to remain below the Kremlin's political radar. "Now we are taking things to the next level. It is normal in other countries to raise funds for political parties – but not in Russia," says Borisovich.

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Popova's arm was broken by the OMON (Russian special forces) after she and some of the protesters refused to leave the square. But this incident did not deter her. Since then, she was involved in negotiating with the police when they tried to arrest protesters of Occupy Barrikadnaya, a smaller open-air camp that formed after Moscow's answer to Zuccotti Park, Occupy Abai, was dispersed several days earlier.

Faces of the new Russia – Alyona Popova Julia Reed in Moscow

ollowing the violent clashes between police and protesters during the opposition rally on the eve of the inauguration Vladimir Putin on May 6, the future for freedom of speech in Russia looked bleak. A proposed new law on rallies that is wending its way through the Duma is going to tighten the Kremlin's control over protesters and organisers, making them liable for RUB600,000 ($18,000) fines for violating strict and extensive rules. The law has only passed its first reading, but the first arrests of ordinary protesters who were at the May 6 protests have already started. The authorities are ratcheting up the pressure slowly. Students have been threatened with expulsion from universities if they are arrested and young men have received national service summons from the army after being detained by the police. Still, there are enough young Russians determined to fight for their political freedoms and political reform for the protests to continue. Alyona Pop-

ova, 29, is one of those "angry citizens" who has found herself thrust into the front line of the struggle. An entrepreneur of exactly the type the government say they want to encourage, she works out of an office that with its white carpet and modern red and white furniture looks like an advertising company. Popova is instantly likeable. Pretty and

Open Initiatives A former Just Russia Duma deputy candidate from Novosibirsk region, Popova brought guest speakers to Occupy Arbat, (the site of another Moscow protest camp) to talk about Russia's political future and the future of Russian democracy. A believer in constitutional monarchy, Popova is the mastermind and the head of the Open Initiatives Fund, which she runs together with Ponomaryov, a Duma deputy and one of the heads of the Left Front, a radical socialist movement. Not content with steering Russia onto a more democratic path, she is also the guardian of four children with health issues, two of whom suffer from epilepsy. When she first met the

"My motto is the words of Muhammad Yunus, who said that he wants to be a person who says what he thinks and who does what he says" with a positive, outgoing personality, one would never peg her as one of the new faces of the Russian opposition. Her name may not appear in print as often as some others, but Popova was there after the Moscow opposition rally of March 5 standing on top of the frozen

children, Popova was told that they must not swim or play sports in order to avoid the risk of a fit. "I immediately signed them up for swimming and they started going to a normal school, because I thought people have fits as a result of stress and tension. If they were in a normal environment, why would

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they have fits? And they haven't since then," says Popova.

Russians getting richer faster

bne The personal wealth of the average Russian is rising faster than that of any other nationality in the world, according to the research firm Boston Consulting Group's annual "Global Wealth" report. Russians' personal wealth rose by 21.4% in 2011 to $1.3 trillion, according to the report, which is slightly less than the value of the whole Russian economy and compares to the global total of $122 trillion (which itself is twice the size of global GDP). To put the Russian rise in wealth into perspective, the total personal wealth of the planet was up only 1.9% in 2011. Boston Consulting found Russia's income distribution is still extremely top heavy, with just 686 families with incomes over $100m a year accounting for a massive 40% of all of Russia's personal wealth, who saw their wealth rise by a quarter in the year. Still, even counting out the super-rich, the level of wealth of the average Russian is still rising very fast. The share of households with less than $100,000 is 15% of the total and their wealth rose by 12.7% last year. Russia famously has more billionaires per capita than any other country, but in terms of the number of households with assets worth more than $100m, Russia ranks fourth behind the US, UK, and Germany. A bit further down the scale, the 111,000 households with at least $1m or more â&#x20AC;&#x201C; one household in every 475 â&#x20AC;&#x201C; puts Russia in 18th place in the world, according to Boston Consulting. China has 13-times more households with at least $1m or more, but it also has 8.5-times more people. And the US has 46-times more millionaires with twice as many people.

GDP per capita at current prices

$12,000 Brazil Russia

$10,000 $8,000

South Africa $6,000 China

$4,000 $2,000 $0 1960

India

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A blogger and IT specialist, a businessperson and a young politician, Popova is interested in generating greater awareness of e-government in Russia and helped establish the project Duma 2.0 in Moscow. Yet her main goal is to set up grassroots institutions in Russia that will aid public debate of social issues and boost the development of socially meaningful business initiatives. "I don't like rallies. I don't believe in the effectiveness of protest rhetoric, I prefer direct action," says Popova. She is searching for ways to effect change and has several successes to her name already. Under the auspices of her fund, Popova initiated a series of internet-based projects in order to raise public awareness and government accountability. One of them is OpenDuma, a free online resource allows the general public to follow the activities of the Duma. Another project, InData, is a source that provides financial support and teaches journalists how to transform dry official statistics into the information useful to the general public. OpenAction is an all-Russia daily database of protest activities. "Every month, our fund runs open days when people come and talk about their projects and look for investment. I serve as an intermediary between the projects and the investors providing them with publicity, advice and facilities. For example, Grazhdanin Nablyudatel (or Citizen Observer), one of the grassroots election watchdogs, is housed on the premises of the fund," says Popova proudly. The Open Initiatives Fund pays special attention to projects in the regions and helps raise money for socially meaningful start-ups, another for start-ups run by women. The fund stores an open database of ideas and offers for discussion as well as crowd sourced fundraising using the online Russian payment system YandexMoney. "We are completely transparent. It's our principle. Our sponsors are on our website with all the budgets," she says.

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The scope of the projects varies from a national database of all road accidents through to a legal database listing cases, lawyer profiles, illegitimate trials, and so on to a source that helps diabetics monitor their sugar levels at home and another site that helps families find their missing children. What all these initiatives have in common is that they address the issue of the lack of publicly open information on the day-to-day needs and services of the people. Until recently almost all public services were only available to those that trekked down to the relevant government office in person. It was impossible to book a doctor's appointment or print out a communal payment bill remotely. Popova believes that transparency of public data and vehicles for idea generation, such as the Open Initiatives Fund, lead to greater government accountability and improvement in the quality of life and services. "We are looking for new regional leaders who have already launched initiatives. We want to give proactive people a public

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forum and national recognition," Popova explains. Her initiatives are in line with modern western thinking. Popova just wants to modernise Russia's public services, make them user-friendlier and help new businesses get off the ground. Currently, she is in the middle of a public debate about what the opposition could do to bring about the change that many want.

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Popova's projects still seem exotic. "I am optimistic about the future. I see new projects coming and ideas flowing every day," she says. And looking at her commitment and enthusiasm, one can believe that Popova might even fulfill her ambition one day to become the first Russian female prime minister. "My motto is the words of [Bangladeshi economist and a founder

"We want to give proactive people a public forum and national recognition"

Popova doesn't see herself as a politician, but simply as a citizen who wants Russia to become a developed society with vibrant public debate where people can initiate action. In the current environment of societal inertia,

of the micro-loan Grameen Bank who won the Nobel Peace Prize] Muhammad Yunus, who said that he wants to be a person who says what he thinks and who does what he says."

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arriving to the Black Sea this month at around 1m. Eventually Kolesnikov, who like most of the government hails from the unpopular venue of Donetsk, came clean in an interview with the Financial Times: "I cannot explain why spectators aren't coming. I feel bad about this," he said. Location, location, location Usually at such tournaments, tickets are gold dust and many fans follow their national teams to the host countries just to sip in the atmosphere and gulp down the local lager in the bars close to the stadium. But in Ukraine the unthinkable has happened – the stadia have not been sold out, let alone the pubs filled, even for "le crunch" games such as England vs. France.

Potemkin village football Graham Stack in Kyiv

eldom can so much have been paid by so many to so few: Ukraine spent €8bn to get the country ready for co-hosting the Euro 2012 football tournament, but the paltry flow of football fans – a maximum 80,000 came – means the country will have splashed out a staggering €100,000 on each single visitor. Ukrainian director for Euro 2012, Markian Lubkivsky, in the run-up to the tournament put the expected number of visitors at 1.5m, without revealing the source of the figure. But with the group phase ending and Ukraine knocked out, a ring round of embassies of visiting countries produces a generous total figure for visiting fans of at most 80,000. Cross-party consensus puts the total spent on the championship at €8bn, so the low-show figures "means that the cash-strapped country has splashed out around €100,000 euros on each individual fan who came to Ukraine for the championship.

To paper over the debacle, Ukraine's PR machine has gone into overtime: Farcical claims that 4m foreigners had arrived since the start of the tournament circulated in press releases June 19, and the deputy prime minister for

The biggest noshows have been the French and the English, which meant their thrilling game in Donetsk wasn't even sold out, with fan numbers estimated at a miserly 5,000-8,000 on each side. The Swedish camp in Kyiv, on the other hand, has been the surprise party of the tournament, with an estimated 15,000 in attendance – and the conclusion is that the Swedes, playing all their games in the capital, with its superior connections, attractions and accommodation, saw Ukraine through very different lenses than did the English and

"The chorus calling for Uefa to investigate claims that as much as $4bn had been stolen by Ukrainian officials is growing"

Euro 2012 in Ukraine, Boris Kolesknikov, was earlier claiming 90,000 visitors crossing the border every day. Being charitable, such statistics may not be an outright lie: they simply reflect the annual June migration of hundreds of thousands of Russians and Belarusians to their beloved beaches in the Crimea, whose government on June 19 put the number of visitors

French, exiled to the industrial far east of the country. The German fans have shown up in slightly more respectable numbers of around 15,000, based in the West Ukrainian tourist mecca of Lviv, as did the Danes and Portuguese. Ukraine's fatal choice of the two east Ukrainian venues that have proved so unpopular was down to the political and economic chaos of the late "Orange

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era" in 2009 when the choice was made, and when local financial support from regional oligarchs such as Aleksandr Yaroslavsky in Kharkiv and Rinat Akhmetov in Donetsk proved decisive. But Ukraine is now ruing the decision – Black Sea tourism pearl of Odesa would have been more appropriate in terms of logistics – but most importantly, in generating the all-important knock-on effects for Ukraine's image and nascent tourism industry. Costs soar Also, because of the financial and political crisis that broke over Ukraine in 2008, the preparations for the tournament were fatally delayed, and at the peak of the crisis every week brought new warnings that European football's governing body Uefa might reassign the Ukrainian venues to Poland or Germany. The crisis also caused the flow of funds for construction to dry up; when the flow resumed in 2010, the speed needed meant that costs spiralled, according to current government officials. According to Euro 2012 tsar Kolesnikov, who assumed responsibility in 2010, for a lot of construction projects needed to fulfil Ukraine's commitments to Uefa, the previous government had not even drawn up blueprints. Kolesnikov claims in the time he has been in charge, Ukraine has built five international airports, launched high speed trains imported from South Korea and built around 2,000 kilometres of road surface. But the speed needed caused construction costs to soar from an initially projected €1.5bn to €8bn. Opposition critics say that the spiralling costs under Kolesnikov were not a result of the previous government's tardiness, but Kolesnikov's and others' venality. "The door to corruption was opened by the government's cancellation of competitive tenders for Euro 2012 construction projects, claiming that this would slow down things too much," shadow Euro 2012 minister Ostap Semerak, Kolensikov's opposite number, tells bne. "Then what happens is that the government officials awarding contracts and the contractors massively inflate the

Eastern Europe

budget and contractors pays a large part of their payment back to the official. Most payments are in cash and this does not even require the use of offshores or anything sophisticated. Up to $4bn of the total Euro 2012 budget was stolen this way." And according to Semerak, a member of the BYuT parliamentary group of jailed former PM Yulia Tymoshenko, Kolesnikov is directly connected to two of the main contractors involved in such

I 27

city during match days, with many municipal functions, including childcare facilities, and utilities closing on match days, creating the feeling among ordinary people that the tournament is not for them but for the few exotic foreign guests. Ukrainian police have also received orders to treat foreign fans' misdemeanors – drinking alcohol and/or urinating in public places – with lenience, while the locals usually enjoy no such lassitude. And while an initial sparkling victory against Sweden

"The impression is hard to dispel that Ukraine's Euro 2012 was a very expensive and ultimately unconvincing Potemkin village" corruption schemes, both companies, like him, apparently hailing from Donetsk – Altcom and AK Engineering. Kolesnikov himself has strenuously denied any connection to these companies, the ownership of which is unclear. By late June, the chorus calling for Uefa to investigate the claims that as much as $4bn in state funds had been stolen by officials was growing, with Rebecca Harms, a German Member of the European the Parliament, telling the media that she intended to confront Uefa with the allegations. "I will also raise them in parliament. In whose private pocket did the money go? Uefa must take responsibility." Potemkin village Ukraine were knocked out on June 20 by, ironically enough, England. The tournament will now progress without Ukraine, to the enormous disappointment of tens of thousands of local supporters packed into the fan zone on Kyiv's Kreschatik. But many other Kyiv citizens will heave a sigh of relief. The municipal authorities have been urging inhabitants to leave the

gave the country a much needed lift, it did not last long as the national team predictably crashed out of the tournament after the group stage. The foreign fans who came will leave convinced that Ukraine is a liveable country, and BBC reports of violent extremists awaiting visitors were irresponsibly alarmist – not a single attack on visiting fans has been reported to police. But the UK's Channel 4 on May 18 aired another documentary on Ukraine, "Ukraine's forgotten children", based on the heart-wrenching fate of handicapped kids abandoned to decay in derelict state care institutions. This topic may be more pertinent when asking whether the costs of €100,000 per visiting fan were justified. The impression is hard to dispel that Ukraine's Euro 2012 was a very expensive and ultimately unconvincing Potemkin village.

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midst of crisis, especially as the EU puts a new emphasis on fiscal management. As the International Monetary Fund (IMF) pointed out in a 2011 report, the recent austerity drive implemented by Brussels in a bid to rein in debt and deficit levels acts to penalize those countries that rolled out a second pillar in the last decade or so. With flows diverted to private funds, CEE states still waiting for the payout phase have had to raise borrowing and loosen deficit limits to meet ongoing obligations. However, as Juraj Kotian, economist and head of fixed income at Erste Bank, points out, countries in the region are storing up a lot of trouble for later. "In the short term, it significantly helps governments with fiscal consolidation," he agrees, "but for the sustainability of the pension system, it's pretty dangerous. It increases the future liabilities of the government, as the negative effects of demographic trends grow. It's like accelerating a car as a brick wall approaches."

CEE pensions accelerating into a brick wall Tim Gosling in Prague

n May, Slovakia become the latest Central European state to put pension reform into reverse in a bid to shore up its budget. Whilst the move may offer some respite from the crisis in the short term, looking further ahead analysts worry that the region's governments are "accelerating towards a brick wall". Pledging to reel in the budget deficit after returning to office in April, Slovak Prime Minister Robert Fico recently announced a raft of new taxes, as well as a cut "to 5-6%" of the current 9% of a contributor's tax base that flows to private pension funds. That makes Bratislava the sixth CEE country since the crisis hit in 2008 to roll back pension reforms enacted in the last decade or so. Joining Lithuania, Latvia, Romania and Estonia, which temporarily stemmed contributions to private pension systems in 2008–09, Hungary and Poland started kicking at the second pillar early in 2011, peeling back pension reform

conducted in the 1990s by diverting compulsory private pension contributions to the state. Whilst Warsaw's cut (from 7.3% to 2.3% of wages) in contributions to private pension funds is permanent, the Poles have been restrained compared with

flows, but took the stock," says Peter Kadesca, director of asset management for Aegon in CEE. "Around 96% of savers returned to the state. It made us ask if it was worthwhile to operate a fund fighting for just 4% of the population. At first, we thought it would be okay, as the government promised to return

"We were left with a very small fund with no growth prospects" Hungary, which obliterated the second pillar when it halted all mandatory contributions and essentially nationalized over €10bn in private pension assets. The country has spent the time since mopping up those fund mangers that remain. Aegon, one of the world's largest pension fund operators, finally took the hint in March and closed its fund. "In Hungary they didn't just cut the

to the private pillar in December – but that never happened. We were left with a very small fund with no growth prospects." Storing up trouble Whilst Hungary is an extreme example, the temptation of huge volumes of funds sitting within the grasp of governments is easy to understand in the

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That brick wall is built of an ageing population. According to the IMF, the demographic dependency ratio (pensioners to working population) of the new CEE member states (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia) was around 17% in 1990, but threatens to rise to a projected 63% by 2060. Kotian estimates there are "currently, around six workers to each pension in Slovakia; in 2050, there will be only two." Yet given the time it takes for the benefits of pension reform to be felt – not only the relief for the state system, but also employment levels, national savings rates and capital market development – it takes no little determination to stay the course. The pressure is so great right now that even insurers such as Aegon can comprehend the pullback. Kadesca suggests that "the politicians and people don't care so much about the longer term right now, and I think the markets understand that." Kotian, noting that "there's still discussion and pressure in Slovakia over

whether private pensions can provide a solid payout at all," suggests that this empathy between the markets and the governments could be in for a further test. "We’re likely to see a further squeeze on flows to private funds in Poland and Slovakia as the crisis deepens," he predicts. The long road back Complicating matters further, the slow results of pension reform will make it harder for governments to go back to a

In the run-up to the reform, Prague has increased the retirement age, reduced disability payments and pension payout growth, and amended the first pillar – moves the IMF has welcomed as a "resolute" implementation of reform. The Washington-based lender said the changes have already improved the system's sustainability "considerably", cutting forecast deficits in the state pay-as-you-go scheme for 2040-2060 from 4-5% to 2% of GDP. "I hope they go through with it," says Kadesca, who

"Currently, there are around six workers to each pension in Slovakia; in 2050, there will be only two" second pillar once the economic crisis passes. "I'm not sure these countries can simply return to the second pillar," says Kotian. "The transitional period and costs are a clear disincentive for politicians. Uncertainty in the system over both the accumulation and payout phases will make both providers and savers wary." Whilst at pains to stress it is merely a personal view, Kadesca suggests that would very much be the case for Aegon in Hungary. "It's just my opinion – decisions like that are made in Amsterdam – but without very strong guarantees, I think we would be unlikely to go back to Hungary." There are alternatives on the horizon in the region however, with one country headed in the opposite direction. The Czech Republic, nowadays a favourite amongst austerity-minded economists, is leading its first major attempt to overhaul its pension system since the fall of communism with a plan to introduce an opt-out second pillar in January. The scheme, which is forecast to cost the state over €800m in lost revenue in the first three years, will see private funds receive 3 percentage points of the social security contribution – currently 28% of wages – with savers required to make an additional contribution of 2% of their wage.

disagrees with critics of the Czech reform who say it should have been made mandatory. "There have been mistakes made in the region. To an extent, I think making private funds mandatory can be an excuse to close them later."

Old Age Dependency Ratio (In percent of working age population) Poland Slovak Rep. Lithuania Romania Latvia Bulgaria EU10 Slovenia Czech. Rep. Hungary Estonia 2060 1990

Euro area 0

Source: Eurostat

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popular because Swiss interest rates are much lower than those set by Poland's National Bank, but the crisis caused a reversal of the zloty's long-term appreciation trend against the franc and the euro – leaving several hundred thousand mortgage holders owing more than the value of their loans.

Poland's banks buck European trend Jan Cienski in Warsaw

s Spain heaves a sigh of relief at the helping hand its banks are getting from the EU, Poland's bank executives insist that local financial institutions are well placed to ride out the turmoil in the Eurozone. Polish banks posted a record profit of PLN15.7bn (€3.6bn) in 2011, 37% more than in 2010, and the sector looks set to earn more or less the same in 2012, despite much more difficult macroeconomic conditions. "I'm being cautious, but it shouldn't be a bad year," says Krzysztof Pietraszkiewicz, head of the Polish Banking Association, who expects banking profits in 2012 to range from 3% more than last year to 8% less. However, the make-up of those profits is likely to change as banks scale back mortgage and consumer finance lending, and ramp up corporate lending, especially to small and medium-sized enterprises. "This year, there will probably be a drop in mortgage loans and in 2013 we will see a mild recovery," says Mateusz Morawiecki, CEO of Bank Zachodni WBK, a recent acquisition of Spain's

Santander, one of that country's most solid banks and one which is now the third largest player on the Polish market. Poland's real estate prices still have not recovered from the hammering they received in the 2009 downturn, and developers are also finding it increasingly difficult to get financing. Now all new projects need a very high level of pre-sales or pre-leases to even get a bank to take a

Although new forex loans are now rare – Pietraszkiewicz says out of 13,000 mortgages issued in February, only 1,200 were not in zlotys – they still make up almost 60% of outstanding mortgages and the worry is that if Poland's economy slows or unemployment rises, more borrowers will get into trouble. "Both banks and borrowers are much more aware of the risk," says Andrzej Jakubiak, head of the Polish Financial Service Authority, the banking regulator, which has clamped down on forex lending by increasing standards to such a level that very few banks offer anything but zloty mortgages. Despite the problems with forex mortgages, very few are delinquent; only 2.5% of mortgages are endangered. That is in large part because such loans were mostly made to upper middle-class clients in large cities, people who are still doing well despite the crisis in other parts of the EU. For the sector as a whole, nonperforming loans are about 7%, a number that shows signs of having stabilised. Safe haves Polish banks have a Tier 1 capital ratio of 12%, the core measure of a bank's

"I'm being cautious, but it shouldn't be a bad year" second look. "I'm not a big fan of cement in the economy," says Morawiecki. "I'm very careful not to repeat the mistakes that happened in Ireland and Spain." Lessons learned Polish borrowers and lenders are still smarting from the lesson administered by the country's affair with foreign currency loans – largely those denominated in Swiss francs. Such loans were very

financial strength, higher than in many west European countries. "We are very conservative when it comes to quality of capital," says Jakubiak, whose agency has pressured many foreign-owned banks not to pay out dividends this year in order to beef up capital. About two-thirds of Polish banks are owned by foreign parents – mostly Western European banks – and there

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had been worries that the Eurozone crisis could rebound on Poland if those banks decided to deleverage their Polish operations and siphon capital back to their home banks. "If there is a problem with those banks, it could be a problem for Poland," worries Marek Belka, the central bank governor. "If bad things happen, people tend to run to so-called safe havens." However, that has not happened yet in Poland. One reason is that Polish laws make management liable for any actions

Central Europe

that harm a Polish business. "If any banker sends capital to head office in a way that harms the Polish subsidiary, he'll be getting a swift visit from the prosecutor's office," says one banker. Another is Jakubiak's office, which closely monitors interbank flows to be sure that nothing untoward is happening. Finally, Polish banks are very profitable, often the only bright spot on the landscape of otherwise troubled European institutions. That was the reason that when Germany's Commerzbank

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said it was limiting lending throughout the region, it specifically excluded Poland. "The return on equity is much higher here than in western Europe," says Morawiecki, who adds that he see no sign of a "credit crunch" on the Polish market. It was that sort of environment that brought Santander to Poland – buying Bank Zachodni WBK in 2010 for €3.1bn from the troubled Allied Irish Banks and then buying the smaller Kredyt Bank from Belgium's KBC earlier this year.

companies will need to find funding of about €9bn by 2015. In all, Poland is expected to need about €50bn in energy investments until 2025 as old coal-fired plants are phased out and replaced with modern ones, as well as gas and nuclear plants, all while overall energy generating capacity is built up to accommodate Poland's growing economy.

A new energy in Poland

Cleaning up Poland has committed to generating more than 15% of its power from clean energy by 2020 – part of the EU's pledge to reduce CO2 emissions – creating a quickly growing new market. Wojciech Hann, a partner at Deloitte, the consultancy, estimates that coal's slice of the energy pie will shrink to about 55% by 2030, with the rest being taken up by renewable, natural gas and nuclear.

Jan Cienski in Warsaw

hen the last football fans decamped from Poland at the end of June, there were fears that the investment boom that they helped cause – Poland's five-year rush to build highways and airports in time for the Euro 2012 tournament – would fade, dragging down the economy with it. While indications are that the peak of the transport building frenzy have passed, the economy's salvation could lie in the forthcoming wave of investments in power generation. Mateusz Morawiecki, CEO of Poland's Bank Zachodni WBK, a unit of Spain's Santander, estimates that Poland will need to invest as much as €41bn in

energy over the next six or seven years. "The wave of investment could act as a cyclical buffer for the economy," he says, calculating that energy investments could make up for a predicted coming slump in consumption – one of the main drivers of the Polish economy in recent years – as well as a fall off in public investments in transport infrastructure. The scale of Poland's future needs is vast. Most current generating capacity was still built in communist times, and is largely fired by black or brown coal – providing more than 90% of Poland's electricity. Fitch, the ratings agency, estimates that Poland's three largest power

Although new coal plants are much less polluting than those built decades ago, there is little indication that hopes of turning coal into a true clean fuel through the use of techniques such as carbon sequestration are feasible. PGE, the country's largest utility, recently backed out of a pilot plant being built in central Poland, that is supposed to investigate whether there is an economic case for pumping carbon underground. PGE decided that with the cost of carbon emissions credits in the EU Emissions Trading System hovering at about €6 a tonne, while carbon sequestration costs 10 times as much, the scheme currently does not make much sense.

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Unconventional in Europe

bne There's no doubt predictions like that from the US Energy Information Agency (EIA) that the development of shale gas could potentially lead the US to become a net exporter of liquefied natural gas (LNG) by 2016, has Emerging European states, cowed by their overwhelming dependency on Russia for gas imports, salivating at the prospects for such production in their backyards. Yet while the consultancy KPMG argues in a June report that shale gas development in the region is "inevitable", it admits the industry won't be able to mirror the success of that in the US for a number of reasons. First, there simply isn't the same level of reserves of unconventional gas — hard-to-get-at deposits of tight and shale gas, as well as coal-bed methane — as in the US. Preliminary studies suggest that there are more than 650 shale formations worldwide, in 142 basins. This amounts to 456 trillion cubic metres (cm) of shale gas, of which 40% is estimated to be economically recoverable. Geographically, the US and CIS countries are estimated to account for nearly 60% of available shale gas resources worldwide. Europe, however, accounts for a much lower 7% of global shale gas reserves. Poland has the largest reserves in Europe, with technically recoverable shale gas resources put at 5.3 trillion cm of gas. KPMG also notes that while shale formations in the US are spread over a large basin area, within which mining developments have concentrated on a number of "sweet spots", Europe is more densely populated and a similar style of development to the US would bring drilling rigs closer to inhabited areas. The lack of free land for drilling stations might become yet another issue for European shale gas developments. Furthermore, known reserves of shale gas in Europe are located 1.5 times deeper on average than similar formations in the US, which might raise a problem of increased temperatures. "In some areas of Europe, the geothermal gradient is very high: for every 15-20 metres of drilling depth, the temperature rises by 1 degree Celsius (as compared to the worldwide average of around 33 metres)," KPMG says. The European regulatory stance towards the development of shale gas resources also varies greatly. Bulgaria and France banned exploration earlier this year, and on May 7 the Czech environment ministry put a two-year moratorium on shale gas exploration licenses until new legislation to oversee the process is put in place. "US legislation regarding land and mineral rights has played a major role in spurring the development of shale gas there… Rights to natural land and their soil minerals are generally granted to the land owner… This is a major difference as compared to the permitting process of EU member states, where land ownership does not grant the automatic ownership of underlying minerals, as every ground resource, unless legally specified, is owned by the state."

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Central Europe

level of emissions by the equivalent of Serbia's entire annual emission levels of 46m tonnes of carbon. But even that is not enough; the International Atomic Energy Agency (IAEA) reported last year that the overall levels of carbon emissions continues to climb strongly, up 38% between 2006 and 2011 to 389 parts per million.

That leaves scope for a stronger focus on renewables. "Poland is facing an explosion in renewable energy investments," says Hann. "This is proof that regulatory systems can create miracles." Renewables already make up just over 10% of Poland's energy production, however a significant portion comes from the questionable practice of dumping biomass – largely wood and straw – into coal-fired boilers to make them greener. The other main source of renewable power is wind, currently located mainly along the Baltic coast and with increasing interest in building offshore power stations. PGE has committed to spending more than €3bn on offshore wind farms, which it hopes will replace part of its existing coal capacity. Poland is also going to build up its natural gas generating capacity. Currently, almost no gas is used for power, with most of the 17bn cubic metres (cm) used by the country going to homes and industrial users. However, with Poland potentially sitting on large deposits of shale gas, the growth of gas in the energy mix is expected to increase, says PWC, the consultancy. Nuclear controversy Finally, Poland, like almost every other country in Central Europe, is looking at building up its nuclear power capacity. Poland was one of the few Soviet satellites that did not build a power plant in communist times, but the government is committed to opening two nuclear power stations by 2035. The issue has divided Poland from Germany, where opposition to nuclear power is strong in the wake of the Japanese disaster at the Fukushima plant, but Warsaw is determined to go ahead despite the cost of about €25bn. "There is no retreat from nuclear energy," insists Hann. PGE will formally open a tender for technology suppliers later this year, and the contract has attracted interest from the US-Japanese group GE Hitachi, France's Areva and Westinghouse, a unit of Japan's Toshiba.

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Now the bank is stepping up the pace. In 2011, the EBRD contributed $9bn of investment in 380 projects that have a total investment of $29.5bn, which means carbon reduction and energy efficiency made up 29% of the bank's entire investment portfolio.

Cutting carbon with the EBRD Ben Aris in London

istracted by the immediate problems of an imminent meltdown of the global financial system, global warming and the problem of rising carbon emissions has fallen off the radar for most governments, but not for the European Bank for Reconstruction and Development (EBRD). Carbon-reduction investments have grown to just under a third of the bank's entire investment portfolio, Jose Tanaka, head of the EBRD's division that deals with the issue, said at the EBRD's annual meeting in May. "The time to act is now, but where is the action?" he told journalists at a press briefing. "The problem is not going to go away." Since 2006, the bank has launched over 450 carbon-reduction projects that range from the large – focused on stopping Russian and Kazakh companies from flaring gas – to the small, such as putting heating insulation in "granny flats" as Tanaka calls them. "If we were

only concerned with bringing down the overall levels of carbon emissions, then we would concentrate all our efforts on working with a couple of energy companies flaring gas, where the reductions can be counted in the million parts per cubic metre for each project. But we

Baking hot Part of the reason for the bank's push is that energy efficiency and carbon reduction investments work especially well in emerging markets, says Tanaka. Widely seen as a rich world's problem, in developing markets issues like the cost of energy and pollution actually impact the poor more directly than in the West. Efficient energy and clean power producers bring much more immediate health benefits, plus they save money for the government that is badly needed for other things like social services and infrastructure investment. The trick is covering the high capital costs associated with these types of investment. Here a second problem comes in. As part of the drive to finance a transition to more responsible energy production

"Carbon reduction and energy efficiency made up 29% of the bank's entire investment portfolio"

need to take a more balanced approach if we are going to change attitudes and make people aware of the problem," said Tanaka. And the EBRD is having an impact. Its energy efficiency programme aimed at improving the use of energy at places like bakeries has already reduced the

following the Kyoto Protocol and then the climate conference in Copenhagen, a system of carbon credits was introduced that was supposed to allow countries with carbon surpluses to sell allocations, but the system has failed to take off. Of the $9bn the EBRD contributed to a total value of $29.5bn of projects, only $100m-$120m of the

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Lithuania pans Russian, Belarusian nuclear plans

Mike Collier in Riga Lithuania upped the ante in its nuclear wrangles with neighbouring Russia and Belarus on May 28 when Foreign Minister Audronius Azubalis launched a forthright condemnation of plans to build two nuclear power plants close to Lithuania's borders, alleging sub-standard safety, regulatory and environmental procedures and accident cover-ups at these and other plants being built in Russia. Speaking in Riga after talks with his Latvian counterpart Edgars Rinkevics, Azubalis didn't mince his words, saying he suspected both Russia and Belarus were "bypassing international safety and environmental standards". "This is not just an issue for Lithuania... it should be a matter of concern to all countries in this region," Azubalis said. "We should do everything possible to make these two projects develop according to international standards – it is vital." Asked by bne what proof Lithuania had concerning the safety of the Russian and Belarusian projects, Azubalis provided a Lithuanian Ministry of Foreign Affairs document containing detailed critiques of the two nuclear projects. According to Lithuanian government experts, the Belarus project, which will be just 50 kilometres from the Lithuanian capital Vilnius, has "No comprehensive seismic safety assessment", "No genuinely independent and capable regulator", and "No emergency preparedness and contingency planning". As regards Russia's Kaliningrad project a few kilometres from Lithuania's western border, the alleged faults include: "No environmental impact assessment of spent nuclear fuel transportation to nuclear waste repository in Sosnovyi Bor, near St Petersburg", and "Possible act of terrorism neglected – containment building not designed to withstand heavy aircraft crash." And that's not all - the document also alleges a Russian cover-up of a recent accident at the Leningrad Nuclear Power Plant II (NPP-2), which is currently under construction, saying that, "the mounted fixtures of [the] containment building collapsed. Such information has not been proclaimed in Russia officially." No date is given in the Lithuanian document for this alleged incident, but bne's own investigation found that it was on July 17, 2011. A source close to the principal contractor St Petersburg-based AtomEnergoProekt (SPb AEP) said the cause of the accident was "due to bungling and incompetence", and violations over the design and construction technology. It was only by chance that there weren't any casualties, as a few minutes before the collapse the construction workers had left to go to lunch. Other nuclear fears outlined in the Lithuanian government document include the possibility of an earthquake near the Belarusian site (a large one was recorded nearby in 1908) and the contamination of the Baltic Sea if something goes wrong when spent fuel rods are being transported hundreds of kilometres by ship from Kaliningrad to the huge Sosnovyi Bor waste facility – which is being built by the same companies responsible for Leningrad NPP-2 and are, therefore, notable for "mistakes, lack of quality, lack of competent staff, etc."

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financing was raised in the form of carbon credits. Ironically, despite being a notorious polluter, Russia has one of the world's biggest surpluses of carbon credits (because of its continent-wide forests). In January, the state-owned Sberbank said it would offer 100m carbon credits for sale worth approximately $500m, four times as many as the year before, but perhaps predictably, nothing happened. Part of the problem is the Russian government has made Sberbank the exclusive agent for Russian carbon credits (buyers of the credits have to pay the bank a fee on each deal). Secondly, the enormous volume of Russian credits potentially available – over 6m credits say experts – would be enough to swamp the European market and destroy the still-uncertain price for carbon credits and so destroy the market at its inception. "Six years ago, we were expecting carbon credits to be a major source of financing, but it is not – it has proven to be exceptionally difficult to develop," says Tanaka. "Where is the price of carbon now? The impact of the international economic and financial crisis means there is a difficult situation and the market that was supposed to be given an indication on the price of carbon is not functioning. We need to continue to work on developing this market, but we are clearly at the bottom of the cycle now."

"Six years ago, we were expecting carbon credits to be a major source of financing, but it is not – it has proven to be exceptionally difficult to develop"

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I 35

BOOK REVIEW:

"Hungary: Between Democracy and Authoritarianism"

Kester Eddy in Budapest

uring a cabinet meeting one day in 1990, Ferenc Rabar, then Hungarian finance minister, was called out to receive an emergency call; the deputy governor of the central bank said that the country's foreign exchange reserves had run out: he should therefore tell the cabinet of the need to freeze imports. Rabar returned to the meeting to find Hungary's leadership arguing over whether the pre-communist title for a county leader should be restored. Often outvoted at such meetings, Rabar kept the matter about the reserves to himself. The cabinet eventually voted - the old title was not restored. Democracy is an unwieldy, cumbersome form of government at the best of times. This anecdote, described by Vienna-based journalist Paul Lendvai in his book, "Hungary: Between Democracy and Authoritarianism", shows how even more cumbersome was the process of trying to establish democracy after 40-plus years of one party rule. In 256 pages, the Hungarian-born author surveys the tumultuous past quarter century of Magyar history, from the collapse of communism in 1987-89 to the current regime of Viktor Orban. To the Viktor, the spoils His early chapters contain numerous,

fascinating Rabar-esque insights (many otherwise now largely forgotten) woven into readable, well-buttressed analysis as to why the leader of the day – be he Antall, Boross or Horn – moved this way or that. In Chapter 4, he provides a penetrating analysis of Hungarian antiSemitism.

More worryingly, given the rise of Hungarian nationalism after 1920 and the unwillingness of the Hungarian right to fully acknowledge Magyar responsibility in the extermination of a large part of its Jewry in World War II, he says: "Fidesz now consciously played the card of the myth of the Hungarian nation."

Lendvai is scathingly critical of later Socialist prime ministers (Peter Medgyessy, who came to power in 2002, in particular), but given the remarkable rise of Viktor Orban to the summit of political power in Hungary, first in 1998 and again in 2010, and the subsequent partisan politicking that he has inspired throughout these years, it is understandable that much of the later pages focus on the former dissident law student.

Point by telling point, from orchestrating the "ruthless" and "mendacious" attacks on Socialist prime ministers Peter Medgyessy and, especially, Ferenc Gyurcsany, Lendvai chronicles how Orban was determined to win power in 2010, and then ensure he kept it. And on the way, he details how Orban uses powerful friends in the world of business to build up a loyal and sophisticated media network to provide unswerving support, while continually playing a dangerous game with neighbouring states that contain ethnic Hungarian minorities to keep national emotions running high.

In Lendvai's eyes – with the exception of his famous speech at the re-burial of executed 1956 leader Imre Nagy on June 16, 1989 – Orban starts off badly in terms of democratic deficit, and goes rapidly downhill from there. "After 1994, Orban and a handful of his closest friends began to transform the original grass-roots movement of young revolutionaries [ie. Fidesz]… into a charismatic 'Fuhrer' party," with the former liberal-style policies "replaced in both style and substance" towards the conservative values that Orban and his friends had once so mocked, Lendvai observes.

By the final chapter, written earlier this year, the author quotes Charles Gati, the Hungarian-US academic, to sum up the state of Hungary today: "Hungary is no longer a western-style democracy. It is an illiberal or managed democracy, in the sense that all important decisions are made by Orban." Playing the man Orban's supporters (and there are still many among the Hungarian public,

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"In Lendvai's eyes, Orban starts off badly in terms of democratic deficit, and goes rapidly downhill from there" despite falling in the opinion polls) will no doubt denigrate this volume as one written by a traitor to the Magyar cause. True, Lendvai has a spotted past. He was a communist and worked for the security forces in the early years of communism, but has denied right-wing media accusations that he continued such work in Vienna. Regardless, throughout this work he reveals an intimate, if depressing, knowledge of his native land and its politics, and is thoroughly well researched on Orban in particular. Given this, it is surprising he appears unaware that even Orban's famous entry onto Hungary's political stage – his dramatic 1989 speech at Imre Nagy's

reburial – was just one early example of his willingness to betray allies and break promises: Orban – along with other speakers – had earlier agreed to eschew modern politics at the event; all had pledged to dedicate the day to the "martyrs" of 1956. To this correspondent, this epitomises Orban's political existence – the very thing that launched his career and made him famous was based on a broken promise. And the foreign-currency crisis that Rabar faced in 1990 did not "somehow resolve itself" – it simply surfaced a few weeks later and, due to the inept handling of the Antall government, precipitated the famous "taxiblockade" in October that year.

Warehouse rising Jacy Meyer in Prague

hampagne, a string quartet, an aging but amusing Czech actor as the emcee – welcome to the new warehouse for supermarket chain Globus that was built by Prologis. If all that seems a bit much, consider this is Prologis' first new building in nearly four years and you'll get why they are so happy to celebrate. "Generally, the last three and a half years have been difficult for everyone

in real estate," says Ben Bannatyne, Prologis' managing director for Central and Eastern Europe, where this owner, operator and developer of industrial real has 3.5m square metres (sqm) of property across Poland, Czech Republic, Slovakia, Hungary and Romania. "But because we own, we have been able to keep leasing even through the crisis. In 2011, we had our biggest leasing year, signing 1.7m sqm of deals."

A colleague described this book as "antiOrban": but it is more than that. Lendvai shines a light into the murky, swirling psychological undercurrents that have dragged – and in the author's view, are once again dragging – the peculiar waters of Hungarian patriotism into a damaging and ultimately self-defeating nationalism: and, as Lendvai repeatedly points outs, this is once again against the weight of historical evidence. A history of Hungary is unlikely to be a global best seller, but this will surely be high up the "must-read" list for foreign diplomats and politicians who need to deal with Budapest – and will be so for many years to come.

"Hungary – Between Democracy and Authoritarianism", Paul Lendvai, Published by Hurst, ISBN: 978-1849041966

The Czech Industrial Research Forum reported that the total stock of modern warehouse space rose 75,600 sqm in the first quarter of 2012 to 3.9m sqm and that another 132,500 sqm is under construction. This suggests that the market isn't quite as dead as people have been making out. And Prologis certainly proves that point across the CEE region. Besides the newly opening 29,000 sqm Globus facility, the company recently opened another build-tosuit (when a company commissions a particular warehouse be built to their needs) in Wroclaw, Poland and has two more under construction. The latter are speculative builds, meaning that Prologis has yet to secure tenants for them. One is in Bratislava and the second in Warsaw. Both are set to be completed in 2012. CTP, a developer of manufacturing, logistics and office properties which also operates a network of industrial parks throughout the region, is building a variety of warehouses across the Czech Republic as well. "We are currently completing several projects such as a new 6,000-sqm production facility for the

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company ABB at our CTPark Ostrava; a production building for the company Coavis at the CTPark Brno; a warehouse for Dachser at CTPark Brno; a HP Pelzer production facility extension at CTPark Ostrava and others," says Paul Deverell, CTP's business director. Not all created equal While business in the region as a whole is looking up, one should be wary of lumping the various countries into the same CEE basket. Bannatyne says the group's operating portfolio is doing very well, but Prologis is staying very focused on its core markets. For Prologis, Poland is the leader on the market, then the Czech Republic and Slovakia; Bannatyne says these countries are where they see the most interest and plan to direct their resources. "Expanding geographically is definitely off the cards, expanding where we are is our focus – we are where we want to be and will grow in those markets." "Many people group the CEE together, but that shouldn't be done – each country is extremely different," he says. "Poland is the biggest, it is close to 50% of our total market, but it's also the most challenging for retailers and producers, as it's the most competitive market in the CEE. However being the biggest also means it's a focus for investors." He lists the Czech Republic and Slovakia as the most stable and least impacted by the global recession, and this can be seen in the company's focus on the two countries. CTP also has positive plans for the Czech Republic. "Long ago CTP decided to concentrate its efforts in the Czech Republic," Deverell says. "The central location sandwiched between Western and Eastern European markets as well as the skilled workforce, long history of manufacturing, universities and road transport infrastructure is still, we believe, a very attractive reason for businesses to set up here." Moving south though, Prologis finds a more difficult region. "Hungary is the most challenging overall from a

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real estate perspective; they are not proactive in terms of foreign direct investment and are a bit politically volatile," Bannatyne says. "Romania is completely different, they are much more southern Europe; they went through a real estate bubble in 2007 and were the hardest hit of all these countries in 2008." Poles apart While Poland is a clear regional leader – Colliers International said in a recent report the country "is set to emerge as a major force as it benefits from new infrastructure, manufacturing and consumer demand growth" – infrastructure remains a big question mark. Colliers warns that if there is any let-up in the development of planned transportation improvements and expansion, it would hinder industrial growth. CEE has a number of pluses, including low wage rates, strong transport links with Germany and central Europe, and independent, floating currencies. While these will help drive manufacturing growth, in the long term better linkages to global supply chains will be needed to sustain growth. And all this manufacturing and production growth will need warehouse space. Proximity to Germany is a huge plus for the Czech Republic, Deverell believes. "There is much speculation about what the future holds, however I believe the Czech market will remain buoyant partly due to the strength of its immediate neighbour, Germany," he says. "Happily, we have seen most of our existing clients follow through with their expansion plans in the first half of 2012 and we expect that to continue throughout the year." Deverell says CTP is keeping its eyes on other markets too. "We have land plots in strategic locations in countries such as Romania and Slovakia and will start developments there as we believe the potential still exists and demand is starting to return."

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Criticism from on high Nobel economist Paul Krugman is a garrulous fellow, often heard on the airwaves and read in newspapers and on social media. As such, he is a target for frequent criticism on Twitter – but it's not often it comes from a European head of state, according to the Wall Street Journal. The Baltic states of Latvia and Estonia have received plaudits, particularly from deficit-hawks, for engineering an economic recovery based on austerity. Yet Krugman, in a post on his New York Times blog in June, put up a chart of Estonia's inflation-adjusted GDP from 2007 to 2012, writing: "So, a terrible – Depression-level – slump, followed by a significant but still incomplete recovery. Better than no recovery at all, obviously – but this is what passes for economic triumph?" This prompted a response from Estonian President Toomas Hendrik Ilves, who tweeted with a link to Krugman's blog post: "Let's write about something we know nothing about & be smug, overbearing & patronizing: after all, they're just wogs… Guess a Nobel in trade means you can pontificate on fiscal matters & declare my country a 'wasteland… But yes, what do we know? We're just dumb & silly East Europeans. Unenlightened. Someday we too will understand. Nostra culpa." Fake tweets are a problem, so the WSJ checked it really was what it described as "the genial, bow tie-wearing Mr. Ilves who lobbed the Twitter bomb at the Nobelist? "Yes I send my own tweets," the president replied in an email. "It was a sincere and immediate defence of the major and often difficult efforts of Estonia to deal with the economic crisis and to stick to the rules adopted in the European Union."

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A blast from the past in Serbia

www.pierremorel.net

Nicholas Watson in Prague

ith government coalition talks on a knife-edge and barely hours after being sworn in as president, it seemed an odd time for the new Serbian president, Tomislav Nikolic, to cast aside his carefully honed pro-EU image and upset the country's neighbours by making some retrograde remarks about the Balkan wars that were more in keeping with his ultranationalist past. So why did he do it and what might this tell us about his presidency? Perhaps, say some, it's merely a new take on an old adage: that you can take the Serb out the ultranationalist party, but you can't take the ultranationalist out the Serb. Certainly, the comments were a blast from Nikolic's past; until four years ago, he was the right-hand man of Vojislav Seselj, the head of the ultranationalist Serbian Radical Party who is currently mouldering in a cell in The Hague.

Nikolic first infuriated Croatians with reported comments to a German newspaper, later denied, that Vukovar "is a Serbian town". Vukovar, located in northeastern Croatia, was the site of particularly nasty event during

no genocide in Srebrenica." Although Nikolic prefaced his comments by calling the Srebrenica massacre, in which Bosnian Serb forces killed an estimated 8,000 Muslim men and boys in 1995, a "grave crime", this wasn't good enough

"You can take the Serb out the ultranationalist party, but you can't take the ultranationalist out the Serb" the Balkan wars when Serb militias massacred over 200 mostly Croatians, including civilians and POWs, in a hospital, and by the end of the war the historic town had been reduced to rubble. A few days later, Nikolic declared in a TV interview just hours after he was sworn in on May 31 that, "There was

for most of the Balkan states involved in the bloody break-up of the former Yugoslavia in the 1990s. The most visible impact of his remarks was seen on June 11, when Montenegro was the only country to send its head of state to attend Nikolic's inauguration ceremony. Croatian President Ivo Josipovic and Bakir Izetbegovic, the

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Muslim head of Bosnia-Herzegovina's collective presidency, openly boycotted the inauguration over the remarks; the Slovenian and Macedonian presidents simply said they would not attend. The EU's enlargement commissioner, Stefan Fuelle, was the highest ranking official to attend the ceremony; most countries were represented by their ambassadors.

Kosovo were heating up. Northern Serbs have erected dozens of barricades since July 25, blocking roads in reaction to a Kosovan government police operation aimed at seizing border crossings in the north. This culminated in a June 1 operation to remove roadblocks that resulted in a peacekeeper from Nato's Kosovo Force, KFOR, being wounded.

Aleksandar Vucic, head of the Serbian Progressive Party, the party that Nikolic created after splitting with the Radical Party, explained away the controversial comments with a rather ambiguous: "Tomislav Nikolic used to say this, but it is not what he is saying today."

Gerard Gallucci, a former UN peacekeeper in Kosovo, speculates on his blog that, "the order for KFOR to upset peace and calm in Kosovo must have come from some cabbadost somewhere

Except he is, leading to the not-soshocking conclusion that Nikolic was merely guilty of blurting out what he actually believes. Few are under any illusions that Nikolic underwent a Damascene conversion and is an ardent pro-European (his first visit after winning the May election was to Moscow). Rather, he is a pragmatist, and his move to the centre is one that he believes will benefit Serbia (and his party) in the longer run. And in comments to bne before he was elected, he hove to the pragmatic line over Kosovo, saying that "the use of force in order to create a new and different reality on the field cannot represent a good alternative to mutual agreement, mutually accepted by Serbian and Albanian people". Instead, he said, "with goodwill, the mediation of the international community and probably uncomfortable concessions on both sides, it is possible to come to sustainable solution acceptable for both sides."

classic politics and low level tensions on the ground in northern Kosovo." The main task at hand for Nikolic is not abroad, but at home. By the end of August, the president has declared that Serbia must have a new government in place, following the May 6 parliamentary elections that were narrowly won by his Progressive Party, but ultimately inconclusive. That uncertainty over the country's political direction plus a lack of talks over the renewal of a $1.3bn international bailout loan has caused the local

"Tomislav Nikolic used to say this, but it is not what he is saying today" within the Quint [France, Germany, Italy, the UK and the US] who has not yet learned the lesson that force won't subdue the Serbs." "It may also have been that these Quint 'thick-heads' thought it a good thing to teach the new Serbian president a 'lesson' just as he takes office," Gallucci goes on to say.

Indeed, throughout June, Nikolic strove to make amends, insisting at meetings with officials in Brussels that he intends to press on with Serbia's bid to join the EU and even held out the possibility of holding direct talks with Kosovan President Atifete Jahjaga. And it's there, in Serbia's erstwhile province of Kosovo that declared independence in 2008, that analysts believe lies the reason and timing for the unfortunate comments.

An aide to Nikolic tells bne that the recent actions of KFOR and comments from Nikolic are merely political "foreplay" before new talks between the EU and Serbia start, which promise to be tough, not least because the ongoing crisis in the EU has meant the bloc has lost its sparkle to many Serbs and Nikolic is going to be a much tougher person to deal with than previous president Boris Tadic ever was. Indeed, Nikolic seemed to say as much when he asked rhetorically: "If Boris Tadic has already been to Srebrenica, if he condemned the crime in Srebrenica, if the Serbian parliament has done the same, then why would I revive that issue again?" (A statement that was rather undermined by him going on to do just that.)

Wherefore, KFOR? Nikolic's comments came just as tensions in the Serb-dominated northern part of

Assuming it's mostly political posturing, the Nikolic aide concludes: "I do not expect that these tensions go beyond

currency, the dinar, to fall to historic lows against the euro. Worse is ahead, as the country's Fiscal Council, a three-member body monitoring budget performance, said on May 30 that Serbia faces the threat of a debt crisis after the budget deficit rose to 7-8% of GDP and public debt approached 50% of GDP. Nikolic's Progressive Party won 73 seats in the 250-seat parliament, but without a majority and no ally large enough to form a majority with, the next government was looking to be a repeat of the old one, made up of Tadicâ&#x20AC;&#x2122;s Democratic Party with 67 seats, the Socialist Party with 44 seats, and a third partner that would give them the 126-seat parliamentary majority. However, things have not proved so straightforward. And on June 14, Tadic described the talks as tough, "because it's difficult to establish a majority in a parliament that has 46 parties." He added that, "People need to make a compromise and that's tough". And indeed, in this part of the world where inat rules hearts (a self-evidently counter-productive action done precisely because it is self-evidently counterproductive, in order to display defiance), that's been precisely the region's problem.

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"with an estimated 0% growth rate for 2012, the odds are that things could get even worse…[unless] strong and decisive measures [are] implemented immediately after the inauguration of the new government." Limited options Serbia's room for manoeuvre, however, remains limited. As Prokopijevic warns, the country cannot borrow on the international market, because yields would surpass 9% for 10-year bonds. Though "Serbia has a much lower debt than nearly all Eurozone countries, it is nevertheless on the Greek path."

Serbia's public finance imperative Ian Bancroft in Belgrade

midst much conjecture about the direction that Serbia's new president wants to take the country, it is the state of the country's public finances that is causing most concern domestically – expediting the usually lengthy process of forming a government after the May elections. On June 7, the Serbian central bank was forced to raise interest rates by a half point to 10% as a way to halt the precipitous decline of the dinar, which is down around 11% this year on a combination of a deteriorating economy and a lack of government in place since the inconclusive elections. The direst warning yet about the economy came on May 30 from the country's Fiscal Council, which monitors budget performance, which said that Serbia will require an additional €2.5bn to finance its liabilities this year. With its year-to-date deficit totalling some €687m (equivalent to 7-8% of its GDP), Serbia's budget deficit remains

considerably higher than that agreed with the International Monetary Fund (IMF), whilst its public debt now stands at 46.7% of GDP, above the IMF-stipulated limit of 45%. As a result, the IMF's €1bn standby loan deal is now on hold. According to Miroslav Prokopijevic, a Belgrade-based professor of economics,

Not that Serbia is the only country in the region facing such challenges. "Slovenia, as an EU and Eurozone member, faces similar problems with a debt of only 45% of GDP," Prokopijevic points out. A quick fire sale of remaining state assets is unlikely given the unfavourable market conditions. The Serbian government was last year forced to cancel the sale of a 51% stake in Telekom Srbija after failing to secure the €1.4bn minimum asking price (the sole bidder, Telekom Austria Group, offered only €1.1bn). This comes on the back of failed efforts to privatize Jat Airways, the national airline. The proposed sale of Komercijalna Banka, meanwhile, has caused a great deal of controversy and there is a general reluctance to relinquish other strategic assets – such as Elektroprivreda Srbije and Srbijagas – in the current economic climate.

"Though Serbia has a much lower debt than nearly all Eurozone countries, it is nevertheless on the Greek path" Serbia will face a debt crisis in 20122013, as the public debt in real terms is probably "close to 60%, because GDP is heavily overestimated in 2012". As Dr Danica Popovic, from the Faculty of Economics in Belgrade, tells bne,

Indeed, Serbia was recently forced to renationalise the former US Steel plant to prevent its closure. In the short term, Popovic believes that Serbia will need to adopt "fire-extinguishing measures," such as raising VAT

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(from 18 to 20-21%) and freezing pensions and public sector wages. Serbia will also have to cut back the subsidies and sovereign guarantees provided to inefficiently state-run companies, lay off some 5% of public sector workers and raise the retirement age for women to 63 (up from 60). Looking ahead, however, "reforms of the tax administration and of the pension system seem to be the only long run remedy in this situation," claims Popovic. The foreseen spending cuts – which could bring €1bn in savings – will

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With Tomislav Nikolic of the Serbian Progressive Party (SNS) having defeated previous presidential incumbent Boris Tadic of the Democratic Party (DS), Serbia faces a period of cohabitation, with the latter expected to serve as prime minister in a government containing, amongst others, the Socialist Party of Serbia (SPS). Attempts to redefine the relationship between the post of prime minister and the constitutionally weak office of the presidency – through which Tadic had previously consolidated power – is likely

"Serbia will face a debt crisis in 2012-2013"

further fuel socio-economic tensions in a country where unemployment stands firmly above 20%. The deficits have already driven Serbia's currency to a record low against the euro, despite the National Bank of Serbia having sold some €1.18bn this year to prop up its value. Whilst those with borrowings in foreign currencies feel the strain, Popovic insists that, "a feasible strong depreciation might well reduce labour costs and thus raise competitiveness, which could make foreign investors more interested in coming to Serbia than would otherwise be the case." Against the backdrop of Europe's debt crisis, however, the prospects for sizeable foreign direct investment remain bleak. For Prokopijevic, "without profound pro-market reform, including the rule of law – and this is highly unlikely to happen – Serbia will remain a relatively poor business environment able to attract €0.8bn to €1.5bn in FDI per year… even less if the Eurozone crisis worsens."

to result in severe political instability, as politicians jostle to assert blame and attribute responsibility. Facing a disparate governing coalition, internal factions within the DS jockeying for influence and questions about his political legitimacy, Tadic may soon wish that he'd retired gracefully. Whilst many presume that cohabitation between a president and government of different political shades will allow Serbia's politicians to take tough political decisions on Kosovo, the escalating public finance crisis will provide a more severe challenge of a very different sort. Indeed, in order to distract from the rising social tensions that await, a slightly tougher stance on Kosovo – plus renewed impetus for ties with Russia – may prove ever more appealing. First, however, as Popovic notes, Serbia's politicians and public will need to understand and appreciate just "how grave the situation is."

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A shot rings out In terms of marking a turning point in Romania's fight against corruption, it was certainly dramatic. The police arrived at Adrian Nastase's house four hours after a court sentenced Romania's former prime minister to two years in prison for a party funding scam on June 20. Affable as ever, Nastase reportedly asked the police officers to wait a moment while he fetched some books. When he did not return after a few minutes, the police followed him inside to find the 61-year-old brandishing a Smith & Wesson pistol, which he turned on himself, firing a single shot. He underwent minor surgery for injuries to his neck and collarbone soon after. His doctors said his life was never in danger, but he is expected to stay in hospital for five days and his lawyers asked to delay the start of his sentence by three months. Good behaviour could see him released after eight months. Nastase's government from 2000 to 2004 is widely seen as among the most corrupt in Romania's post-communist history, but after an eight-year trial involving 972 witnesses, he was sentenced for the relatively minor crime of concealing his donations to his party, the Social Democrats. Though the trial was long-winded and the conviction relatively minor, his sentencing, the first of such a senior politician, is a sign that Romanian courts are now functioning, argues Alina MungiuPippidi, a professor at Berlin's Hertie school of governance. Until now, she says, senior judges in higher courts have tended to be particularly favourable to Social Democrats, having taken their positions under the party's communist forbears. This time, the judges have revealed a nest of corruption and nepotism, operating on the basis of punishment and reward.

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bne July 2012 A Turkish man stands drinking beer in the central Istanbul restaurant and bar district of Beyolgu. For years, tables and chairs crowded this neighborhood, including the passageways behind him. Now they are gone, with some proprieters claiming they are being pressured to pay taxes on them.

the grey economy, according to some analysts. Rather than increasing direct taxes, Turkey has actually decreased taxation for corporations with the aim of increasing the country's competitiveness. On May 31, Turkey's parliament passed a draft bill that will change tax regulations that are seen as an obstacle to preventing fund management firms from opening offices in Turkey.

Taxing times in Turkey

The government also appears to be leaning toward supporting entrepreneurs via tax incentives. "In this period when the global economic outlook is grim, it is very important to support and encourage our entrepreneurs," Deputy PrimeMinister Ali Babacan was quoted by the Anatolia News Agency as saying in May.

Justin Vela in Istanbul

ables and chairs are slowly reappearing in front of many cafes and bars in Istanbul's central Beyoglu district. Last summer they disappeared, with city officials saying they were not permitted, dramatically altering the landscape of Beyoglu and causing a downturn in business that is said to have led to the closure of some establishments. Now they are coming back, along with rumours that the city is extracting taxes for the permission to have the tables and chairs outside. Was the bizarre show of force followed by leniency only an example to make taxadverse Turks pay up? The trend in Turkey is to evade taxes at all costs. According to a study by Istanbul's Bogazici University, only 24.6% of total taxes are collected as a percentage of GDP in Turkey. In 1995, it was only 16.8%. The current average for the Organisation for Economic Co-operation and Development (OECD) countries is 33.8%. According to the country's revenue administration, laws on taxes in

Turkey are the income tax law (ITL) established in 1960 and corporate tax law (CTL) established in 1949. Any individual with their place of residence in Turkey is liable to pay tax of 15-35% on his worldwide income. Anyone in Turkey for more than six months of a year is assumed to legally be a resident. Corporate entities with their head

The flip side of not strongly going after tax evaders is that many Turks tend to remain working in the grey economy. In October 2011, the Parliamentary Assembly of the Council of Europe (PACE) named Turkey as one of several leading economies with a large informal, and therefore untaxed, economy. The study estimates that Turkey's grey economy constitutes about

"The flip side of not strongly going after tax evaders is that many Turks tend to remain working in the grey economy" office in Turkey or place of effective management are taxed on their worldwide income at a rate of 20% of all earnings.

33% of the country's GDP. In April, tax revenue growth slowed to 4%, a sign of this year's economic slowdown, according to economists.

Laws are laws, but in Turkey clearly most people skirt these direct tax ones. There is even a sense in Turkey that direct taxes are actually bad for the economy and that they push people towards

Partly due to many citizens not paying the required income and property taxes, Turkey has struggled to address budgetary issues. First-quarter data released by TurkStat shows that the budget regis-

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tered a TRY6.4bn (€2.8bn) deficit in the first three months of the year. So in order to increase the budget, the country has introduced a raft of indirect taxes in recent years, an example of which is the alleged tax on the tables and chairs around Beyoglu. Unpaid dues The main indirect tax in Turkey is VAT, which currently stands at 18%. There is also a stamp duty on contracts, agreements and notes payable at rates that range from 0.15%-0.75%. There are taxes on motor vehicle registration that are paid in two yearly instalments, and banking and insurance transactions. Casinos are not legal in Turkey, but there is a gambling tax levied on lotteries and other forms of betting. There are also taxes on inheritance, gifts and also customs duties. Yet, the most irksome form of taxes for Turks are the ones they just cannot escape: special consumption taxes (SCTs). Today, about 60-65% of Turkey's total tax revenues comes from SCTs, according to the Bogazici University study. These include taxes on petroleum

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products, natural gas, lubricant oil, solvents, derivatives, automobiles, planes, helicopters, yachts, and luxury products such as tobacco and alcohol. Some argue that indirect taxes put the tax burden unfairly on the poor and let the rich get away with paying less, increasing inequality. However, instead of more aggressively going after tax evaders and increasing direct taxes, the Turkish government has focused on indirect taxes to gain revenues. SCTs on alcohol and tobacco have been raised several times in the past two years, fostering concerns among secularists that the Islamist-rooted ruling Justice and Development Party (AKP) is using taxes to stealthily impose its religious views on society. The effects of the SCTs are felt in other ways also. Sales of automobiles and light commercial vehicles in Turkey shrank by 20.7% between January and May, partly due to the increase in SCTs, claims Hayri Erce of the Association of Automotive Distributors.

Ian Bancroft in Belgrade

A spate of incidents – including the killing of five ethnic Macedonians in early May – demonstrated the persistence of underlying tensions between

the UK and Sweden in taxes on diesel gas. "Turkey imposes the highest tax on gasoline, with a €1.04-per-litre tax," according to a March statement from the Petroleum Industry Foundation of Turkey (PETDER). Petroleum accounts for 30% of Turkey's tax revenues, Finance Minister Mehmet Simsek said in April, according to the Hurriyet Daily News. Confusion over these indirect taxes have also fed conspiracies among traditionally suspicious Turks. Take the alleged taxes over tables and chairs – according to some bar and cafe owners interviewed by bne, taxes must now be paid to the Istanbul municipality for the right to have tables and chairs outside their establishments. Yet others dispute this, saying that once they painted the outside of their properties and scaled back the number of chairs and tables so as to not impede passersby, the municipality had no issue with them. Still others say they have not been asked to pay anything yet still are not allowed to have tables and chairs outside.

Turkey has some of the highest gasoline taxes in Europe, ranking third between

Macedonia's ethnic fragmentation

ver a decade on from the signing of the Ohrid Agreement that ended armed conflict between the ethnic Albanian National Liberation Army and Macedonian security forces, this small former Yugoslav state is once again showing signs of inter-ethnic strife.

I 43

the respective communities, despite the much-vaunted success of international engagement. As Edmond Ademi, executive director of the Liberta Institute in Skopje, tells bne, "inter-ethnic relations and trust between the two largest ethnic communities are at their lowest" point since 2001. Ademi points to failures to fully implement the Ohrid Agreement (the deadline for which passed in 2004),

accusing Macedonia's prime minister, Nikola Gruevski, of demonstrating questionable devotion to strengthening inter-ethnic relations with remarks that "we respect – but don't like – the Agreement." On the flip side, Ademi blames Albanian political parties for misusing the Ohrid Agreement for their own interests and for "making the secretariat for implementation of the Agreement an employment agency for party activists of the ruling Albanian party." Ademi holds out little hope for any positive changes under the current administration, asserting that the spirit of the Ohrid Agreement has gone, only the body remains. Named and shamed Aside from renaming Skopje's international airport after Alexander the Great, other provocative moves by the Mace-

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donian government include the "monoethnic" and somewhat ostentatious Skopje 2014 project. With its showpiece 22-metre-high bronze equestrian statue of the aforementioned ancient warrior, Skopje 2014 – which has cost some €300m to date – invokes the spirit, if not quite the style, of classical antiquity. Macedonia's progress towards the EU and Nato membership has remained stalled by the infamous – yet to many, tedious – name dispute with Greece, which opposes the use of "Macedonia"

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gration is maybe the only issue that all of the ethnic communities agree on… [and] the faster the country integrates, the less possibility for the escalation of inter-ethnic relations." Without the unifying orientation provided by EU accession – itself a potential victim to enlargement fatigue – the strain on inter-ethnic tensions will likely continue to mount. Misery heaped upon misery Macedonia's dire economic situation is another contributing factor. As Ademi

"The spirit of the Ohrid Agreement has gone, only the body remains" without some geographic qualifier, and insists upon reference to "the former Yugoslav Republic of Macedonia" (FYROM). As Ademi warns, "it's clear that without finding a mutual solution on this issue, there will be no way forward for Macedonia." Despite December's ruling by the International Court of Justice that Greece had breached its obligation under the 1995 Interim Accord, a lasting resolution remains elusive. Assertions that the Greek debt crisis strengthens Macedonia's hand are pure wishful thinking, as the former's renewed opposition at the recent Nato summit in Chicago clearly demonstrates. For Damir Neziri of the Community Development Institute, which promotes inter-ethnic tolerance, the problems run much deeper. "People live in two parallel societies – a Macedonian and Albanian one," he says, unaware of the other's "culture, language and traditions." Neziri points to "systematic problems" that mean school children study in "different schools, different shifts or different buildings." External obstacles to Macedonia's EuroAtlantic integration have had profound ramifications on such internal relations. As Neziri points out, "EU and Nato inte-

notes, Macedonia is a country with 35% unemployment and 30% poverty. "Recently, The Economist placed us on top of its Misery Index." Ademi warns that the state coffers are almost empty and the government continues to borrow at enormous interest rates, like the last one of €270m from Deutsche Bank, with a 7% interest rate. Further, instead of investing in job creation and economic growth, "the government keeps spending millions on unproductive projects." On June 1, the International Monetary Fund (IMF) concluded its assessment of

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persevere in their pursuit of macroeconomic and financial stability, building on advances made thus far."

With continued instability in neighbouring Kosovo, there are concerns of another type of "spillover" as incidents in one place spread to another, thereby exporting instability throughout the region. Such a hypothesis pertains, in particular, to the case against partitioning north Kosovo – that such a step would ignite similar claims not only in Macedonia, but in southern Serbia, Bosnia-Herzegovina and even Montenegro. For Ademi, "all three aspects - bad inter-ethnic relations, no progress on Nato and the EU, and a weak economy – make the country very fragile; both inside and outside." With little sign of progress on the external obstacles, full implementation of the Ohrid Agreement remains essential if Macedonia is to continue on the path of reform, particularly as Europe's carrots turn sour. Building inter-ethnic tolerance is, however, a much weightier and lengthier challenge.

Nonetheless, there is always cause for optimism. As Neziri wisely points out, "there is one thing that is true – in the business sector no one cares if their partner is part of this or that ethnic community." Stimulating business, therefore, may hold the key to building Macedonia's inter-ethnic and economic harmony.

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these efforts. As a small and open economy, Croatia is being negatively affected by the weak economic conditions in the euro area and other EU countries, which are its main trading partners and sources of foreign credit and investment."

Indeed, without urgent reforms, Macedonia faces the continued prospect of economic stagnation, leaving its citizens ever more dependent on remittances from abroad. Neziri is highly critical of politicians exploiting inter-ethnic tensions to distract from the economic difficulties and win votes, thereby "further radicalizing the whole situation."

"Bad inter-ethnic relations, no progress on Nato and the EU, and a weak economy make the country very fragile – both inside and outside" Macedonia, which was mildly supportive, saying that while economic growth has slowed (expected to slow to 2% in 2012 form 3% in 2011), Macedonia’s medium-term outlook remains generally favourable. However, "to address challenges posed by possible adverse spillovers from the euro area, [IMF] directors encouraged the authorities to

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Croatia's conundrum – spending or rating cuts? Guy Norton in Zagreb

n recent times, the economic news out of Croatia has been as changeable as the country's weather – with bright blue skies and scorching sunshine one minute, only to be followed by coal black clouds and torrential downpours the next. Looking on the bright side, Moody's Investors Service at the end of May became the last of the three major global rating agencies to confirm that Croatia had maintained its investment grade position. Given that more than a few observers had seen Croatia as a shoo-in for a downgrade to junk status this year, the centre-left coalition that came to power just before Christmas has notched up a noteworthy hat-trick in retaining the country's prized investment grade status. For the moment at least. For while Moody's kept Croatia's rating at 'Baa3', it did revise the outlook on it from stable to negative, citing concerns about the sustainability of the country's current economic model and doubts over whether the government can push through fiscal reforms.

With the Croatian economy more or less continually mired in recession since 2008, Moody's is skeptical about whether

Lack of industry Recent data also have given rise to concerns over Croatia's economic outlook. Although the government is sticking to its forecast that the economy will emerge from recession this year – it is looking for GDP to expand by 0.8% – that looks an increasingly tall order after the Central Bureau of Statistics announced that GDP in the first quarter had in fact fallen by 1.3%, which was better than the consensus estimate of a 2% decline by local analysts, but confirming the fact that after two quarters of mildly positive growth in the third and fourth quarters of 2011, Croatia is once again on the brink of recession. Another troubling statistic concerns the fall in industrial production, which fell by 9.4% on year in April. That is the biggest drop since November 2009 when industrial production sank by 9.9% and was almost twice the 5% consensus forecast expected by local analysts. With industrial production having fallen a total of 7.1% in the first

"We need to pray to god for warm weather so the agriculture and tourism sectors grow by 10% and the drop in GDP would be just 1%" the country's leaders can implement the structural reforms that will be necessary to return Croatia to a sustainable growth path. "Croatia's future growth prospects face significant risks, in part because of uncertainties regarding the pace and scope of the structural reforms being undertaken by the authorities to re-orient the economic model towards exports and foreign direct investmentfinanced investments," notes Moody's sovereign risk analyst Lucie Villa. "The unfavourable external environment will also present significant challenges to

four months of this year, hopes of an industry-led economic recovery this year are looking increasingly forlorn given the toxic combination of both weak domestic and foreign demand. Zrinka Zivkovic Matijevic, head of research at Raiffeisen Bank in Zagreb, says the recent poor industrial production numbers reflect the extremely low competitiveness of Croatian industry. "For this year as a whole, we expect industrial production to fall around 5% year on year."

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Not a LOT for Turkish Airlines

bne In June, Turkish Airlines backed out of talks to buy loss-making LOT Polish Airlines. Warsaw says it will continue to talk to the other suitors it insists there have been all along, though the fact the deal was scuppered by EU legislation barring owners from outside the bloc holding majority control is bad news for struggling airlines across Europe hoping for a saviour from the east. Turkish Airlines had been upfront and bullish on its bid to buy out the struggling Polish flag carrier in order to establish a base in Central Europe, saying it hoped to have the deal wrapped up by early summer. Therefore, its blunt statement to the Istanbul Stock Exchange on June 1 that it was withdrawing from negotiations came as a surprise, especially given Turkish Airlines has known all along about the EU law that outlaws companies from outside the bloc owning more than 50% in any EU airline. In an interview published on June 11, Turkish Airlines CEO Temel Kotil told daily Rzeczpospolita that he had "hoped that his lawyers would find some kind of loophole [in the EU law]. Unfortunately, it turned out this is not possible." This will alarm a host of flag carriers outside the three major European alliance groups (Star Alliance, Sky Team and One World) that are hunting for new investment. The pool of candidates is limited, with Turkish Airlines joined by operators from the Middle East such as Emirates as the only likely saviours. Spokeswoman for Poland's Treasury Ministry, Magdalena Kobos, told journalists that after receiving formal notice from Turkish Airlines, "we will return to talks with other partners who have declared an interest in LOT." Poland has been enthusiastically chatting up China in recent months, inviting investment as it seeks to make itself the Asian giant's premier partner in CEE. Although it may have come relatively early in the relationship, the sale of a 68% stake in LOT is just the sort of situation for which that effort has been designed. On May 31, Polish Deputy Treasury Minister Rafal Baniak met with the chairman of Air China, voicing hope that that the airline may be interested in the privatisation of LOT. However, sources close to Air China told Polish Radio that privatisation talks took place only once, and that "that is too little to warrant talks concerning any interest of Air China to purchase LOT." At the same time, like any other investor, the Chinese are unlikely to be interested in a non-controlling stake in the Polish airline.

Similarly, Croatian consumers seem an equally unlikely source of help for the country's financial fortunes, with retail sales in April slumping by 7.3% on an annual basis. That figure was also much weaker than expected, with local analysts having forecast a drop of just 1.9%. The last time retail sales recorded such a large drop was in April 2010 when they fell by 8% on an annualized basis. "This was really a negative surprise," says Alen

Kovac, chief economist at Erste Bank in Zagreb, adding that while he expects some rebound in spending in the summer holiday season, for the year as a whole he expects consumption to shrink compared to 2011 as a result of falling disposable income levels attributable to increases in VAT and utility prices. The recent set of downbeat data mean the consensus estimate among

economists in Zagreb is that GDP could decline by as much as 2% this year. Commenting on the economic prospects for the rest of the year, Ljubo Jurcic, a professor at the economics faculty of Zagreb University, told state broadcaster HRT: "We need to pray to god for warm weather so that the agriculture and tourism sectors grow by 10% so that the drop in GDP would be just 1%, which would be a good result for 2012." Cutting the fat Given the weakness of the real economy in Croatia, the onus is now firmly on the government to act quickly and decisively to shore up the public sector's finances to ensure that the country retains its investment grade ratings and attracts much-needed foreign direct investment to kickstart the economy. One of the thorniest issues that the government is looking to address is the level of staffing at a number of leading state-owned enterprises such as power company HEP, rail firm HZ and motorways operator HAC. Finance minister Slavko Linic has announced that at least 15,000 employees will be laid off from these and other firms by 2015. While the private sector has shed over 150,000 since 2008 and many employees have had to accept pay cuts, the public sector has so far been spared any redundancies and workers in state companies have actually seen their salaries rise by an average of HRK350 (â&#x201A;Ź46.60). Unsurprisingly, public sector union leaders firmly oppose the idea that their members should pay the price for past governments' economic failures and have already threatened to stage a series of nationwide strikes if the government seeks to push through radical changes to existing collective bargaining agreements which expire at the end of July. Whether the government displays the required mettle to face down any labour unrest will be a key test of its economic credibility. According to Raiffeisen, "the government has no alternative but to continue down the road of cutting expenditures."

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The CES â&#x20AC;&#x201C; like the EU, but better Ben Aris in London

he countries of the former Soviet Union have tried to join forces into a common economic bloc three times since the fall of the USSR with middling success, but with the approaching Common Economic Space (CES), it looks like they have finally cracked it. If things go according to plan, most of the countries of the former Soviet Union will end up in a trading bloc designed to function better than the EU. The governments of Russia, Belarus and Kazakhstan have already been in a Customs Union since January 2010, but the next step will be to create a CES, which should take shape over the next year or so, with a final foundation agreement drawn up and signed by the beginning of 2015. "We were trying to copy the European Union," says Tatiana Valovaya, who has done much of the negotiating for the Russian side. "We are extremely grateful to the EU for its problems, as they have taught the lessons we need to make the Common Economic Space a reality." Uniting the markets of Eastern Europe and Central Asia makes a lot of sense. Their economies remain tightly tied

together by trade and industrial connections imposed by Stalin that have never been completely undone. For example, nearly all of Ukraine's helicopter engine production is exported to factories in Russia's Tatarstan, and a "Minsk" fridge can be found in the majority of homes from the Baltic Sea to the Pacific coast. But obvious political enmities have made building a common trade bloc difficult and trade spats abound. Ukraine and Russia had a big row over gas deliveries in 2006 that is still roiling relations. Moscow banned Belarusian dairy products last year and Ukrainian cheese this year. Georgia's salty Borjomi mineral water (a favourite Russian hangover cure) is still absent from stores in Moscow four years after the short Russo-Georgian war. And Moldovans have been unsuccessful in persuading the Kremlin to restart imports of their wine and cognac. First steps The first attempt to unite the economies of the former Soviet Union was the Commonwealth of Independent States (CIS), signed by Boris Yeltsin for Russia, Stanislau Shushkevich for Belarus, and Leonid

Kravchuk for Ukraine in Brest in December 1991, which brought the Soviet Union to an end. Two weeks later, another eight of the former republics joined the club (the Baltic states stayed out.) The CIS has been a useful body and a badly needed forum for the former states to disentangle themselves, but as an economic bloc it doesn't work very well. Vladimir Putin tried to restart the process with the Eurasian Union early on in his first stint as Russia's president in 2000, but the idea didn't catch on. Putin has had more success with the Customs Union, which has unified import duties and regulations between Russia, Belarus and Kazakhstan. Since it was founded, Russia has seen trade with the other two members increase by just over a quarter to a total of $91bn in 2010 and it was up again in 2011 by another 35%. But the CES is the big prize and looking increasingly likely to happen. "The additional growth in Belarusian GDP by 2030 from the CES could be 14%, Ukraine 6%, Kazakh 3.5%, and Russian 2%," predicts Igor Finogenov, chairman of the Eurasian Development Bank (EDB), which is dedicated to promoting

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regional integration. "Belarus, Ukraine and Kazakhstan are expected to benefit the most in terms of per-capita effects and Russia the most in absolute terms." Kazakhstan and Belarus are far smaller than Russia, but the benefits for Minsk in particular are huge: despite its small size, Belarus is the most export-oriented economic by far, not only in the CIS but

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a common economic space where companies will be free to move to any of the member countries and enjoy exactly the same business and trade conditions. "We need a fully integrated space, not like the European Union of 1968. Companies need to be able to choose freely between countries and pick the place that suits them best," says Valovaya, who has consistently argued

"Russia has decided that it doesn't want to dictate to the others as the biggest economy in the club" Europe as a whole, sending 85% of its production overseas. Russia's commitment to Belarus was underlined after Putin snubbed US President Barack Obama's invitation to a G8 summit and chose instead to visit Belarusian President Alexander Lukashenko in Minsk at the end of May as his first foreign trip after reassuming the presidency. He also flew to Beijing, Astana and Tashkent on the same trip. "The choice of countries for Putin's first diplomatic trip is a strong signal of his focus in the coming years," says Lilit Gevorgyan, an analyst with IHS Global Insight. "His priority will be developing trade ties with key EU players and China, while strengthening the relations with those former Soviet counties that could become the core of the Eurasian Union envisaged by Putin." One serious fly in the ointment of the CES plans is Ukraine. Already a major trade partner with the other Customs Union members, Kyiv wants to integrate further with the EU and has negotiated an EU Association Agreement (though that is currently in limbo and remains unsigned due to the political row over the fate of jailed opposition leader Yulia Tymoshenko). Valovaya says that Kyiv cannot be a member of both CES and the EU at the same time – unless the CES as a body signs a free trade agreement with the EU, something that she doesn't rule out. Further integration The Customs Union caters to 170m consumers, but it is still only a halfway house; the goal of the CES is to create

for a "Separately impossible. Together" approach to regional politics. And the recent global meltdown has turned out to be a boon for the project. "The crisis that began in 2007 made everyone see that we need to enhance our integration and pushed everyone into acting," says Valovaya, who holds a doctorate in economics and is a professor at Russia's Financial academy. "The Customs Union is now in place. At first no one believed the rhetoric, but they were pleasantly surprised and it is there now." But there is still a lot of work to do. The CES will be built through signing treaties and 17 already have signatures on them with another 80 under discussion now. Moreover, the CES lacks a basic foundation document – analogous with Europe's Treaty of Rome – to underpin all the other legislation. "Joining up to the CES cannot be an 'a la carte' deal, but a set menu," says Valovaya. "Countries can't pick and choose what they want for lunch; they have to eat everything that is put on the table." Creating the foundation agreement will take even more treaty negotiation, but Valovaya says there is a concrete plan to draw up the document and get it passed by January 1, 2015. "There is a difference between enlarging the CES and deepening it," says Valovaya, taking an implicit swipe as the 2003 accession of several Central European countries to the EU. "Any new member that joins has to bring benefits for not only itself, but

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also the existing members."

invested over all four quarters last year. "[Iranians] are looking to Turkey, they are looking to Azerbaijan, they are looking to Armenia. They have very specific relations with all our neighbours," he says. "I think more or less these business guys analyzed this situation and made this business decision, 'why not Georgia?'"

In practical terms that means full, unfettered access to any members' market where the domestic rules, regulations, registrations and documentation can be used anywhere in the union without restriction - which is more than the EU can currently boast. The intangible benefit of this freedom of movement is that the countries will tend to converge to the standards set by the fastest reformer. If they don't, their business will simply move to another member country with a more convivial business environment. "The CES is not just about trade, but should create an efficient climate for doing business thanks to the smooth functioning of a single market based on mutual recognition," says Valovaya. "One paper will work in all countries." All this is fine in theory, but during a panel on the CES during the European Bank for Reconstruction and Development's annual general meeting in London in May, Michael Emerson, associate senior research fellow at the Centre for European Policy Studies and one of the architects of the EU, broached the real issue that worries most observers. "I am going to say the naughty word: 'hegemon'. Can the regional hegemon really organise deep integration in the region?" asked Emerson. "China, the USA and India don't have [free trade] relations with their smaller neighbours, as they are nervous of the power of the largest country. Can a hegemon accept the power of supra-nationality?" Emerson basically articulated what many are wondering, that all this talk of free trade regions is just a jumped-up ploy by Russia to rebuild the Soviet Union, but on modern terms. Russia, after all, is not shy when it comes to throwing its weight about. "Russia doesn't want to dominate," insists Valovaya. "Any CES decision requires only a two-thirds majority. That means [Kazakhstan and Belarus] can make decisions without Russia. This is the main difference between the CES and EU. Russia has decided that it doesn't want to dictate to the others as the biggest economy in the club."

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Georgia's Persian partners Molly Corso in Tbilisi

s international sanctions take their toll on Iran's economy, businessmen from that country appear to be increasingly interested in doing business with Georgia. But with Washington stepping up pressure on countries doing business with Iran, Georgia could face a difficult balancing act between its allegiance to the US and its economic interest in its southern neighbour. Tbilisi raised eyebrows in 2010 when it lifted visa requirements for Iranians, a move that appeared to fall foul of its strategic partnership with Washington even as the US invested $1bn to prop up the economy following the 2008 war with Russia. Slowly, the overture has turned into concrete investments in joint ventures and real estate, and increased the number of Iranians visiting Georgia, helping its anaemic tourism sector to recover; according to official statistics, 9,000 Iranians visited in the first half of 2012, twice the number during the same period last year. Much of the increase in trade is largely anecdotal, like groups of Iranians photographing monuments and the

opening of new Iranian restaurants in Tbilisi, but business groups too are now reporting an up-tick in investment. Giorgi Isakadze, president of the Georgian Small & Medium Enterprises Association (GSMEA), tells bne he had

Sidestepping sanctions But with new sanctions hitting major parts of the Iranian economy, including the banking and energy sectors, there has been mounting concern that Iranian businesses are looking to Georgia for possible loopholes around the restrictions they face at home. There are also fears that close relations with Iran could bring security risks: in February, Georgian police uncovered a plot to bomb an Israeli diplomat the same week as a similar attack was carried out in India. Georgian officials have been quick to quash concerns that its open policy with Tehran was equivalent to leaving the country open to terrorist attacks. Instead, the government has stressed the need to foster good relations with its southern neighbour, to improve tourism links and trade. In May, the Georgian Chamber

"Tbilisi raised eyebrows in 2010 when it lifted visa requirements for Iranians" three groups of Iranian businessmen visit in the first week of June alone – and he fielded over half a dozen calls from Georgian businesses seeking out Iranian investors. The Iranians, he says, are largely focused on "due diligence" in specific sectors like retail and real estate. Isakadze stresses that Iranians have been investing in Georgia for years, but interest has definitely increased this year. Official statistics show Iranians invested $246,800 in the first quarter of 2012, far below that of Georgia's main investment partners like Germany ($131m), but already more than Iran

of Commerce welcomed a large Iranian trade mission that promised new investments in transport, food, agriculture, banking and the insurance sector, according to media reports. Maintaining good relations with Iran is a prudent strategy, according to political scientists like Dr Alexander Rondeli, founder of the Georgian Foundation for Strategic and International Studies. Georgia has to "balance" its need for good relations with Iran with its international obligations to the US and Europe, as Iran is among the three most important neighbours for Georgia (the

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other two being Russia and Turkey), Rondeli says, adding that the South Caucasus is also strategically valuable to Iran as a "buffer zone" and a potential sphere of influence. The sanctions, however, are "grey areas" for bilateral relations, a "sensitive point" between the two countries, Rondeli notes. Nevertheless, Isakadze shrugs off concerns that Georgian businesspeople will be lured into playing the role of an unwitting accessory to violating

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international law. "I am more than sure that, in general, businesspeople are aware about these international problems and sanctions. But what they can see is that regarding businesses, so far nothing has happened, nothing has been stated," Isakadze says. "Did anyone sanction such private relations?" Isakadze asks. "I think not. [Businesspeople] consider it a green light. So the risks of these relations are calculated personally by private people, not public [officials]."

Rondeli, however, warns that Georgia – like any small country – has to be acutely aware of turmoil that could shift the balance. "Georgia has to balance. It is a small country, and for small countries the only real instrument of foreign policy is internal unity, social and political cohesion, which is still not Georgia's strong [suit], and it is skillful diplomacy," he says. "You have to be very diplomatic; you have to go always on the edge of the knife – especially when you live in the South Caucasus."

and four Azeri soldiers died in the ensuing battle. A fifth soldier died in a nearby skirmish later in the day.

A frozen conflict heats up Clare Nuttall in Almaty

ine soldiers were shot dead in a series of clashes on the border between Armenia and Azerbaijan in June, in the deadliest few days the troubled region has seen in four years. While the situation is now calmer, it has raised fears of an escalation in the frozen conflict over the disputed enclave of NagornoKarabakh. The recent violence took place during US Secretary of State Hillary Clinton's

visit to the South Caucasus. Three Armenian soldiers were killed and several soldiers from both countries injured in a shootout on June 4, which Armenia's Defence Ministry said was caused by an "invading" group from Azerbaijan. The following day, five Azeri soldiers were killed in two separate incidents. A statement from Azerbaijan's Ministry of Defence said that a group of Armenian "saboteurs" tried to "infiltrate a position of the Azeri armed forces" early on June 5,

The shootings on June 4 and 5 took place on the border between Armenia proper and Azerbaijan, rather than on the de facto border dividing Azerbaijan from Nagorno-Karabakh, which has seen numerous clashes in the last 15 years. Since then, there have been no further deaths, but there are reports from the unrecognised NagornoKarabakh Republic's Defence Ministry of a higher level of activity on its de facto border with Azerbaijan. On June 18, the Ministry said that Azeri soldiers had violated the ceasefire agreement signed in May 1994 no less than 1,000 times between June 10 and June 16. Despite the signing of a ceasefire agreement in May 1994, Armenia and Azerbaijan have never signed a peace settlement to end the war that broke out in the early 1990s over the tiny Nagorno-Karabakh enclave, which was part of the Soviet republic of Azerbaijan, but had a mainly ethnic Armenian population that declared its independence in 1991. When Baku tried to regain control of the republic by force, Azeri forces were driven out by Karabakhis supported by the Armenian army. While Nagorno-Karabakh is now de facto independent and closely integrated with Armenia, under international law it remains part of Azerbaijan, and Baku shows no sign of giving up its claim on the territory.

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All-out war Incidents on the Armenian-Azeri border and the dividing line between Azerbaijan and Nagorno-Karabakh are not uncommon; more than 60 people have been killed in skirmishes between Armenia and Azerbaijan since the beginning of 2011. But the June incidents were the deadliest for several years. There are growing concerns that rather than being isolated incidents, the recent clashes could escalate into a full-scale war between Armenia and Azerbaijan. Another frozen conflict also in the South Caucasus exploded into all-out war in August 2008 when a similar series of incidents on the border between Georgia and the self-declared republic of South Ossetia took place in the first half of 2008, before erupting into a five-day war between Georgia and Russia, which had consistently supported the breakaway South Ossetian republic. Both Armenia and Azerbaijan have steadily increased military spending in recent years. Azerbaijan, which has considerably greater spending power thanks to its oil and gas revenues, has embarked upon a massive military build-up, with the implicit threat that it might try to re-take Nagorno-Karabakh by force. Azerbaijan almost doubled its defence budget from $1.59bn in 2010 to $3.1bn in 2011, equivalent to 6.2% of GDP. In fact, Azerbaijan's military budget for 2011 was around 30% higher than the entire Armenian budget for all sectors of the economy, allowing Baku to invest in cutting edge Russian and Israeli military hardware. But even with Azerbaijan's financial advantage, Armenian and NagornoKarabakhi forces are considered to be at least a match for Azerbaijan, which also would have more to lose from a new outbreak of war. "The possibility of a larger-scale conflict is relatively low. There would be huge pressure on both Baku and Yerevan, especially from the US, to prevent a wider conflict. Despite the spending on the Azerbaijani military, it is not yet as strong as the Armenian army, and Baku wouldn't want to risk losing even more territory,"

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Anna Walker, senior analyst for Central Asia and the South Caucasus at Control Risks Group, tells bne. "An escalation would also put Azerbaijan's oil and gas export potential at risk. During the Russian-Georgian war, oil and gas transport was halted even though no pipelines were directly attacked." Past experience has shown it is not unusual for both sides to up the ante when there is a high-profile visitor in the region, as during Clinton's visit in early June. The change of leadership in Russia and to a lesser extent France – the third co-chair country of the OSCE Minsk Group, which is working towards a settlement of the conflict – has also created a higher than usual level of uncertainty about the settlement process. Efforts by the international community to bring about a peace deal between

I 51

taken place between the two presidents. Every meeting took place under the aegis of Russia's former president Dmitry Medvedev, who was replaced by Vladimir Putin in March 2012. "Dmitry Medvedev made a lot of effort to bring the two sides together. There are concerns that with Vladimir Putin back in charge, Russian engagement may weaken," Walker points out. Clinton's initial warning in Yerevan on June 4 that the incidents could lead to "a much broader conflict" has been followed by more international efforts to calm the situation, with the presidents of the US, France and Russia meeting during the G20 summit on June 18 to discuss the issue. The foreign ministers of Armenia and Azerbaijan, Edward Nalbandian and Elmar Mammadyarov, met in Paris on the same day in a "positive, constructive atmosphere,"

"An escalation would put Azerbaijan's oil and gas export potential at risk" Armenia and Azerbaijan appeared to progress in recent years following the election of new presidents in both countries – Ilham Aliyev in Azerbaijan and Serzh Sargsyan in Armenia. Both Aliyev and Sargsyan have been more amenable than their predecessors to opening talks, and for the first time since 1994 a series of meetings have

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ARMENIA

with both ministers agreeing to continue working with the Minsk co-chairs and to carry out confidence building measures. But the meeting was short on concrete progress, and came just four days after Nalbandian had flatly turned down an appeal from OSCE chairman Eamon Gilmore for the Azeri army to withdraw its snipers from the border.

RUSSIA

AZERBAIJAN NAGORNO-KARABAKH

TURKEY AZER.

IRAN

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The issue of a sovereign or quasi-sovereign sukuk has been seen as an important next step to develop the market, as it is expected to pave the way for corporate issues. "I believe the DBK’s Islamic bond issue is a very positive step," says Prasad Abraham, chairman of Kazakhstan’s first Islamic Bank, Al Hilal Bank Kazakhstan.

A Kazakh sukuk

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A sea change in Caspian relations

However, Abraham points out that a pure corporate issue on the scale of DBK’s offering is unlikely, given that as DBK is government owned, the risk level is more acceptable for investors. "Within Kazakhstan, there is a group of very strong top-end companies, many with a degree of government ownership, that are being targeted by all major banks. At the other end of the scale, small and medium-sized companies are still struggling for money, as the banks are being more conservative,” Abraham says.

Clare Nuttall in Almaty

The Kazakh government's interest in establishing an Islamic finance sector grew during the first wave of the 2008 crisis, when finance from traditional sources dried up. Although the majority of Kazakhstan’s population is Muslim, many – though by no means all – have embraced western credit culture. However, Astana is looking to diversify its funding sources, and interest in Islamic finance remains high.

Turkmenistan is reported to have started exploration work at the field – known as Kapaz in Azerbaijan and Serdar in Turkmenistan – which lies on the maritime border between the pair's Caspian waters. On June 18, the Azeri Ministry of Foreign Affairs (MFA) summoned Turkmen Ambassador Toyli Komekov for a meeting, during which, according to a statement on the Azeri MFA website, Azeri Deputy Foreign Minister Khalaf Khalafov "strongly objected" to the attempt by Turkmen geologists to start seismic work in the area. "The illegal activities of Turkmenistan in the Caspian Sea,

he break-up of the Soviet Union left many loose ends. One of them, the division of Caspian Sea between the five coastal states, became entangled in June when a row broke out between Azerbaijan and Turkmenistan over the ownership of an offshore oilfield, with the pair accusing each another of "illegal" moves and issuing threats of further "action" against one another.

Clare Nuttall in Almaty

he Development Bank of Kazakhstan is in the final stages of preparing to issue the country’s first sukuk, or Islamic bond. The quasi-sovereign issue by the state development bank is expected to set a benchmark for Kazakh sukuk, opening the way for corporate Islamic bonds to be placed in future.

has assigned an 'AA2' rating to the bonds, indicating the DBK’s high level of reliability on financial liabilities payment. A roadshow for domestic investors took place in Kazakhstan’s financial centre of Almaty on June 13, with the bank’s management also planning to target investors in Kuala Lumpur.

The DBK, which is 100% state owned, is planning a Malaysian ringgitdenominated Islamic Medium Term Note Programme with a limit of MYR1.5bn ($500m). The first sukuk, which is structured to comply with Sharia law by not paying interest to investors but giving them a share of the revenues from certain assets that are placed in a special-purpose vehicle, will be issued in Malaysia, one of the world’s centres for Islamic financing, with part of the issue to be placed on the Kazakhstan Stock Exchange (KASE). A spokesperson for the DBK told bne in June that the bank might look into issuing the sukuk within a month, subject to market conditions.

Islamic centre Malaysia is the world’s largest Islamic banking and financial market, with total Islamic banking assets of MYR113.5bn ($30.9bn), according to PriceWaterhouseCoopers, and an Islamic

The bank has already obtained all the necessary authorisations to go ahead with the sukuk placement, according to a statement published on the KASE on June 12. The Malaysian rating agency, RAM Rating Services Berhad,

Kazakhstan’s first Islamic bank, Al Hilal, obtained its license in 2010 and in March 2012 closed Kazakhstan’s first fully Shariacompliant investment, a $10m investment in KazPost. The bank has branches in

"Islamic finance in Kazakhstan is in its infancy, but the market is already the most developed in the former Soviet Union" money market channelling MYR30bn40bn a month. By contrast, Islamic finance in Kazakhstan is in its infancy, but the market is already the most developed in the former Soviet Union thanks to a large extent to backing from the top levels of government; President Nursultan Nazarbayev is a strong supporter of Islamic finance.

Almaty, Astana and Shymkent, and this year plans to expand its geographic footprint as well as exploring options to enter the retail banking sector. In July 2010, the DBK signed an agreement with Almaty-based investment house Fattah Finance and Malaysia's AmanahRaya Financial Group to set up the country’s second Islamic bank.

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are unacceptable to Azerbaijan, which is taking appropriate actions in connection with the protection of their sovereign rights," Khalafov said. The following day, Turkmenistan's Foreign Ministry responded with its own statement, saying that it had sent a diplomatic note to Azerbaijan "strongly

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published by quasi-official news site Turkmenistan.ru. Ashgabat and Baku signed a deal in 2008, under which they agreed not to explore the field until issues concerning the depth of the seabed and the division of the field could be resolved. The Kapaz/Serdar field has estimated reserves of 80m tonnes of oil and 32bn cubic meters of gas. It was discovered by Azeri geologists in 1959, when both Azerbaijan and Turkmenistan were part of the Soviet Union. Drilling started in 1986, but was put on hold after the dissolution of the Soviet Union in 1991. Since then, the pair have been unable to reach agreement on how the subsea resources should be divided. Azerbaijan

"In case of continuation of such provocations the Turkmen side would take appropriate actions" protesting" the "illegal actions" by Azerbaijani border guards "against [a] civilian vessel conducting research and development in the sector of the Caspian Sea which does not belong to Azerbaijan." "It was also stressed that in case of continuation of such provocations the Turkmen side would take appropriate actions," read the statement, which was

wants to divide the sea along a median line from the shore, while Turkmenistan insists that the oilfield's location relative to the shore should be taken into account. Law of the Sea Disputes over the delimitation of the Caspian Sea between all five littoral states – Azerbaijan, Kazakhstan, Iran, Russia and Turkmenistan – have held

I Eurasia

TANAP on tap

bne The gas pipeline project that more than any other sounded the death knell for the EU-backed Nabucco pipeline is set to be formalised within weeks with an inter-governmental agreement signed between Azerbaijan and Turkey. Senior Turkish officials told newswires that the signing ceremony to build the Trans-Anatolian gas pipeline (TANAP), to be attended by Turkish Prime Minister Tayyip Erdogan and Azeri President Ilham Aliyev, could be held as soon as June 26, but could be delayed by a few days. TANAP, which is planned to carry 16bn cubic metres a year (cm/y) of gas from Azerbaijan's Shah Deniz II field to Turkey's European border, cut the ground from under the ambitious Nabucco project. The EU-backed pipeline had planned to do the same, before heading to Austria, but was struggling to convince the operators of Shah Deniz that it was a viable project. Estimated costs had risen to €12bn-15bn, and the failure to secure the extra gas from Central Asia and the Middle East needed to fill its 31bn cm/y capacity had caused some members of the consortium trying to build it to either desert the project or at least publicly voice their doubts about it TANAP, which will cost just $5bn-7bn and will be 80% owned by Azeri state firm Socar (a member of the Shah Deniz consortium) and 20% by Turkey's Botas, gets round Nabucco's problems by limiting its capacity to 16bn cm/y, of which Turkey will take 6bn cm for its own use, whilst the remainder will be shipped to Europe through a connecting project. A number of pipelines, including a scaled down "Nabucco West" and the Trans-Adriatic Pipeline (TAP), are competing for that role, with the Shah Deniz consortium yet to make a decision on its eventual European route.

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back drilling work for the last two decades. The disagreements also prevented the construction of a proposed subsea pipeline that would carry gas from Central Asia to Baku, allowing Kazakhstan and Turkmenistan to send their oil and gas direct to Europe, without crossing Russian soil. Russia publicly objected to the pipeline on environmental grounds, though few doubt that its attempt to keep a stranglehold on the flow of oil and gas to Europe was at the heart of Moscow's veto. Before 1991, the sea was divided between Iran and the Soviet Union, but the situation is now clearly far more complex. Russia, backed by Azerbaijan and Kazakhstan, wants the sea to be divided according to the length of each country's coastline – the Law of the Sea convention. Iran, which would get just 12-14% of the sea by this measure, says that each country should get 20%. Turkmenistan would also lose out to a lesser degree and has wavered between the two positions, but since President Gurbanguly Berdymukhamedov came to power in 2007 Ashgabat has moved closer to the Russian position. With another simmering conflict in the region, the disputed Armenian enclave of Nagorno-Karabakh in Azerbaijan, erupting into violence in June, the last thing the region needs is another flashpoint.

TAP, being built by a consortium of Statoil, E.On and EGL, will actually require the shortest pipeline to be built – a 520-kilometre section with 10bn cm/y capacity that will transport gas via Greece and Albania and across the Adriatic Sea to Italy’s southern Puglia region. The cost of that project is approximately $2bn. TAP is the only project competing to serve the Azeri field that has one of the members of the Shah Deniz consortium in its shareholder structure: Statoil with a 42.5% stake. However, BP, which is the lead operator of the Shah Deniz consortium, has entered the fray by unveiling in September plans for the South East Europe Pipeline (SEEP), which would run from eastern Turkey to the Baumgarten gas hub in Austria. "BP's SEEP proposal has gone from dark horse to frontrunner in the past three and a half months since it was first mooted," says Andrew Neff of IHS Global Insight.

"Before 1991, the sea was divided between Iran and the Soviet Union, but the situation is now far more complex"

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Opinion

The Baltic banking bust bne

ince the financial crisis first broke in the US in 2007, the public have been treated to an ever-lengthening list of outright fraud, theft, cheating, lying, unethical and amoral behaviour, greed, hubris and incompetence on a galactic scale in the world's financial industry. One of the latest chapters in this sorry saga is the 2011 collapse of Lithuania's Bank Snoras and its Latvian subsidiary Latvijas Krajbanka amid hundreds of millions of missing euros, the circumstances surrounding which the investigative outfit Re:Baltica has done a forensic examination. Its conclusion is that patently unfit owners were allowed to buy the banks by governments and regulators, who then didn't see fit to oversee them properly. The main villain in the piece is the 36-year-old Vladimir Antonov, an Anglo-Russian son of a Russian oligarch, who describes himself on the business-networking site LinkedIn as a "banker, entrepreneur and investor", but to everyone else is a chancer who is now facing serious jail time for alleged fraud on a massive scale. He and his Lithuanian business partner Raimondas Baranauskas are, according to the European arrest warrant, "recognized as suspects with regard to misappropriation of property on a large scale and forgery of documents. The grounds are allegations of fraudulent accounting, forgery of documents, abuse of authority, misappropriation of property, money laundering and other criminal offenses committed by the bank Snoras." Antonov may include the word "banker" in the description of himself, though Re:Baltica says he is not a typical banker. The banks were merely a means to an end to allegedly illegally funnel money to other types of larger and riskier business dealings. By the time Antonov and Baranauskas were picked up on November 24 in London after the Lithuanian authorities found around €290m in assets missing from Snoras, which the pair had a majority stake in, he had numerous interests in manufacturing, transport, media and real estate, not to mention the typical fleet of Aston Martins, Maseratis and Ferraris that every flash financial spiv sports these days.

Re:Baltica identifes two main modus operandi of Snoras as a bank. One of them is the Ponzi scheme – that old faithful of fraudsters from Charles Ponzi, who it was named after, to Bernie Madoff, who took it to a whole new level – where old liabilities are covered with new deposits. The targets seduced this time with the promised high returns were small depositors around Lithuania and Latvia, with plans in the works to expand into other countries such as the Czech Republic. The other strategy of the bank, Re:Baltica says, was to create an international network of banks that enabled the owners to transfer money from bank to bank according to their needs, helping to disguise the real capital level of the group. This has two benefits: first, if payments go to certain companies

"Antonov describes himself as a 'banker, entrepreneur and investor', but to everyone else he's a chancer who is now facing serious jail time for alleged fraud on massive scale" or individuals, they are subject to money-laundering prevention investigations, but bank-to-bank payments avoid such supervision; second, as one of the Lithuanian professional investigators told Re:Baltica, if one looks just at the figures, everything seems in good order, and extra effort is needed to find out to make sure the bank deposits aren't pledged elsewhere. The schemes for the dealings had a similar model: for example, using offshore companies in Cyprus, trusted partners or investment bankers, Antonov became a direct or indirect co-owner in companies to which “his” banks made business loans. These transactions were illegal, as the law forbids persons associated with a bank of receiving loans exceeding 15%

Opinion

of the bank’s own capital. For example, if Antonov owned at least 25% of a company, then Krajbanka was allowed to loan a sum not exceeding €3.7m to his company (which was 15% of Krajbanka’s capital in 2005). Three years later, this ceiling was raised to €12m. The offshore schemes were developed to bypass this restriction. According to insolvency experts Zolfo Cooper, which was brought in after the collapse to find out where the money went, more than €283m was funnelled into accounts linked with Antonov and Baranauskas, though the company says that it's chasing at least €567m in assets that have disappeared from Snoras. On June 4, Lithuanian prosecutors raised the estimate of how much the men allegedly stole to about €490m. Past catches up That extra effort identified by the Lithuanian professional investigator that was needed to keep on top of Snoras' interbank dealings was conspicuously absent when it came to the regulators of both countries, argues Re:Baltica. Since its founding 20 years ago, Snoras has had a chequered past, with links to Russian organised crime. By the spring of 2003, Snoras had 695 shareholders, many of them little more than shell companies registered in places like Cyprus. No one in authority seemed to worry about who was behind those shell companies. Even before Antonov took over the bank later that year, his shady business practices were well known and he was clearly not the kind of person who should've been allowed to take over what would become Lithuania’s fifth biggest bank by assets. In 2007, for example, the UK rejected Snoras’ attempts to open shop in its jurisdiction. Janis Brazovskis, a board

"Ultimately, the Latvians were not informed, officially or fully, on the Lithuanians’ growing concerns, despite what the Lithuanians may have thought" member of Latvia’s banking watchdog tells Re:Baltica that, "Next time I wouldn’t let persons like Antonov come into the banking sector in Latvia. It was a mistake." Antonov's partner at the bank, Baranauskas, who had worked at the bank since its inception and survived various changes of ownership, was an equally ludicrous, puffed-up individual, who had introduced the habit at the bank that all employees had to stand up when he, the director, entered the office. The Snoras owners' kept to that time-tested strategy of

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keeping your friends close and your enemies closer still. Re:Baltica says Kazys Ramonas, head of the bank surveillance department at Bank of Lithuania, was among the select guests at Baranauskas’ son’s wedding. At the same time, influential individuals were invited to work in the bank. The core of Re:Baltica criticisms is that, "Regulators in both countries [Lithuania and Latvia] not only were slow to act on growing warning signs reaching them, but missed supposedly clear signals they sent to each other." When the Lithuanian authorities discovered in the spring of 2011 with the help of the Swiss banking authorities that Snoras had no securities at the stated value in banks that Snoras said it had, and the Swiss had instead found the securities in the private Swiss accounts of "persons connected to the bank" – later identified as Antonov and Baranauskas – they planned to drop a hint to their Latvian counterparts on their worries concerning Snoras and its Latvian subsidiary Krajbanka. According to Re:Baltica, a few discussions with the Latvians ensued, in which the Lithuanian authorities asked about the situation at Krajbanka, hoping it would spur the Latvians to do some digging. Yet all they received back from the Latvians was a simple reply that Krajbanka had €200m in liquid assets – nothing more. So the director of the economics department at the Bank of Lithuania, Mindaugas Leika, who had been put in charge of the investigation because the surveillance chief Ramonas was deemed too close to Snoras, decided to meet with Irena Krumane, head of Latvia’s securities watchdog, the Financial and Capital Market Commission (FCMC), to mention again the concerns about Krajbanka’s liquidity. "The Lithuanians’ thinking," says Re:Baltica, "was that it would have been obvious, to any professional that something was wrong at Krajbanka, due to their twice raising, albeit indirectly, the issue."

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to bring charges against Snoras. Yet no notice was sent to the Latvians. "Ultimately, the Latvians were not informed, officially or fully, on the Lithuanians’ growing concerns, despite what the Lithuanians may have thought," says Re:Baltica. "It seems that the problem was handled in a typically bureaucratic fashion: no formal notice on paper, no action taken."

Opinion

earlier this year, in which they and other major creditors had sought to halt the bankruptcy process of Krajbanka and remove KPMG as administrator, claiming the accountancy firm bungled the insolvency, charged too much in fees, had violated the law and was motivated by political goals rather than maximizing returns for all creditors. They lost, and the judge on May 8 ruled that bankruptcy proceedings could begin against Krajbanka.

The state of play In spite of the obvious fraud, there is still a battle to be fought in the courts. Lawyers for Antonov and Baranauskas working to save them from extradition back to Lithuania from the UK are arguing that this is a political issue and the court system in Lithuania is politicized. Antonov claims his life would be in danger if he's sent back to Lithuania. Both Antonov and Baranauskas are out on bail.

Already the case is becoming murkier and drawing in other shady actors. In March, exiled Russian banker German Gorbuntsov was shot six times on his doorstep in London in an attempted assassination attempt, which he claims is tied to his giving evidence to Russian prosecutors about a botched assassination attempt on his former business partner Alexander Antonov, the father of Vladimir, who was shot in Moscow in 2009.

Their line of attack could be seen in a court case in Latvia in

The apple never seems to fall far from the tree.

Sbrioka Monologue and Velvet Tithes Bank squash competition bne

Yet Krumane maintains even today that the Latvians had not been warned by the Lithuanian side about their investigations or suspicions about Snoras, not in September there was a meeting of the Latvian and Lithuanian monitoring officials, nor in October. Why could the Lithuanians not be more explicit? Their argument is that they couldn’t give anything more than these hints, as the annual inspection of Snoras had just started. In addition, the information from Switzerland was only informal at that point. On top of all this, there was probably a dose of mistrust of the Latvians, that the information could have been leaked to the Snoras owners. "No one is saying it out loud, but it seems like Lithuanian officials didn’t trust the Latvian regulators. They were afraid that information would be leaked to Antonov," claims Re:Baltica. Perhaps most emblematic of the lack of communication and trust between the regulators was that on November 11, 2011 the Bank of Lithuania appealed to the General Prosecutor's Office

n the 1990s, Charlie Ryan, head of the investment bank UFG (now Deutsche Bank), used to say of Sberbank: "It's the 800-pound gorilla in the sitting room." It was too big to get out of the door and too big to ignore. Commanding three-quarters of the retail bank assets in the country, to a large extent Sberbank was the Russian banking sector. These days, maybe a better analogy is to talk about the elephants in the room. During the start of the last decade, Russia's investment banks flourished on the back of a stock market boom. Sberbank's share of deposits fell to under 50% and money poured in from abroad. However, since the stock market collapse in 2008, the two state-owned elephants are crowding out the investment-banking sector in Russia: the recently merged Sberbank/Troika Dialog (I suggest the state rename it "Sbroika Monologue") and VTB Capital. The widespread assumption is that these two make use of

their purple pedigrees to snaffle all the best business in Russia with the largest (state-owned) companies. Both banks deny the accusation (we asked them) and say there are Chinese walls between the bank and the state, forcing them into real competition with the commercial banks. But their "quango" status means they can borrow more money for longer periods at cheaper prices than the commercial banks. They have the implicit backing of the state, which is enough to chop several percentage points off their cost of money. Competition in the banking sector is a good thing, but not when it is skewed so heavily towards the state-owned end of the spectrum. The problem was highlighted in May when Renaissance Capital, now the last big commercial investment bank (and even this is half-owned by Kremlin-friendly oligarch Mikhail Prokhorov), sacked 40 people after racking up a $94m loss in 2011 – three times more than the loss in 2010. Analysts warn

Opinion

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that more sackings are on the way and owner Stephen Jennings will have to dump at least one in ten of the employees this year. It all makes Jennings' decision several years ago to get into Africa look like a very smart move.

provide in-house. "The margins that we used to earn were in percentages, but now they are in tens of basis points," Kaufman said, referring to a banker's units for counting hundredths of a percent. Kaufman quit at the end of last year.

But the rot was already advanced before Renaissance's spring-cleaning. Ed Kaufman, former head of Alfa Capital

VTB wants to become a privately owned bank, but selling 10% a year means it will be at least seven years before this happens. "Sbrioka" is also included in the government's privatisation programme, but it is clear it won't let the state's stake fall below 50%, which means the next sale of a 7.6% stake that is on the block will be the last.

"The margins we used to earn were in percentages, but now they are in tens of basis points" (part of the Alfa Group), told bne in an interview over a year ago that his investment bank couldn't stand on its own any more and exists only because the commercial banking clients need some investment banking services that they want to

The only bright spot is that these two elephants tend to only chase elephantine deals and ignore the raft of small and medium-sized enterprises looking for investment bank services, which is creating work for a tier of SME specialists. But for the newly laid-off star traders from Renaissance's proprietary desk, the options available to them aren't that appealing: work for the state or do a (Wall Street's) Bud Fox and slave in the sweatshop of a second-tier brokerage.

Gorillas in the Tatra mist Tom Nicholson in Bratislava

hen a Bratislava district court judge became the first to ban a book in Slovakia's post-Communist history last February, he was playing with fire. "Gorilla", as the book was known, promised to take readers behind the scenes of a massive political corruption scandal that was then roiling pre-election waters. But Judge Branislav Kral, even though he had never read the book, decided its content violated the right of a local corporate raider, Jaroslav Hascak, to protection from attacks on his good name. The decision outraged voters who had been counting on the book to provide crucial details of the Gorilla corruption scandal – named after a secret service surveillance file that comprises transcripts of a dozen incriminating chats that was leaked onto the internet last year – and whether the Slovak secret service had really caught Hascak and top politicians in a bugged Bratislava flat discussing the rigging of privatisation sales in 2006 for millions of euros in kickbacks. The key to fixing such tenders, the financier told one state official, was to discover the competitive offers by inflating the sealed envelopes containing the bids and inserting a microcamera. "Then you just read the contents, line by line." The risk of discovery is small, the financier adds, "but if by some

chance they find out, the results are fatal." He was clearly talking from experience - such skullduggery was indeed exposed at the privatisation agency where the state official works. Judge Kral was forced to hire a bodyguard following his decision over the book. "I asked for protection, I'm not going to say anything else about it," he revealed in an interview published a week after he granted the injunction. Small wonder he felt threatened. At the time, Bratislava was the scene of weekly "Gorilla protests" that drew thousands, even in bitter sub-zero temperatures, and always ended in violence. The right-wing parties of the outgoing Iveta Radicova government, which were most heavily implicated, were in disarray and heading for a thrashing at the polls. Meanwhile, Hascak's Penta was filing lawsuits and fighting to have the transcripts removed from the internet. But by the time a Bratislava appeals court overturned Kral's ban on June 11, Gorilla was yesterday's news. The Smer party, led by Prime Minister Robert Fico, had won an outright parliamentary majority in March elections. The winter's powerful protest movement had ended with a whimper in May. And while Gorilla had meant red cards for some right-wing politicians – chief

Opinion

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among them former-Prime Minister Mikulas Dzurinda – it had no discernible impact on the sleaze at the heart of Slovak politics. Many of those named remain fixtures, and the cynicism on display in the Gorilla file echoes a very contemporary disregard for the rules of the game. "The voter is shit," says the financier at one point. "The voter knows nothing, he sees only the surface." Brought to book As the author of the book in question, I visited some Smer politicians around the March elections to get a sense of whether they supported the court ban, and especially whether they believed the transcripts were authentic. "Not so much," replied Interior Minister Robert Kalinak, who will be leading the police inquest into the case (an elite 14-member task-force was formed last January). Meanwhile, Fico – who according to the transcripts also met Hascak in the bugged flat, but did not discuss bribes – staunchly refused to confirm or deny whether he had actually met the financier. "What use would such information be to you?" he asked cheerfully. His reluctance to confirm the authenticity of a file so devastating to his right-wing foes made more sense after he announced his new cabinet: Economy Minister Tomas Malatinsky, it turned out, has been renting a luxury mansion to Hascak since 2005. In other business-as-usual signs, the man overseeing the current Gorilla investigation, with absolute authority to file or dismiss charges, is Special Prosecutor Dobroslav Trnka. In 2009, when I first turned over the security service file to police, Trnka was present at my interrogation, and was interested in one thing only. For him, the content was irrelevant; my source was the key. "You lie, witness!" he shouted, when I told him I had received it anonymously in the mail. Back then he was in charge of the case too, and dismissed all charges. The new chief of police, Tibor Gaspar, is the man who ordered the Gorilla file I handed over to Trnka to be buried in a regional police archive after a cursory investigation in December 2009. In the first interview he gave after assuming the top job, he said: "Let's not talk about Gorilla so much." Today's reluctance to discuss Gorilla contrasts with the run-up to the March elections, when then-Interior Minister Daniel Lipsic held weekly press conferences on the investigation, wrote regular blogs outlining circumstantial evidence against the ringleaders, and praised the file as "a legitimate, authentic, and superbly-executed intelligence operation." Radicova was also at the time rummaging in her government office archives for proof that the Gorilla surveillance operation took place – and having found it, turned it over to police. Police chief Jaroslav Spisiak, the country's anti-mafia crusader, was securing evidence in Switzerland and admitting that he had dropped the ball in failing to take the Gorilla file more seriously when he first read it last year.

But Spisiak is now out of a job – "I'm a house husband now, gotta make things right with the wife," he said in late June – and Lipsic is starting a new political party, casting doubt on the sincerity of his very public anti-Gorilla stance. The policemen and secret service officers who helped to bring the file to public attention remain fired and disgraced, while their colleagues who helped cover up the scandal have been promoted. The only sign of life in the whole sordid episode is the half-dozen online book sites that are now offering my "Gorilla" book for sale, and the media coverage of democratic Slovakia's first experience of censorship courtesy of Judge Kral. "The regional court ruled that Kral's verdict was wrong, which in the language that judges use is a very strong criticism," says Juraj Javorsky, deputy editor of the Sme broadsheet. "But I doubt that Kral views it as a defeat. Because the six months that he managed to delay the book were probably enough to achieve his purpose.”

Gorilla file fact box • Gorilla was a court-sanctioned surveillance operation that ran from December 2005 to August 2006 • In a bugged flat in downtown Bratislava, and in rotating meetings, an economy minister, a senior civil servant, a future prime minister (then in opposition), a corporate raider, and several current and former elite police officers allegedly discussed millions of euros in kickbacks for rigged privatisation sales of state property, as well as influence over police investigations of top-level corruption cases • While politicians from various parliamentary parties were implicated, blame fell mostly on the SDKU party of Mikulas Dzurinda, which was in power when the transcripts were made • One government minister was alleged to have received 10 million euros in kickbacks for six months’ work • The Penta financial group was alleged to have financed millions of euros in bribes to secure the support of renegade MPs after the Dzurinda government almost collapsed in summer 2005; in return, Penta was allegedly allowed free rein in arranging cabinet-approved privatisation tenders • The surveillance operation was cancelled in August 2006 by the incoming Robert Fico government, allegedly because knowledge of it was leaked • Until the formation of a special police task force in 2012, the file was investigated three times, with little vigour; no charges have been laid

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Special Report: The Grexit effect

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Pavel Kysilka / Photo: Jan Zátorský / MF DNES / Profimedia

Czech-Slovak split offers Greece history lesson Jennifer Rigby in Prague

f you believe the headlines, if Greece exits the euro it will be cataclysmic, earth-shattering and quite possibly the end of the economic world as we know it. But this isn't the first time a country has left a currency union; in fact, according to research by London firm Variant Perception, there have been 69 currency exits in the last century. Moreover, these exits did not lead to the financial Armageddons some commentators are currently predicting for the Eurozone – in many examples, the countries actually started growing again relatively quickly. So even though the pro-bailout New Democracy party won the June 17 elections, few believe the possibility of a Greek exit from the euro, or Grexit,

has gone away, and it's worth asking whether there are any lessons from history that could help the country navigate an expulsion from the euro (and in the subsequent stories in this Special Report what possible effects such a thing would have on the countries in Central and Eastern Europe). A growing number of experts believe there are lessons to be learned. Indeed, the man who handled the split of the Czech and Slovak currencies in the 1990s, Pavel Kysilka, has already had phone-calls from the International Monetary Fund in Washington to check on what he is up to at the moment. Speed is of the essence While there are obviously major dif-

ferences between the two splits – not least that the Czechoslovakian split was not taking place amid a continent-wide debt crisis – at the very least, there are practical lessons to be learned, including the fact that you may need helicopters on standby, armed guards and around 40,000 people to pull it off successfully. Kysilka, now chief executive of the Czech savings bank Česká spořitelna, was in charge of proceedings on the Czech side of the split. He said speed and secrecy were both key, to prevent public panic. "The split took place under an urgent time-scenario," he says. The Czech Republic and Slovakia became separate countries on January 1, 1993. At first there were plans to maintain a common currency, at least

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temporarily, but this was not to be. Slovak individuals and firms, spooked by the belief that there would be a currency split at some point, began funnelling their money into the Czech Republic, where it would be worth more because of the country's stronger economy. The same thing is happening in Greece now, as Greeks move their euros out of the country to avoid seeing their life savings plummet in value if the drachma were re-introduced in place of the euro, and subsequently devalued. The outflow of cash from Slovakia became so serious that the leaders of both countries were already in secret

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which became legal tender on February 8. To save time, old Czechoslovak notes were stamped with either Czech or Slovak identification to mark them as the separate currencies. People were encouraged to deposit their money in the banks, with limits on withdrawals imposed. They were allowed to transfer 4,000 crowns in cash. All of the transfers were done on a 1:1 basis, meaning that one Czechoslovak crown was worth one Slovak crown or one Czech crown. "The stamps had to be pre-printed in Latin America and then transported by sea in boxes, and secretly stored in the safe

"We had to find people who would stamp hundreds of millions of bank notes"

stamp hundreds of millions of bank notes... The army was assisting, as well as the police rapid deployment team. All in all, there were 40,000 people involved. We had a 24/7 dispatching centre, helicopters, and thousands of cars available," he says. The exchange was completed in just four days, with similar processes taking place in Slovakia. Banks and post offices had extended hours to accommodate savers, some with armed guards, and the notes exchange took place over the weekend. In the modern world, this process would probably also include a banking system shutdown, including a blackout of internet banking websites to prevent last-minute transfers. "The scenario is simple in principle – but it is very difficult not to botch it. If you give it to professionals, they won't, but if you give it to politicians, they will," says Kysilka. Later in the year of the split, both countries printed their new currencies to replace the stamped notes. As the Slovaks had feared, the Slovak crown was devalued. However, in the longer term, the split and the autonomy it provided worked out well for both countries, with both economies experiencing growth over the 1990s.

negotiations to split the currencies as early as mid-January. And on February 2, in a surprise announcement, politicians in both countries told their citizens the currency union would end six days later, marking the end of the Czechoslovak crown and the beginning of two separate currencies, the Czech crown and the Slovak crown. The next day, all payments between the two republics stopped, capital controls were tightened and border controls were stepped up to prevent cash transfers between the two countries. Over the next few days – Thursday to Sunday – the old Czechoslovak currency was exchanged for the new currencies,

of the Czech National Bank," recalls Kysilka. "When the workers asked what it was, we told them it was gold, so they did not need to pay attention to it – so they did not, even though the stamps were so very valuable."

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Kysilka believes an exit from the euro, and a subsequent devaluation of the Greek currency, is the only option for the Eurozone. However, he acknowledges that it is not going to be easy. "The similarity is huge, but the situation in Greece is a hundred times worse than it used to be in Slovakia," he says.

The logistical operation was massive. "We had to find people who would

"The similarity is huge, but the situation in Greece is a hundred times worse than it used to be in Slovakia"

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mega-companies that actually got into difficulties; over the last four years, most have paid off debt or at least significantly extended the maturities of their debt burden. "Levels of external debt have fallen, thus reducing its vulnerability to financial contagion from the euro-crisis. What's more, Russia's export base has diversified away from Europe and towards stronger Asian markets. Overall, we think the combination of robust credit growth and supportive fiscal policy should ensure fairly healthy growth this year, driven in large part by consumer spending," says Neil Shearing, chief emerging markets economist at Capital Economics.

Bear up well

And unlike 1998 when the entire toptier of the Russian banking sector was destroyed, most of Russia's banks were in a fairly strong position before 2008, a position they have improved on since, says the CBR.

Ben Aris in Moscow

The CBR carried out bank stress tests as of January 1 based on two microscenarios depending on the development of the debt crisis in Europe. The pessimistic scenario found a slowdown of GDP growth to 2%, inflation at a rate of 6%, zero increase in investments, and a 1% fall of real income among the population – which would all hurt, but no more than that. Under the extreme scenario of a disorderly collapse of the Eurozone, Russia's growth would fall by 1.4%, inflation rise to 5.7%, investments to fall by 1.3% and real income of the population to decline by 2.4% – which would also not be the end of the world.

ussia is probably the best placed of the countries in Emerging Europe to deal with a break-up of the euro, say analysts. The pain inflicted in the 2008 financial meltdown has squeezed out much of the debt that did so much damage last time round, while the Russian government has worked hard to rebalance its finances and is now sourcing much of its credit needs from the domestic, rather than external, capital market. Perhaps most significant of all was the Central Bank of Russia's (CBR) decision to widen the band in which the ruble can trade against the dollar, which has made the economy a lot more flexible when it comes to dealing with external shocks. Analysts expect Russia to be one of the best performing markets in the region, thanks to a strong recovery in domestic demand, which also goes a long way in helping to cushion the Russian economy from external shocks. Still, the size of the shock matters and if Europe suffers a disorderly break-up of the euro and a series of sovereign debt defaults, the result could be messy. "At Timetric, we

believe that the Russian economy can weather an orderly Greek Eurozone exit, with growth likely to be dented only in 2012. However, the economy would be subject to a deeper downturn both this year and next in the (not implausible) event of a disorderly break-up," says Stephen Rocks, an economist with new kid on the think-tank block Timetric. Turning east Russia's economy went from about 7% growth in the first part of 2008 to a 7% contraction in 2009 as the

"Russia's economy would be subject to a deeper downturn both this year and next in the (not implausible) event of a disorderly break-up" private sector simply seized up. With the 1998 financial crisis still fresh in everyone's minds, companies froze payments and hoarded cash, bringing the wheels of commerce to a standstill. But it was only a few heavily leveraged

Foreign bank ownership is one of the classic channels for a crisis in one country to be transmitted to another. However, foreign banks only make up a quarter of Russia's banking sector in terms of assets (and several big names

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like HSBC and Barclays have left the market in the last two years). Indeed, the Russian branches of international banks were so cash rich that they sent $40bn of cash home to bolster their parents in 2011, accounting for half of all the country's capital flight. The high levels of capital flight have caught the headlines, but another quarter, or $20bn, was simply Russian companies reinvesting profits in overseas operations. That leaves $20bn of genuine capital flight – or about the net worth of just two big oligarchs. Put another way, the share of GDP that $80bn of capital represents is a fraction of capital flight/GDP in the 1990s.

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Clearly, Russian equity prices have been pummelled by the uncertainty, but as of the middle of June most of the potential pain of a meltdown looked already to have been priced in. Trading at a 50% discount to other emerging markets, Russia's stocks are close to the bottom they hit in 2009 when the price/earnings ratio of the Russian stock market fell to around 3x. As of the start of June, share prices were at a PE ratio of around 4x – the cheapest they have been for three years, so there is not much left to fall. The one real danger for the Russian economy is a catastrophic fall in the oil price. The state's heavy spending

requires an oil price of about $115 for the budget to break even, but Citibank's chief Russia strategist, Kingsmill Bond, called for the state to cut this to $80 in the middle of June to avoid a train wreck should a fresh crisis appear. Even the state forecasts oil prices to fall to an average of about $80 in the years to come.

lysts at Citibank Global Research suggested in late May. Strong deposit ratios in the Czech Republic and Slovakia, and robust regulation in Poland having helped shore them up against deleveraging by the Eurozone banking groups that dominate their markets. Budapest's bitter fight with the foreign banks puts Hungary in stark contrast.

"If [oil prices fall to $85 and stay there], the budget is likely to record a deficit of around 3.5% of GDP next year," says Capital Economic's Shearing, who has been persistently negative on Russia for years. "All told, we expect the economy to grow by 3.8% this year and 2.5% in 2013 – by no means a disaster."

However, an indirect risk for Central Europe is that the big names that dominate the region's banking markets, such as UniCredit Group, Raiffeisen Bank International and Erste bank Group, also have high exposure to Southeast Europe. Should the Greek banks that enjoy shares of up to 25% in some these markets pull back funding even further, "this could lead to liquidity problems, which if inadequately managed by local and regional authorities, could lead to a loss of confidence and bank runs," the Citi analysts say.

all three routes. Hungarian Prime Minister Viktor Orban has claimed that, "work has begun" on strengthening defences "so that such a quake doesn't bring Hungary down on one knee." Capital Economics, in a June report that exhibits its usual dramatics when it comes to the Eurozone by predicting a full break-up of the single currency, also picks the highly open Czech economy. And Mert Yildiz of Renaissance Capital expects in the case of a "Grexit", "definite recession in the Czech Republic and Hungary in 2012, but Poland could still stretch to flat growth."

A three-pronged threat to Central Europe Tim Gosling in Prague

entral European countries have few direct links with Greece, and apart from Slovakia and Estonia, have mostly yet to join the euro. Yet there are several Eurozone contagion routes that stand to threaten the economies in the region should Greece be forced out of the single currency, with banks, capital markets and trade presenting the major risks.

Whilst governments in Central Europe are mostly right to point out that they are in better economic shape to face another crisis than in 2008, they're also clearly preparing for a shock of unknown proportions that's likely to reach directly to their core. By all accounts, Hungary looks the most exposed due to its high vulnerability to

Banks of the River Styx A recent World Bank report sketches out a more sober reflection on the rippleeffect that a Grexit would likely have across European banking. "So far, a fair bit of European banking-sector deleveraging has already been undertaken, in a more or less orderly fashion. Nevertheless, the recent developments in Greece have put enormous pressure on an already stressed Euro-area banking system. Deleveraging by Greek-owned banks is likely to accelerate, with possible spill-over effects to other Euro-area banks." Thanks to a relatively stable banking sector in Central Europe, "the direct impact of any potential Greek exit from the Eurozone [is] likely to be limited," ana-

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Citigroup goes on to warn that aside from the banks, the indirect implications of a Grexit on the CEE economies are likely to be more severe, but are difficult to quantify. "CEE exchange rates are likely to weaken, liquidity conditions will tighten, trade flows may be negatively impacted, and confidence will be shaken," they say. The adverse effects of that blow to confidence have been seen throughout the crisis, with investors over the past four years proving they're always ready to flee perceived riskier assets when news turns negative. The hammerings that the Polish zloty has taken, whether driven by sentiment centred on Brussels or Budapest, despite Poland's casting as a European star, are testament to the likely contagion. A sharp slide in the region's currencies would hurt espe-

cially Poland and Hungary, which have significant levels of foreign-currency denominated debt. Such a sell-off would also hit sovereign debt and raise the cost of borrowing during another year that Central European states need to fund budget deficits. Renaissance's Yildiz says that the current account positions of the Czech Republic and Hungary should offer some protection, but "Poland will find it more difficult to fund its chunky deficit." Hungary also has to roll over existing debt this year, and the combination of rising costs and shortening maturities on recent state bond issues is rarely sustainable. Already facing yields of close to 9%, Hungary is likely to find that a Grexit will effectively cut access to credit markets altogether, which would likely push it towards finally sealing another bailout loan from the International Monetary Fund (IMF). Yildiz says he's changed his previous view that Budapest will hold out for some time yet, and "sees a deal in the fourth quarter now." Shrinking markets Meanwhile, the high dependency of the region's economies to demand in the Eurozone is another huge risk. Some analysts suggest a Grexit could hit German GDP – the driving factor for the region's exporters – by up to 3% or so. That would see the highly dependent Czech, Slovak and Hungarian economies – where exports to the Eurozone amount to over 50% of GDP – struggle in particular. High domestic demand in Poland would offer some protection. However, huge uncertainty over the actual effect of a disorderly exit

"CEE exchange rates are likely to weaken, liquidity conditions will tighten, trade flows may be negatively impacted, and confidence will be shaken"

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for Greece remains, making policy response tricky to form. Russia recently announced it will boost its (already considerable) war chest by $15bn for 2013-15, and Charles Robertson of Renaissance suggests it "would be wise for others in Emerging Europe to follow... in preparing contingency plans to address a Eurozone break-up scenario". Plans, he suggests, could include fiscal tightening, maintaining high real rates and building up forex reserves. "The result would be more modest growth than in 2005-07, higher bank deposits and a cap on currency appreciation by central banks; all factors that coincidentally will improve credit ratings as Eurozone members suffer downgrades," he says. "[Emerging market] debt issuers should target maturities of at least five years to avoid refinancing risk, while equity issuance will need to continue being very flexible in timing." Poland's hawkish central bank is unlikely to persist with keeping monetary policy on a tight leash. Although the slowing European economy is likely to cap the inflation it has been fighting, zloty weakness has been another driving point in pushing rates up to 4.75%. The same pressures on the currency mean Hungary already has little room to ease, despite having the highest interest rates in the EU. In fact, the opportunity to cut rates to promote growth in the region is really only limited to the Czech Republic, although with rates at 0.75% there isn't far for the Czech National Bank to go either.

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have relied upon cross-border lending from their parents to support their loan portfolios, with loan/deposit ratios well over 100%," the World Bank said. Capital Economics picks Bulgarian and Croatian banks as the most dependent in Emerging Europe on short-term credit lines from parent banks in the Eurozone periphery. Its main view is that this financing will be withdrawn, but only gradually. However, it warns that a more sudden withdrawal of funding is a distinct possibility, given their banking sectors' ties to Greece and Italy. "If this scenario does materialise, both economies face a severe domestic credit crunch that could knock some 1.5-2.0% off GDP. In the worst case, both could be forced to turn to the International Monetary Fund for help," the economic consultancy says.

A bullseye on the Balkans Nicholas Watson in Prague

outheast Europe, by common consent, is the region most at danger from any Greek exit from the euro. To such an extent that the European Bank for Reconstruction and Development's chief economist in May called for erecting a "ring of defence" around Bulgaria, Romania and Serbia to help them cope.

(direct cross-border lending, and foreign and domestic currency lending through its subsidiaries) in the region by the end of 2011 (see table). "In countries such as Bulgaria and Serbia, subsidiaries of some of these banks

Trading down The euro crisis has already taken a heavy toll on countries in the region as trade with the Eurozone, especially the peripheral states, has slumped. Croatia, Romania, Slovenia and Serbia all saw their economies contract in the first quarter; Bulgaria managed to eke out growth of less than 1%. Bulgaria’s exports to Greece alone are estimated to be worth some 3.5% of GDP, while exports to Italy are worth another 3.5-

Foreign Claims as percentage of GDP (December 2011) "There are already measures in place," Erik Berglof told delegates attending the EBRD's annual meet in London. "We don't speak about it much, but... in these times of crisis one has to understand the importance of financial stability." Greek banks have a huge presence in Albania, Bulgaria, Macedonia, Romania and Serbia, and account for large shares of domestic bank assets in these economies, with the highest being Bulgaria with 24% (and, by some estimates, 20% of the country's bad loans). In its "Global Economic Prospects" report released in June, the World Bank said that despite shedding $8.5bn of their claims between June and December 2011, Greek-owned banks still had $69bn in foreign claims

Ukraine Greece Euro Area (excluding Greece)

Turkey Montenegro Macedonia Albania

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4.0% of GDP for both Bulgarian and Croatian economies. "With the recession in the Eurozone periphery only set to deepen, it looks like exports have further to fall… Expect things to get worse from here on," it warned.

A plucky Turkey

Mert Yildiz of Renaissance Capital Romania, the largest economy in the region, is already looking unstable after succumbing again to its perennial problem of political instability following the fall of the government in April. Fresh parliamentary elections are scheduled for November. Between now and then, the economy is expected to continue contracting, while analysts estimate that a sudden bout of deleveraging by Eurozone parent banks from their Romanian subsidiaries due to a euro break-up could knock as much as 3% off GDP. "The economy is one of the most exposed in Emerging Europe to the growing risk of a Eurozone break-up due to its direct financial and trade linkages with Greece," says Capital Economics. The business daily Ziarul Financiar put together some scenarios for the effect of a Grexit on Romania. It predicted that depreciation of the local currency, which already hit an historic low in May, by 10-15% against the euro and the doubling of interest rates for leu on the interbank market would be the direct and fast effects on the Romanian market. This would have terrible knock-on effects because around two-thirds of household debt is denominated in foreign currencies, meaning further leu weakness would hit domestic demand by raising debt principal and servicing costs. "I hope Greece is going to remain in the Eurozone," Romanian Prime Minister Victor Ponta said on June 6. "Romania and all the countries in the region have already been affected – I hope they won’t be affected even worse in the future."

• What would a Greek exit from the Eurozone mean for Turkey? We think Turkey could withstand another crisis, but further imbalances would build in the system if the country was to avoid a major decline in growth. • We believe the Turkish government and the central bank would assume a proactive stance when managing a Grexit. The government would probably try to balance out foreign currency outflows via a tax amnesty and cut consumption taxes to boost growth, as it did in 2009. The Central Bank of the Republic of Turkey (CBT) would cut rates to boost growth and support the lira through daily interventions (dollar selling auctions). • However, neither the government nor the CBT is in as good a position as they were in 2008-2009. The CBT cut rates from 19.75% to 8.75% in 2008-2009, but it does not have that kind of buffer today. Bringing shortterm rates down from the current level of 10.5% to 5-7% would have some impact on growth, but not the kind of impact it had in 2008-2009, in our view. Similarly, the government’s primary surplus is almost 1% lower than it was in 2008. Hence the stimulus could be smaller in size and might not have a similar effect on growth. • The banking system would come under stress due to a lack of foreign funding, but the CBT’s expected funding operations could help ease the pressure on banks. • Non-financial corporates would suffer from a lack of foreign and domestic demand. We conclude that while foreign demand would fall more than domestic, rising unemployment and falling consumer confidence would mean domestic demand would not be positive either. • Household consumption would decline, largely due to a sudden rise in unemployment. However, we would expect consumption to rebound quickly, as has usually been the case in a crisis. • Inflation would remain high, mainly due to initial lira depreciation. However, the CBT’s lira-supportive measures would see the lira/dollar move back to pre-Grexit levels. The price hikes from the pass-through could offset lower economic activity and inflation would remain high at around 8-9%, at least in 2011.

Romania Bosnia and Herzegovina Bulgaria Serbia 0

Source: Bank for International Settlements; World Bank

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"Romania and all the countries in the region have already been affected – I hope they won’t be affected even worse in the future"

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Eurasia's Eurozone resilience Clare Nuttall in Almaty

housands of kilometres from the EU's eastern borders, the oil- and mineral-rich countries of the Caucasus and Central Asia have so far seen little impact from the growing fears of a Greek exit or a wider collapse of the Eurozone. The region's largest economy, Kazakhstan, has continued to grow and, thanks to increasing oil exports, its foreign currency reserves stand at a record level. In the first quarter of 2012, Kazakhstan's GDP growth was slightly below expectations but at a still healthy 5.6%, according to state statistical agency Kazstat. The International Monetary Fund (IMF) forecasts that Kazakhstan will achieve annual growth of 6% in 2012. Longer term, the picture is even better, with the massive offshore Kashagan oilfield due to start commercial production in 2013, lifting oil production to record levels. That's not to say Kazakhstan would be impervious to the fallout from a deterioration of the situation in the

Eurozone. Although Greece's June 17 elections means an immediate "Grexit" from the Eurozone is less likely, it is still a possibility, and the effect an event on this scale would have on international markets is not something that Kazakhstan would remain immune from. As an exporter of oil and gas, metals and minerals, Kazakhstan's export

effect on other countries. "There will be a negative indirect impact through a slowdown in Kazakhstan's economy as a commodity-exporting country," she explains.

reduced their exposure to real estate, so are considerably healthier. BTA Bank, once the country's largest, is still struggling but is of less importance systemically today.

and 2015. However, Astana has previously taken a pragmatic approach to the programme, waiting for favourable conditions rather than seeking to push the IPOs through at any cost.

The effect of the uncertainty in global markets has already taken its toll on Kazakh equities along with those of other emerging markets. "Events in the Eurozone haven't yet affected the performance of Kazakhstan's economy. Kazakhstan is still accumulating wealth, and reserves and foreign currency are at a record high," says Jean-Christophe Lermusiaux, managing director and head of research at Visor Capital. However, he notes that the current crisis has affected risk appetite, with investors growing increasingly nervous, which "would cause some 'collateral damage' for some listed companies whose assets are in Kazakhstan."

The Kazakh government was caught on the hop in 2007, although it came through with a multi-billion-dollar stimulus package in late 2008, and intervened to bail out BTA and Alliance Bank in 2009. This time around, government officials have been making plans for potential problems for over a year. Whether they will be implemented depends on if this crisis is a "small hurricane or a tsunami", according to Lermusiaux. "If Brent [oil] drops to $50 per barrel, and copper and ferrochrome prices go into freefall, [the government] will have to fight, and will be able to do it... for some time," he reckons.

The Georgian government faced a similar decision in May. The IPO of Georgian Railway, which was due to take place on the London Stock Exchange on May 24, was postponed after consultations with government advisers because of the difficult situation in international markets. The IPO of the rail monopoly had been hotly

Financial link The last financial crisis in 2007-2008 dealt a huge blow to Kazakhstan's banks, due in part to the large amount of funding on international debt markets that had fuelled their growth over the previous years. Today, the situation is different, with there being no direct link between Kazakh banks and the problems in the Eurozone, argues Medeubayeva. "They have no direct exposure to Eurozone countries on either the funding or asset side," she says, pointing out that the banks' foreign-currency assets now exceed their forex liabilities.

"Kazakhstan is still accumulating wealth, and reserves and foreign currency are at a record high"

revenues fluctuate according to world demand and commodity prices. Ainur Medeubayeva, analyst at Troika Dialog Kazakhstan, points out that a Greek exit would not be an isolated event, as it would most likely have a domino

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The US sub-prime mortgage crisis also precipitated the collapse of Kazakhstan's real estate bubble, which in turn helped to push the country's over-leveraged banks nearer to failure. Since then, most of the banks have deleveraged and

One immediate Kazakh casualty of a Grexit could be the national currency, the tenge, which has been maintained at around KZT147-150 to the dollar since its depreciation in January 2008. "The tenge should, in theory, be rock solid because Kazakhstan's reserves are increasing and because M3 coverage ratio is in excess of 110%. But in practice, the probability for a depreciation of the tenge is around 35%," says Lermusiaux. "Now that Kazakhstan is in the Customs Union, a considerable strengthening of the tenge against the ruble would not be healthy for the Kazakh economy. In addition, there is less need to maintain the tenge now since most banks have deleveraged and BTA is no longer considered to be of systemic importance. Conversely, the powerful mining sector, which bears costs in tenges but sells in dollars, would immediately benefit from a depreciation... which would partly offset significant embedded cost inflation." With the uncertainty already bringing down Kazakh share prices, there is also some question about what will happen with the government's "People's IPO" programme. The first in the series of IPOs of major state-owned assets, pipeline operator KazTransOil, is due to take place in September, with nine more companies set to follow between 2013

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"The powerful mining sector, which bears costs in tenges but sells in dollars, would immediately benefit from a depreciation"

anticipated, with the company expected to list with a valuation of between $800m and $1bn. "Unfortunately, the international market has worsened... accordingly we rescheduled the process," Prime Minister Nika Gilauri said in a statement. These concerns aside, however, the Caucasus and Central Asia (CCA) region looks relatively healthy. In its April "Regional Economic Update", the IMF forecasted a slight slowdown from 2011 for both the oil-producing and oil-exporting countries of the region. The high level of growth achieved in 2011 was driven by robust commodity exports and remittances. "Although growth of such flows is expected to moderate in the near term â&#x20AC;&#x201C; reflecting a weaker external environment â&#x20AC;&#x201C; CCA economies are still expected to hold up well," says the IMF report. Only if there is a much sharper global downturn than currently expected, including a big jolt to the Chinese and Russian economies, would the region expect to see a serious risk to its own growth prospects.

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Events I 71 The only magazine covering business, economics, finance and politics in the dynamic new markets of Emerging Europe and the CIS

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