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Week of Febuary 24th Montenegro: Problems with KAP unsettle governing coalition » Read more »
The long-running saga of Podgorica Aluminum Plant (KAP) continues. The highly controversial sale of a majority stake to Oleg Deripaska-owned CEAC in 2005 has been dogged by problems almost from day one. The Russians claim that the financial position of the company was much worse than expected and that they need subsidies for electricity to make the plant viable. The government reached agreement with CEAC in 2009 to take back half of the original stake sold in return for credit guarantees and electricity subsidies. Employment at the plant has been slashed in an attempt to turn the enterprise around. Things have now reached a head, though, because CEAC is allegedly unable/unwilling to pay a EUR22 mn debt payment coming due. The government is now in the unenviable position of having to make this payment in order to avoid the full amount coming due at once. The governing coalition is split over this issue and a vote of confidence will be held on February 28 as Prime Minister Luksic seeks to push approval for the payment through. The political situation in Montenegro has also been affected by strikes against increases in electricity prices which, at least partially, may be the result of ongoing extensive subsidies to KAP. The government will ultimately have to decide whether to retake full ownership of the plant and continue operating it, find a new investor or even close it down.
The forint has strengthened considerbaly over the last couple of months as Prime Minister Viktor Orban has seemingly backed down in his confrontation with the EU. The forint reached 320 to the Euro towards the end of last year but is now trading at 287. Hungary sent an official response to the EU's infringement procedure at the end of last week in which it is thought to have offered a compromise in many areas. The EU is considering its response. There is still a good amount of work to be done here but the government is confident that a solution can be found meaning that talks with the IMF could begin in March. If this is the case some form of program could be agreed by mid-year although IMF talks also are unlikely to be straightforward. Just as one dispute with the EU may be nearing a conclusion another may be on the horizon however. The European Commission appears ready to adopt a proposal to suspend infrastructure funds designated for Hungary equivalent to some 1.5% of GDP as a result of the government failing to improve its underlying fiscal position. Stripping out one-off measures the fiscal position worsened significantly in Hungary last year. The government hopes to head off the suspension of funds by demonstrating a more comprehensive and sustainable medium-term fiscal adjustement plan.
After a long political stand-off following October 2010 parliamentary elections Bosnia finally has a state-level government in place. The Chairman of the Council of Ministers is Vjekoslav Bevanda of the HDZ. The Finance Minister is Nikola Spiric of the SNSD (former Chairman). The Minister of Foreign Affairs is Zlatko Lagumdzija of the SDP. The ten positions in the Council are divided between representatives of Bosniak, Croat and Serb parties in a 4-3-3 ratio with the Chairman rotating each time between the different ethnic groups. The immediate challenge for the new Council is to resolve the budgetary situation. The 14-month political stand-off after the elections (before a agreement was reached between the six leading parties to form a new government) meant that even late last year the 2011 budget had not been passed and state institutions were being financed on a temporary basis based on the 2010 budget. A rushed attempt to get the 2011 budget passed before the year ended (so that temporary financing could be made available in early 2012) led to procedural irregularities. A second attempt to pass the budget is now underway. Various payments have been frozen in the meantime. The Council must, at the same time, make rapid progress on drawing up a budget for 2012.
The Euro area contracted by 0.3% q-o-q, seasonally adjusted in the last quarter of 2011. This compares to a 0.1% expansion in Q3. The EU-27 also contracted by 0.3% in Q4 having expanded by 0.3% in Q3. On a y-o-y basis, the Euro area expanded by 0.7% in Q4 and the EU-27 by 0.9%. While data readings in January were slightly more positive there is a significant risk that the European economy will record negative growth in Q1 2012 as well and thus officially have entered recession. Within the major European economies, Germany contracted by 0.2% q-o-q in Q4 as did the UK. France expanded by 0.2% but Italy contracted by 0.7%. As far as Eastern Europe is concerned, the Czech Republic has already officially entered recession given negative q-o-q growth in both Q3 and Q4. Negative readings in Q4 were also seen in Estonia, Lithuania and Romania. Growth remained in positive q-o-q territory in Bulgaria, Hungary, Latvia and Slovakia (Poland and Slovenia have yet to release data). On a y-o-y basis, the strongest readings across the whole region in Q4 were those in Latvia (5.3%), Lithuania (4.5%) and Estonia (4.0%). The largest contraction by far was in Greece (7.0% y-o-y) followed by Portugal (2.7%).
Latvia will hold a referendum on Russian becoming a second official state language on Saturday. The referendum seems likely to fail because only 27% of the population is Russian according to a recent census and another 7% are non-Russians who consider themselves Russian speakers. Holding the referendum is itself is raising tension though within the country for obvious historical reasons. While many Latvians speak both Latvian and Russian almost a half of the Russian population speaks only Russian. The EU has frequently criticised Latvia for having stringent citizen requirements that lead to a large number of "non-citizens". And yet it is understandable that many Latvians resent the forced Russification of the country during the Soviet occupation and what they consider either the laziness or resistance of some Russians to learn the Latvian language. The referendum was initiated by several small pro-Russian parties and later taken on board by the main Russian party - Harmony Centre. The right to a referendum is guaranteed if signatures of more than 10% of the population are collected. The Mayor of Riga supports the proposal while the President of Latvia and Prime Minister do not. The proponents of the referendum are hoping that the turnout of Latvians will be low or that some might support the proposal in order to make the outcome closer than expected. The main purpose seems to be a party political one however.
A recent opinion poll conducted by NSPM gives the main opposition party, the SNS of Tomislav Nikolic, a lead of four percentage points over the governing DS. This compares to a lead of 1.5 percentage points that the SNS held in November. The government's popularity has fallen as the economic situation has worsened and EU integration seemingly stalled. And yet there would still seem to be some hope for the government ahead of parliamentary elections to be held in early May. The SPS of Ivica Dacic - part of the governing coalition - has boosted its rating to 11% from just 8% in November. Indeed, if one were to include all the different parties in the current coalition the government would be just short of winning a majority. In these circumstances it could possibly include the LDP (6%) in a future government. There is still some time before the vote, other opinion polls give the SNS a slightly bigger lead and there is the possibility that some current coalition partners could consider joining a potential SNS-led government. With so much to play for it is no great surprise that the IMF program has gone off track. The government may well be giving itself enough fiscal space to boost its ratings in order to secure a new term.
The new government led by Janez Jansa has said that it will implement significant cuts to the budget in order to stabilise the public debt to GDP ratio and reduce dependence on foreign borrowing. Slovenia's credit rating has been several times in the last few months. Finance Minister Sustarsic has said that the government will draft the 2012 budget by the end of March and send it to parliament for approval in April. The aim is to cut expenditures by 10% to help bring the fiscal deficit down from an estimated 4.6% of GDP in 2011 to 3.5% of GDP this year. This will be painful as the economy is probably already in recession. Moreover, some analysts doubt whether it can be achieved at all without unpopular cuts to public sector employment and wages. Jansa has tried to emphasize his commitment to fiscal savings by announcing a cabinet that includes him and just twelve ministers. Four come from his SDS and two each from the other four parties in the coalition. By contrast, his previous cabinet between 2004 and 2008 had 17 ministers.
Preliminary data from the Croatian National Bank (CNB) show that the aggregate profit of the banking sector increased in 2011 compared to 2010 by 9.8% to HRK4.7 bn. Capital adequacy remains high (19.2%) and non-performing loans are a relatively small proportion of total loans (8.9% as of Q3). The aggregate figures hide a great divide between the largest five banks which control 76% of total assets (and 90% of total profits) and the remaining 27 smaller banks which, together, are barely profitable. The most profitable bank in Croatia remains Zagrebacka Banka with Privredna Banka and Erste Bank the next two most successful interms of total profit. The sector would appear still to have too many banks relative to the size of the economy. Moreover, confidence in the quality of banking sector data was brought into question by the CNB having to withdraw the banking licence of Credo Banka in November. Credo had reported both a profit and a capital adqequacy ratio above the minimum 12% in 2010 and yet was found to have both misreported its financial situation and subsequently failed to take the required remedial measures. The CNB's swift intervention once Credo's true position became known did at least stop this issue having negative systemic implications.
Vladimir Putin has started a charm offensive to try and boost his poll ratings ahead of March 4 presidential elections. This has included a number of articles in leading newspapers trying to lay out his vision for his third term as President and respond to recent criticism of the government and the conduct of December 4 parliamentary elections. However, this campaign also now extends to the traditional populist spending pledges made before important elections. Putin has promised large pay increases for teachers, scientists and the security services. He has himself suggested that these will cost 1.5% of GDP without indicating how they are consistent with plans to close the fiscal deficit in the medium-term. He has also suggested a windfall tax on those that profited from the controversial privatization process of the 1990s. There appears, indeed, to have been a slight bounce in his approval ratings recently although it remains unclear whether he will win outright in the first round. It would certainly be a major embarrassment if he fails to do so although he could be certain of a comfortable win in the second round against Communist Party leader Zyuganov (a perennial loser in such elections).
Industrial production (IP) figures in December were very weak as had been feared. On a seasonally adjusted, m-o-m basis IP contracted 1.1% in the Euro area and by 0.6% in the EU-27. On a y-o-y, non-seasonally adjusted basis IP contracted by 2.0% in the Euro area in December and by 0.9% in the EU-27. The December y-o-y readings were the only negative ones in 2011 but mark a steady deceleration in IP growth throughout the whole of last year. Both the Euro area and EU-27 recorded a modest increase in IP of about 3% for the year as a whole however. Within Eastern Europe, four of the nine EU countries that reported data saw y-o-y contractions in December. The majority of those that had readings that remained in positive territory still saw a significant slowdown. This demonstrates how difficult it is for Eastern Europe to grow while Western Europe does not due to significant trade and financial linkages. The major exception here continues to be Poland which saw a healthy IP expansion of 10% y-o-y in December despite the difficulties noted elsewhere.
Growing signs of economic stabilisation have led to the central bank cutting its refinancing rate by 200 bps to 43%. This is the first rate cut after a balance of payments crisis and associated currency collapse forced a massive cumulative hike in the refinancing rate last year. The ruble continues to be relatively stable against its basket. The inflation picture also seems to be improving. Inflation in January was still a massive 109.7% on a y-o-y basis. However, the m-o-m increase was 1.9%. This follows another fairly low 2.3% m-o-m reading in December. If monthly inflation rates stay around this level then annual inflation will start to fall sharply in the spring given a favorable base effect. While inflation should drop significantly this year it will still likely remain high in a 20%-30% range. However, this will be enough for the central bank to cut its refinancing rate on a number of occasions. Apart from the economic situation, the central bank is also under political pressure. President Lukashenko called for rate cuts just a day before the Bank moved on this issue. Clearly, the authorities are keen to see rates fall quickly to allow the economy to recover having contracted in Q4 2011.
The National Bank of Poland (NBP) left its key interest rate on hold once again at 4.5%. It has now left rates steady for eight months in a row after a couple of 25 bps hikes at the beginning of 2011. The outlook for inflation seemingly deteriorated in late 2011 with the sharp sell-off in the zloty. The central bank both intervened on the FX market and threatened to hike rates. However, the zloty has recovered somewhat in early 2012. Having been as weak as 4.5 to the Euro it is now back to 4.17 - this is still above the average for 2011 (4.12). Given that the situation on the currency market has improved the risks that the NBP may be forced into a rate hike have receded for the time being although it retains the language in its accompanying statement that it will do so if necessary. Otherwise, it retains its core view that growth was strong in 2011 but will slow this year. Inflation is above target but will fall over the forecast period due to favorable base effects (tax hikes falling out of the equation and softer food prices). If the zloty remains fairly stable then the NBP has a fairly neutral outlook for rates in the short-term.
The National Bank of Serbia (NBS) left its key interest rate on hold at 9.5% at this month's monetary policy meeting. This decision came despite the fact that the central bank has downgraded its forecast for economic growth in Serbia this year from 1.5% to 0.5%. It also expects inflation to keep falling sharply in the next few months from the 7.0% y-o-y recorded in December. Two things probably persuaded the NBS to wait before cutting rates further. First, the dinar has weakened sharply in the last few days to over 108 to the Euro. This is most likely due to the extreme cold and the extra energy imports that this is requiring. Any persistent weakness of the dinar will impact negatively on inflation. The dinar's sell-off may also be due to signs that the government is going off track with the IMF. The NBS has already made it clear that it sees continuation of the IMF program as very important for Serbia. In today's accompanying statement it again emphasizes that keeping the budget in the agreed framework is important for macroeconomic stability and, therefore, the scope for further interest rate cuts going forward.
Serbia's Stand-By Arrangement with the IMF agreed last September seemingly went off track at the turn of the year when the Fund's Executive Board refused to approve the first review of the program. A recent IMF tehnical Mission has failed to reach agreement with the government that could put the program back on course. The initial problem was that the Serbian government looked to issue guarantees to state-owned enterprises beyond that agreed with the Fund. An even more pressing issue has since occurred. With the Fund downgrading Serbia's growth forecast for 2012 from 1.5% to 0.5% the budget is now likely to require a significant rebalance if its target deficit of 4.25% of GDP is to be met. It appears little agreement was reached on either issue. The Fund did not accept Prime Minister Cvetkovic's verbal assurances that these state guarantees would not be triggered and were only designed to allowed state-owned companies to borrow at more favorable rates. Moreover, the government appears unprepared to countenance a budget rebalance ahead of the elections. The Fiscal Council estimates, on unchanged policies, that the fiscal overshoot could exceed one percentage point of GDP. This news will be very worrying for investors. It seems another IMF Mission is unlikely before elections in May and the government will now certainly break its own public debt to GDP rule.
Mihai Ungureanu has won a vote of confidence confirming him as the new Prime Minister of Romania following Emil Boc's resignation on Monday. Ungureanu has appointed a cabinet full of relatively young technocrats. Bogdan Dragoi is the new Finance Minister and Lucian Bode the new Economy Minister. The PD-L/UNPR/UDMR coalition had just enough votes to win the vote in the joint session of parliament as expected despite the boycott of the opposition USL and the defection of a couple of coalition deputies recently. The Prime Minister has said that we will consider the possibility of public sector wage increases if the economic situation warrants it. More generally, there is a significant risk that the new-look government will loosen fiscal policy to try and reclaim some of its lost voter base ahead of parliamentary elections. These are normally held in November although some consider it likely - given the scale of the opposition's lead which the government will have to overturn - that these might be delayed until early 2013. Either way, a more populist approach could possibly push the IMF agreement off track, reduce the scope for further rate cuts and even weaken the Leu against the Euro other things equal.
Emil Boc resigned as Prime Minister of Romania on Monday. He will be replaced by Mihai Ungureanu, head of the foreign intelligence service. As Boc had defeated a number of votes of confidence in parliament comfortably this move seems to be the result of internal tensions within the PD-L. The party is concerned that its poll ratings are dreadful ahead of local and parliamentary elections this year. Boc, who has overseen the implementation of a tough economic program which has been praised by the IMF and EU, may have been sacrificed by President Basescu (leader of the PD-L) in an attempt to draw a line under recent anti-government demonstrations in Romania. The change of personnel may also be designed to introduce more populist policies in the next few months. The government has just won approval from the IMF for the approval of the fourth review of the Stand-By Arrangement. There is now, though, an increasing chance that the program will go off track as local elections approach in June. This will be an important signal as to the likely result of November parliamentary elections. Ungureanu has ten days to form a cabinet which must then win a vote of confidence to confirm itself in office.
An IMF Mission to Zagreb has outlined the significant challenges facing the new government. Growth is weak (likely -1% this year) due to corporate and household deleveraging and weak export competitiveness. The fiscal deficit overshot its target last year (5.6% of GDP rather than 5%) and public debt dynamics are unsustainable. The Fund considers that the new government's fiscal outlines for 2012 are a step in the right direction. They would reduce the deficit to 4.6% of GDP according to the Fund if implemented in full. However, this will require legislative changes as a high proportion of expenditures is mandatory. Moreover, this fiscal tightening (which includes a hike in VAT) must form part of a medium-term plan to bring the deficit and debt down to sustainable levels. Such a plan would require reducing the size of the public sector and making it more efficient which will face considerable opposition. Competitiveness must also be improved more generally. The labour market is extremely inflexible and wages high relative to productivity according to the IMF. Hence, the government must develop an economic model less reliant on domestic demand and debt accumulation to generate growth.
Inflation in Russia fell sharply from 6.1% y-o-y in December to 4.2% y-o-y in January. Tradable goods inflation in January was 2.0%, non-tradable goods prices rose 6.2% and services inflation was 4.7%. A significant fall in inflation at the beginning of this year had been expected. Food prices have remained low given a warm early winter. Administered prices are also traditionally increased less in the January before an important election. Economic growth is also slowing even if it ended 2011 slightly better than expected due to a good harvest. Even though inflation is now at a record low the central bank is cautious about rate cuts. It did cut the refinancing rate by 25bps in December but has left it on hold at the last two rate setting meetings. The central bank is wary of the fact that many of these factors keeping inflation so low are temporary and can quickly be reversed. Moreover, the government's fiscal stance - as reflected in the very large non-oil fiscal deficit - is very loose. On the other hand, the ruble has strengthened significantly against its currency basket so far this year as oil prices have risen due to geo-political risks.
After a disastrous 2011, equity indices in South Eastern Europe (SEE) were fairly stable in January. With the exception of the Romanian BET index (which jumped up 12.7%) there were fairly modest gains and, indeed, some indices fell in value. The Bulgarian SOFIX was up 1.3% and the Slovenian TOP by 1.2%. The Macedonian MBI-10 fell 3.8% while the BIRS in Bosnia (Banja Luka) fell 3.5%. All the other indices showed little movement. The BELEX-15 in Serbia rose 0.6% while the CROBEX-10 in Croatia fell 0.4%. Turnover was even weaker than usual in January with many investors following the evolution of the crisis in the Euro zone. Even if many companies in these indices are profitable the near-term outlook is not as favorable as had previously been hoped given slowing economic growth across the region. After a positive start to 2011, the majority of these indices gave up some of their gains in Q2 and then fell sharply in Q3. Many finished the year almost 20% below their starting values.
The IMF's Executive Board has approved the fourth review of the Extended Credit and Fund Facilities (ECF/EFF). This enables a disbursement of US$77 mn. The economy expanded robustly in 2011 although some slowdown is expected this year. The authorities took fiscal measures to bring the 2011 budget back on track and the 2012 budget is consistent with the need for medium-term fiscal consolidation according to the Fund whilst also increasing investment and social assistance. Inflation has moderated and hence the central bank is loosening monetary policy. The banking system appears relatively stable despite the large macroeconomic shocks it has been exposed to in recent years. Measures to improve the business climate and increase competitiveness are starting to have some effect although more progress is needed. Privatisation should continue. The energy sector is in need of urgent reform to make it more financially viable. The AEI government continues to manage the economy fairly well in other words even though a solution to the political crisis has yet to be found.
Another in a series of mass demonstrations protesting at the conduct of parliamentary elections in December is scheduled for Saturday. The protests have unsettled the authorities but their effectiveness is ultimately constrained by a lack of unity amongst the participants. They do, however, signal a loss of confidence in Vladimir Putin, whose approval rating has dropped significantly in recent months, and his calls for stability. Putin is still almost certain to win presidential elections scheduled for March 4. However, he could face the embarrassing prospect of failing to win outright in the first round if he fails to win over voters in the coming months. Putin unveiled an economic program this week calling for reform of the economy but it was not very warmly received in the Russian press. It appeared to be a weaker version of current President Medvedev's calls for a modernised Russian economy. Little progress was made in this regard in the last few years. There is also the question how much economic reform can progress without political reform. The largest unknown is how much a stability-oriented Putin will be forced to undertake reforms in his next term as president by a poorly performing economy.
The National Bank of Romania (NBR) has cut its key monetary policy rate by 25 bps to 5.5%. This is the third such cut in the last five months. This reflects the fact that inflation has fallen sharply during this period. Headline inflation was 3.1% in December and core inflation 2.4%. Inflation, then, has returned to within the target range of 3% plus or minus one percentage point as the impact of previous tax increases have passed out of the base for calculation and as a very good harvest has led to food prices dropping sharply. The NBR sees inflation staying within the target bands during the forecast period. A negative output gap remains a dampening effect on underlying inflationary pressures. Other things outside the Bank's control such as administrative prices and food and fuel are less predictable. Indeed, a reduction in risk appetite towards the end of last year weakened most emerging market currencies (including the leu) and was most likely why the NBR decided not to cut in November and December. The currency has been more stable in recent weeks. If it continues to be so the NBR may consider further small cuts.
The Czech National Bank (CNB) has left interest rates on hold at 0.75% at its monetary policy meeting. The CNB sees interest rates being left on hold in the near-term with a possible "moderate decline" in the second half of the year. While headline inflation will rise this year due to an increase in VAT underlying inflationary pressures are very weak. The economic growth outlook has worsened because of the situation in the Euro area and the Czech economy already contracted by 0.1% q-o-q on a seasonally adjusted basis in Q3. The one thing perhaps persuading the Bank to wait are developments with regards to the koruna. The currency weakened by 5% against the Euro towards the end of last year as the growth outlook deteriorated and investor risk appetite fell. The koruna has recovered by over 1% against the Euro so far this year however. Assuming it remains stable or strengthens further any possible upside inflationary risk from exchange rate developments will be seen as minimal and the Bank can consider cutting rates to reflect the oncoming economic recession.
The government of Serbia remains committed in principle to the privatization of state assets even if it has not been very successful in implementing its program to date. However, in the last few days it has chosen to increase its stake in two large enterprises on a temporary basis. It has (indirectly) bought back OTE's 20% stake in Telekom Srbija for EUR380 mn and bought back the large steel producer in Smederevo from US Steel for US$1 dollar. The government has chosen this course of action for different reasons but in both cases will divest the newly acquired stake when market conditions are favorable. The government tried to sell a stake in Telekom Srbija last year but its tender failed to receive a suitable bid. The asking price may well have been too high but the process was also hindered by OTE's indecision as to whether it would sell its stake purchased in 1997. A renewed sale attempt will likely come only after May elections. The other case is more urgent. US Steel has booked up huge losses at its Smederevo operations in the last two years and was threatening to close the plant down. The government has stepped in to safeguard jobs and the local economy. However, it needs to find a buyer soon otherwise paying the running costs of this sizable enterprise will have adverse consequences for the state budget.
The Russian economy expanded at a faster than expected 4.3% in 2011 thanks mainly to very strong numbers in the agricultural sector. Agricultural output rose by 16.1% last year having contracted by 9.7% in 2010. Manufacturing output growth, on the other hand, slowed from 8.3% to 6.1%. In terms of expenditure, private consumption was very strong (growing 6.4% compared to 5.1% in 2010) while fixed investment also grew robustly (6.0% compared to 5.8% in 2010). Net exports provided a drag on growth however. Exports grew by just 1.0% while imports surged by 21.5%. The 2011 GDP outcome was above the 4% that had been expected and matched the 2010 outcome. The outlook for 2012 is less rosy. GDP growth is expected to slow to 3.3% given the less positive global growth outlook. Indeed, the 2011 growth numbers were flattered somewhat by the dreadful harvest Russia endured in 2010 due to a serious drought and widespread forest fires. A positive base effect this year in the agricultural sector may have added as much as 1 percentage point to the full-year GDP growth number according to some estimates. There is clearly a lot to do if Russia is to return to its pre-crisis 7% per annum growth rate. Economic reforms will be needed not just policy stimulus.
The Czech Finance Ministry has reduced its GDP forecast for 2012 from an already modest 1.0% to 0.2%. It has reduced the 2013 forecast from 2.0% to 1.6%. The downgrades result from economic uncertainty in the Euro area which takes a large proportion of Czech exports. Weaker growth means that budget revenues will be less than planned. Hence, Finance Minister Kalousek announced that he would implement an additional CZK20-26 bn in spending cuts in order to keep the budget deficit on target this year. The government is seeking to bring the deficit down to 3.5% of GDP in 2012 in order to reach its medium-term target of bringing it below 3% of GDP in 2013. The additional cuts will come from discretional spending. The centre-right government has won plaudits from financial markets and credit rating agencies for bringing the fiscal deficit down decisively via a combination of expenditure cuts, tax hikes and structural reforms. Its popularity has fallen, however, as these painful measures (such as higher VAT and public sector wage cuts) have hit home at a time of anyway weak economic growth and high unemployment.
An IMF Mission is arriving this week to continue negotiations with the government with a view to completion of the first review of the Stand-By Arrangement (SBA). Staff-level agreement on completion of the review was reached late last year but the Executive Board failed to approve it because the 2012 budget approved in parliament was not in line with the program. There are a number of issues to be resolved here. Budget guarantees to public enterprises included in the budget were significantly larger than agreed with the Fund. However, even if agreement is reached on this issue other problems remain. The Fiscal Council considers that budget revenue assumptions in the budget are over-optimistic. Moreover, the IMF seems likely to downgrade its growth forecast for Serbia in 2012 from 1.5% to 1% or below (GDP growth in Q4 2011 was just 0.8% y-o-y) given a weakening global economy. The culmination of these factors means that the budget deficit is unlikely to meet its 4.25% of GDP target without a rebalance. The Fund may allow a small increase in the budget deficit target to accomodate lower growth (although this would almost certainly mean a breach of the public debt to GDP threshold of 45%). However, the government must also come up with some additional fiscal savings. Failure to reach agreement with the Fund ahead of parliamentary elections would impact negatively on investor sentiment and possibly also Serbia's credit rating.
The IMF has released an update to its World Economic Outlook (WEO). This marks a significant downgrade to its forecast for global growth in 2012 and 2013 relative to its projection in September. It now sees an expansion of 3.3% this year (down 0.7 percentage points (pp)) and 3.9% in 2013 (down 0.6 pp). The main cause of the weaker outlook is the situation in Europe. The slow response to resolving the debt crisis sees the growth projection for the Euro area reduced by fully 1.6 pp to -0.5% in 2012 and by 0.7 pp to 0.8% in 2013. Moreover, the European crisis is seen having spillover effects elsewhere. The growth outlook for developing Asia has been cut by just over 0.5 pp in both 2012 and 2013 although remains an impressive 7% plus. The emerging markets in Eastern Europe will suffer the most from the European debt crisis and its consequences given their strong trade and financial links with Europe. The growth forecast for Central and Eastern Europe has been downgraded by 1.6 pp in 2012 (to 1.1%) and by 1.1 pp in 2013 to 2.4%. If the WEO update does not already bring enough bad news the Fund has emphasized that there is a considerable downside risk even to this forecast if European problems are not resolved quickly. A downside scenario would see a much deeper recession in Europe than currently envisaged.
Janez Jansa has announced the formation of a 5-party coalition. It includes DeSus, the Citizen's List, the Nsi, the SLS along with his SDS. The grouping holds 50 seats in the 90-seat parliament and is therefore expected to win a vote of confidence on Saturday. The party that won parliamentary elections in December, Positive Slovenia, failed to form a government when the Citizen's List decided it did not wish to participate in it. President Turk is opposed to Jansa becoming Prime Minister because a corruption investigation is being conducted against him. However, Turk's informal efforts to nominate an independent candidate as prime minister designate following the failure of Zoran Jankovic, leader of Positive Slovenia, to secure a vote of confidence apparently came to nothing. Jansa had no interest anyway in supporting such a candidate and Jankovic preferred early elections given that he had failed to become Prime Minister. The likely new Jansa government - he was Prime Minister from 2004 to 2008 - will have its work cut out in reducing the budget deficit, stimulating growth, recapitalising large banks and reforming an unsustainable pensions system. The last of these tasks will be complicated by the presence of pensioners party DeSus in the coalition.
The authorities have reached staff-level agreement with the IMF on completion of the review of the Flexible Credit Line (FCL). This two-year arrangement was agreed in January 2011 as a precautionary program to insure Poland against financial market contagion. This review confirms that economic fundamentals and policies in Poland remain strong enough to be eligible for the FCL. In particular, the Fund notes that growth is strong and well balanced although some slowdown is likely this year due to a worsening external environment. Significant fiscal consolidation was undertaken in 2011 given restrictions on expenditure increases and hikes in VAT and excise taxes. The 2012 budget continues this process and is broadly in line with Poland's medium-term fiscal goals. The government is committed to improving the sustainability of the public finances by raising the retirement age. The Inflation Targeting regime is credible and the external position sound even if increased risk aversion has temporarily reduced capital inflows and weakened the zloty.
The SDP-led government has laid out its fiscal plans for 2012. It seeks to reduce the general government deficit significantly from the 6.1% of GDP recorded last year to 4% of GDP. A key part of this fiscal adjustment is to come from an increase in VAT from 23% to 25%. The regressive nature of this tax increase will be offset by some items being taxed at the lower VAT rate and the threshold for paying income tax being increased. The government is hoping to stimulate employment by reducing employers mandatory contributions to health insurance from 15% to 13%. The rest of the fiscal adjustment is anticipated to come from expenditure restraint. In particular, the government seeks to restrict current expenditures so that it can spend more on investment projects. The budget is based on a GDP growth assumption of 0.8%. In the current global environment even this modest number may prove optimtistic. Recognising this, the government claims that it has identified further expenditure cuts that it will implement if growth disappoints.
The Bank of Latvia has reduced its forecast for economic growth in 2012 significantly from 2.5% to 1.3% given recent developments in the Euro area. This is not only a substantial downgrade but marks a considerable deceleration from the 4.5% growth estimated for 2011. With inflation relatively contained (4%) the Bank has responded to the lower growth outlook by reducing its minimum reserve requirements. For bank liabilities of above two years the rate has dropped from 3% to 2% and for all other liabilities from 5% to 4%. The Bank's interest rates remain unchanged (these move infrequently as the Lat is tied to the Euro). The weak growth outlook has significant consequences for Latvia and requires action beyond that already taken by the central bank. The government has targeted a budget deficit of 2.5% of GDP this year (compared to about 4% of GDP in 2011) in order to demonstrate that Latvia is ready to join the Euro in 2014. With the growth assumption for the budget now likely to have proved over-optimistic the government should consider a budget revision in order to maintain this deficit target. To do so, additional fiscal measures worth Lat100 mn need to be identified according to the Bank.
The majority of voters backed EU entry in a referendum held on Sunday. A relatively high percentage (66%) voted in favour although turnout was low (44%). Croatia will now join the EU in July 2013 as long as all member states have ratified the Accession Treaties by that stage. With the referendum out of the way, the new SDP-led government can focus on presenting a budget for 2012 by March. It has already announced an increase in VAT and some expenditure constraints at the central government level. It will take rather more, however, to stabilise Croatia's rising public debt to GDP ratio, attract more foreign investment and unleash higher productivity growth. It is not clear whether the government is prepared to restructure Croatia's large and inefficient public sector given opposition from its support base. On a regional level, Croatia's vote in favour of joining the EU is being hailed as proof to other potential candidates that EU Enlargement has not been halted. There will, however, likely be a considerable gap between Croatia's entry and that of any other country. This is due both to slow implementation of reforms on the behalf of candidate countries and an element of fatigue on the behalf of existing members to accept new ones.
The IMF's Executive Board has delayed approval of the 1st review of the Stand-By Arrangement (SBA). A new SBA worth EUR1.1 bn was approved in September. An IMF Mission reached Staff-level agreement with the Serbian government on completion of the first review of the SBA in November. However, the budget approved by parliament in December was not in line with the Fund's program. While the headline budget deficit was 4.25% of GDP as required the budget included various guarantees beyond that agreed with the Fund. These could very well lead to the government taking on extra debts when it is already close to breaching its public debt to GDP threshold of 45% of GDP. More specifically, the budget included guarantess to public enterprises worth RSD45 bn rather than the RSD30 bn agreed. It also included the possibility of the government raising EUR300 mn from institutional investors rather than the EUR200 mn agreed. Serbia may well breach its debt threshold anyway if economic growth comes in less than targeted this year. Hence, extra spending would aggravate the situation and make this fiscal rule almost worthless. Negotiations with the Fund will continue in early February. The central bank, ratings agencies and foreign investors will be keen to see the program come back on track before elections in May. If it does not the government will lose a fair amount of credibility.
The National Bank of Hungary (NBH) surprised most analysts by leaving its key rate on hold at 7.0% at its monetary policy meeting for January. The NBH hiked rates by 50 bps at each of its last two meetings given a significant weakening of the forint against the Euro and a related deterioration in the outlook for inflation. Hungarian financial markets have stabilized in the last few days as Prime Minister Orban has appeared to take a less confrontational tone with respect to the EU. Nevertheless, a lot must yet be done before an IMF/EU agreement is in place. The forint, moreover, remains above 300 to the Euro having spent most of 2011 around 270. The NBH points out that the economic growth outlook remains weak even if current inflation is relatively high and will increase, following the implementation of indirect tax increases, above 5%. It believes that the weak growth story will allow inflation to fall back towards the 3% inflation target in 2013 once the effects of forint weakness and tax increases have waned. It states, though, explicitly that it stands ready to hike rates again should financial market turbulence return and thus effectively retains a tightening bias.
Several days of, at times, violent demonstrations in Romania emphasize the difficulty the PD-L government will have in trying to be re-elected in parliamentary elections later this year. The proximate cause of the disturbances was an unpopular reform to the healthcare system. The Deputy Health Minister resigned in protest at the changes and was soon supported by members of the public. This then grew into a more general demonstration against the government and its harsh austerity measures. While the reform was shelved and the Minister urged to return to office the disturbances continued for several days. Romania has won praise from the IMF and international investors for implementing an economic program aimed at reducing large macroeconomic imbalances. However, opinion polls suggest that the opposition Social-Liberal Union could gain 48% of the vote in the elections scheduled for this winter compared to 21% for the PD-L.
Talks between Ukraine and Russia about a possible discount on the price of gas Ukraine pays to receive Russian imports continue. The background to the talks is not favorable for Ukraine. Its current account deficit is rising, the level of its FX reserves is falling and the market price of natural gas is increasing. Ukraine has apparently ruled out the two most obvious solutions to this problem. It cannot get money from the IMF if it refuses to raise the domestic gas price. The government does not wish to do this because it is politically unpopular. On the other hand, it seems unlikely that Ukraine will get the major discount it seeks from Russia on the market price for gas without a significant concession in return. However, Ukraine has refused thus far to enter the Russian-led customs union or hand over control of its gas pipelines to Russia. Failure to compromise in order to secure an agreement with either the IMF or with Russia would mean that the Ukrainian authorities would most likely seek to hobble through to parliamentary elections in October and then perhaps undertake the economic reforms requested by the IMF following the formation of a new Rada.
The National Bank of Serbia (NBS) has cut its key interest rate by 25 bps to 9.5% reflecting falling inflation and a weak growth outlook. The NBS has now cut rates by a cumulative 300 bps since last May. Inflation fell sharply from 14.7% in April to 7% in December and is expected to ease further in coming months. Economic growth is very weak with real GDP expanding just 0.5% y-o-y in Q3 and industrial production readings mainly negative over the last few months. The NBS sees inflation falling further due to weak demand pressures, lower food prices and smaller expected administered price increases this year compared to last. It could temporarily fall below target in Q1 as a result although it is expected to return within the fluctuation bands in H2. The dinar has weakened a little in the first few weeks of the year but not excessively. The risk remains of a larger adjustment however as other floating currencies in the region have depreciated far more against the Euro even where economic fundamentals are stronger. The NBS is likely, then, to continue to cut only in small steps going foward. Moreover, it warns that the outlook is uncertain and depends on fiscal developments in Serbia and risk appetite on global financial markets.
The European Commission (EC) has reduced its forecast of the Polish budget deficit for this year significantly. The budget deficit came in lower than planned last year but still amounted to a hefty 5.6% of GDP according to EU methodology. This undershoot and the measures announced by Prime Minister Tusk in November have persuaded the EC to reduce its forecast of this year's deficit from 4% of GDP to 3.3% of GDP. As such, Poland is one of only a few EU countries which the EC considered to have a potential excessive deficit in 2012 that has taken effective action to remedy this. Nevertheless, questions clearly remain about whether the government's deficit target of 2.9% of GDP this year will be met. Moreover, some commentators have criticized the government's recent measures for consisting too much of tax increases rather than necessary expenditure cuts in the health and education sectors. The government has though previously resticted discretionary spending and limited the increase in social entitlements. Part of the deficit also results from a large-scale investment program.
Inflation fell from 3.0% in November in the Euro area to 2.7% in December. It fell from 3.4% to 3.0% during the same period in the EU-27. Inflation remains above target in the Euro area but these figures would tend to confirm the idea that the higher inflation seen in the September to November period was due to temporary external factors. In the medium-term, weak growth and loose labour markets are likely to push inflation downwards barring further shocks (such as higher oil prices). Within Eastern Europe, inflation fell in December in nine of the ten countries reporting. The exception was Poland where it edged up from 4.4% to 4.5% partly as a result of a weaker zloty. Neverthless, a weaker forint did not stop inflation falling in Hungary from 4.3% to 4.1%. Neither did a softer Leu stop Romanian inflation falling from 3.5% to 3.2%. The highest inflation rate within these Eastern European countries was in Slovakia (4.6%) while the lowest was recorded in Bulgaria (2.0%).
The Russian government appears to be responding to large-scale protests following parliamentary elections held on December 4. President Medvedev has asked the Duma to reintroduce the direct election of regional leaders which was scrapped in 2004. Many Russians - amongst them many former Putin supporters - were angered by the brazen way in which Prime Minister Putin and President Medvedev announced in September an exchange of posts through presidential elections to be held in March and the blatant rigging of the parliamentary elections in December in United Russia's favour. The announcement of the reintroduction of regional elections is a recognition of the concern felt within the administration at the protests (another demonstration is scheduled for early February). However, it seems unlikely that this headline announcement will restore power to the regions in any significant way. The Kremlin still has many ways of influencing indirectly who will be elected even if the legislation proposed does not give it a direct power of veto as Putin had earlier hinted. It can, for instance, heavily influence which candidates stand for election.
The European Union has launched infringement procedures against Hungary for recent legislative changes that threaten the independence of the central bank, judiciary and data management agency. Even as the EU formally expresses concern about the erosion of democratic procedures since Fidesz returned to power the financial markets are becoming a little bit more sanguine. Some believe that Orban is preparing to back-down over the key central bank issue using the excuse that he has been forced to do so following interference from abroad in order to retain his nationalist/populist credentials. Whether this plays out or not remains to be seen. It would still appear optimistic that Hungary will have an IMF agreement in place by the end of the first quarter as the market rally would seem to suggest is increasingly being discounted. Certainly an IMF agreement, if reached, would improve investor sentiment. However, until it is concluded yields on government debt auctions remain very high and the forint very weak. The central bank may well have to consider another rate hike at its monetary policy meeting next week.
Zoran Jankovic has failed to win a vote of confidence in parliament securing only 42 of the 90 votes. Jankovic's Positive Slovenia pulled off a surprise in recent parliamentary elections by winning the most seats (28) and pushing the favourites (the SDS) into second place with 26 seats. Jankovic appeared to have a deal at the weekend to form a government with the SD, DeSus and the Citizen's List of Gregor Virant. However, Citizen's List subsequently changed it mind citing major differences in proposed policy platforms. President Turk now has 14 days to nominate a new premier-designate. It seems increasingly likely that this will now be Janez Jansa of the SDS. He claims that he has secured the backing of 50 deputies. This suggests that the SDS will be supported not only by the Citizen's List and DeSus but also by the Nsi and SLS. In other words, Slovenia may end up with a centre-right government after all despite the election results given the failure of Jankovic to form a centre-left one. Even assuming Jansa is nominated and subsequently secures a vote of confidence Slovenia will be left with a five-party coalition as it seeks to overcome significant economic challenges: slow growth; an unsustainable pension system; and weakly capitalised big banks.
Belarus has released its economic results for 2011. GDP growth expanded by 5.3% y-o-y. This seems impressive. However, given that GDP expanded by an extraordinary 12% in H1 this suggests that growth was negative in the second half of the year. Moreover, inflation accelerated from 9.9% at the end of 2010 to a massive 108.3% at the end of 2011 given the depreciation of the currency seen since the spring as the result of a balance of payments crisis. There are finally some signs of stabilization here. Inflation increased by only 2.3% m-o-m in December compared to the average 9% m-o-m increases seen in the preceding seven months. Much of the reason for this is that the central bank has hiked its key refinancing rate dramatically to 45% in an effort to stop the currency weakening further. This effort seems to be bearing fruit. The currency may have dropped an alarming 180% against the US$/Ruble/Euro basket during the course of 2011 but actually appreciated by 4.3% against the basket in December. Clearly tighter monetary policy is one of the factors - along with tighter fiscal and incomes policies - that are slowing economic growth as the government desperately tries to restore macroeconomic stability.
The Monetary Policy Council (MPC) of the National Bank of Poland left its key interest rate unchanged at 4.5% as expected. In an accompanying statement, the MPC noted that growth appeared to be relatively strong still in Q4 although leading indicators suggested a likely weakening in the first quarter of 2012. November inflation was higher than expected at 4.8% and well above the target of 2.5%. The MPC sees slowing growth and the waning impact of previous tax increases as factors that will bring inflation back down to target over the medium-term. However, high commodity prices and the significant weakening of the zloty in recent months work in the opposite direction. The MPC has not hiked interest rates in response to currency weakness as has been the case in Hungary. However, the central bank has intervened in the FX market and made clear that it would consider hiking rates if currency weakness persists and threatens to stop inflation converging to target. In effect, the central bank has changed its bias from neutral to tightening in the short-term until the zloty situation normalises. It has made clear that it does not think that the currency move in recent months was in line with fundamentals. There has been some stabilization in recent days but the currency is still weak against the Euro.
The weakness in the European economy towards the end of last year is emphasized by very poor industrial production (IP) data for November. Both the Euro area and EU-27 saw a fairly modest 0.1% m-o-m, seasonally adjusted decline. However, this translated into a y-o-y reading of -0.3% in the Euro area and -0.2% in the EU-27. This is the first time since the end of 2009 that either region has recorded negative y-o-y growth. All eight countries from Eastern Europe that reported data managed to record positive y-o-y readings though in most cases the pace of output growth declined. Solid IP numbers were recorded in Poland (9.9%), Latvia (8.5%) and the Czech Republic (5.4%). Most of the other countries saw IP growth of around 1%. Leading indicators suggest that things may have got worse in December. This weak growth outlook has helped to persuade the ECB towards the end of last year to reverse its two rate hikes from earlier in 2011. It has stayed on hold this month but may need to take further steps in coming months. The weakening of the Euro against the US$ should, though, help the European economy to recover towards the middle of the year and offset ongoing fiscal tightening.
Having failed to secure the status of official EU candidate in December as hoped the Serbian government is keen to achieve this at the next possible date in March. However, there is reason to doubt whether this is likely. On the positive side, negotiations between Pristina and Belgrade about technical issues are likely to continue later this month with the focus on Kosovo's representation at regional meetings. It is possible that a deal will be reached. Implementation of previous agreements is also underway e.g. regarding freedom of movement. However, even if progress continues on both fronts significant challenges remain to securing "status". Germany announced in August that it expects Serbia to dismantle "parallel institutions" financed by Belgrade in the north of Kosovo. This seems unlikely to happen any time soon especially with elections due in Serbia. Other member states may urge Germany to alter its stance and allow this to happen at a later stage of the EU integration process. However, it remains to be seen whether this lobbying will be successful. The Serbian government must announce in early March when exactly elections will be held in May. At this stage it will become clear that elections will also almost certainly be held for the said "parallel institutions" in northern Kosovo. This may be interpreted as aggravating the situation in Berlin but given the Serbian government's stance that Kosovo remains part of Serbia would appear to be unavoidable.
Outgoing Prime Minister and current leader of the HDZ, Jadranka Kosor, has announced that a date for electing a new head of the party will be chosen at a meeting of its presidency on January 23. The election of a new leader would appear to be a close-run thing. Former Health Minister Milinovic, former Minister of Internal Affairs Karamarko and former Deputy Prime Minister Milosevic have all announced that they will stand against Kosor. The HDZ's convincing defeat by the Kukuriku coalition in December elections raised expectations that Kosor would be replaced as leader of the HDZ. In fact, it appears that some party members feel that in the circumstances - an economic recession and widespread corruption investigations into senior HDZ members - its vote held up pretty well. Indeed, many centrist parties did poorly in the vote at the expense of the left (Kukuriku) and the right (HDZ). Presumably on this basis, Kosor is actually leading according to opinion polls at the moment by a few percentage points over second-placed Milosevic. Whether her re-election would appeal to non-HDZ voters is another matter. Certainly, real progress was made in the fight against corruption from the point at which she became prime minister but at the same time, as a long-standing senior member of the HDZ, she is hardly a "new broom" with which the party could start to reconnect to disgruntled voters.
The leading parties in Bosnia finally reached agreement on forming a state-level government on December 28. The deal sees Vjekoslav Bevanda of the HDZ becoming Chairman of the Council of Ministers. 13 months of political stalemate since October 2010 elections were finally ended when Zlatko Lagumdzija of the SDP accepted the post of Foreign Affairs instead of Chairman of the Council. The long delay in forming a government has resulted in serious adverse consequences for Bosnia. It has fallen further behid in the EU Accession process as it has been unable to pass the required reforms. However, the end to the political deadlock should allow the resolution of some important issues. On December 31 a state-level budget for 2011 was finally passed. This allows temporary financing of budgetary institutions for the first few months of 2012 until a budget for this year is approved. A political agreement on the holding of a highly sensitive census has also been reached. The appropriate legislation should be passed next month and the census held in the spring of 2013. This will be the first census since the war and whether individuals need to state their ethnicity and the treatment of displaced persons had long delayed the passage of the enabling legislation.
Hungarian financial markets sold off significantly at the end of last year as the government pushed through legislation which makes an IMF deal more difficult to obtain. The adoption in parliament of changes to the way the central bank's board is appointed has brought sharp criticism from the EU which fears the Bank's independence has been weakened. This helped the forint reach a record low against the Euro (315) and sent bond yields sharply higher. Prime Minister Orban has recently made some more dovish comments suggesting that the government will seek to reach any agreement with the IMF rather than one "without conditions" which the government has unrealistically claimed it required earlier. However, there have been no concrete steps to improve the government's negotiating position with respect to the Fund. In the absence of any such measures the central bank may well need to hike its key interest rate further to stabilise the currency. Without this, the inflation target is jeopardised and households will struggle to pay back debt denominated in foreign currencies. Fitch joined other credit rating agencies last week in donwgrading Hungary to "junk" status given a series of erratic policy steps by the Orban administration.
Inflation in Russia at the end of 2011 was just 6.1% y-o-y, down from 6.8% in November and the 8.8% recorded at end-2010. End-year inflation was 3.9% in the tradable goods sector, 6.7% in non-tradable goods and 8.7% in the services sector. The most immediate reason for the fall in inflation has been a good harvest which has seen food prices fall. However, sub-trend economic growth has also been an additional factor. The Central Bank of Russia has responded to falling inflation by lowering its refinancing rate by 25 bps in December to 8.0%. This reversed one of the two rate hikes of the same magnitude implemented earlier in the year when inflation had risen to almost 10%. Average inflation for 2011 was a rather higher 8.5% (compared to 6.9% in 2010) highlighting that for all the near-term softness in inflation the Bank's record on keeping inflation low remains poor. Loose fiscal policy (the government is running a massive non-oil fiscal deficit) does not help the effort to keep inflation low over the medium-term. While weak short-term inflation readings could persuade the Bank to cut again there is little suggestion that Russia's inflation problem has been solved on a more enduring basis.
The National Bank of Hungary (NBH) hiked its key interest rate by another 50 bps to 7.0% at its monetary policy meeting on Monday. This is the second such rate hike forced on the central bank by the weakness in the forint and the rising country risk premium for Hungary. The unsuccessful start to preparatory talks between the Hungarian authorities and the IMF/EU has further hit market sentiment. Proposed changes to the central bank law have been heavily criticised by these two institutions. While the government has announced amendments to the new law these do not appear sufficient to satisfy the EU. In this case, further talks designed to secure a new IMF program may be delayed. Moreover, the central bank's rate hike at its last meeting may have stopped the forint weakening further against the Euro but it is still over 300. This is a rate at which the central bank is in danger of missing its inflation target. If the forint does not strengthen and the policy outlook improve in the next couple of weeks the central bank may have to hike rates again; and this at a time when the outlook for economic growth is very weak. If things continue like this Hungary also risks another credit rating downgrade. A new IMF program (even if treated as precautionary) is an important signal to investors that economic policies will improve and become more predictable.
The IMF notes in its Annual IV report that growth in Turkmenistan is strong and likely to remain so. GDP growth in 2010 was 9.2% and in 2011 it is likely to have accelerated to 9.9%. This is due both to increasing production in the hydrocarbon sector and large-scale public investment programs. Trade diversification is being improved given increasing gas exports to China and Iran. However, more needs to be done to reduce reliance on the hydrocarbon sector itself. In this regard, a boost in public spending may be appropriate but only if the money is well spent and is not disbursed at such a pace that it endangers macroeconomic stability. Despite high oil and gas prices, the state budget surplus has fallen significantly in the last couple of years. The overall fiscal balance may now be negative. Moreover, the current account is likely to have recorded a deficit of over 10% of GDP in both 2010 and 2011. Inflation is forecast to have increased from 4.8% at end-2010 to 7.5% at the end of this year. Turkmenistan has an enviable growth outlook in coming years. However, tighter fiscal and monetary policies would seem to be more appropriate. Measures should also be implemented to improve the efficiency of government spending and improve the conduct of monetary policy. The money directed to the stabilisation fund should be saved not spent while the central bank should not engage in directed lending.
The Alliance for European Integration (AEI) has once again failed to secure enough seats in parliament to have its candidate elected as President of Moldova. An attempt to elect a president was aborted earlier this month. This time around, Marian Lupu - the AEI candidate - received 58 votes rather than the 61 (of 101 necessary). This is another set-back for the AEI which is doing well in implementing its IMF program but has failed on a number of occasions to end this ongoing constitutional crisis. Previous attempts to elect a president failed and caused early elections. A plan to win a referendum that would change the Constitution and see the president elected by direct vote also came to nothing. The AEI hoped that a splinter group of three ex-Communist deputies would vote in favour of Lupu and (with its own 58 seats) secure the 61 necessary to see him confirmed in office. However, this did not happen. Another attempt to elect a president is likely in January. If this again ends unsuccessfully then yet more parliamentary elections will be triggered. The group of defectors from the Communist Party may just be attempting to maximise its political leverage ahead of this vote. But on the other hand, if the price of its support is considered to be too high the AEI may just decide to settle for early elections if it is confident that it will secure the crucial 61 seats this time around.
The first sitting of the new Sabor is being held today after parliamentary elections held on December 4. The Kukuriku coalition - with 80 of 151 seats - is expected to win a vote of confidence tomorrow with ease to confirm the cabinet of Zoran Milanovic (SDP leader) in office. One of the first orders of business of the new government has been to decide on the date of the referendum on EU entry. It is due to be held by January 7 under current legislation (based on the date of signing Croatia's EU Accession Treaty) but will be put back to January 22 according to the government to allow for a more extensive campaign ahead of the vote. A positive decision with regards to EU entry is expected although not certain. Some voters are indifferent although all the main political parties are pro-EU entry. A more challenging assignment for the new government may be devising an appropriate fiscal adjustment strategy. Everyone agrees that the budget deficit and debt to GDP ratios are too high but there is little agreement on how to address this. Moreover, the coalition promised that it would not cut jobs in the hugely bloated public sector during the election campaign. The other issue to be watched is the stability of the coalition itself. Tensions it seems have already broken out between the SDP and HNS during the process of putting the cabinet together.
As had been expected, the EU refused to sign the Association Agreement with Ukraine at this week's EU-Ukraine conference despite the fact that all the technical negotiations have been completed. The EU has made it clear on a number of occasions that it is unhappy with the imprisonment of opposition leader Yulia Timoshenko. This is, according to the EU, just one of a number of moves recently that have raised concerns about the direction of human rights and democracy in Ukraine. It was stressed during the conference that member states and the European parliament must also ratify the Agreement before it comes into force and it is hard to expect that this process will be smooth unless concrete steps are taken to address these concerns. The conduct of parliamentary elections in October 2012 will be particularly important in this regard. The EU is trying to use a carrot and stick approach here (given that the Agreement includes the possibility of securing a free-trade agreement). However, it is also aware that if it pushes too hard on these issues Russia would be more than glad to try and incorporate Ukraine into its customs union in return for lower gas prices and other economic benefits.
The accession of Russia and Montenegro to the World Trade Organisation (WTO) was approved during the 8th WTO Ministerial Conference in Geneva. The two countries will actually join once their respective parliaments have ratified their accession packages. Clearly most focus has been on the Russian negotiations given that it is the largest economy by far that remains outside the WTO and its accession process has also lasted the longest (18 years). Russia's accession should improve the competitiveness of its economy and offer more reassurance to foreign investors that it is a safe place to invest although improvement on both fronts will take some time. Tariffs will be reduced only partially and gradually and there are too many high profile cases of foreign investors suffering at the hands of the Russian authorities/administration to change its investment image overnight. Montenegro's accession took only 7 years by contrast. However, it still took longer than expected given a dispute with Ukraine. The Montenegrin economy is of course tiny in comparison with Russia's. However, it is highly reliant on foreign investment so WTO accession is an important step forward even so. It also complements Montenegro's EU integration process.
An IMF/European Commission Mission to Budapest intended to begin preparatory talks towards the agreement of a new program did not go well. Agreement of a new program was anyway likely to be less than straightforward given the Fidesz government's apparent (but mistaken) belief that it can secure a program without any conditions attached. However, this process has been strained yet further by another attempt to undermine the independence of the central bank. The government has already watered down the Governor of the National Bank of Hungary's ability to appoint external members. It is now seeking to limit his right to appoint Vice Governors and increase the number of members on the Monetary Policy Council. Indeed, there is even a (seperate) proposal to merge the central bank and the financial markets regulator with the Governor to be just the deputy in the merged institution. Political attacks on the central bank are, unfortunately, common-place in Hungary. The Socialists were guilty of watering down its independence too. However, the proposed changes are very significant and come against the back-drop of other efforts to water down independent institutions. The ECB has expressed its concern at the proposed changes.
It remains unclear which countries exactly will be subject to the new "fiscal compact" agreed at the EU Summit on December 8-9 and what form it will take. However, one country has already decided to join Poland and Germany in putting in place its own debt-ceiling. Slovakia has passed legislation which triggers a series of actions as soon as public debt to GDP exceeds 50% and which is aimed at preventing it ever reaching 60%. The Slovak law is rigorous not only in the sense that it sets the requirements for remedial action at a relatively low share of public debt to GDP but is very explicit at each stage what steps must be taken. If public debt to GDP exceeds 60%, for instance, the government faces an automatic vote of no confidence in parliament. Indeed, the level of public debt to GDP at which this ultimate sanction is triggered will fall gradually over time until it reaches just 50% of GDP. Other debt ceilings have higher trigger points or are less explicit about the required policy response. Moreover, the debt ceiling is fairly unusual in Slovakia in having won cross-party support. It remains to be seen whether any new fiscal measures agreed at the EU-level will require a referendum in Slovakia. SaS is pushing for one to be held at the same time as the parliamentary elections on March 10 clearly wishing to turn this into an election issue. However, at that stage it may not even be clear what extra powers are being transferred to Brussels.
The National Bank of Serbia has released more detailed results of the performance of the banking sector in the third quarter. The aggregate profit of the sector at RSD25.1 bn for the first three quarters of 2011 was an improvement of 21.2% on the same period of last year. However, the share of non-performing loans as the share of the total remains high (at 18.8%) by regional standards and continues to rise (if less slowly than previously). Nevertheless, all other indicators are satisfactory. Capital adequacy is very high at 19.7%. Liquidity is ample (2.11) and provisions for bad loans (140.1) very healthy. Profitability of the sector as a whole is, though, relatively low (ROE 6.5%, ROA 1.3%) by regional standards and yet to recover from the crisis. However, there is a significant divergence in performance between a few large and very profitable banks and a large number of those with both a small deposit share and low profitability. The banking sector remains solid, then, but a weak real economy will doubtless delay its recovery. On the other hand, its profitability even during a crisis is raising political pressures on the government to try and persuade the banks to lend more to business or on cheaper terms.
Industrial production (IP) contracted by 0.1% m-o-m, seasonally adjusted in the Euro area in October and by 0.2% m-o-m in the EU-27. These numbers were slightly better than the readings for September (-2.0% and -1.5% respectively). However, they translate into a continued slowdown in the y-o-y figures. IP expanded by just 1.3% y-o-y in both the Euro area and EU-27 in October. This was a decelaration from the already weak readings from September (2.2% and 2.1% respectively). Leading indicators suggest things may get worse rather than better in coming months. Within Eastern Europe there was a notable slowdown in IP growth in the Baltic States which had shown robust double-digit growth in previous months. Relatively strong y-o-y readings were still recorded in Slovakia (7.8%), Poland (7.1%) and Latvia (5.1%). However, most countries saw an IP expansion of between just 1% and 2% and in Lithuania there was actually a contraction of 1.1% y-o-y. As IP has been one of the few areas of relatively good growth in the European economy so far this year its slowdown seems to confirm that the continent is heading into recession.
An IMF Mission to Poland notes that economic growth is robust and well-balanced although likely to slow next year due to worsening external conditions. The Fund commends the government's ongoing fiscal consolidation. The budget deficit is likely to fall to 5.5% of GDP this year and to 3.25% of GDP in 2012. More measures will be needed further out to bring the deficit down to the desired 1% of GDP and bring the public debt to GDP ratio onto a downward path. Given the slowing growth outlook and an expected easing in inflationary pressures the IMF considers that the central bank will have room to respond with lower interest rates. The central bank has kept rates on hold recently despite a worsening growth outlook because inflation remains above target. However, once it starts to fall it will have room to react. The IMF supports the central bank's recent foreign exchange interventions too. The central bank is not supporting a particular level of the exchange rate. However, the sharp fall in the zloty appears to be largely a result of financial contagion rather than the economic fundamentals in Poland. Moreover, such sharp moves in the exchange rate can have a destabilizing effect by themselves on the banking sector which is otherwise performing strongly.
Inflation in the Euro area stayed stable at 3.0% y-o-y in November for the third month in a row. In the EU-27 it edged up to 3.4% having been 3.3% in the previous two months. The ECB sees inflation staying above target in the next couple of months but falling next year on a weak growth outlook. Amongst the Eastern European countries reporting, inflation was highest in November in Slovakia (4.8%) and in Estonia, Lithuania and Poland (all 4.4%). The lowest inflation was recorded in Bulgaria (2.6%), Slovenia (2.8%) and the Czech Republic (2.9%). Both Poland (a rise of 0.6 percentage points) and Hungary (a rise of 0.5 percentage points to 4.3%) saw a significant rise in inflation in November partly as a result of recent exchange rate weakness. The Hungarian central bank has already responded by hiking rates and made clear it will do so again if needed. The Polish central bank has kept rates on hold but has made it clear that it will have to raise rates (despite a worsening growth outlook) if the zloty depreciates further.
The IMF sees economic growth of 3% in Macedonia this year and 2% in 2012 although the risks to the latter are to the downside. Inflation is relatively low and the current account deficit at about 6% of GDP should be readily financeable via a combination of FDI inflows and government borrowing. FX reserves may, then, increase slightly in the period ahead. The exchange rate peg to the Euro remains stable. The fiscal deficit of 2.5% of GDP targeted for next year is appropriate. Moreover, the government has committed to cutting expenditure in the eventuality that budget revenues underperform. Public debt to GDP is low compared to many of the countries peers. However, the Fund recommends that the authorities develop the local debt market to reduce reliance on issuance of external debt. This would reduce reliance on volatile international capital markets. The banking sector is well capitalised and its share of non-performing loans is low by regional standards. These non-performing loans are also well covered by provisions.
The European Council has noted the progress that both Montenegro and Serbia have made in meeting the criteria for further EU integration. However, both must do more to achieve the next stage in the process. Serbia was not granted the status of candidate as it had hoped. While the government has done a lot to improve co-operation with the ICTY and pass European reforms it has failed as yet to implement agreements reached with Pristina and to reach agreement on the presentation of Kosovo at regional meetings. Progress on these issues will be assessed by the Council of Ministers on February 12 with a view to the status issue being reconsidered at the European Council meeting scheduled for March 1/2. Likewise, Montenegro will be allowed to start Accession negotiations in June if it gets a positive assessment of measures it takes in the meantime to tackle organised crime and corruption. Croatia also signed its Treaty of Accession. It will join the EU in July 2013 assuming that all 27 member countries have ratified the Treaty by that stage.
An IMF Mission to Sofia has concluded that economic policies are generally sound but that fiscal contingency measures should be identified for the eventuality that economic growth next year comes in worse than expected. The Fund notes that a slowdown in the European economy means that growth in Bulgaria will likely be 1.9% in 2011 and just 1.3% in 2012. The budget appears on track to hit its 2.5% of GDP target this year. The IMF commends the 1.3% of GDP fiscal target for 2012 however the adoption of additional measures seems warranted to ensure the budget stays on track given the sizable macroeconomic risks presented by the ongoing global financial crisis. The adoption of these measures would partly offset the impact on the budget of slower than expected growth although some relaxation of the fiscal target could also be justified in these circumstances (and could still be consistent with the Financial Stability Pact). The IMF welcomes the adoption of the pension reform. It also notes that the banking sector is well capitalised and liquid. Hence, banks should be able to increase lending once the economic situation stabilizes and the demand for loans picks up.
The government is looking to identify new fiscal measures worth up to HUF200 bn to maintain its budget deficit target of 2.5% of GDP in 2012. The original budget projected economic growth of 1.5% and assumed a HUF/EUR exchange rate of 268. These assumptions are now clearly unrealistic in the present economic and financial environment. The government has announced that it will reduce the growth forecast for next year to 0.5% given weakness in the European economy and raise the HUF/EUR forecast to 300 given the recent sharp weakening of the forint. The details of the new measures will be presented at a later date. It is very important that the budget for 2012 be considered realistic. This will be a key factor in talks with the IMF as the government looks for a new program. It will also be a decisive issue in persuading credit rating agencies whether they should continue to downgrade Hungary or not. Financial investors would be more assured if they were to be presented with a list of orthodox revenue hikes and expenditure cuts rather than the largely ad hoc measures which the government has preferred to date.
The IMF notes following its recent Mission to Moscow that the economy is recovering relatively strongly. However, economic growth is expected to slow from 4.1% this year to 3.5% in 2012. High oil prices suggest that this is the right time to rebuild policy buffers, according to the Fund, and implement measures which will raise economic growth in the future. The non-oil fiscal position is extremely loose and is unlikely to tighten soon according to current fiscal plans. The Reserve Fund stands at a fraction of its pre-crisis level. The banking sector is still burdened with a high share of non-performing loans. All these issues should be addressed as soon as possible. This would entail at the very least saving any possible fiscal surplus this year in the Reserve Fund and improving both supervision and crisis resolution procedures in the banking sector. If these issue were addressed successfully this would put the economy in a better position to cope with external shocks such as the expected slowdown in the European economy. Recent progress made towards WTO Accession should be positive for the Russian business climate. However, more needs to be done to diversify the economy away from the oil and gas sector.
The National Bank of Poland (NBP) left its key interest rate on hold at 4.5% as expected. In an accompanying statement, the Monetary Policy Council (MPC) highlighted that growth in Q3 was strong but indicators in the Euro area are weakening significantly. Inflation rose in October and remains above the upper fluctuation band of the 2.5% plus or minus one percentage point target. The recent weakening of the zloty will add to inflationary pressure in the short-term. In the medium-term, tighter fiscal policy and favourable base effects should cause inflation to fall. The MPC believes that its rate hikes earlier this year will help bring inflation back down to target. However, it notes explicity that further rate adjustments could be necessary if the chances of this happening appear to have deteriorated. In other words, if the zloty weakens further the central bank may have to consider hiking rates (as has already happened in Hungary) due to the adverse effect this would have on the inflation outlook.
The National Bank of Serbia (NBS) has cut its key policy rate by 25bps to 9.75%. This takes the cumulative rate cut this year to 275bps. The NBS has been cutting rates fairly swiftly because inflation is falling sharply. It remains above target but should converge to it in the first quarter of next year. Growth is also weak. The latest data readings in Serbia have been disappointing and leading indicators in the EU suggest that the situation will worsen. On the other hand, the central bank does not want to cut too fast and destabilize the dinar. This has been surprisingly stable so far this year as other currencies in the region have weakened significantly. This is not the result of strong economic performance in Serbia but a number of temporary factors: a large eurobond issue; the sale of Maxi to Delhaiz; and high domestic interest rates. The smaller rate cut this time around and a more neutral statement suggest that the NBS will be more cautious going forward. Future policy moves, according to the NBS, will depend on the international environment and the fiscal policy stance at home and how these will impact on inflation.
The Latvian authorities have reached Staff-level agreement with the IMF on the completion of the fifth and final review of the Stand-By Arrangement. An IMF Mission to Riga a few weeks ago failed to reach agreement on completion of the review but talks continued. Since then, the fiscal situation has been complicated by the failure of Latvijas Krajbanka and the government's subsequent decision to buy back its stake in Air Baltic (the owner of Krajbanka's parent bank was part of a consortium that had bought a stake in this air company). The IMF is confident that, despite these extra fiscal costs, the budget deficit will come in below target this year. This is largely due to strong economic growth and better than expected tax revenues. The authorities have committed to delivering a budget deficit of just 2.5% of GDP next year as part of their strategy to join the Euro in 2014. The IMF is not entirely happy with all the specified measures and there is a risk that economic growth will not only slow but come in lower than expected. Therefore, the authorities have identified some contingency measures with which they would seek to stick to the existing fiscal target should a worst case scenario arise.
Chancellor Merkel made it clear last Friday that she considers that Serbia has not yet done enough to fulfill the conditions necessary for achieving the status of candidate for EU entry. Since then there has been a significant step forward in talks between Belgrade and Pristina - the agreement on Integrated Border Management (IBM). There has subsequently been the removal of some but not all of the barricades laid by Serbs in northern Kosovo. Agreement has yet to be reached, moreover, on the representation of Kosovo at regional meetings. It remains to be seen whether the IBM deal and the lobbying of other member countries will be enough to change Berlin's stance. A decision is due during the European Council meeting (ongoing at the time of writing). Some member states consider that Serbia has met all the necessary conditions for status. Others consider that it hasn't quite done so but has made so much progress with respect to the Hague and passing reforms required for European Accession that it should be allowed to achieve candidate status for the greater good of integration of the Western Balkans into Europe. If these lines of reasoning are insufficient to change the German position the decision will be delayed to a Council meeting during the course of next year. The Austrians are apparently proposing a compromise: a form of conditional status based on further progress in Belgrade-Pristina talks in coming months.
The European Central Bank (ECB) has cut its key policy rate by 25bps to 1.0%. It has also reduced reserve requirements (from 2% and 1%) and increased the duration of (and reduced the quality of collateral required at) liquidity auctions. Much market commentary focuses on the survival of the Euro and whether the ECB will step up its purchase of sovereign bonds. However, an even more pressing problem is an oncoming recession and credit crunch. The latest Markit PMI reading (for November) was just 46.4 compared to 47.1 in October. Some analysts are predicting as a result that Euro area GDP could contract by more than 0.5% q-o-q in Q4. Banks are having problems financing themselves also which threatens to make the situation even worse. Hence, the ECB's steps are very important. More may be required. Eastern European countries are heavily integrated into European trade and capital markets. They are typically small and open economies whose growth, FDI and bank financing outlooks are deteriorating step-by-step with that of the Euro area/EU-27. A resolution to the Euro area's current problems - such as deeper fiscal co-ordination between member states - will also ultimately be needed to improve market confidence but this could yet take several months.
United Russia secured a majority in Sunday's parliamentary elections despite preliminary vote counts which suggested that it might not. However, the 238 seats it secured in the 450-seat Duma is a major reduction on the 315 seats it won in 2007. It is also a significant pyschological blow to United Russia when one considers that it failed to win 50% of the vote despite widespread vote-rigging, media bias and intimidation of the opposition. International monitors heavily criticised the conduct of the elections. Only four parties crossed the 7% election threshold for representation. The Communist Party (92 seats), A Just Russia (64 seats) and the Liberal Democrats (56 seats) all improved their positions in the Duma significantly. This underlines that the message of the election was disillusionment with United Russia rather than a rise in popularity of any one other particular party. Voters appear to be frustrated by increasing corruption, cronyism and weaker real wage growth. The result will change little in the short-term. Vladimir Putin will still win March presidential elections comfortably. The government can use its fiscal reserves to boost incomes ahead of the vote. However, the authorities are no longer benefitting from the sort of economic boom that gave Putin sky-high popularity in his first two terms as president. Economic reforms are needed to stimulate stronger growth and reduce reliance on the oil price not just "stability".
A new political party - Positive Slovenia - led by the mayor of Ljubljana defied the opinion polls and won the most seats (28) in parliamentary elections held at the week-end. The expected victors, the centre-right SDS of Janez Jansa, came only second winning 26 seats. Leader of the victorious party, Zoran Jankovic, will now seek to form a centre-left government. He has already had talks with Borut Pahor leader of the SD. The SD was the leading party in the outgoing government which fell in September. It took 10 seats and third place in these elections. Another new party - Citizen's List - was fourth with eight seats. This is another potential coalition partner for Jankovic. These three parties together would only hold a slim majority in the 90-seat parliament. Hence, another party may well be invited into the government. Both pensioners' party DeSus and the SLS gained six seats each and could be possible candidates for the new government. Whatever the exact make-up of the coalition it will face significant economic challenges. Economic growth is weak, external indebtedness is high and the pensions system is in need of urgent reform.
The International Court of Justice (ICJ) has ruled that Greece was wrong to block Macedonia's bid for NATO entry in 2008. The bid was made under the name of Former Yugoslav Republic of Macedonia. Greece had agreed in 1995 that Macedonia would be allowed into international insitutions under this name rather than the Republic of Macedonia. This deal saw the lifting of a Greek trade embargo. The ICJ ruling is a big politial victory for the ruling party in Skopje. It will also make it more difficult for Greece to block Macedonian entry to NATO and the EU in the future. However, the ruling does not impact on the "name" dispute directly. Greece claims that the name Republic of Macedonia implies territorial designs on its northern province of the same name. Both sides remain committed in principle to resolving the underlying dispute but in practice there has been little progress on this issue for some time. Macedonia wishes not only to join NATO but start Accession negotiations with the EU having won candidate status as far back as 2005.
The second round run-off in the presidential election in South Ossetia has ended in chaos and scenes of violence. Partial results showed that Alla Dzhioyeva was set to win 56% of the vote and comfortably defeat the Kremlin's preferred candidate - Anatoly Bibilov. Bibilov appealed to the Supreme Court claiming that Dzhioyeva's supporters had committed electoral violations. The Supreme Court then anulled the vote, set a new election date of March 25 and disqualified Dzhioyeva from standing next time around. Most election observers considered the conduct of the election to be generally fair. However, it is unclear exactly why the vote was cancelled. Some might see some Russian involvement here. South Ossetia is one of two breakaway regions of Georgia (along with Abkhazia) that consider themselves to be independent states. They are recognised only by Russia and a few other countries. On the other hand, this could be an attempt by outgoing President Eduard Kokoity to prolong his rule. He has served two terms and failed to get the Constitution changed to run again. Relations between him and Moscow are very poor despite South Ossetia's geo-political reliance on Russia.
The main novelties in the European Commission's Enlargement Reports in October were that it suggested that Montenegro be given a start date for Accession negotiations and that Serbia be granted the status of candidate conditional on progress in talks with Pristina about resolving outstanding "technical" issues. The expectation was, then, that the European Council would possibly approve both changes at its meeting on December 9. However, things have not gone as planned since then. On the one hand, the euro zone debt crisis has distracted attention from Enlargement as an issue. On the other, some member states appear to believe that neither country has made sufficient progress to have earnt advancement to the next stage of European integration. Some believe that Montenegro needs to do more to clamp down on corruption and improve the rule of law. Some others consider that Serbia has not made enough progress in talks with Kosovo nor, indeed, fully implemented agreements already reached. In both cases, then, it is possible that these decisions will be delayed to a later Council Meeting. We are likely to get a better indication of the outcome on both counts on Monday when foreign ministers meet to make a recommendation to the Council.
There is little doubt as to which party will win parliamentary elections on Sunday. United Russia will certainly dominate but yet still seems likely to win less seats in parliament than it did four years ago. While United Russia seems certain to obtain another a majority in the Duma it could win up to 50 or 60 seats less than it did in 2007 (when it took 315 of 450) according to latest opinion polls. Vladimir Putin remains popular even if his ratings have started to slip in recent times. Some signs of dissatisfaction amongst the population have started to emerge although few see elections in Russia as a realistic means of change. Faced with the potential embarassment of losing its two-thirds majority in the Duma United Russia is making full use of its dominance of the media to try and engineer a last minute recovery in its fortunes. The government has yet, however, to convince the population that it has a strategy for improving mediocre economic performance. This is highly unlikely, though, to stop United Russia controlling parliament for another four-year term or prevent Putin being re-elected comfortably as President on March 4.
Preliminary GDP data for Q3 shows that the Polish economy grew by a slightly faster than expected 4.2% y-o-y. This marks a very modest slowdown from the 4.5% seen in Q1 and 4.3% in Q2. However, these are remarkable readings given the weak growth seen in most of the rest of Europe. Domestic demand contributed 3.2 percentage points (pp) to growth. Net exports accounted for the other 1.0 pp. Within the former, private consumption contributed 1.8 pp and fixed investment 1.6 pp. The net exports situation was no doubt helped by the recent weakening of the zloty from 4.0 to the Euro to over 4.5. This move is clearly not warranted by Poland's strong economic fundamentals. Nevertheless, growth is likely to slow next year. The Ministry of Finance sees growth slowing to 2.5% in its base case whilst market participants are less optimistic (seeing a number closer to 2.0%). Poland will continue to be one of the fastest growing countries in the EU next year even so. The EU will barely grow at all in 2012 and may even enter recesssion given the ongoing debt and banking crises.
The opposition SDS of Janez Jansa leads in the opinion polls ahead of early elections to be held on December 4. The SDS is polling just over 30%. In second place is a new party - Positive Slovenia - with about 20% of the vote. Another new party - Citizen's List - will fight for third place with the largest party in the outgoing government (the SD of Borut Pahor). Positive Slovenia has ruled out working with the SDS. The SDS will then likely to seek a coalition with Citizen's List and a couple of smaller rightist/nationalist parties. However, both the Nsi and SLS are not certain to pass the 4% threshold for participation. Neither is pensioners' party DeSus which has participated in the previous two governments irrespective of the fact that they were of centre-right and then centre-right leanings. The ease with which the SDS will form a coalition seems likely, then, to depend on how many of its potential allies cross the threshold. Whatever the make-up of the new government, economic reforms will need to be implemented to make the economy more flexible and the pension system more sustainable.
The severe economic crisis unfolding in Belarus has driven President Lukashenko to accept a Russian offer of financial help in return for a greatly increased stake in the Belarusian economy. Poor economic policies enacted in an attempt to smooth Lukashenko's re-election as president last December led to a collapse of the currency and spiralling inflation. While the central bank has hiked interest rates and the government started to tighten fiscal and credit policies balance of payments support is urgently required. Attempts to secure a new IMF agreement remain unsuccessful so far. Belarus has, instead, accepted the first tranche of a loan from EurAsEc. Further instalments were seemingly conditioned on greater Russian access to Belarusian state assets - something Lukashenko has been cautious about in the past. The new deal secures Belarus some urgently needed cash (through the sale of the second half of Beltransgaz to Gazprom), a lower gas price next year (US$164 per tcm rather than the US$244 it currently pays) and a loan of up to US$10 bn to be used to finance the building of a nuclear power station. It remains to be seen whether the economic benefits of this deal will boost Lukashenko's standing or the perceived loss of sovereignty for Belarus will ultimately hurt him more.
The National Bank of Hungary (NBH) has hiked its key interest rate 50 bps to 6.5%. This move comes despite a very weak growth outlook for Hungary and soft underlying inflation. The sharp depreciation of the forint in recent weeks has proved sustained and thus poses a significant upside risk to the 3% inflation target. The announcement of talks with the IMF on a possible credit arrangement provided only temporary respite in the markets as Hungary's credit rating was downgraded by Moodys soon afterwards. Certainly, some of the forint's weakness relates to increased risk aversion emanating from the ongoing euro area debt crisis and downgrades to the growth outlook for the European economy which will impact Hungary adversely. However, currency weakness may also be attributed to the government's erratic and unorthodox economic policies. The talks with the IMF may not prove easy given this and the arrangement (likely to be precautionary in nature) will probably anyway only be in place in early 2012. The NBH may have to consider further rate hikes if the currency remains weak (both due to inflation risks and a weak currency worsening debt dynamics for those with foreign currency loans). However, if market confidence returns and the forint recovers the NBH could reverse its course on rates relatively quickly reflecting the poor growth outlook.
Opinion polls suggest that the opposition Kukuriku coalition (SDP-HNS-HSU-IDS) will win parliamentary elections on Sunday comfortably. This will end the eight-year rule of the HDZ. The latter's popularity has tanked following a string of corruption scandals linked to senior officials in the party including former Prime Minister Sanader. The polls, indeed, suggest that the Kukuriku coalition might even win a majority in parliament. Thus, the incoming government could have a much stronger mandate than previous ones (many of which have secured a small majority only with the support of representative of the minorities). However, it remains to be seen how the new adminstration will seek to solve Croatia's growing economic challenges. The popularity of the HDZ is so low that the Kukuriku coalition has not had to go into any great detail about what its policy priorities will be on coming to office. An anti-corruption platform is certainly popular but the new government will also have to tighten fiscal policy, stabilize a high and growing external debt to GDP ratio and implement reforms that will stimulate productivity growth.
The Serbian banking sector recorded an aggregate profit of RSD25 bn in the first three quarters of 2011. This was a 20% increase on the same period last year. The profit for the third quarter alone was RSD7.2 bn (up 30% y-o-y). The most profitable banks were Banca Intesa (RSD7.8 bn), Raiffeisen (RSD4.3 bn) and Unicredit (RSD 4.0bn). Performance across the sector continues to vary widely. The top 10 banks (of 33) account for not only 70% of total assets but over 95% of profits. In other words, there are a lot of small institutions that are barely profitable. The banking sector also has a high proportion of non-performing loans by regional standards (over 18%) although provisioning and other key banking indicators such as liquidity and capital adequacy ratios remain very favorable. Banks deliver high profits even during a recession or period of weak growth by both maintaining a high margin between lending and deposit rates and by charging high fees for various banking transactions.
The Lithuanian authorities this week took Bankas Snoras into temporary administration. The move was taken to ensure the confidence and stability of the banking sector according to the central bank. Similar steps were also taken in Latvia given that Snoras holds a majority stake in Latvijas Krajbanka. The Lithuanian central bank had previously warned Snoras about its poor asset quality but assessed that it had subsequently failed to reduce operational risks or even provide sufficient information to supervisors. Deposits in both countries are insured up to EUR100,000 although when and how this money will be refunded remains to be seen given pressures to reduce budget deficits. In the meantime, severe restrictions have been imposed on withdrawals. Governments will nationalise both banks meaning that shareholders will be wiped out. However, these developments have wider repercussions too. Corruption allegations have been levelled against senior managers of both banks. While neither bank is very large the issue still raises not just fiscal issues but questions about the quality of bank regulation/supervision in both countries.
Negotiators from Belgrade and Pristina have held talks to resolve "technical issues" for the first time since September. While this is positive in itself little progress was made on key issues. Agreement was reached on the recognition of university diplomas but not on the border/administrative line or on Kosovo's presence at regional conferences. Progress must be made in the latter two areas if Serbia is to have any chance of securing the status of EU candidate on December 9 as it hopes. The next round of talks is due to start on November 30. The situation on the ground in northern Kosovo does not appear to be very promising. All Serb barricades remain in place and representatives of the local Serb communities there now even seem unwilling to accept any possible deal with Pristina even if it should appear in the next few weeks. The restart of talks in itself would appear to be insufficient to convince all members of the European Council to back Serbia's bid for candidate status. Some countries have emphasized that all existing agreements reached must also be implemented before Serbia's bid will be considered. Some leading Serbian politicians have even started to try and play down the importance of status given the increasing risk that it might not be secured.
The announcement from Austrian financial regulators this week that banks from that country will face tougher rules on lending to branches in Eastern Europe increased the fears of some who see foreign banks committing less funds to the region during the coming downturn. More specifically, the changes will limit new lending of Austrian banks in Eastern Europe to 1.1 of funds raised in the region. They will also be required to hold a higher level of capital. These changes will make financing for local branches of Austrian banks more difficult at the margin. However, the effect should not be over-exaggerated. Rumours about banks withdrawing en masse from the region during 2008/2009 turned out to be untrue. The majority of foreign banks in Eastern Europe are very profitable. Even those cases in which an institution has wished to withdraw from the region has usually seen its operation bought up by another foreign bank. Foreign banks may have to raise a higher share of their funding from domestic sources going forward suggesting that deposit rates may increase. This could raise the cost of credit other things equal. However, credit growth may well slow in 2012 as much due to demand issues (fewer people/firms seeking loans in an uncertain economic environment) than a supply one.
Having won a vote of confidence securing itself a second term in office late last week, the PO/PSL government has committed itself to reducing the budget deficit to 3% of GDP next year. This is part of a medium-term plan to reduce the fiscal deficit to 1% of GDP by 2015 and, thereby, reduce public debt to GDP to 47%. Prime Minister Donald Tusk has laid out some details of the plan but more will be needed to satisfy financial markets and credit rating agencies that it is fully implementable. The size of the fiscal adjustment depends on which growth assumption is used as a basis for next year's budget. These range from an optimistic 3.2% growth scenario to a pessimistic 1.0%. Given a base case of 2.5% the government intends to close the implied fiscal gap (PLN8 or 9bn) by raising some tax rates, increasing the tax base and cutting expenditures. While the government's economic management was generally sound in its first term it could have done more to reduce the fiscal deficit and implement structural reforms given Poland's solid economic growth during the global crisis. The junior coalition partner (the PSL) sometimes acts as a brake on the reformist instincts of the PO. However, many hope that the PO will be braver in pushing through controversial measures this time around having secured a second term.
An IMF Mission to Sarajevo has emphasized that the growth outlook for the Bosnian economy is deteriorating. The Fund sees growth of just 1.7% this year and 0.7% in 2012. On the basis of this, the budgets being planned for 2012 at all levels of government would seem to be based on overly optimistic revenue assumptions. Bosnia, like other countries in the region, will suffer from a growth slowdown in the EU. However, an additional factor in its case is the absence of a state-level government for over a year which is slowing the implementation of reforms necessary to advance EU integration. No resolution to this political impasse appears to be in sight. Indeed, the government in the Federation has also been slow at implementing reforms which will make its finances more sustainable in the long-run. The IMF also notes that the share of non-performing loans in the banking sector is rising faster than expected and so strengthened supervision is advisable there. All in all, it seems unlikely that the IMF program will be restarted any time soon.
Inflation remained at 3.0% y-o-y in the Euro area and at 3.3% y-o-y in the EU-27 in October. Within Eastern Europe, the highest inflation rates are seen in the countries growing the fastest broadly speaking. Hence, inflation is 4.7% in Estonia, 4.6% in Slovakia, 4.3% in Latvia and 4.2% in Lithuania. The lowest rates of inflation were recorded in the Czech Republic (2.6%) and in Slovenia (2.9%). Inflation in the Euro area remains above the 2% target. However, a rapidly weakening growth outlook (and the fact that high current inflation is largely due to temporary factors) has already persuaded the ECB to reverse one of its 25 bps rate hikes from early this year. Many market participants expect another cut in the next few months. However, if the Euro area not only stagnates (as forecast by the European Commission) but enters recession the ECB may yet have to cut further or even join other leadings central banks in having to consider non-orthodox monetary policy steps.
The government has formally requested a financial assistance program from the IMF and the EU to prevent what it sees as financial market contagion. The forint has weakened dramatically over the last few weeks. The announcement that a program is being sought has helped to stabilize the Hungarian financial markets to some extent. The government will treat the IMF/EU program as precautionary once it is in place i.e. it does not intend to draw down tranches as they become available but use the program as a signalling device to investors and a form of insurance should market volatility increase further. The move to seek a program represents something of a political defeat for the Fidesz government which had made a big deal of rejecting IMF supervision when it came to office. A series of ad hoc and non-orthodox policy moves have concerned investors as well as a deteriorating external situation (which will impact negatively both on growth and financial inflows). With high public debt to GDP and a large stock of unhedged FX loans in the private sector external supervision of policies is to be welcomed whatever the domestic political ramifications for a nationalist/populist government.
An IMF Mission to Kiev has left without agreeing a restart of the Stand-By Arrangement with the authorities. This was no great surprise as the government flatly refuses to implement one of its key commitments under the program - another increase in domestic gas prices. The government's opinion poll ratings have fallen and the gas price increase implemented last year was extremely unpopular so its caution is perhaps understandable from a political point of view (although parliamentary elections are not due until October next year). However, without the domestic gas price converging towards market prices the financial position of Naftogaz will remain weak. This increases the fiscal deficit. The government has won passage of pension reform in parliament but without movement on the gas price issue a restart of the Fund program remains unlikely. Ukraine has ample FX reserves and so does not need IMF money as urgently as it once did. However, the failure to complete the program has seen it draw on loans from Russia to mount short-term payment difficulties. The government is hoping, too, to renegotiate the price of its gas imports from Russia by the end of the year although whether any significant reduction is feasible given that Ukraine does not want to join the Russian-led customs union is questionable.
The Serbian authorities have reached Staff-level agreement with the IMF over the completion of the first review of the EUR1.1 bn Stand-By Arrangement (SBA). While a disbursement of EUR190 mn would become available on approval of the first review by the Fund's Executive Board the authorities are intending to treat the SBA as precautionary and hence don't intend to draw it down. The key issue necessary for approval of the first review was agreement on the draft budget for 2012. The IMF has downgraded its forecast for growth in Serbia in 2012 sharply from 3% to 1.5%. On the basis of this, it has agreed that the fiscal deficit for 2012 should be 4.25% of GDP rather than the 3.9% of GDP previously envisaged (and the 4.5% of GDP target maintained for this year). The Fund was keen that the fiscal deficit should fall next year relative to GDP even in a continued low growth scenario because otherwise the government would almost have immediately broken its 45% of GDP public debt fiscal rule. Indeed, any fiscal slippage, weaker than expected (nominal) GDP growth or significant weakening of the currency could, anyway, see a breach of this threshold as public debt has risen already to over 44% of GDP.
A presidential election was due to be held on November 18 but now seems likely to be delayed. No candidates had registered for the vote (held in parliament rather than by direct election) by the deadline. Any candidate must secure 61 of 101 possible votes in parliament to become president. Previous attempts to elect a president failed given that the governing AEI coalition holds 59 seats and the opposition Communist Party (until recently) held 42. These failed attempts precipitated early parliamentary elections. The defection of three deputies from the Communist Party recently has changed the electoral arithmetic. However, it appears that the government has failed to agree with these departing Communist deputies a common candidate for the presidency. It is not clear what happens now. Most likely the vote will just be rescheduled once agreement has been reached on a candidate who will secure the required votes. This would end a longstanding consitutional crisis in Moldova which has not had a proper president in place for a couple of years. However, if the presidential election is held and fails another set of parliamentary elections could result.
Industrial production (IP) data for September was very poor. IP fell by 2.0% m-o-m, seasonally adjusted in both the Euro area and the EU-27 (although August data was revised upwards). On a y-o-y basis, IP increased just 2.2% in both the Euro area and the EU-27 (non-seasonally adjusted). This is the weakest set of readings this year on both a m-o-m and y-o-y basis. Leading indicators suggest that the situation could worsen further in the months ahead. Industrial production rose 5.0% y-o-y in the first nine months of the year in the Euro area and by 4.6% y-o-y in the EU-27. Within Eastern Europe, fairly strong IP readings for September (between 7% and 10% y-o-y) were recorded in the Baltic States, Poland and Slovakia. IP growth was barely above zero in Bulgaria, the Czech Republic and Slovenia. With stagnating GDP growth (or worse) seen in Europe in the quarters ahead it seems inevitable that countries in Eastern Europe will soon see weaker demand for their exports.
The National Bank of the Republic of Belarus (NBRB) has hiked interest rates sharply yet again (by 500 bps to 40%) in an attempt to rein in spiralling inflation. The collapse of the Belarusian ruble as a result of a balance of payments has been dramatic. At the end of last year the ruble was 1053.5 to the Euro/Russian Ruble/US$ basket. Now it is 3131.1. This devaluation of almost 200% has inevitably pushed inflation up massively. Ending last yeat at 9.9% y-o-y, a number of huge m-o-m increases in recent months pushed the y-o-y inflation rate to 92.3% as of October. The NBRB has suggested that it is starting to see some stabilization in the currency. It is therefore hoping that inflation will soon peak and that it will not have to hike rates much further. Such macroeconomic instability and higher interest rates are having a negative impact on growth (although the full-year reading will remain strong because of very strong growth in H1). For inflation to be brought back down on a sustainable basis tighter monetary policy will have to be supported by appropriate fiscal, credit and incomes policies.
The Hungarian forint has been weakening against the Euro in the last few months. It weakened by over 4% in both September and October. However, the depreciation has accelerated in the last few days causing the National Bank of Hungary (NBH) to issue a statement. The forint averaged 296.4 to the Euro in October and yet today's rate is 316.7. The NBH claims that this move is not in line with fundamentals. This raises the chances that the central bank will either intervene in the FX market or even hike interest rates if the currency does not stabilise. There is a strong pass-through from the currency to inflation in Hungary. Hence, sustained currency weakness could easily lead to inflation picking up and threatening to overshoot its target. However, the NBH's claim that Hungary's fundamentals are strong is somewhat questionable. Some weakening of the currency would seem to be justified as European growth slows because Hungary is highly integrated into the European economy and its exports are likely to weaken as a result. Moreover, it has high public debt and a large currency mismatch in relation to private borrowers. The ad hoc and non-orthodox measures used by the Fidesz government don't help. However, the NBH is right in as much as that the government is committed to a 3% of GDP fiscal deficit. Moreover, whether justified by fundamentals or not the growing expectation of NBH action could help to stabilise the situation in the currency market on its own.
The preliminary GDP reading for GDP in Q3 shows a modest increase of 0.2% q-o-q, seasonally adjusted in both the Euro area and the EU-27. This is unchanged from Q2. GDP is expected to lose momentum and perhaps even contract in Q4. Growth performance continues to be very mixed. Some of the largest economies such as Germany, France and the UK recorded relatively robust readings in Q3. Others such as Portugal contracted while Spain recorded no growth (Italy, Greece and Ireland have not yet released data). Within Eastern Europe, there was a positive surprise as regards the Romanian growth figure (1.9%) and GDP data remains relatively strong in Latvia (1.3%) and Estonia (0.8%) also. By contrast, Bulgaria and the Czech Republic recorded no q-o-q growth in the third quarter. On a y-o-y basis, GDP growth was 1.4% y-o-y in Q3 in both the Euro area and the EU-27. Estonia (7.9%) and Lithuania (7.2%) remain the fastest growing countries on an annual basis.
The National Bank of Serbia (NBS) cut its key interest rate gain at this month's monetary policy meeting. The cut of 75bps to 10.0% was larger than expected. Inflation is falling fast in Serbia but remains above target. It peaked at 14.7% in April and had fallen to 9.3% as of September. The Governor of the NBS has said that he expects inflation to have fallen below 9% in October. The NBS has admitted that this year's 4.5% plus or minus 1.5 percentage point end-year target will be overshot but sees inflation falling back within its targeted range in H1 2012. Recent economic data readings have been very weak. Q3 GDP growth was just 0.7% y-o-y. The IMF has already downgraded its growth forecast for Serbia for 2011 and 2012 and may do so again during its current Mission to Belgrade. This weakening growth outlook means underlying inflationary pressures should stay soft. The NBS's cumulative 250 bps cut so far this year has had surprisingly little effect on the dinar which has remained relatively stable against the Euro. However, this is because of significant government debt issuance in Euros rather than being a sign of a strong economy. Domestic economic conditions may justify such cuts but they are at the same time risky as global investor sentiment is poor and the dinar could easily weaken from here.
An IMF Mission to Riga considering progress towards completion of the last review of the Stand-By Arrangement has reached agreement with the government on significant expenditure cuts and tax hikes worth about Lat122 mn. However, further talks will be required to identify further measures and reach Staff-level agreement on completion of the review. Latvia's economy is growing strongly and considerably faster than expected. The government had already planned to bring the fiscal deficit well below 3% of GDP next year. This is consistent with it meeting its target of joining EMU in 2014. However, with the worsening global growth outlook and fiscal over-performance due to strong growth (and hence high tax revenues) the Fund wants the authorities to build some contingency measures into the 2012 budget. The government had already planned for the fiscal deficit to be somewhat under the 3% of GDP Maastricht target (2.5% of GDP). The additional fiscal measures would bring the projected deficit down to 1.7% of GDP according to the Finance Minister. This would ensure that both the current revenue over-performance is saved and that a contingency buffer is in place should growth disappoint next year.
Donald Tusk has formally been invited by President Komorowski to form a new cabinet following the victory of his Civic Platform party (PO) in parliamentary elections on October 9. Tusk hopes to have a cabinet in place by the end of next which would then seek to win a vote of confidence. As expected, the PO will again form a coalition with the Polish Peasants Party (PSL). The PSL will retain three seats in the new cabinet although which ones has yet to be determined. The leadership of the PSL has unanimously approved entering another government with the PO. The immediate challenge for the new government will be passage of a tight budget for 2012. Jacek Rostowski is expected to stay on as Finance Minister in the new administration. The 2012 budget will aim to see a significant reduction of the fiscal deficit. The deficit is likely to fall from this year's target of 6.5% of GDP to just 2.5% of GDP. Growth in Poland is strong and hence a budget of this magnitude for 2011 is excessive. On the other hand, a tightening of this magnitude will be made more difficult if, as expected, Polish growth slows next year. Fiscal tightening is important to make sure that the constitutional public debt to GDP limit is not broken. It will also allow Poland to move closer to EMU entry although plans to enter the Euro area have been pushed backwards somewhat by the global financial crisis.
The National Bank of Poland (NBP) left its key interest rate on hold at 4.5% at this month's monetary policy meeting. The Bank notes that inflation is falling though remains above target. It is expected to fall further at the beginning of 2012 due to favorable base effects. GDP growth likely remained strong in Poland in the third quarter according to positive monthly indicators. However, some slowdown is likely in the fourth quarter and beyond given the worsening growth dynamcis in the Euro area (a key trading partner). While falling inflation and a weaker growth forecast might otherwise suggest a cut in interest rates a significant upside risk to the inflation projection is the recent weakening of the zloty. While this is more a reflection of reduced risk appetite on global financial markets rather than a deterioration in Poland's economic fundamentals it could, if it persists, feed through to higher inflation via increasing import prices. Even though the NBP has left rates on hold today the chances of a cut next year seem to be increasing. If the zloty recovers in coming months the weak growth story may ultimately dominate the NBP's thinking and lead to a rate cut.
After all the hard work the Serbian government has undertaken in the last few years to further EU integration by improving co-operation with the ICTY and passing key legislation developments in Kosovo could yet stop it from winning EU candidate status on December 9. When the outstanding fugitives from The Hague were handed over earlier this year, the government implemented its Action Plan for European integration and talks on technical issues with Pristina got underway candidate status in December appeared almost assured. However, a deterioration of the situation on the ground in northern Kosovo over the summer led to the postponement of talks. While the European Commission recommended on October 12th that Serbia should secure candidate status it made this conditional on Belgrade-Pristina negotiations restarting. Not only has this not happened but Serb barricades blocking the movement of representatives of the international community in northen Kosovo are still in place. The Serbian government is running out of time to reach a compromise on this issue. It is committed to European integration but does not control the situation in northern Kosovo fully. It hopes to win passage of a resolution in parliament which will give it political cover to try to see the barricades removed and to restart talks with Pristina. Otherwise it is quite possible that the European Council will delay granting status to a later date.
The series of weak economic indicators in Europe continues. Retail sales growth was -1.5% y-o-y in September in the Euro area and -0.8% y-o-y in the EU-27. After modest growth in Q1, retail sales in the Euro area contracted in both the second and third quarters and are now down 0.3% y-o-y for the year as a whole to September. This is not a great surprise as economic growth (such as it is) has been more based on strong exports and industrial output rather than private consumption. Nevertheless, this data does give further evidence to suggest that the euro area may be close to recession; especially as even those stronger sectors are now showing signs of weakening. Moreover, leading indicators remain extremely soft. A few countries in Eastern Europe are faring slightly better. Retail sales growth in the Baltic States is fairly robust for now (Lithuania 10.6%, Latvia 8.1% and Estonia 4.4% in September). However, other countries are seeing a contraction in retail sales (Romania -4.9%, Slovakia -3.7% and Bulgaria -3.0%).
The authorities have reached Staff-level agreement with the IMF on completion of the fourth review of the Stand-By Arrangement (SBA). The IMF Executive Board is expected to approve completion of the review in December. Although this would make Romania eligible to receive a EUR475 mn disbursement the authorities are treating the arrangement as precautionary. The IMF has downgraded the growth outlook for Romania for 2012 from 3.5% to between 1.75% and 2.25% on the basis of recent weak economic indicators in Europe. It still expects growth of 1.5% this year. Despite this, the government seems on track to meet its fiscal targets: to bring the budget deficit (on the ESA accrual definition) below 5% of GDP this year and 3% of GDP next year. It will do so by freezing public sector wages and reducing public sector employment. Progress has been less marked in terms of the implementation of structural reforms. Privatization plans have proved overly optimistic. This reflects not only resistance to the sale of state assets in some quarters but also poor market conditions: the sale of a stake in Petrom failed in the summer.
A list of the 100 largest companies by revenue in South Eastern Europe (SEE) published by Econom:east magazine shows that these firms in aggregate improved their profitability in 2010 significantly compared to 2009 despite the economic crisis. Most of the better performance, however, was due to higher profits in the energy sector with other sectors (e.g. construction, industry) doing rather less well. The list of the top ten firms by profit in SEE is dominated by a few sectors: there are four telecom firms; four energy firms; and two chemicals producers. The largest profit in 2010 in the region was recorded by T-HT (telecoms) in Croatia. Another Croatian firm, HEP (energy), was second while Krka of Slovenia (chemicals) was third. Two Serbian firms, Telekom Srbija and NIS, (telecoms and energy respectively) were fourth and fifth. Some companies with large revenues are, nevertheless, large loss-makers (e.g. US Steel in Serbia). Many small and medium enterprises in the region complain that their performance is impaired by larger companies failing to pay their invoices on time though this actually varies by country and by sector.
As if the HDZ was not facing enough obstacles in winning re-election in December 4 parliamentary elections a court in Croatia has frozen its assets as an investigation is carried out into whether the HDZ financed previous elections campaigns by diverting money from public funds. Whether the timing of such a freeze is appropriate or whether it will have a significant impact on the HDZ's ability to campaign is a matter of opinion. What is clear, however, is that the opposition Kukuriku coalition (consisting of the SDP, HNS, IDS and HSU) is far ahead in the opinion polls and is expected not only to win the elections but may end up enjoying an unusually strong parliamentary position. Most governments in recent times in Croatia have had small majorities cobbled together with the support of deputies representing various ethnic minorities. The HDZ has lost popularity due to a succession of corruption scandals, Croatia's poor economic performance relative to its peers during the global financial crisis and despite having secured a target date for EU entry and the conclusion of Accession negotiations.
The Moldovan authorities have reached a Staff-level agreement with the IMF on the completion of the fourth review of the ECF/EFF program. With implementation of associated prior actions the Fund's Executive Board is expected to approve completion of the review in early 2012 which will enable the disbursement of a tranche worth US$77 mn. The program remains broadly on track. The authorities have committed to taking extra measures to bringing the fiscal deficit down to the targeted 1.9% of GDP this year. Growth remains strong though will slow given the deteriorating state of global economy. This, and the fiscal consolidation process, should help bring down inflation and the current account deficit both of which remain too high. Further efforts are required too in the implementation of structural reforms. In particular, the Fund believes that improving the efficiency of the public sector, reforming tax collection, removing barriers to external trade and other measures to advance the business environment would boost the country's medium-term growth potential.
The National Bank of Romania (BNR) has surprised most analysts by cutting its main policy interest rates by 25bps to 6%. In making its decision, the Bank highlighted that both headline and core inflation have dropped sharply in the last few months. This is a result of a combination of factors: tax rises last year have fallen out of the basis for calculation, food prices are lower and economic growth remains below trend (meaning the persistence of a negative output gap). On the basis of its latest inflation projection (to be released on Monday) the BNR sees inflation staying within the fluctuation bands (plus or minus one percentage point) of the 3% target both this year and next. This much was already anticipated by financial markets. The surprise is that the Bank has decided to move rates now rather than later. The Leu has weakened substantially against the Euro in recent weeks (as have many other floating currencies in Eastern Europe) due to reduced risk aversion on the global financial markets. Hence, it was thought likely that the Bank may wait until things had stabilised before cutting as a lower interest rate differential could, in itself, exacerbate currency weakness.
An IMF Mission has arrived in Belgrade to consider progress towards completion of the first review of the EUR1.1 bn Stand-By Arrangement (SBA) approved at the end of September. The key factors determining whether the Mission will reach agreement with the authorities will be progress in meeting this year's (upwardly revised) budget deficit target of 4.5% of GDP and in drafting a realistic budget for 2012 with a target deficit of 3.9% of GDP. There are some indications that this year's budget may still be off track even in relation to the recently approved budget rebalance. In this case, adjustment measures will have to be identified. Moreover, the budget deficit target next year must be credible. The IMF recently revised down its forecasts for growth in Serbia for 2011 and 2012 by a full percentage point (to 2% and 3% respectively). With industrial output declining y-o-y in the third quarter and the outlook for growth in the Euro area deteriorating almost by the day there is a risk that even these lower forecasts may prove too high. Hence, the 2012 budget will have to be based either on yet weaker GDP forecasts or at least contain contingency measures to be enacted in a situation where growth does indeed turn out to be worse than expected.
After almost two decades since it first applied to join Russia finally seems set to become a member of the World Trade Organization (WTO). Russia concluded lengthy negotiations with the EU earlier this month leaving agreement with Georgia as the outstanding issue. All existing 153 members of the organization must agree to the entry of a new candidate country. The Georgian side has long insisted that trade through South Ossetia and Abkhazia (still formally part of Georgia but recognised as independent states by Russia) should be monitored. A compromise solution (whereby this trade would not be monitored directly by the Georgian side but by an international intermediary) appears to be acceptable to both sides. If this indeed turns out to be the case then Russia could be invited to join the WTO at its December 15 meeting. Russia's entry should be beneficial both for it and existing WTO members. Russia should benefit in the long-run both from increased access to foreign markets and increased competition in its domestic markets following WTO entry. It is also the largest country not yet part of the organization and so its joining will mark a significant expanision in the WTO's reach and therefore, its attraction to future members.
The European Central Bank (ECB) has surprised financial markets by cutting its key interest rate by 25bps to 1.25%. Weak economic data over the last few months had increased market expectations that the ECB would have to reverse its two recent 25bps hikes (in April and July). However, a move was not expected at this meeting as it was the first presided over by new ECB President Mario Draghi. Draghi noted that inflation is likely to stay above 2% in coming months but fall below that level next year. He also suggested that recent very weak leading indicators suggest that the Euro area could be headed for a "mild recession". Given this very negative growth outlook, many now expect the ECB to reverse the second of its rate hikes as well; possibly as early as the December meeting. Draghi is keen to point out that the change in the direction of interest rates had early been signalled in previous ECB rate-setting meetings and is not a reflection of him being more "dovish" than his predecessor. Many in the financial markets will, nevertheless, welcome the move as a sign that the ECB is looking beyond what is likely to have been a temporary pick-up in inflation (currently 3%) and is now focusing more directly on the worrying state of the real economy.
Preliminary results from Sunday's presidential election give a clear victory to Almazbek Atambayev (until recently Prime Minister). He has secured about 63% of the vote. This is enough to win the presidency outright in the first round. The two main challengers - Kamchibek Tashiyev and Adakhan Madumarov - both won about 15%. International observers generally praised the conduct of the election. The campaign was considered to be free although there were some voting irregularities on the day itself. According to the new Constitution, Atambayev will serve one, six-year term. Rosa Otunbayeva - Acting President since former President Kurmanbek Bakiyev's overthrow in April 2010 - chose not to stand in the election. While the Kyrgyz Republic faces many challenges (both political and economic) the international community will be pleased that the elections have been conducted peacefully and that there appears to have been a decisive result. The last two changes of power, of course, were a result of revolutions rather than via democratic elections.
After the hectic falls seen in the last few months, the main equity indices in Former Yugoslavia showed signs of stabilisation in October. In Serbia, the BELEX-15 posted a loss in value of 1.3% (in RSD terms) meaning that it is now down 16.3% for the year as a whole. In Croatia, the CROBEX-10 fell 2.0% (in HRK terms) in October and is now down 13% year-to-date. In Slovenia, the SBI TOP rose 3.9% (in Euro terms) this month but is still down a hefty 23.9% for the year as a whole. Many firms in these indices are performing well despite the global economic crisis. However, a lot of foreign investor liquidity has been sucked out of markets in the region as risk aversion has increased. The immediate outlook is not improved by signs that the global economy is weakening. Economic growth forecasts for countries in the region have, accordingly, been revised down substanially. Hence, even though it remains true that there are some attractive valuations according to traditional equity indicators (such as the P/E ratio) it is difficult to anticipate when investor sentiment will turn around given the ongoing Euro area crisis and other negative external factors.
An IMF Mission conducting the annual Article IV review has released its Conclusions. The economy is growing strongly not only due to the hydrocarbon sector but a good harvest. High commodity prices have increased the current account surplus and foreign direct investment further boosts the balance of payments position. Kazakhstan has a strong buffer against external shocks with the stabilisation fund and international reserves combined amounting to some 40% of GDP. Inflation is above target and the banking sector remains vulnerable: despite restructuring and public sector intervention the share of non-performing loans remains high. Large corporations also continue to deleverage. Remaining problems should be addressed systematically as a slowing global economy will likely reduce commodity prices other things equal. Loose monetary policy has not managed to stimulate lending given structural problems. Greater flexibility in the exchange rate would help absorb external shocks going forward.
Russia has recorded relatively strong GDP growth of 5.1% y-o-y in Q3. This compares to the 3.4% recorded in Q2 and the 4.0% posted in 2010 as a whole. The Q3 number is boosted somewhat by a favorable period of comparison - growth was weak in Q3 last year because of a poor harvest. Russian growth is driven primarily by domestic demand. Private consumption and, to a lesser extent, fixed investment are strong. A strong recovery in credit growth helps both. Meanwhile, net exports continue to make a negative contribution to GDP growth with imports growing faster than exports. GDP growth averaged a respectable 4.2% in the first three quarters of this year. This is pretty much in line with forecasts. Some deceleration in growth is likely in Q4 as the slowing global growth impacts adversely on the Russian economy. However, a Q4 outcome of close to 4% is still expected. What the number will be exactly depends partially on the extent to which the government resorts to pump-priming ahead of December parliamentary and March 2012 presidential elections.
Despite last minute problems, a new governing coalition of Reform, Unity and the National Alliance has been confirmed in office. The coalition has won a vote of confidence given that it has 56 seats in the 100-seat parliament. Valdis Dombrovskis will continue as Prime Minister and Andris Vilks also stays on as Finance Minister (both are from Unity). Coalition agreement proved harder than anticipated. First, Reform leader Zatlers angered some potential partners by considering an alliance with Russian-based Harmony Centre. Second, some within his own newly formed party defected unhappy with the allocation of places in the cabinet. The net result of these actions is that Zatlers' position has been weakened. Indeed, he failed to win election as speaker of parliament. This now goes to Solvita Aboltina (also of Unity). It seems clear, then, that Unity has strengthened its position within the coalition having won only 20 seats in parliament to Reform's 22. Harmony Centre won the most seats (31). The key challenge for the new government will be making progress in fiscal tightening and the implementation of structural reforms to complete the current IMF/EU bailout program.
Almazabek Atambayev is strong favourite to win the first round of presidential elections to be held on Sunday according to opinion polls. The question is whether he will win the more than 50% of the vote necessary to win the presidency outright or will need to head into a direct run-off with the second-placed candidate. Atambayev has benefitted from his high profile as Prime Minister (though he has temporarily stepped down from this post). This has given him the opportunity to make populist spending pledges, meet Russian Prime Minister Putin and benefit from extensive media coverage. It had looked likely that a second round would be necessary. One of two candidates from the south of the country (either Adakhan Madumarov or Kamchybek Tashiyev) would likely make it through to a run-off in second place. However, recent polls suggest that Atambayev may secure enough votes to win outright. If not, he may face a stiffer challenge in the second round. A single candidate from the south could possibly gather votes from other defeated candidates from that region against Atambayev given that he is seen as representing the north. He would still be favourite to win, however, having more chance of securing the Uzbek minority vote.
The National Bank of Hungary (NBH) left its key interest rate on hold at 6% at its monetary policy meeting as widely expected. In an accompanying statement, the Bank noted that the outlook for growth is now much weaker than previously expected given developments in the euro area (to which Hungary sends most of its exports). This means that a negative output gap will remain in Hungary for some time and underlying inflationary pressures will remain weak. However, in the short-term inflationary pressures are to the upside. The currency has weakened during the last few weeks and the government has announced VAT and excise tax rises to make its fiscal target for next year more achievable. Both will push the headline rate of inflation up in coming months other things equal. The Bank tracks inflation adjusted for the effects of tax increases. However, a rise in the headline rate will still impact adversely on inflation expectations. This will likely mean a delay to any possible rate cut that has been forecast by some commentators on the back of the weaker growth forecast.
While Kosovo continues to be the main focus as to whether Serbia will get the status of candidate for the EU in December there is another issue to be addressed. The recently passed Law on Return of Property (i.e. Restitution) excluded members of "occupying forces". This has led to strong criticism from the Hungarian minority in Serbia and, in turn, the Hungarian government claiming that this will discriminate against their community. If the issue is not resolved Hungary could decide to veto Serbia's obtaining the status of candidate (which requires unanimity). A solution to the problem is likely via changes to the Law on Rehabilitation which should be approved by the government in the next few days and go to parliament for approval in the second half of November. These changes will distinguish between the rights to rehabilitation (and the return of property) of those that were mobilised by occupying forces during the Second World War and those that are actually accused of committing war crimes. This should in principle satisfy the concerns of the Hungarian minority and government in Budapest that there will be no discrimination against their community as a whole but that each case will be treated on its own merits.
The recent fall of the centre-right government raised the question who will govern the country until early parliamentary elections scheduled for March 10? A solution appears to have been found. The centre-right coalition will reform temporarily, once more under the leadership of Iveta Radicova. Even SaS, the party that effectively brought the government down in an October 11 confidence vote, will remain in the coalition having won concessions in a number of areas. This solution required the support of opposition SMER in facilitating a change to the Constitution. SMER did not want to be part of any interim government before its expected victory in the March elections. The formation of an interim government will both reduce political noise in the short-term and allow for the passage in parliament of a budget for 2012. It will also clarify who will represent Slovakia at European Council of Minister meetings.
Rosen Plevneliev of the governing GERB party won the first round of presidential elections as expected. He took 47% of the vote with Ivaylo Kalfin of the opposition Socialist Party taking second place with 26.8%. Turnout was low at just 47%. The failure of any candidate to win over 50% of the vote will mean a run-off between these two candidates will be held on October 30. Plevneliev is widely expected to win. GERB secured another important victory in local elections also held this weekend as its candidate, Yordanka Fandakova, was easily re-elected as Mayor of Sofia. The presidency does not hold many significant powers. However, governing will be somewhat easier now for GERB if it will have its own man in the presidency. Outgoing President Parvanov of the Socialist Party has challenged the government on a number of issues which has sometimes delayed the passage of legislation if not stopped it. These elections, moreover, point to some consolidation of GERB's political position after more than two years in power. Despite the economic recession it appears that the Socialist Party is still not in a strong position to challenge GERB's grip on power.
The preliminary reading of Markit's Purchasing Manager's Index (PMI) gave another weak reading in October which suggests that the euro area economy could be close to recession. The PMI reading for October was 47.2 (a number less than 50 indicates a contraction in activity) following September's already very weak 49.1. Both the manufacturing (47.3) and services (47.2) components of the index disappointed. The weak PMI (a fairly good advance indicator of GDP growth) suggests that the slowing global economy and the ongoing sovereign debt crisis are having an adverse impact on growth. As the euro area governments search for a solution to the debt crisis the increasing prospects of a Greek debt default are raising concerns about the stability of the euro area banking sector which it seems will have to absorb significantly larger losses on its exposure here than in the deal agreed as recently as July. This has made it more difficult for banks to raise financing and, in turn, threatens to choke off credit growth.
The National Bank of the Republic of Belarus (NBRB) has today devalued the ruble by 50% against its ruble/US$/euro currency basket. The move comes as the authorities battle to control a raging balance of payments crisis. The currency has now weakened by a staggering 190% against the basket since the beginning of the year. Even before this move, previous devaluations in May and June had led to a sharp rise in inflation (which stood at 79.6% y-o-y in September). The NBRB has already had to hike its refinancing rate massively to 35% to try and stabilise inflation and may now have to move further in this regard. The root of the crisis was a massive economic pump-priming ahead of December presidential elections that delivered rampant 12% GDP growth in H1 but also led to a sharp deterioration in the external accounts and run-down of FX reserves. The authorities have secured some financing from the EurAsian Economic Community and are seeking a new IMF loan. The move to a unified and flexible exchange rate is an important part of achieving this as are moves toward tighter monetary, fiscal, directed bank lending and incomes policies if the balance of payments crisis is to be addressed.
The obligations to be taken on by the Serbian government if it wishes to secure the status of candidate for the EU in December (as recommended by the European Commission) clash with the situation on the ground in northern Kosovo. The EU expects to secure the free movement of both goods and of personnel of KFOR and EULEX before then. However, the Serbs in the north of Kosovo continue to man barricades that prevent KFOR and EULEX from operating freely protesting at the presence of Kosovar Albanians on the border/administrative line between central Serbia and northern Kosovo. A meeting between KFOR and local Serb representatives yesterday appeared to achieved little. At the time of writing KFOR has started to move some of the barricades unilaterally and has met with a violent response in some areas. The demands of the local Serbs for a return to the situation before July 25 (i.e. before the arrival of the Albanians) seems highly unlikely as Pristina is pushing to secure all of its "borders" supported by some influential members of the international community. Both sides wish to avoid violence in principle but without an agreement on the ground there is a significant risk of this occurring. What's more, Belgrade will have to try and find a compromise here that helps it secure status but is not seen in the local media as selling out the interests of Serbs in the north of Kosovo ahead of parliamentary elections. This appears extremely difficult to achieve at the present moment and will require skillful diplomacy to say the least.
A coalition agreement was announced last week between the Reform Party, Unity and the National Alliance to form a new government. This was to give the coalition 56 seats out of 100 in the newly formed parliament following elections last month. An attempt to form a coalition with Harmony Centre instead of the National Alliance (which would have given the coalition a larger majority in parliament) failed when the Russian-centric Harmony failed to recognise the Soviet occupation of Latvia. The new coalition agreement appears now to be in jeopardy however. Six members of the Reform Party are threatening to defect, unhappy with the allocation of ministerial positions. Clearly this would rob the proposed government of a majority and raise questions about whether it could secure a vote of confidence in parliament. As an indication of this, Reform leader Valdis Zatlers has failed to win election as speaker of parliament. The way forward now is unclear. The support of the rebels could be bought off with a re-jig of ministerial seats, they might support the proposed government from the opposition or a new coalition might have to be formed. It seems that government formation will now be more complicated than had been thought.
The decision of the opposition LDP to declare that it will no longer back the government in certain parliamentary votes has raised the level of political noise about the date of parliamentary elections in Serbia. Elections must be announced by March 11 and held by May 11 although the government has said elections are likely to be held in March or April. Some analysts suggest that the government might plump for an early vote if Serbia obtains EU candidate status following a Council of Ministers meeting in Brussels on December 9. The government has only a slim majority in parliament and one or other of the ethnic Hungarian partes (LSV or SVM) periodically threatens to withhold support. However, one large hurdle has just been cleared. The budget rebalance for 2011 has just been passed. The government is still likely to be able to cobble together a majority with the help of various independents where it needs to. Hence, it is essentially a choice as to when it is optimal for it to hold the vote. The government had probably hoped that waiting a few extra months would give the economy a chance to pick up and bring the unemployment rate down. In fact, the growth outlook is now deteriorating and the risks of a second global crisis rising. Hence the temptation to call the elections slightly earlier may now be rising.
The passage in parliament (at the second attempt) of changes to the European Financial Stability Facility (EFSF) last week came at a high price for the government: an agreement to hold early elections on March 10. With Smer backing the EFSF legislation the second time around the vote passed easily - 114 votes to 3. However, SMER's support was conditioned on bringing forward parliamentary elections which were otherwise due only in June 2014. President Gasparovic is talking with party leaders about how to proceed from here. There are a number of possibilities with respect to what sort of government will be formed before the elections. It is possible that the outgoing government could continue in a minority (without SaS) or that a technical government could be formed for the first time in Slovakia. Smer has indicated that it does not want to be part of any government before the elections. Whatever the outcome of these talks, it seems likely that the implementation of economic reforms will be shelved for the time being. The key challenge for the incoming administration will be to win approval of the 2012 budget. Financial markets and ratings agencies will look to see that the commitment to bringing the budget deficit down to below 3% of GDP by 2013 is not watered down.
An IMF Mission preparing the annual Article IV report notes that the economic recovery in Estonia continues to be robust. A fiscal surplus was recorded in 2010 and another one is expected this year. However, inflation is high. Both growth and inflation are likely to moderate somewhat given the deteriorating outlook for the EU, Estonia's largest export market. A budget deficit is likely in 2012 without the adoption of fiscal adjustment measures. While compression of current expenditure has its limits (e.g. public sector wage freezes cannot remain in place forever) it is important that fiscal policy should not increase demand in a pro-cyclical fashion. The authorities have committed to running a small fiscal surplus over the medium-term. The (largely foreign-owned) banking sector has proved stable during the crisis. Non-performing loans rose as a proportion of the total but the levels of provisioning for these were adequate and the sector as a whole has quickly returned to profit. The labour market has shown itself to be flexible but skill mismatches must be addressed. Long-run unemployment has risen as a result of the crisis even as the overall unemployment rate has started to fall.
The controversial jailing of former prime minister and leading opposition figure, Yulia Timoshenko, in Ukraine has had it first concrete impact on EU-Ukraine relations. A meeting scheduled to take place this week between President Yanukovych and European Council President Van Rompuy has been cancelled. The EU considers that the imprisonment of Timishenko is politically motivated. It had hoped to persuade Ukraine to downgrade the charges against her from criminal to civil in nature. Not only has it failed to achieve this but several other charges against Timishenko appear to be in the pipeline. Yanukovych denies that her imprisonment is political and states that it should not impact on the signing of an Association Agreement and ultimately a free trade agreement. This is unlikely to be the case. Technical talks between the two sides will certainly continue despite the delayed meeting. However, a number of member states will be unlikely to ratify any potential agreement until they are satisfied that a perceived erosion of democratic processes in Ukraine has been addressed. Ukraine will, however, from its side use the potential (if not fully credible) threat of it moving closer into a Russian sphere of influence to try and nullify these pressures.
The European Commission (EC) has released its annual Enlargement Reports for potential EU Accession countries. The EC has recommended that Montenegro should open Accession negotiations on the basis of good implementation in the seven key priority areas over the last twelve months. It has also recommended that Serbia be granted the status of official candidate. A date for Serbia to start negotiations is to be conditioned on its making further meaningful progress in talks with Pristina (currently stalled). Earlier this year Croatia concluded its Accession negotiations and is expected to join the EU in July 2013. Macedonia still awaits the start of negotiations because the "name" issue with Greece has yet to be resolved. The tense political environment in Albania likewise has delayed the start of EU negotiations there. Progress on EU-related reforms in Bosnia has been very poor due to the lack of a State government during the last twelve months. Division amongst member states over the status of Kosovo complicates its EU Accession drive (anyway in its early stages) although visa liberalisation is possible at some stage. The recommendations made by the EC will be considered by the Council of Ministers (and approved or otherwise) in December.
Inflation fell from 4.3% in August to 3.5% in September due to the effect of a good harvest on food prices. This inflation reading was somewhat lower than expected (the consensus was for 4%) although it confirms the central bank's view that inflation would return to the 3% plus or minus one percentage point target range before the end of the year. A sharp fall in inflation will increase expectations of an interest rate cut in the near term. The central bank has left its key monetary policy rate on hold at 6.25% for some time. However, it may want to wait to see that the Leu has stabilised after a recent period of weakness before cutting rates. The strength of the currency is partly a function of global risk appetite. Risk appetite is low at the moment given financial market distress in the Euro area. Once/if this settles down then investors will be more willing to direct more portfolio flows to countries with reasonably high interest rates (such as Romania) as part of a carry trade. Cutting rates thus reduces the attractiveness of the currency other things equal and could therefore exacerbate a weakening trend.
The centre-right coalition government has lost a vote of confidence in parliament. Longstanding efforts to persuade a junior coalition partner, SaS, to approve changes to the European Financial Stability Fund (EFSF) have ultimately proved to be in vain. Only 55 deputies of the 124 present voted to support the government. The government had linked passage of the EFSF legislation to a vote of confidence in a last ditch attempt to persuade the SaS to change its stance. SaS had earlier said it would vote in favour given a list of conditions which proved unacceptable to the government. Opposition SMER has said it will vote in favour of the legislation in a second vote to be held in the next few days. However, the price of its support is the holding of early elections (which SMER would be expected to win). The failure to win a vote of confidence means that the President could, in principle, seek to form a new government without calling early elections. However, a new prime minister-designate would appear unlikely to win sufficient support to win a vote of confidence at this stage. The key result of these political machinations, then, is not that the EFSF vote won't ultimately be approved but that the government (which had committed to reducing the fiscal deficit and implementing structural reforms) has fallen less than 18-months into its four-year term.
Industrial production (IP) expanded by 1.2% m-o-m, seasonally adjusted in the Euro area and 0.9% m-o-m in the EU-27. On a y-o-y basis, IP grew by 5.3% in the Euro area and by 4.3% in the EU-27. These numbers were better than anticipated. Within Eastern Europe, the fastest IP growth remained in Estonia (22.7% y-o-y). Romania (7.7%), Lithuania (6.6%) and Latvia (6.4%) also recorded relatively good readings. Slovenia, however, was the only country to register a contraction (of 1.5% y-o-y). These figures show that the European economy is still growing if less quickly than might have been hoped. They are not as negative as some leading indicators had led the markets to believe. At the same time, the outlook over the next few months also remains fairly poor given the likelihood of softer global economic growth. The Euro has weakened somewhat over the last few months given changing interest rate expectations. The ECB is unlikely to hike again and it seems to be moving towards an easing bias. These factors should help the economy at the margin but weak domestic demand and increasing signs of a credit crunch in the banking sector would appear to offset the impact of this potential monetary easing.
The European Commission (EC) has strongly criticized the seven-year jail sentence handed to opposition leader Yulia Timoshenko in Ukraine this week. Timoshenko has succeeded in painting the trial in the West as an attempt by the Yanukovych government to stifle the opposition. There is no doubt a political element to this as she is now ruled out of standing in presidential elections. However, the perception of the trial and Timoshenko generally is somewhat different in Ukraine. While the particular charges - that she exceeded her authority in signing a gas deal with Russia in 2009 and therefore damaged the Ukrainian oil company (Naftogaz) - seem questionable many consider her to have accrued her considerable personal wealth in dubious circumstances as head of the very same organization. The fact that gas prices have risen sharply as a result of the deal (largely because the world market price of gas has increased significantly) has also helped to undercut her political support on this issue. President Yanukovych has emphasized that the verdict is subject to appeal and that the law may be changed to downgrade the charges from criminal to civil. However, if a leading opposition figure does end up in jail this will likely jeopardise Ukraine's ties with the EU in general and its chances of getting a free trade agreement in particular.
Despite some last minute opinion polls suggesting that its lead had evaporated, the Civic Platform (PO) seems to have secured another term in office with its existing junior coalition partner (the People's Party). Preliminary results from Sunday's parliamentary elections gives the PO 206 seats and the People's Party (PSL) 28. This should be just enough to form a two-party coalition in the 460-seat parliament. If these results are confirmed these two parties will have six seats less than they won in the 2007 vote. However, the result is still likely to be positively assessed by financial markets which had feared that a messier three-party coalition might have to be formed. The existing PO/PSL government has managed to deliver sound economic growth even if it has proved less ambitious in implementing structural reforms than had initially been hoped. The new government will also have to reassure markets that its plans to close the large budget gap are credible. The right-conservative Law and Justice was the second largest party with 157 seats while the liberal Palikot Movement (a new party) and the leftist Democratic Alliance also gained representation.
The IMF notes in a statement at the end of its annual Article IV Mission that economic growth in Lithuania has been extremely robust in H1. GDP grew by 6.2% and both exports and domestic demand contributed. This is a result of both strong global growth and increased competitiveness due to wage cuts. Growth will inevitably slow in coming quarters due to worsening external conditions. However, growth should remain at a solid 3.5% pace in 2012. Some fiscal consolidation has already been undertaken (helped by the strong growth story). However, additional fiscal measures must be identified if the ambitious target of bringing the fiscal deficit down to 2.8% of GDP next year (i.e. below the Maastricht criteria) is to be met. This would both help to restore favorable public debt to GDP dynamics and allow Lithuania (already a member of ERMII) to enter the Euro area in 2014. The implementation of structural reforms remains important also. Pension reform and increased labour market flexibility would boost fiscal sustainability and growth potential respectively in the medium-term.
A number of currencies in Eastern Europe have weakened significantly in the last couple of days and weeks. This has led to several central banks intervening on the FX market (selling foreign exchange) to try and stabilise these abrupt movements. The sell-off in these currencies has been related to a sharp drop in risk appetite among investors as financial market turbulence has risen in recent weeks (the most liquid currencies in E Europe have mainly been affected). In some cases this effect is augmented by some unfavorable domestic developments. The Polish zloty averaged less than 4 to the Euro in July but was 4.39 at the time of writing. Risk aversion has added to growing concerns that the parliamentary elections this weekend will be much closer than expected (see related note). The Hungarian forint averaged 267.6 to the Euro in July but is now trading at 298.8. Again general market factors have been supplemented by domestic ones: concern over the announced early repayment of CHF loans at non-market rates. The Czech koruna has been less affected. From an average of 24.34 in July it has weakened only to 24.81 today.
For some time it has seemed that the Civic Platform (PO) would easily win re-election at upcoming parliamentary elections. However, as the vote actually approaches this weekend opinion polls show that the PO's healthy lead s starting to evaporate. Long gaining 40% or thereabouts in the opinion polls its support has recently dropped to 30%. A number of factors seem to be at play here. First, there has been some resurgence in support for the main opposition party, the conservative Law and Justice (PiS). PiS is expected to get about 20% of the vote. Second a new liberal party - Palikot's Movement - is gaining 7% in the polls. Third, there may be some disaffection with the PO itself which has disappointed in delivering some of its election promises relating to economic reforms (even if its stewardship of the economy at a difficult time has generally been sound). The Democratic Left Alliance and People's Party are also expected to cross the threshold for representation. The PO is still likely to form the next government. However, many voters remain undecided and so uncertainty ahead of the vote is quite high. Financial markets would be concerned if the PO does poorly on Sunday and has to form a weak coalition government as a result.
The National Bank of Serbia (NBS) has cut its key interest rate by 50 bps to 10.75%. This brings the cumulative cut in rates to 175 bps since the high point in May. Inflation peaked at 14.7% in April and had already dropped to 10.5% as of August. It may well have dropped back into single digits in September. Governor Soskic has indicated that inflation on a quarterly basis will be zero or even negative in Q4. Although inflation currently remains above target it should, then, re-enter the target band in H1 2012. Moreover, economic growth readings so far for Q3 have been very weak. The IMF has recently downgraded its growth forecast for Serbia this year from 3% to 2%. Both inflation and growth indiactors would seem to support further rate cuts. However, the NBS has reason to be cautious. Many eastern european currencies have weakened in the last few weeks while the dinar has remained pretty stable. Its relative strength so far this year has been more the result of high interest rates attracting short-term capital inflows rather than a reflection of strong economic fundamentals. At some point, removing the interest rate differential currently working in the dinar's favour could have adverse effects on its stability.
Inflation in Russia in September was 0.0% on a m-o-m basis and 7.2% on a y-o-y basis. This marked a significant drop in inflation from the 8% y-o-y recorded in August and, indeed, inflation of almost 10% y-o-y in the first quarter of 2011. Inflation was 6.4% y-o-y in September for tradable goods, 6.8% y-o-y for non-tradable goods and 8.8% y-o-y for services. A significant deceleration in inflation had been expected in Russia given a favorable base effect - the sharp rise in food prices last year following a serious drought and forest fires - and weakening economic growth. The central bank says that it sees inflation of 2% q-o-q in the fourth quarter. This compares to the 2.4% recorded in Q4 2010. Hence, we can expect that the headline rate could drop further in coming months to the extent that this prediction proves accurate. Against this backdrop it would seem likely that the Central Bank of Russia will consider rate cuts. However, it will have to balance weak inflation and GDP numbers against the effect of a weakening ruble (now up to 37.4 against the basket from 33.1 in July) in making its decision.
President Berzins has urged political parties to conclude their coalition negotiations by Monday following recent parliamentary elections. Unity and the Reform Party (ZRP) are likely to form the basis of the new government. They have 42 seats between them in the 100-seat parliament and thus are seeking an additional coalition partner. The ZRP has suggested that a coalition be formed with the Russian-based Harmony Centre (which came first in the elections with 31 seats but has never been in a national government). The ZRP is also opposed to a coalition with the Union of Greens and Farmers (13 seats) which it accuses of corruption. The ZRP has proposed that Valdis Dombrovskis of Unity should remain as Prime Minister. Such a coalition would have a strong position in parliament. However, another possibility that has been mentioned is that a "national unity" government should be formed (which would also include the National Alliance with its 14 seats). Such an government would clearly have an even stronger position in parliament although it is not clear how well it would function in practice given the proposed presence of a Latvian nationalist party alongside Harmony Centre.
The European Union (EU) held an Eastern Partnership Summit at the weekend. This is an initiative that was launched in May 2009 designed to further integration between the EU and six countries in the South Caucasus and western Former Soviet Union. The aim is to develop Association Agreements (AA) which can lead to a Deep and Comprehensive Free Trade Area (DFCTA) between a particular country and the EU and visa liberalisation. There has been some progress in these technical negotiations. A DCFTA could be signed with Ukraine by December. However, some EU member states have expressed concern over the Timoshenko trial and perceived selective justice that it implies which could jeopardise this timeline. Progress has been made on AA agreements with Moldova, Armenia, Azerbaijan and Georgia. Moldova and Ukraine are making progress in implementing their Action Plans on visa liberalisation. Georgia is effectively implementing its visa facilitation and readmission agreement and it is hoped that the other countries will ultimately launch negotiations in this area. The Summit participants, however, expressed "deep concern" over the deteriorating human rights, rule of law and democracy situation in Belarus.
The IMF's Executive Board has approved the second review of the Stand-By Arrangement (SBA). This makes a disbursement of EUR495 mn available although the authorities have indicated that they will not draw it down as they are treating the SBA as precautionary. The Fund notes that implementation of the program remains good. The 2011 budget deficit is on track to meet its target although the 2012 goal, nevertheless, remains challenging. Fiscal discipline has helped improve investor sentiment. However, implementation of structural reforms is also vital if economic growth is to be boosted in the medium-term. Here reform of loss-making state-owned enterprises remains the key challenge. This politically sensitive issue requires a combination of restructuring, better regulation and more market-orientated pricing. The effects of these measures will be very unpopular both with trade unions (given potential job losses) and the population at large (given the need for higher utility prices). Precisely because of this, these difficult issues have remained largely unaddressed during the transition to date.
The very weak performance in equity markets in South Eastern Europe (SEE) seen in August continued in September. In Serbia, the BELEX-15 fell a massive 12.6% in September (in dinar terms). This takes its year-to-date performance (YTD) to -15.2%. The strong performance seen in the first five months of the year has, therefore, been more than erased and the index is now at levels last seen at the peak of the crisis in late 2008. In Croatia, the CROBEX-10 lost 7.2% in September (in kuna terms) taking it to -11.2% YTD. In Slovenia, the SBI TOP lost 7.3% in September (in Euro terms) and it is down 26.7% YTD. Many of the firms in these indices are actually performing well in very difficult trading conditions. Certainly the deteriorating outlook for growth in the EU justifies some weakening in these markets. However, much of the recent sell-off is related to foreign investors reducing their appetite for risk. Financial turbulence is high due to both softer global growth and concerns about the effects of a possible Greek debt default on European banks.
As if to underline the economic challenges facing an incoming government, Fitch has downgraded Slovenia's long-term foreign currency rating from AA to AA-. The rating has a negative outlook. The reason for the downgrade does not relate to political uncertainty caused by the need to hold early parliamentary elections but the weak financial position of the banking sector. The share of non-performing loans (as a percentage of total loans) is relatively high at almost 15% and may rise further. The levels of provisioning and capital adequacy are low. Hence, Fitch considers it likely that additional capital will be needed. While some of this may be raised privately there is a good chance that the government will have to contribute significantly (in any potential emergency situation and given its large stakes in key banks). This against a back-drop of low GDP growth and with key economic reform measures having recently been rejected via referendum. NLB, Slovenia's largest bank, barely passed an EU stress test of large, cross-border financial institutions early this year. Such government participation in a possible recapitalization of the banking sector would worsen public debt levels and dynamics.
The National Bank of Romania (BNR) left its key interest rate on hold as expected at 6.25% at its latest monetary policy meeting. The BNR noted that headline inflation has fallen sharply in the last few months (from 7.9% in June to 4.2% in August) due to lower food prices and the fact that the effects of the July 2010 VAT tax rise have no fallen out of the base for calculation. Core inflation has also fallen (from 4.7% to 2.9% over the same period). Such disinflation is in line with the BNR's expectations. Inflation is forecast to fall further in the coming months and converge to the 3% inflation target. There are indications that growth is weakening although the agricultural season has been good. Keeping nominal rates on hold as inflation falls is effectively increasing the real interest rate. However, the leu has weakened somewhat against the Euro due to increased investor risk aversion. This offsets the real interest rate effect by loosening monetary policy. The outlook for the currency going forward is also highly uncertain in the current environment justifying the BNR's wait and see approach.
After another failed to attempt to form a State government (Entity governments are already in place) Bosnia will soon have gone a full year without a central government. This is of some concern to the international community which has repeatedly (but in vain) called on both sides in the dispute to bury their differences and focus instead on European integration and providing jobs and a higher living standard for the citizens of Bosnia. At a basic level the dispute remains centred on whether the SDP or HDZ party is the genuine representative of the Croats in Bosnia (which party would then be entitled to name a candidate for the chairmanship of the Council of Ministers this time around). However, this plays also into a wider disagreement between the Bosniaks and a tactical Croat/Serb alliance over whether the central state should have more power or should it remain (as now) largely centred on the Entities (indeed some Croats are pushing for their own Entity). There has, unfortunately, been little sign of compromise from either side and so it is not clear when this issue will be resolved. Nor is there any mechanism for calling early elections to circumvent the current impasse.
The European Commission (EC) has expressed concern on a number of occasions about the use of nationalist rhetoric in the election campaign ahead of December 4 parliamentary elections. The governing HDZ is trailing the opposition SDP in the opinion polls by some way and is resorting to controversial tactics to try and turn the situation around. It is not only using negative tactics (reminding voters of the SDP's former communist past) to try and win votes but playing up its nationalist past (it was once the party of war-time leader Tudjman) claiming to have been the key force in breaking up Federal Yugoslavia and winning/preserving Croatian independence. This is not the first time this has happened. What is more extraordinary in the current setting is that serving Prime Minister Kosor has glorified those Croat Generals convicted in April in The Hague of war crimes relating to operation "Storm" in 1995 as war heroes. The EC has noted that Croatia is committed to co-operation with the ICTY and trying to undermine the legitimacy of these verdicts (while certainly popular with some voters) is not helpful. Nor does it help regional reconciliation. These statements will possibly consolidate the HDZ's voter base. Whether it will help consolidate centrist voters is less clear at this stage.
Political tensions raised within the administration following the announcement that Vladimir Putin and Dimitri Medvedev will swap positions next year appear to have contributed to the dismissal of well respected Finance Minister Alexei Kudrin. Kudrin apparently expressed dissatisfaction at the prospect of working with Medvedev in what will be his new role as Prime Minister. Medvedev, currently President, wasted no time in removing Kudrin from office. This came as a nasty shock to investors who have viewed Kudrin as a fiscal hawk at a time when pressures have been building (once again) to spend more of Russia's oil and gas windfall. His replacements, Anton Siluanov as Acting Finance Minister and Igor Shuvalov as Deputy Prime Minister responsible for the Economy and Finance, are well respected and will provide some reassurance to investors. However, Kudrin's parting comments suggested that the real reason for his departure was related to his growing inability to restrain excessive spending. This outlines what a difficult task the new Finance Minister will have as elections (parliamentary and presidential) approach.
As expected, President Turk was unable to find a suitable candidate for prime minister-designate within seven days of the collapse of the previous government who would have been able to secure a vote of confidence in parliament. Hence, he has announced that parliament will be dissolved on October 21 and parliamentary elections held on December 4. Borut Pahor's coalition government last week failed to secure the support of a majority in parliament for five new ministers needed to replace those that had resigned (as parties successively left the coalition). This is the first time since independence that early parliamentary elections have needed to be held. The leading opposition party, the centre-right SDS of Janez Jansa, is widely expected to win the elections. The Pahor cabinet will continue in office in a care-taker capacity until a new government is formed after the elections. The outgoing government has lost popularity because of the effects of the global economic recession and attempts to introduce painful structural reforms that would ultimately have made the Slovenian economy more competitive. The new administration will effectively have to find solutions to the same difficult problems whatever measures are promised during the election campaign.
Minister Putin or President Medvedev will stand in March 2012 presidential elections has been ended. At a United Russia party conference it was announced that Putin will stand (and without doubt win) while Medvedev will become his Prime Minister. This comes as no great surprise to anyone. The "tandem" seemed likely to continue in office at any rate although there was a small chance that Putin and Medvedev might have retained their current positions. The two work well together in the sense that Putin offers a no nonsense "stability"-based approach. Medvedev is more of a political and economic liberaliser although his achievements on both these fronts have been somewhat modest. Indeed, the fact that the next president of Russia has effectively just been announced as the result of a back-room deal underlines the lack of real democracy in the country. Those (few) that had started to believe that Medvedev had started to offer a genuine change will be disappointed by the nature of this deal. However, a conclusion to this long-running saga will be of some relief to investors and to many Russians. Putin remains the more popular of the two and could now be in office for two (now elongated) six-year terms.
The Serbian parliament has passed two important laws. The laws on public ownership and restitution are key parts of the governments EU Accession road map. They are also of historic significance for Serbia. The former reverses some of the decentralization of the state forced through during the Milosevic years. Most notably, the government has delivered on its promise to return some property (largely infrastructure) to Vojvodina. The latter finally (partially) compensates owners of property seized by the Communists via return of that property (where possible) or the issuance of bonds (where not possible). Neither law is without some controversy in Serbia. Some try and claim (implausibly) that the former is a step towards separatism in Vojvodina. The latter is unpopular for those that are not compensated 100% for property taken. Sadly, Serbia does not have the capacity to repay all in full and this solution (in consultation with the IMF) is the most that it can afford to pay (i.e. EUR2 bn or 6% of GDP). It is also similar to restitution laws implemented elsewhere in the region. The passage of both laws will not only improve Serbia's EU Accession chances but also improve the investment climate significantly.
As if sentiment on financial markets is not already bad enough due to poor economic data, the flash PMI reading for September for the euro zone was very weak. The PMI survey (released by Markit) showed the index falling from an already weak 50.7 in August to 49.2 in September. This is the first time in over two years that the index has been lower than 50.0. This indicates that the economy is contracting. A seperate index of consumer confidence released by the European Commission also showed a very weak reading for September. Following bad numbers in July and August this data suggest that GDP growth in the Euro area may have slowed from the already modest 0.2 q-o-q pace recorded in Q2. It could also suggest a possible undershoot of the Commission's latest GDP growth forecasts of 0.2% and 0.1% for the third and fourth quarters respectively. This is an extremely difficult back-ground against which to be tightening fiscal policy as is the case with the Euro area as a whole and the periphery countries in particular.
Serbia has issued its first Eurobond. It is a US$1 bn offering of 10-year maturity with a 7.25% coupon. Demand for investors for the Eurobond was very strong reflecting both the high yield and confidence in the sovereign credit given a prospective new IMF agreement. This issuance helps to develop the array of Serbian financial instruments available to investors and provides an alternative source of funding for the budget. It also helps to move the government away from its reliance on short-term financing via T-bills which leads to high roll-over risk. The government should now have the (recently enlarged) budget deficit for this year and some of next's covered which is important as parliamentary elections approach in the spring. It is, however, important that this money is spent wisely rather than as a source of financing for populist pledges. The IMF will act as an important external anchor here (in addition to the recently convened Fiscal Council) in trying to ensure that fiscal rules this government itself adopted are adhered to during the election campaign and after.
The Czech National Bank (CNB) left its key interest rate on hold at 0.75% as expected. It continues to believe that monetary policy-relevant inflation will stay close to the 2% inflation target over the forecast horizon. Headline inflation will rise above 3% (i.e. above the upper fluctuation band of the target) temporarily due to a planned VAT increase. The forecast, though, remains consistent with stable rates in the near-term and a gradual rise in rates in late 2011/early 2012. However, the CNB now emphasizes that the risk to the inflation forecast are slightly on the downside (growth is weakening and food and fuel prices dropping) and substantially on the downside in relation to the interest rate outlook. Hence, the CNB is suggesting that the first rate hike may well be pushed back beyond the current base case scenario. A flight from risk could weaken the koruna which represents an upside risk. Slowing growth in key trade partners and financial market turbulence (which is adversely impacting economic confidence), though, would seem to present a more significant downside risk.
The Serbian authorities have just a couple of weeks left to influence the make-up of the European Commission annual report on Serbia’s EU integration process. The government drew up a road map of issues earlier this year which must be addressed if the EC is to recommend in this report that Serbia be given the status of official EU candidate (or less likely a date for the start of Accession negotiations) by the Council of Ministers at the end of the year. While implementation of the road map is behind target the government is confident that all key pieces of outstanding legislation (including long-delayed laws on restitution and public ownership) will be passed in parliament in the next couple of days. Even if all required legislation is indeed passed there is still the difficult situation in Kosovo to consider. While the agreement on a Kosovo customs stamp on September 2 was positive Serb barricades have returned in the north of Kosovo because of differing interpretations of its implementation. More negotiations between Pristina and Belgrade are due on September 28 but will be extremely difficult. Without a compromise that will see these blockades removed all the hard work undertaken in other areas with respect to status could yet be called into question.
The coalition government of Borut Pahor has failed to secure a vote of confidence in parliament for the approval of five new ministers. Parliament voted by 51 to 36 against the new cabinet. Several ministers had needed to be replaced as two parties (DeSus and Zares) had left the government over the last few months. In doing so, they left the Social Democrats and LDS in a minority. Hence, it always seemed likely that the government would struggle to limp on to regular parliamentary elections due next September. President Turk now has seven days to appoint a new Prime Minister-designate who will have 30 days to win a vote of confidence in his/her proposed cabinet. However, it seems much more likely - given the current political arithmetic in parliament - that early elections will result instead. These would then be held by December 20. The opposition centre-right SDS of Janez Jansa is widely predicted to win this vote and return to power.
The ruble has weakened sharply against its US$/Euro basket over the last couple of weeks. The prime reason has been evidence of a slowdown in the global economy and the expectations of weaker oil prices as demand for oil slackens. The ruble stood at just above 33 to the basket in the summer. In the last couple of weaks it has dropped sharply to 36.6 at the time of writing. While the Central Bank of Russia (CBR) has abandoned its 26-41 corridor for the ruble it still has a daily fluctuation band which has a spread of five rubles (currently 32.15-37.15). Clearly, the ruble is moving towards the upper (weaker) side of that band and so the CBR is starting to sell FX reserves to slow its movement. An improvement in global sentiment could quickly reverse this trend. However, the large current account surplus that Russia continues to post is partially offset by outflows on the capital account side. This helps to make the ruble more volatile than otherwise would be the case as does the Russian economy's high structural dependence on oil revenues.
Harmony Centre, a party backed by many of Latvia's Russian inhabitants, won parliamentary elections held at the week-end. It took 29% of the vote, a clearer victory over the second-placed Reform Party (20%) than had been predicted by the opinion polls. Unity, the key party in the outgoing government, came third with 18%. It seems many non-Russians may have backed Harmony this time around having become fed up with allegations of corruption amongst parties regularly in government - Harmony has never been part of a national government. They may also have felt that backing the completely new and untested Reform Party was a risk. However, if these factors did play a role in the outcome of the election the voters' wishes may ultimately be frustrated. It appears that Reform and Unity will try and form a government with one of the other smaller parties that passed the electoral threshold (the Union of Greens and Farmers or the National Alliance). Talks may be held with Harmony too but it is only likely to be part of a new government if it drops some of its pro-Russian positions which other parties have so far found unacceptable.
Inflation remained at 2.5% y-o-y in the Euro area in August and at 2.9%y-o-y in the EU-27. Inflation peaked in April at 2.8% and 3.3% respectively. It seems, then, that the acceleration in inflation seen earlier this year due to rising food and fuel prices has been successfully contained. With growth now significantly weaker than expected the emphasis for monetary poicy setters is generally shifting from rate hikes to rate cuts in many places. The ECB has effectively removed its hiking bias although it has not gone so far as introducing a bias to cut at this stage. Further soft data may yet force it to do so. Within Eastern Europe, inflation is highest in the fast-growing Baltic States - Estonia 5.6%, Latvia 4.6% and Lithuania 4.4%. It remains high (but has fallen sharply over the last few months) in Romania (4.3%). Inflation rose by 0.4 percentage points in August in both Poland (to 4.0%) and in Hungary (to 3.5%). Inflation is lowest in Slovenia (just 1.2%) and in the Czech Republic (2.1%).
Industrial production (IP) rose by 4.2% y-o-y in the Euro area in July and by 3.6% in the EU-27. These figures are better than the (revised) numbers for June (of 2.6% and 1.7% respectively) but are still slightly weaker than financial markets expected. IP grew by 1.0% m-o-m, seasonally adjusted in the Euro area and by 1.1% in the EU-27. Despite these fairly solid numbers the outlook for growth in coming months does not look great. Leading indicators are weak both in Europe and in much of the world. Within Eastern Europe, the strongest IP numbers were recorded once again in the Baltic States. Estonia continued to lead the way (22.9%) followed by Latvia (9.2%) and Lithuania (8.4%). For most of the other countries IP growth was between 3% and 7% y-o-y in July. Slovenia recorded the weakest figure (1.9%) while Hungary is yet to report.
As parliamentary elections approach in December the main party in the governing coalition, the HDZ, continues to suffer from a scandal relating to the misuse of government funds. A former treasurer of the party has confirmed allegations that, under the leadership of then Prime Minister Ivo Sanader, the HDZ transfered money from state-owned enterprises to finance its election campaigns. Prime Minister Kosor has strongly denied claims that she knew about these actions and even benefited to the extent that they were used to finance her (unsuccessful) 2005 election campaign. The current leadership of the HDZ is desperately trying to convince voters that only Sanader and a few close associates were involved in this corrupt activity claiming that the issue is being used by the opposition and press to smear the party. Whatever the truth it is a key issue in the election campaign and the voters will ultimately decide which version of events they chose to believe.
The Central Bank of Russia (CBR) has left its key refinance rate on hold at 8.25% as expected. Nevertheless, expectations are growing in some quarters that the next move in rates could be downwards. Inflation has fallen from a recent peak of 9.6% y-o-y to 8.2% y-o-y as of August as food prices have stabilised (offering a positive base effect relative to last year's sharp rises). Growth has also disappointed. GDP expanded by just 3.4% in Q2, down from 4.1% in Q1. With the global economy slowing (and oil prices falling) the full-year growth target - also 4.1% - looks to be out of reach. An independent central bank with an inflation targeting regime would probably not cut its policy rate when real rates are close to zero and inflation above (if converging towards) target. However, neither of these things applies in Russia. The CBR is not fully independent and the government clearly has a growth priority. This is particularly true as parliamentary and presidential elections approach in the next three to six months.
Latvia holds parliamentary elections on Saturday after the dismissal of the previous parliament via referendum. Opinion polls show a close race between former President Zatlers' new Reform Party and the Harmony Centre (backed mainly by ethnic Russian voters). Unity, the leading party of the outgoing coalition, is in third place and the Union of Greens and Farmers fourth. Harmony Centre led in the polls before the last elections but most undecided voters opted to go for Unity at the last minute handing it a surprise victory. If undecided voters again avoid Harmony Centre (which for some is too closely linked to Russian interests) then Reform could be the one to benefit this time around. Both Reform and Unity have said that they will negotiate with Harmony Centre about it joining a future coalition but only if a demand for Russian to become an official state language is dropped. A Reform/Unity/Greens coalition is conceivable but a number of other combinations are also possible as the result is too close to call. Either way, an extended period of coalition building is likely.
The European Commission (EC) has released its interim forecast. This sees q-o-q growth in the Euro area and EU-27 in Q3 and Q4 being about a quarter of a percentage point weaker than had previously been expected - 0.2% and 0.1% in the Euro area and 0.2% and 0.2% in the EU-27. GDP growth expanded at a strong q-o-q pace in Q1 (0.8% in the Euro area/0.7% in the EU-27) but had already slowed substantially in Q2 (0.2%/0.2%). The full-year forecast for y-o-y growth remains almost unchanged (1.6%/1.7%) relative to the spring forecast due to a better than expected H1. The EC notes that net exports are now likely to be less strong than expected, large balance sheet imbalances are still being worked off and financial market stresses are undermining confidence and raising investment costs. Full-year growth is likely to be little changed, in fact, from the modest 2010 outcome (1.8%/1.8%).
Inflation fell from 12.1% in July to 10.5% in August. It has now fallen quite substantially from its recent peak of 14.7% in April. However, it remains well above its end-year (upper) target of 6%. The central bank had been expecting inflation to fall sharply given lower food prices. Indeed, it is expected to fall back to single digits by the end of the year and move back into its target range in H1 2011. On the basis of this, and a weaker economic growth outlook, the central bank cut rates last week by 50bps. Governor Soskic outlined in a press conference this week that the Bank has cut its growth forecast for this year from 3% to 2.5% following weak industrial production, export and retail sales numbers. This forecast is still above the 2% now forecast by the IMF for 2011. The central bank sees growth having been fairly robust in Q3 (0.6% q-o-q, seasonally adjusted) due to a good agricultural season even if the industrial sector is weakening. However, with growth anyway weaker than target in H1 (2.8% y-o-y) and the global economy slowing the central bank may ultimately have to lower its growth forecast further.
The government is considering the adoption of a plan under which borowers that have taken mortgages in Swiss Francs (CHF) will be able to repay their loans early at a more favorable FX rate than that prevailing in the market. A high proportion of households have taken loans in CHF only to see that currency appreciate dramatically against the forint in the last few years (making their loan payments much more burdensome). Such is the extent of the problem that private consumption is currently very weak as households try to repair their balance sheets. A plan which would allow households to repay at an exchange rate of 180 rather than the 230 plus currently prevailing would seem, then, to make good political sense and may even help the macroeconomic situation partially by reducing FX exposure. However, there are several problems with the plan. First, where would the cash-constrained households find the money to repay early even at the more favorable exchange rate? Second, the plan could potentially hit bank profits substantially and reduce willingness/ability to lend. Third, this would not be consistent with the honouring of legal contracts. Fourth, the suggestion that foreign banks would have to bear the losses and domestic banks might receive assistance would be yet another discriminatory move against foreign investors (following the imposition of various ad hoc taxes) which could prove counter-productive in the long-run.
The IMF has assessed the current economic situation in Belarus as part of Post Progam Monitoring which provides an indication of what the authorities must do as they seek to win a new IMF program. Following the expiry of the last program in March 2010 a significant loosening of economic policies ahead of the presidential election at the end of the year boosted growth but lead to a balance of payments crisis. As FX reserves fell sharply the central bank had to let the currency depreciate leading to a rapid rise in inflation (now over 60% y-o-y). The authorities obtained a US$3 bn loan from the Eurasian Economic Community and have started to implement policies which might help to stabilise the situation. The central bank has hiked rates, fiscal policy is being tightened, directed lending is being controlled and some state-owned assets sold off. However, the IMF feels that these measures have not yet been consistently implemented. A multiple exchange rate is still in place, real interest rates are still negative and privatization has so far been piece-meal. The Fund underlines that "demonstrated commitment" to strong policies and structural reforms are necessary to win renewed financial support from the IMF.
The National Bank of Serbia (NBS) has cut its key policy rate by 50bps to 11.25%. Inflation and inflationary pressures continue to fall thanks to lower global food and fuel prices and weak domestic demand. Inflation is likely to fall to single digits by the end of the year and return to the target range in the first half of next year. Recent economic growth indicators have been weak. The NBS left rates on hold at its last meeting due to uncertainty caused by turmoil on the world financial markets. While markets have stabilised only partially there is at least less uncertainty about the course of fiscal policy in Serbia. The fact that the government has reached agreement with the IMF (in principle) about a new program makes it more like that fiscal policy will stay within its allotted framework than would otherwise be the case ahead of parliamentary elections. The associated reduction in the risk premium for Serbia that this should imply could mean that cutting rates will not disturb the recent stability of the dinar against the Euro. However, any sharp reduction in general risk appetite could do so arguing for caution in the pace of further rate cuts.
The European Central Bank (ECB) left its key interest rate on hold at 1.5% as widely expected at this month's monetary policy meeting. Of more interest to financial markets were Governor Trichet's comments about the growth and inflation outlook. The ECB has downgraded its growth forecast for this year marginally and more substanstially for 2012 refering to "intensified downside risks". While the ECB sees inflation (currently 2.5%) as likely to remain clearly above 2% in coming months medium-term risks are now "broadly balanced" rather than "to the upside" as previously. Financial markets are interpreting this as a move to a neutral bias for rates following 25 bps hikes in April and July. In other words, further hikes which had once seem likely to be in the pipeline are now unlikely to materialise in the immediate future although the policy stance remains "accomodative" from a long-run perspective. Those most pessimistic about the growth outlook for the Euro area are betting that the ECB might ultimately have to reverse its rate hikes early next year.
The opposition Socialist Party has ended an unofficial boycott of parliament in effect since the disputed outcome of May 8 local elections in Tirana. A preliminary vote gave victory in the mayoral contest to Socialist leader Edi Rama by a handful of votes. However, a recount including mis-cast ballots gave victory instead to Lulzim Basha (backed by the governing Democratic Party). This outcome was later backed by the Central Election Commission. Rama had been Mayor of Tirana on the last three occasions. This boycott was similar to (if shorter) than a boycott imposed by the Socialists after they narrowly lost parliamentary elections in the summer of 2009. As then, it is not clear what the boycott actually achieved. The outcome of neither electoral process was changed. Meanwhile, reforms necessary for EU Accession have been delayed. Moreover, the European Commission has criticised both sides for a lack of mature political dialogue.
The National Bank of Poland (NBP) left its key interest rate unchanged at 4.5% as expected as its Monetary Policy Council (MPC) meeting. Economic growth in Poland in H1 was relatively robust however there are signs of weakness in the EU, Poland's main trade partner. Inflation has started to drop (as have inflation expectations) but at 4.1% y-o-y remains relatively high. Downward risks to the inflation projection on the growth side are potentially matched by upside risks if global financial market turmoil weakens the zloty according to the Bank. Indeed, inflation is seen coming down to its 2.5% target without further policy adjustments. Hence, the MPC has a neutral bias but is ready to respond with interest rate changes in either direction if needed. Weakening global growth has reduced the chances of a further hike rather than cemented a rate cut. However, financial markets are increasingly betting that the next move (if leading indicators remain weak) could be down rather than up.
The Swiss National Bank (SNB)'s decision this week to fix the Swiss Franc (CHF) to the Euro offers a partial respite for European borrowers indebted in CHF and receiving income in local currency. The decision to fix the exchange rate at 1.20 is not without cost for the SNB but clearly it was concerned about the effects of a super strong currency on the domestic economy. Assuming that the peg holds, the fix at an exchange rate somewhat weaker (9%) than that which was prevailing at the time offers a marginal improvement for borrowers in Hungary, Poland, Croatia, Serbia etc that are struggling to pay higher repayments due to considerable CHF appreciation. However, this only addresses part of the problem. First , this reverses only a fraction of the appreciation of the CHF seen over the last few years (the CHF had appreciated from 1.7 to the Euro to close to parity). Second, financial market turbulence could still see local currencies (at least those that are flexible) depreciate against the Euro which would offset part of the gain just locked in. In other words, this move should help (mainly in preventing further CHF appreciation) but not resolve underlying balance sheet issues which are impacting adversely on private consumption.
The weakness of the economic recovery in Europe is underlined by continued soft retail sales figures. Retail sales growth in the Euro area in July was -0.2% y-o-y and was the same in the EU-27. Retail sales growth for the first seven months of the year was also negligible on a y-o-y basis at both the Euro area and EU-27 levels. The economic recovery in most places has been charterised by strong export and industrial production growth and weak domestic demand. Even the former two bright points are jeopardised by signs of a global slowdown. Poor retail sales figures suggest that consumers are either over-indebted and/or too concerned about their job prospects because of rising unemployment to spend freely. This dichotomy is noticable in most East European economies also. Only in the Baltic States is retail sales growth solid (5%-7% y-o-y). In the majority of countries it is close to zero or even negative.
The IMF Executive Board has approved the first review of the Precautionary Credit Line (PCL). This agreement was put in place in January and the EUR460 mn available for disbursement under the program was only expected to be drawn down in exceptional circumstances. In the end, the Macedonian authorities drew down EUR220 mn just two months later on the basis that their plans to issue a Eurobond were adversely impacted by financial market turmoil and the calling of early elections. The IMF notes that economic growth is recovering, FX reserves are stable and fiscal policy on track. Nevertheless, it considers that the need to draw down this facility highlighted remaining external vulnerabilities. These relate to debt management and vulnerability to economic shocks. The authorities have commmitted to improving debt management both with respect to external financing and developing the domestic market. Policy-makers also need to be vigilant because Macedonia is highly exposed to developments in the global economy and financial markets.
Agreement has been reached on a key issue in talks between Pristina and Belgrade. Belgrade's refusal to accept the Kosovo customs stamp (it has accepted up to now only UNMIK - Kosovo) has meant that goods from Kosovo could not go into Serbia. In response, Pristina recently placed an embargo on Serbian goods entering Kosovo. A compromise has been found in which two stamps will be used but without refering to Kosovo sovereignty (which of course Serbia disputes). This should restart the flow of goods between both regions. The situation on the ground in north Kosovo remains tense however. Any further attempt by Pristina to put its customs officers on the border/administrative line between Kosovo and Serbia could destabilise the situation as happened during a break in negotiations in late July/early August. However, successful negotiations are important both in order to reach agreements on other important issues (such as telecoms and electricity supply) as well as demonstrating to the EU that both sides are committed to dispute resolution via dialogue - an important condition for EU integration.
After many failed attempts over a number of years it appears that Bulgartabac has finally been sold. The privatization agency has accepted a bid of EUR101 mn from BT Invest (owned by Russian bank VTB) after other bidders had dropped out of contention. The sale is controversial in the sense that some argue that the state should have cancelled the tender and tried again to get a better price. However, this sort of argument is exactly why the sale has taken so long (some of the less profitable parts of the holding were sold off in 2009). What is more important is whether the new owner will make production more efficient. In this sense, the sale to a company that is not involved in this industry could be considered more questionable. The deal requires BT to buy a certain amount of tobacco over the next five years and forbids resale during this period. The purchaser has also committed to an investment program.
Polish GDP grew by a stronger than expected 4.3% y-o-y in Q2. This was also a slight acceleration on the first quarter (4.1%). The government has declared that it is maintaining its full-year growth forecast of 4% despite the slowing world economy. This is not just due to a solid H1 but the fact that certain domestic generators of growth (in particular investment) are strong and suggest that Poland's relatively large economy can bear this global slowdown more readily than some of its smaller and more open peer economies in the region. On the basis of this growth forecast, the government expects the budget deficit to drop to 5.6% of GDP this year (below target) from 7.9% of GDP last year. A budget deficit of just 3% of GDP is targeted next year.
Parliamentary elections have been set for the beginning of December. As United Russia will, without doubt, win by far the largest share of the vote the main point of interest is how well it will do compared to its strong performance in December 2007 elections (in which it won 315 of 450 seats). It is thought likely to win less seats this time around but should still win a majority. Its performance will be analysed in great depth to give indications as to whether Vladimir Putin (Prime Minister) or Dimitri Medvedev (current President) will stand for the presidency in rather more important presidential elections due in March 2012. No decision has yet been taken (or at least announced) although Putin is considered the strong favourite to return to the post. Otherwise, the rest of the parliamentary vote is likely to be split between four other parties according to the latest opinion polls. These are the long-standing Communist Party and Liberal Democratic Party and A Just Russia (based on the former Rodina) and the new "The Real Thing" of Mikhail Prokhorov.
If Borut Pahor was hoping for solid economic numbers as his coalition clings to power (and likely faces early elections around the turn of the year) he is likely to be disappointed. GDP growth in Q2 was just 1.0% y-o-y, half the rate recorded in the first quarter. The economic recovery is unbalanced with net exports strong but domestic demand soft (due to high unemployment, tight credit and an over-indebted corporate sector). Moreover, Slovenia is more integrated into the global economy than most of its peers in former Yugoslavia. Hence, bad news on the global growth front is likely to hit it proportionally harder. In other words, the growth outlook for the second half of the year is hardly likely to be any better than in the (very modest) first half and quite likely to be somewhat worse. Economic growth of about 1% or less for the year as a whole will not dent unemployment or improve voter sentiment ahead of the elections whenever they actually turn out to be.
The Serbian authorities have reached a Staff-level agreement with the IMF on a new 18-month, EUR1bn Stand-By Arrangement. The program is to be treated as precautionary. Serbia already has sufficient FX reserves but wanted to secure a new arrangement (the previous one expired in April) as a signal to investors that policies will stay on track through parliamentary elections in spring next year. The need to secure a new program has been accentuated by recent global financial market turmoil and possible related negative external shocks to emerging markets. The key sticking point in the negotiations was a likely budget overshoot for this year of as much as RSD30 bn. In the end, the IMF has downgraded its forecast for growth in Serbia substantially from 3% to 2% (because of slowing global growth). The Fund, then, has allowed an increase in this year's budget deficit by just over RSD10 bn (from 4.1% of GDP to 4.5% of GDP) to reflect the impact of this lower growth on revenues. The government, for its part, has given undertakings that it will find measures to correct the rest of the overshoot relative to the original plan.
Negotiations between Belgrade and Pristina are set to restart at the end of this week having broken down in July. The sharp rise in tensions and incidents of violence that occurred as soon as talks ceased underline that the intermediation of the EU is necessary to try and foster agreements on ten technical issues which might improve conditions on the ground. Both sides continue to blame each other for the rise in tensions. However, some sort of uneasy calm has prevailed in northern Kosovo over the last couple of weeks since a temporary agreement relating to the operation of the border/administrative line between northern Kosovo and Serbia was reached with KFOR. This agreement expires in a few weeks, however, and it is important that some common ground is found on the Kosovo customs stamp issue as soon as possible. Both sides lose out economically from a mutual blockade of exports. They also stand to lose out in respective EU Accession processes if they are not seen to demonstrate good faith in the talks and hence support "good neighbourly relations" as sought by the EU.
Aleksander Ankvab won presidential elections in Abkhazia, one of the break-away regions of Georgia, at the week-end. The elections were held after the death of President Bagapsh in May. Abkhazia fought a war with Georgia in 1992-93 and thereafter declared itself an independent state. Following the Russian war with Georgia in August 2008 Russia recognized Abkhazia's independence although only four other countries have also done so. Bagapsh was elected President in January 2005 and won a second term in December 2009. Ankvab, Acting President and a former Prime Minister, won the elections in the first round gaining 55% of the vote. Current Prime Minister Sergei Shamba came second with 21% while former Vice President Khadzhimba came third with 20%.
Incumbent President Ilves has won re-election in parliament to a new five-year term. This outcome was widely expected as Ilves's candidacy was supported by both the coalition government (the Reform Party and the Union of Pro Patria and Res Publica) and one of the leading opposition parties (the Social Democratic Party). He secured 73 votes in the 101-seat parliament. The opposition candiate, Indrek Tarand, took 25 votes. A two-thirds majority of votes is required otherwise the president is elected by an Electoral Assembly. Last time round, Ilves secured 64 of the 65 votes cast but the opposition Centre Party and People's Union boycotted the vote meaning that he did not secure the requisite majority. He was later elected by the aforementioned Assembly. Indeed, this is the first time that a candidate has secured election in parliament in this way by securing the necessary 68 votes or more.
The resignation of highly controversial Internal Affairs Minister Katarina Kresal recently continues to dominate the Slovenian press but is just one of the difficulties facing the Borut Pahor-led coalition government. Kresal, surrounded for over a year by bizarre allegations relating to her private life, finally resigned when a contract signed by her department to rent office space was deemed to have been corrupt. Kresal remains leader of the junior coalition partner (the LDS) at least for the time being. Pahor has lost two coalition partners so far this year and his SD and the LDS together hold only 33 of 90 seats in parliament. Even if the LDS remains in the government it seems unlikely that the government will survive until regular parliamentary elections next September. Pahor has to replace 5 cabinet ministers (members of the departed parties) over the next couple of months and also has to secure a budget rebalance given the overturning of the pension reform by referendum. How he will secure majorities in these votes is not yet clear. His preference is for his government to struggle on at least until the spring. But he has recognised failure to win these upcoming votes could lead to early elections in December.
S&P has upgraded the Czech Republic's credit rating by two notches from A to AA-. The reasons given for the credit rating improvement were low public debt to GDP, a stable banking system that has largely resisted FX-lending and expectations that the pension reform will be fully implemented (hence improving long-term debt dynamics). S&P is also changing the way it does its ratings to give greater weight to political and economic factors. With this upgrade, the Czech Republic follows Estonia in managing to improve its credit ratings when many other European countries are struggling to maintain theirs. It is also worth noting with these recent changes that the leading Eastern European countries now have better ratings than some of their Western European counterparts. The Czech government came to power with pledges of fiscal austerity and the implementation of economic reforms. In the main, the government has stuck to its planned program despite a fall in popularity and tensions within the coalition.
GDP growth of 0.2% q-o-q in Q2 may have been only slightly worse than expectations but all indications point to Q3 being even weaker. A number of leading indicators of economic growth in the Euro area and EU have been published this week and the vast majority have been disappointing. Markit's flash PMI reading for August remained at the same low level recorded in July. The European Commission's confidence indicator fell sharply. Germany's ZEW and IFO confidence indices also registered sharp drops. These releases suggest that GDP growth in Q3 will be close to zero. Signs of slowing global growth give little hope, either, that growth will be markedly stronger in Q4. This has negative implications for Eastern Europe in terms of weaker demand for those countries that have a large export exposure to the EU (Central Eastern Europe in particular). However, it also continues to raise questions about the ECB's rate hike strategy and whether the Euro should remain so strong.
The Monetary Policy Council (MPC) of the National Bank of Hungary left rates on hold again this week. The MPC notes that inflation is falling towards the 3% target as expected. Weak domestic demand and high unemployment should restrain wage pressures for the foreseable future. However, inflation could yet remain above target for the next couple of months. This justifies leaving the policy interest rate at its current level (6%) for a sustained period, according to the MPC, to keep inflation expectations in check. Moreover, the risk premium on emerging market assets has risen due to recent turbulence on global financial markets (which could possibly weaken the forint). Economic growth data has been slightly weaker than expected in recent months and indications are that the global economy is slowing. Hence, the next move in rates could conceivably be downward although it seems clear that this is not expected to happen anytime soon.
Ahead of Angela Merkel's visit to Belgrade this week there was frenzied speculation in the local press that Germany would demand Serbia's recognition of Kosovo as the price of further European integration. While this was always unlikely to be the case it does appear that Germany has hardened its stance somewhat with respect to implementation of the Ahtisaari plan for the north of Kosovo. Serbia seems likely to gain EU candidate status by the end of the year. However, a date for the beginning of Accession negotiations always seemed less likely unless it manages to implement all the required reforms as well as achieving a successful outcome to negotiations with Pristina on technical questions. Chancellor Merkel appeared to interpret "good neighbourly relations" on this occassion, however, not only as a good outcome to the dialogue between Belgrade and Pristina (the usual formulation) but the removal of Serbia's "parallel institutions" in the north of Kosovo. This issue was always going to be a sticking point at some stage in Serbia's EU Accession. However, it was not expected to be raised this early as it would presumably require in return assurances of greater autonomy for Serbs in northern Kosovo which Pristina at the moment seems unlikely to accept.
Inflation in the Euro area dropped from 2.7% in June to 2.5% in July. Likewise, in the EU-27 it slowed from 3.1% to 2.9%. While this is only one month's reading and inflation is still above target this data strengthens the hand of those who say that the ECB is fighting the wrong battle: hiking rates to combat a temporary rise in inflation while growth has turned out somewhat weaker than expected. Market participants are scaling back expectations of further rate hikes and some are even now calling for a cut in rates next year. The likelihood of further rate hikes in Eastern European countries would also seem to be diminishing. Inflation dropped from 3.5% to 3.1% in Hungary and from 3.7% to 3.6% in Poland. In both cases central banks are likely to stay on hold having hiked earlier this year. A sharp (though expected) fall in inflation was seen in Romania (from 8.0% to 4.9%) as last year's tax hikes fell out of the equation. Inflation, though, remains well above target even so.
Despite Russian claims to the contrary, it seems fairly evident that those countries that agree to closer economic integration with Russia gain lower gas import prices in return. Belarus is the latest example. Russian officials have made it clear that Belarus will gain a gas discount based on an "integration" co-efficient while Ukraine will not. The aforementioned integration refers to the fact that Belarus has joined a Russian-led customs union while Ukraine has not. Both countries are suffering from worsening current account positions as gas price imports from Russia become more expensive. However, the situation is much more desperate in Belarus which is running out of FX reserves and has had to devalue its currency. The details of the new gas deal with Belarus have yet to be announced. At the same time, the Russians are finalising the purchase of the rest of Belarus's pipeline network (a move Ukraine has so far resisted). Other Belarusian assets may also be sold to Russian interests. While privatization in the largely state-owned Belarusian economy is generally desirable it would be better conducted by open tender than in a non-transparent fashion at low prices in return for cheaper gas imports/emergency loans.
The National Bank of Belarus has an unenviable task in trying to bring down inflation which has rocketed from 13.9% y-o-y in March to 48.3% y-o-y as of July. A balance of payments crisis has led to the collapse of the Belarusian ruble (down almost 80% y-o-y against its Euro/Russian ruble/US$ basket). The central bank has had to respond by hiking its key policy rate on a number of occasions. From 12% in March the refinancing rate has now reached 22%. The central bank can only stabilize and then bring down inflation as part of a co-ordinated strategy with the government. Higher interest rates should help to stabilise the currency (via a higher interest rate differential) and bring down inflation expectations somewhat. However, the government must commit to tightening fiscal policy, control public sector wage growth and limit directed bank lending if disinflation is to be achieved on a sustainable basis. Implementation of these measures would also help to secure a new program with the IMF.
The authorities are due to hold talks with the IMF in Belgrade with a view to agreeing a new IMF program. The previous program expired in March and although the authorities had always indicated that they would seek to secure a new precautionary arrangement they have seemed in no particular hurry to do so. With the budget seemingly going off track and elections due next spring this has raised fears in some quarters that the government might refrain from a new program in order to give itself more room for populist spending promises ahead of the vote. In this sense, recent turmoil on world financial markets may have come at a good time. The government is concerned that recent volatility and indications of weaker global growth will impact adversely in the Serbian economy as it comes out of recession. It could also challenge the recent stability of the dinar. Hence, there would now seem to be more of an incentive to obtain a new program quickly to prevent any loss of investor confidence or contagion effects.
Industrial production readings for June were very weak in both the Euro area and EU-27 regions. On a m-o-m, seasonally adjusted basis IP was down 0.7% in the Euro area and 1.2% in the EU-27. On a y-o-y basis, IP grew by just 2.9% in the Euro area in June (compared to 4.4% in May) and by 1.7% in the EU-27 (compared also to 4.4% in May). For the second quarter as a whole, IP expanded by just 4.2% in the Euro area compared to 6.6% in Q1 and by 3.8% in the EU-27 compared to 6.3% in the first quarter. The Baltic States all managed to record double-digit IP expansions in June even if they, too, saw some deceleration in growth. Elsewhere in Eastern Europe, IP growth in June was between 1% and 5% with the exception of the Czech Republic (7.4%). A slowdown in global growth and the strength of the Euro are two likely explanations for these softer figures although adverse base effects (a stronger period for comparison) may also have played a role.
Prime Minister Luksic has reached a compromise with opposition parties which should now allow changes to the Election Law to pass with the required two-thirds majority in parliament. Despite pressure from hard-liners within his party and the coalition, Luksic has agreed to changes in the Education and Citizenship Laws requested by the opposition. These essentially mean the use of Serbian and other languages other than Montenegrin in schools and allowing individuals on the electoral role but without citizenship to become citizens under an accelerated procedure. The government has, in vain, on a number of occasions tried to push the Electoral Law changes (required by the EU in order to secure a start date for membership talks) through parliament without compromise. Repeated failures to secure passage of the legislation, a shortening timeframe for this to be achieved and significant pressure from leading EU countries seems to have persuaded Luksic that compromise was essential to avoid derailing Montenegro's EU integration.
The National Bank of Serbia (NBS) left its key policy rate on hold at 11.75% this week. Inflation in Serbia is falling sharply due to softer food prices but remains well above target. The NBS is therefore cutting rates but cautiously. This reflects the fact that next year's inflation target is challenging (4% plus or minus 1.5 percentage points) and that it doesn't want excessively fast rate cuts to destabilize the dinar which was boosted in the first half of the year by short-term portfolio inflows. An additional reason for caution is recent extreme volatility on world financial markets. Any sustained reduction in investor risk appetite could potentially weaken the dinar (which has been trading in a 102-104 range over the past few months). Any sharp move weaker in the local currency could be stabilising for corporates (many of which are unhedged) and the banking sector. Hence, the NBS is likely to wait for the right moment before cutting further from here (it has cut by 75bps so far).
Another consequence of world financial market turmoil this week has been a continued dramatic strengthening of the Swiss Frank (CHF) against the Euro. The CHF is traditionally seen as a safe haven during financial crisis and all the efforts of the Swiss National Bank to stem its rise have thus far proved in vain. This is not only a potential problem for growth in Switzerland but has extremely adverse consequences for those borrowers in Eastern Europe (EE) who have taken out loans in CHF but are paid in local currency (because interest rates on CHF loans were much lower). The strengthening CHF (which has doubled in strength relative to the Euro in the last few years) has left them with significantly higher repayments. In many cases, the Euro has also strengthened against their local currency in this period. This problem has led many governments to consider taking measures to ease repayment burdens as many are now struggling to repay. In many cases, new loans in CHF have now been banned and banks are being urged/forced to offer their clients conversion of these loans to local currency.
The downgrade of the U.S's credit rating and concerns over the debt crisis in the Euro area have led to massive fluctuations in the stock-markets of Eastern Europe and the Former Soviet Union (EE/FSU). This is hardly surprising given that much larger and more liquid markets like the Dow Jones Industrial Average have shown massive volatility over the last week. There are several linkages between these developments in the US/Europe and the EE/FSU region. The latter's stock markets often have a high level of foreign investor participation. This leads to contagion: an investor losing money in one area may need to liquidate his/her position in another to cover these losses. Bad economic news in the US/Europe also affects the EE/FSU region through at least two other channels. If economic growth is lower than expected in the former it will feed through to those countries with high trade shares with the West. Moreover, the flow of capital into the EE/FSU region may dry up if companies which would otherwise consider investing there have to delay expansion/investment because of an unfolding crisis at home.
The failure (once again) to pass changes to the Electoral Law crucial for gaining a date for Accession talks with the EU has led to varied reactions in Montenegro. More nationalist-minded members of the governing parties have accused the opposition of holding the country's EU Accession to ransom by failing to give the support necessary to secure the two-thirds majority required for the law to pass. The Serb opposition has demanded that the Serbian language be given equal status as Montenegrin in return for supporting the Law. More moderate members (including Prime Minister Luksic it would appear) appear to realise not only that compromise is necessary for the Law to pass but that the EU is looking for evidence more generally of a more consensual form of policy-making in Montenegro. This has, thus far, rarely been evident and is perhaps the consequence of long-term domination of the political scene by one party (the DPS). The German Foreign Minister underlined the point in Podgorica this week. The government still has time to pass the law before the European Commission makes its assessment on giving the date for talks.
The interim agreement reached between KFOR and both Belgrade and Pristina seems to be having the desired effect of reducing tensions on the ground in the north of Kosovo. The agreement stipulates that KFOR will man the control points on the border/administrative line between Serbia and the Serb-dominated north of Kosovo until September 15. In return, Pristina will not attempt to put its representatives on these points and the Serbs will remove their barricades blocking access from central Kosovo to the serb-dominated areas in the north. While the agreement has not yet been fully implemented at the time of writing, it would appear that both sides have agreed to restart negotiations (brokered by the EU) on resolving a range of "technical issues" on September 5. It was the break-down of these talks in July that raised tensions on the ground. Progress is important for Kosovo if it wishes to achieve progress towards visa liberalisation and for Serbia if it wishes to gain a date for the start of Accession negotiations.
The banking sector as a whole in Montenegro recorded a net loss of EUR9.4 bn in the first half of 2011. Five of the eleven banks were loss-makers in the first half of the year. This compares unfavourably with the performance of the banking sectors in most peer countries in the region which are recording aggregate profits. It is, however, some improvement on the recent past. The aggregate loss recorded in Q1 2010 was EUR25.8 bn and in 2010 as a whole EUR81.7 bn. Montenegro (having had artificially low interest rates due to having adopted the Mark - and then the Euro - as its currency) was subject to a particularly savage credit boom before the global financial crisis hit and it is still picking up the pieces. The largest profit in H1 2011 was recorded by Hypo Alpe-Adria (EUR 2.5 bn) and then Erste Banka Podgorica (EUR1.3 bn). The largest loss was recorded by CKB (EUR10.2 bn). The capital adequacy of the sector as a whole is a respectable if not high 9.4%.
Amongst general world financial market turmoil at least one country is improving its credit rating. S&P has upgraded Estonia's sovereign debt rating by two notches from A to AA-. The outlook on the rating is stable. Despite a savage economic downturn, Estonia managed to keep its budget deficit below 3% of GDP. This required a painful combination of tax rises and expenditure cuts. These steps ensured the sustainability of the peg to the Euro by effecting an "internal devaluation" - improving competitiveness via nominal wage cuts rather than a depreciation of the currency. The authorities have been rewarded for implementing these unpopular measures by gaining entry into the Euro area. The economy is also now recovering quickly. Fiscal and wage discipline must be maintained as growth recovers to stop a potential increase in external imbalances and an excessive build-up of external debt. However, if policy-makers continue on their current course further upgrades could be around the corner.
The National Bank of Romania (BNR) has reduced its inflation forecast in its August Inflation Report relative to the May version. CPI came in lower than expected in Q2 according to the Bank due to moderating food prices. Core inflation was relatively stable. The BNR now sees inflation at 4.6% at end-2011 (0.5 percentage points below its May forecast) and at 3.5% at end-2012 (0.1 percentage points below the level seen in the May Report). The central bank's inflation target for both this year and next is 3% with a fluctuation band of one percentage point. The fact that the NBR sees inflation within the band for end-2012 suggests that its sees its policy rate setting as being broadly correct. However, it does note that medium-term upside risks to the target are significant. Here it refers to possible increases in administered prices and a risk of deteriorating implementation of the economic program as elections approach in 2012 (leading to either a weaker leu and/or excessive wage growth relative to productivity). Hence the BNR does not have a hiking bias now but sees a situation in which it might need to move to one.
Those worried about the erosion of democracy since the Yanukovych administration came to office will point to the arrest of Yulia Timoshenko (a leading figure in the opposition) as proof of selective justice. Timshenko has been charged with exceeding her authority during her time as Prime Minister and signing a gas deal with Russia harmful to Ukraine's interests. Timoshenko is in fact a controversial figure whose considerable wealth accrued whilst head of Naftogaz has not been fully explored. She has seemingly done everything during her trial to date to try and impede it and get herself arrested. Now that she has been taken into custody she senses a major political victory claiming that the charges against her are politically motivated. She will now have a chance to mobilise her domestic political base and has gained words of support too from the international community. The EU has expressed "deep concern" over her arrest. The back-drop to all this is the approach of parliamentary elections next October. If Timoshenko is convicted (on this charge or others also pending) she will not be able to run.
The National Bank of Romania (BNR) left its key policy rate on hold at 6.25% as expected. Inflation fell from 8.3% in May to 7.9% in June. Moreover, the core rate remained constant at 4.7%. A sharp fall in the headline inflation rate is expected in the next few months as last year's VAT tax rise falls out of the basis for calculation. Also, there are signs that food prices are stabilising. However, inflation has come in above expectations so far this year. There is a significant risk that it will still overshoot its 3% target this year and next. The IMF has suggested that the BNR may need to consider hiking rates on this basis although it may be reluctant to do so given that this might strengthen the leu further and weaken the export-led recovery. The Inflation Report to be released on Monday will give more details of the BNR's latest inflation forecast. If its central projection for inflation in 2012 is notably above 3% this will suggest that the BNR has a tightening bias.
The aggregate pre-tax profit of the ten largest banks in Serbia (accounting for about 70% of banking sector assets) rose 22.3% y-o-y in H1 to RSD15.9 bn. The largest profits were recorded at Banca Intesa (RSD5.2 bn), Unicredit (RSD3.1 bn) and Raiffeisen (RSD2.6 bn). Two of the top ten banks recorded losses (Alpha Banka and Vovodjanka Banka). The other notable development in the first half was the relative under-performance of AIK Banka. One of the most profitable banks in Serbia in the last few years, AIK's profits were down 60% in H1 (to RSD1 bn) thanks largely due to problems at Nibens Grupa. AIK is the biggest creditor of Nibens which has been contracted by the government to build a significant part of Koridor 10. However, the head of this group has been arrested and charged with corruption. Hence, there has been a delay in completing these projects while the leading creditors come to an agreement on how to restructure the company and restart operations.
The Czech National Bank (CNB) left its key policy rate on hold at 0.75% as expected. Five members of the Board voted for no change while two voted for a 25bps increase. Monetary-policy relevant inflation is expected to be close to target across the entire forecast period. Headline inflation will rise slightly above 3% because of a rise in the VAT rate at the beginning of next year however a muted second-round effect is expected on wages and so the CNB will not tighten policy because of this. Economic growth is relatively slow and domestic price pressures muted. Much of the pick-up in inflation seen resulted from rising food and fuel prices. Having said that, the CNB recognises that interest rates are abnormally low and, like the ECB, will slowly start to raise them to more normal levels when conditions allow. The current inflation forecast is based on the assumption that rates start to rise in late 2011 or early 2012.
The Central Bank of Russia (CBR) left its financing rate unchanged at 8.25% as expected. It had previously hiked by 25bps steps in February and April. Inflation pressures are falling in the near-term as the price of food is stabilising. Inflation fell from 9.4% in June to 9.0% in July. The CBR has hinted that rates are likely to stay on hold for the next couple of months as it believes that the current setting is consistent both with disinflation and solid growth. However, this statement demonstrates perhaps why Russia has a poor track record with inflation. With inflation above target and real interest rates negative a central bank that was more independent of the government and was fully committed to an inflation target would probably hike rates further even if in small steps. Of course, this might strengthen the ruble (contingent on the prevailing appetite for emerging market risk). However, growth is better boosted in the long-run by the implementation of long-delayed structural reforms rather than via loose monetary (and fiscal) policy.
Zagrebacka Banka and Privredna Banka, between them accounting for some 42% of total banking sector assets in Croatia, have both reported strong results for the first half of the year. Zagrebacka saw its pre-tax profits increase from HRK512 mn in H1 2010 to HRK742 mn in H1 2011 while Privredna Banka registered an increase in profits from HRK342 mn to HRK591 mn. Profits for the banking sector as a whole rose somewhat more modestly but yet still pretty healthily: by 16.9% y-o-y to HRK2.1 bn. There is a big discrepancy between the top few banks in Croatia which are very profitable and a large number of smaller banks that barely break even or lose money. Hence, Zagrebacka and Privredna account for a huge proportion of the total profit in the sector (Raiffeisen and Erste are also highly profitable). While some rationalisation of the sector is probably inevitable in the long-run the fact that the banking system is generally healthy will at least offer some support to an economy which is struggling to recover from the effects of the global financial crisis.
The delay to the next round of negotiations between Pristina and Belgrade has led to a dramatic escalation of tensions on the ground in the Serb-dominated north of Kosovo. Belgrade's continued refusal to accept the Kosovo customs stamp (blocking Kosovan exports to Serbia) led to Pristina responding with counter measures to block Serbian exports to Kosovo. The placing of Albanian members of the KPS on border posts between Serbia and northern Kosovo predictably led to a violent response from the Serbs. The border post at Jarinje was burnt down and other check-points between central Kosovo and the northern part have been blocked. In response, NATO has blocked border posts between northern Kosovo and Serbia. There has been an improvement in the situation in the last 24 hours. However, it is clear that neither side can see beyond its zero-sum-gain approach and the intermediation of the EU is desperately needed. Both sides lose from the current situation.
Montenegro has received positive assessments from the European authorities about its efforts to do what is necessary to receive a date for the start of EU Accession negotiations. However, one area that still needs to be addressed is the passage of a new Election Law. Parliament has failed to pass this law with the required two-thirds majority on a number of occasions. In yesterday's failed attempt Serbian parties either voted against the Law or abstained. They continue to condition their support for the new Law on Serbian being recognised as an official language (the government has been actively promoting the use of Montenegrin in state institutions). There is little obvious difference between the two languages but this issue is highly politicised. Some Montenegrins appear to believe that asserting their own language is crucial to developing national identity while Serbs see it as a threat to theirs. Parliament will have a couple more chances to vote on this issue before the European Commisson finalises its report recommending whether Montenegro should get a date for talks in December.
As expected, the new Macedonian cabinet (little changed from the old one) comfortably won a vote of confidence in parliament at the end of last week to confirm itself in office. The VMRO-DPMNE/DUI coalition secured 70 votes in the 123-seat parliament following its victory in June parliamentary elections. Prime Minister Gruevski has made it clear that the government will focus on stimulating economic growth to try and reduce unemployment. Whether his targeted growth rate of 7% is achievable without triggering inflation or a deterioration in the current account position remains to be seen. As for the resolution of the "name" dispute with Greece (that is stopping Macedonian EU Accession talks) there seems little reason to expect any progress. Gruevski made clear that the strategy in this regard will remain the same. Various moves on the Macedonian side in the couple of years have almost seemed designed to worsen relations with Greece on this issue although in principle Gruevski is committed to negotiations.
The banking sector in Latvia has suffered a couple of traumatic years. The losses it accumulated in 2009 and 2010 together wiped out pretty much all the accumulated profits it has made since 2000. The sector's aggregate loss was reduced from LVL773 mn in 2009 to LVL360 mn in 2010 however. Furthermore, the sector recorded an aggregate profit of LVL33 mn in Q1 2011. Many problems remain. Only 9 of 31 banks in Latvia made a profit in 2010. Non-performing loans remain high at 19% of the total. The sector's capital adequacy ratio (CAR), though, is sound at 14.6% and the majority of banks have a CAR of over 12%. Moreover, the economy has now returned to growth suggesting that credit risk should ultimately decline. Foreign banks dominate the sector (Swedbank, SEB, Nordea are the three largest banks). This helps to explain the large bilateral component to Latvia's IMF/EU-led bail-out package.
Croatia will hold a referendum on EU entry within 30 days of the signature of its EU Accession Treaty. This is expected to be completed either at the end of November or the beginning of December putting the referendum sometime at the turn of the year. The latest opinion poll shows that the majority of citizens are in favour of EU entry. On an expected turnout of 80%, 52% would vote "yes" for entry and 38% would vote "no". Thus, even though 10% of voters are as yet undecided a vote in favour is expected although it will hardly be overwhelming. Opinion polling in June gave a less favorable pro-EU result but this survey was conducted just after the announcement of long sentences for two Croat generals at the ICTY and so is likely to have been somewhat skewed against EU entry. It is also possible, however, that the higher July pro-EU reading may have been boosted somewhat by the conclusion of EU negotiations. Assuming the referendum outcome is satisfactory Croatia is likely to join the EU in July 2013 as long as it continues to fulfill its Accession obligations with respect to improving the rule of law etc in the meantime.
Following a disappointing Purchasing Managers Index (PMI) reading for the euro area (the Markit Composite PMI fell from 53.3 in June to 50.8 in July), the European Commission's Economic Sentiment Index (ESI) also gave a weak reading for July. The index fell from 105.4 in June to 103.2 in July. This marks the fifth month in a row that the ESI has weakened. A deterioration in sentiment is visible both in the manufacturing and services sectors. New orders in manufacturing are down as is consumer confidence. It was expected that euro area GDP growth would slow from the higher than forecast 0.8% q-o-q recorded in Q1. However, not only is a softer Q2 number expected to be released by Eurostat on August 16 but the momentum going into Q3 appears to be even weaker. Financial market turbulence, rising oil and food prices, high unemployment and a strong Euro are all combining to take the edge off growth.
The Monetary Policy Council (MPC) of the National Bank of Hungary left its key interest rate on hold as expected at 6%. Inflation has fallen in the last couple of months in line with expectations. The MPC sees inflation meeting its 3% target at the end of 2012 without further policy adjustments. The underlying picture remains the same. Inflation has risen above target because of high food and fuel prices but domestic demand remains subdued meaning medium-term inflationary pressures are weak. Growth is predominantly driven by net exports at the moment with household consumption constrained as a large stock of CHF-denominated mortgages is paid down. Unemployment also remains high. Risk aversion due to problems in the Euro area may also raise yields on Hungarian government securities and weaken the forint.
The EBRD has published an update to its May forecast for the Transition Economies. This sees the forecast for growth in 2011 increased from 4.6% to 4.8% and the forecast for 2012 kept unchanged at 4.4%. At the same time, the EBRD judges that the risk of cantagion from the euro area crisis has risen. Most exposed here is South Eastern Europe given the large presence of Greek banks in some of these countries. Even if local branches of Greek banks do not need financial assistance they may be less willing/able to lend to entities in the host economy at the margin. Central and Eastern Europe plus the Baltic States could be affected more via financial market turbulence and the possibility of weaker euro area growth (given their greater integration with the euro area both in terms of trade and financial markets). The CIS would be the area least affected. However, there may be some indirect impact here too if slower Euro area growth reduced the demand for its oil and gas exports.
Latvians voted decisively over the week-end to dissolve parliament in a referendum called by outgoing President Valdis Zatlers. Zatlers, who failed to win re-election as President in a parliamentary vote in May, had previously called the referendum alleging that parliament was blocking the investigation of corruption allegations. Over 90% voted in favour of dismissing parliament in the referendum with turnout at about 45%. New parliamentary elections will be held in September less than a year after the previous round. Zatlers has also formed a new political grouping - the Reform Party - which is currently leading in the opinion polls along with the opposition Harmony Centre. Efforts to reduce corruption are to be welcomed but at the same time the calling of early elections raises the level of political noise. Latvia is just returning to growth having managed to defend the Lat's peg to the Euro via a harsh "internal devaluation". However, the incoming government will have to stick with the IMF/EU program if investors are to remain convinced that this peg is sustainable in the medium-term.
The Romanian government has delayed the sale of a 9.8% stake in oil and gas company Petrom after bids it received fell well below the US$700 mn it had been hoping for. The planned Petrom sale is one of a number of proposed sell-offs which form part of an economic program supported by the IMF Stand-By Arrangement. The government will most likely try to sell the stake in early 2012 if financial market conditions have improved by then. It also seeks to sell 15% stakes in two energy distribution companies this year and a stake in gas producer Romgaz next year. The postponement of the sale is unlikely to derail the IMF program. The implementation of structural reforms such as privatization is an important part of the program however fiscal consolidation appears to be on track. Moreover, there are other reform steps (such as restructuring of SOEs) that the government can take to show the Fund/investors that it is implementing its program without selling assets at unfavourable prices.
The sixth round of negotiations between Belgrade and Pristina (with the EU serving as intermediary) which started in March were due to be held this month but have now been postponed until September. The last round of talks did finally produce something concrete - agreements on free movement and civil registries - which were then roundly condemned by nationalists in parliament on both sides. Many more "technical" issues such as telecoms signals and energy supply have yet to be resolved. The most immediate sticking point, though, appears to be Belgrade's continued non-acceptance of the Kosovo customs stamp. In response, Pristina has temporarily blocked Serbian exports to Kosovo causing a furious reaction from the Serbian side. It is pretty clear that without support/pressure from the EU the talks would not get very far given diametrically opposed views about "status". However, both sides need to show that they are seeking to improve relations in the region for the purposes of EU integration. Agreements reached should also improve conditions on the ground for the citizens of Kosovo of all ethnic backgrounds.
The government, as promised, has set the date for parliamentary elections now that EU Accession negotiations have been concluded. Elections will be held on December 4th. The HDZ is faring badly in the polls and the opposition SDP is expected to win. The HDZ is unpopular both because the economic recovery in Croatia is lagging behind that of its peers in the region and because of a number of high-level corruption scandals. The party appears to have got a modest boost in the polls from the conclusion of Accession negotiations and Croatia receiving a target date for EU entry (proposed by the Commission but noy yet endorsed by the Council of Ministers). However, Ivo Sanader's recent extradition from Austria on corruption charges could possibly lead to more unsavoury revelations about the HDZ. As ever, the new government in Croatia will be formed with the inclusion of a number of smaller parties some of whom may well benefit from a degree of disilusionment with the big two (HDZ and SDP).
The effective parliamentary position of the ruling GERB party is still strong even if it remains formally in a minority. After June 2009 elections, GERB won the most seats (117) but fell just short of a majority in the 240-seat parliament. It was initially supported by the Blue Coalition and Ataka in parliament. The loyality of these two parties to GERB has weakened over time with first the Blue Coalition and now Ataka withdrawing their support. However, GERB easily defeated two no confidence motions tables by the opposition this summer given that it is supported by a growing number of independent MPs disilusioned with the other parties. Hence, there seems little chance that yet another no confidence vote tabled by the opposition this week stands any chance of success. The BSP, DZS and RZS hold less than 100 seats between them, well short of the number required. Some of the independent deputies in parliament have even formed a grouping pledging their support to Borisov.
The European Commission (EC) has released its latest report under the Control and Verification Mechanism (CVM) for Bulgaria and Romania. The CVR was created to monitor the fight against corruption and efforts to improve the rule of law in these two countries after their entry to the EU in 2007. In both cases some improvements are noted but the general tone suggests that there is much more to do with regards to implementation even if the general legal framework has been improved. The report is less positive about Bulgaria than the previous ones that had been issued since the arrival of the GERB administration whose central electoral theme had been clamping down on corruption. Fairly negative CVM reports may have at least two consequences. First the chances of Bulgaria and Romania joining the Schengen zone any time soon (even though they now meet the technical conditions) look more distant. Second, pre-entry monitoring for prospective entrants (e.g. Croatia) will be stepped up as post-entry conditionality has shown to be so ineffective.
The arrest of the last ICTY fugitive means that Serbia has finally achieved "full co-operation" with The Hague. This is a powerful boost to its EU Accession credentials and should ensure that it obtains the status of candidate by the end of the year. However, there is still work to do in order to secure a date for the start of Accession talks. The key obstacle here is the long-standing issue of restitution of property seized by the Communist regime. Successive governments have promised to adopt legislation on this issue but failed to do so. The public, then, with some justification is sceptical whether this issue will be tackled this time around. However, the EU is adamant integration requires respect for property rights. The government has committed itself to winning a date for the start of talks before elections next spring and so there would appear to be a decent chance that legislation may be approved in September even if the actual return of property starts sometime later.
The defeat of prime minister-designate Slavo Kukic for the second time in a parliamentary vote at the State-level means that Bosnia continues to be without a national government following elections last October (governments exist at the Entity level). While Kukic won a majority of deputies he did not gain the necessary support from all ethnic groups as required by the Constitution. Kukic was proposed as an independent candidate by the three-member presidency of Bosnia but it was always unlikely that he would be elected because the Serb deputies from the SNSD and SDS were determined to vote against him. Parliament is split fairly evenly between the SDA-SDP grouping and the SNSD-HDZ one. Until these two sides come to some sort of political agreement the impasse is likely to continue with further detrimental effects for Bosnia's EU integration hopes. The presidency now has a matter of days to propose a new candidate whose chances of being elected would also appear to be slim right now.
The IMF's Executive Board has approved the completion of the third review of the ECF/EFF program. This makes a disbursement of US$79 available. The economy is growing robustly with both domestic demand and net exports strong. The AEI government is delivering on its promised fiscal consolidation despite the on-going political stand-off about the election of a new President of Moldova. The central bank has started to tighten monetary policy to combat rising inflation. A generally positive cyclical story must be complemented by improvements to the business climate if Moldova is to improve its export base and medium-term growth potential. The government is seeking to reduce trade barriers and sell-off state-owned companies to improve economic competitiveness and limit the size of the current account deficit (a key economic vulnerability) in the long-term.
The National Bank of Serbia (NBS) has followed its 50bps rate cut in June with a smaller 25bps move in July. The repo rate is now 11.75%. Rate cuts are the result of falling inflation - it has fallen from 14.7% in April to 12.7% as of June - and a relatively stable dinar. The currency had strengthened below 100 to the Euro earlier this year on the back of short-term capital inflows but is now in a 100-105 range which is probably more consistent with a rising current account deficit and weak FDI inflows. Inflation is expected to fall below 10% by the end of the year but remains well above target. Furthermore, if the NBS cuts rates too quickly it may undermine the stability of the dinar. Hence, a couple more small rate cuts may be possible contingent on inflation data. However, a challenging inflation target in 2012 and the risk of fiscal slippage as elections approach next spring reduce the NBS's room for maneuver.
Industrial production (IP) expanded at a modest 4.0% y-o-y pace in both the Euro area and EU-27 in May. This was less than the 5.3% and 4.9% readings respectively seen in April and considerably down on the 6% plus pace recorded in the first quarter. This is another indication that Q2 GDP data will be considerably weaker than that seen in Q1. Within Eastern Europe, Estonia continues to post the strongest IP growth (26.1%) while most other countries are seeing very solid growth of around 10% y-o-y. The weakest performers in May in this region were Slovenia (6.2%), Bulgaria (7.8%) and Romania (7.9%). Solid IP (and export) numbers are being offset by weak domestic demand in many cases. Private consumption and fixed investment are starting to recover but only slowly given weak household balance sheets, cautious banks and high unemployment.
The central bank has released figures that show that the aggregate pre-tax profit of the banking sector in 2010 was HRK4.355 bn, up 3.1% y-o-y from 2009. Moreover, preliminary figures for the first quarter of 2011 show a profit of HRK1.26 bn (up 3.4% on the corresponding period of 2010). The banking sector consists of 33 banks of very different sizes. The largest four banks account for 65% of total assets with Zagrebacka Banka alone accounting for fully 24.6%. By contrast, 24 banks each have less than 1% of total assets. Performance varies significantly. The largest four banks have a much better return on equity and assets than their smaller competitors. Of these four, Zagrebacka, Privredna and Erste all recorded sizeable increases in pre-tax profits in Q1 2011 on a y-o-y basis while Raiffeisen's profits rose only slightly.
The government has approved the creation of private pension funds. The proposal is expected to be voted on by parliament (in which the government has a solid majority) by mid-July. Under the new system every citizen above the age of 18 will have the right to transfer three percent of his/her social insurance contribution to a private pension fund as long as this is matched by a transfer of two per cent of his/her gross income. This step is part of a wider pension reform which seeks to make the system more sustainable given the Czech Republic's rapidly ageing population. The creation of private pension funds should also deepen Czech financial markets and increase demand for long-term government and municipal bonds. Political difficulties within the three-party governing coalition have not dimmed its appetite for implementing economic reforms it appears.
Following President Medvedev's commitment to expanding the current privatization program, Finance Minister Kudrin has laid out some details of a second stage to potential state asset sales. The privatization program already underway seeks to raise US$30 bn over a three year period and started with the sale of a 10% stake in bank VTB. Kudrin suggested that over a three to five year period another round of sales could yield up to another US$45 bn. The list of companies under consideration appears to include Aeroflot. Additional stakes of companies already included in the first round of privatizations would also be included. It remains uncertain whether these plans will be implemented. There will be less impetus behind them perhaps if Putin returns as President in 2012. However, these comments suggest that parts of the government at least realize that privatization is needed to improve corporate governance and economic efficiency even if high oil prices mean that the revenue-raising side of it is, for now, less critical.
The European Commission may have endorsed the closing of the last four chapters of Croatia's Accession negotiations and given a target date for entry of July 2013 but more needs to be done before the actual entry date is set in stone. This was highlighted by the European Council's failure to endorse the 2013 date last Friday. While the Council confirmed that Croatia's Accession negotiations will be finished shortly it also noted that it expects Croatia to "to continue reforming its judicial system and improve the situation concerning fundamental rights". The EU will monitor these efforts up to Accession. Croatia is expected to sign the Accession Treaty in the autumn and will hold a referendum on EU entry shortly after this. All 27-member states must ratify the Treaty before Croatia can join the EU and this will be conditional on progress in implementing its outstanding obligations. It remains unclear whether parliamentary elections will be held before or after the referendum.
Hopes had been raised in the last few months that Armenia and Azerbaijan are making progress to resolving the long-standing Nagorno-Karabakh issue. Russian President Medvedev has been encouraging the two sides to settle some of their differences in this regard. Progress towards accepting the Basic Principles to the resolution of the conflict drawn up by the OSCE's Minsk Group had apparently been made in a meeting of respective Foreign Ministers in Moscow earlier this month. However, any hopes that the two Presidents would sign up to the Principles at a Summit in Kazan hosted by Medvedev on Friday proved to be over-optimistic. It is unclear exactly what the problem proved to be. However, it is likely that disagreement remains over the timing of an eventual referendum to determine the status of the disputed region. Armenia appears to wish a concrete date for the referendum while Azerbaijan does not.
The IMF's Executive Board has approved the completion of the first review of the new, EUR3.5bn Stand-By Arrangement (SBA). Although this step enables the disbursement of a tranche of EUR480 mn the Romanian government has decided to treat the new program as precautionary and therefore will not draw down this money. The fiscal deficit target for 2011 appears to be on track although additional measures will be necessary to bring the deficit down further to 3% of GDP in 2012. Inflation has proved higher than expected and, therefore, the central bank has moved to a tightening bias and may well need to hike rates. Long-delayed reforms of the state-owned enterprises are needed to improve economic efficiency and close the quasi-fiscal deficit. This will involve private sector participation, enhanced regulation and a move to market-oriented pricing. An IMF Mission is expected in Bucharest in H2 July to consider the second review under the SBA.
An IMF Mission to Skopje has assessed progress under the Precautionary Credit Line (PCL) and will recommend completion of the first review. The economy is growing and policies appear to be consistent with the program. The authorities have reaffirmed their commitment to a fiscal deficit of 2.5% of GDP this year and 2% of GDP next year. Inflation and the current account deficit are relatively contained. The Macedonian authorities had announced that they were treating the PCL as precautionary and did not intend to draw down the funds available. However, within a few months of the arrangement being put in place they did so. The Fund accepts the government's argument that the calling of early elections and unfavorable global market conditions were sufficient reason to postpone a planned Eurobond and draw down on the IMF funds instead. Now that the elections are completed both external and domestic debt issuance will remain a key part of the government's financing strategy.
The government of Borut Pahor lost another coalition partner this week but may remain in office for some time yet. DeSus left his government with a minority when it left in May. Zares also departed this week after the convincing defeat for the government in a recent referendum on pension reform. However, Pahor has reached agreement that his SDS and the LDS of Katerina Kresal will continue in a minority with the aim of holding parliamentary elections next spring (they were due anyway next autumn). Whether the government can continue in its much weakened form (it holds just 34 seats of 90 in parliament) may well depend on its winning approval for a budget re-balance and the passage of the 2012 budget in the autumn. The failure of the pension reform means more fiscal adjustments are needed elsewhere to cope with the effects of Slovenia's rapidly aging population. It remains to be seen whether Pahor can drum up enough support in parliament for his minority government to make it through the end of the year.
The European Commission (EC) has commended the efforts of the new Igor Luksic-led government in Podgorica in implementing reforms critical for EU Accession. Montenegro was awarded candidate status last December but was not given a start date for the beginning of Accession talks. In order to obtain a date it has to show progress in seven key reform areas including improving the rule of law and combating corruption. The European Commission will make a formal recommendation in October to the Council of Ministers with regards to whether the negotiations should start. However, Enlargement Commissioner Fuele has commended the government for more openness in its dealings with the media and civil society and pointed to a number of important reforms and legislative changes that are in preparation. If these are completed and implemented properly it seems likely that Montenegro will gain a start date for talks by the end of the year.
Parliament has approved amendments to the Law on the Financing of Local Authorities which allows them to retain a much higher proportion of the money they raise at the local level. The changes were proposed by the URS and have been criticized by both the IMF and Fiscal Council because, as they stand, they are not fiscally neutral. In other words, it is not clear how the reduced inflow of funds into the state budget will be offset. If it is not this would raise the budget deficit and threaten the public debt to GDP limit outlined in the new fiscal rules. URS leader Dinkic has asserted that the lower revenues for the central government can be offset by lower transfers to local authorities and the latter taking fiscal responsibility for infrastructure projects in their respective areas. Even if this is partially true the IMF/Fiscal Council argue that these steps should have been assessed and implemented at the same time. Decentralization is a legitimate aim in itself. However, the risk is that the URS is using such projects to buy votes ahead of the elections and posing a risk to the fiscal framework.
Belarus may have some way to go before it convinces the IMF to approve a new funding program but its international liquidity position has been improved by the receipt of US$800 mn as the first tranche of a 3-year, US$3 bn loan from the Eurasian Economic Community (EurAsEc). This relatively new organization, financed mainly by Russia and Kazakhstan, may help the authorities in Minsk to deal with their immediate payment problems. However, it remains to be seen what conditions will be attached to further disbursements. The IMF will require tighter fiscal, monetary and incomes policies as preconditions for its support as well as an acceleration of privatization and other structural reforms. Russia, however, is particularly interested in gaining access to Belarusian state assets. Belarus has a number of state companies that could raise considerable sums if privatized. The question is whether the government would see the sale of these as undermining its nationalist credentials.
An IMF Mission to Tirana as part of the annual Article IV report has released its Conclusions. These highlight that growth in Albania remains relatively robust (3.5% in 2010 and 2.7% forecast in 2011) given the effects of the global economic crisis. However, the Mission believes that Albania's sustainable rate of growth in the medium-term will be around 4% which is substantially below the 6% seen before the crisis hit. A major problem continues to be the fiscal position and budget planning. The budget deficit remains high, pushing the public debt to GDP ratio up towards the legal limit. Moreover, the budget for this year is off track and will require fiscal adjustment of up to 1.5% of GDP. This is a regular occurrence. Over and above, then, identifying the expenditure cuts and tax increases required to normalise the immediate situation the authorities should establish a system for drafting more realistic budgets in the future.
The IMF has released a brief update to its April World Economic Outlook (WEO). It states that global growth in the first quarter was 4.3% at an annualized rate roughly in line with expectations. Growth was weaker than expected in Japan and the US but stronger than anticipated in Germany and France. Leading indicators point to a slowdown in Q2. This is partly due to supply disruptions following the earthquake and tsunami in Japan and partly the result of higher than expected oil prices. Nevertheless, the Fund has not changed its growth projections markedly as it expects a re-acceleration of growth in H2. It sees global growth at 4.3% this year (down by 0.1 of a percentage point from its April forecast) and at 4.5% in 2012 (unchanged). It does, though, note that downside risks to the forecast have increased due to the possibility that the US recovery will disappoint and the onset of renewed financial market contagion in the Euro area.
President Medvedev further outlined his reformist vision for Russia at the St. Petersburg annual economic forum. In his view, Russia must seek to modernise its economy rather than rely on "stability". Further, it should allow some (limited) political competition. His views clash with those of Prime Minister Putin and find some support in the Russian business community. However, the question is whether they will ever be implemented? Medvedev has made such views known before but has only been able to make a difference at the margin. It is expected that Putin will decide to stand in the presidential elections in March 2012. Even if he doesn't and Medvedev secures a second term few people believe he has the power to change the system. This is particularly true when high oil and gas prices are rebuilding FX reserves and pushing the budget back towards surplus. Any impetus for reform in these circumstances is likely to be dulled.
The GERB government comfortably defeated a no confidence motion in parliament tabled by the opposition BSP on Friday. Only 70 deputies in the 240-seat chamber voted in favour of the motion while 124 voted against (117 GER members and 7 independents). The Blue Coalition and Ataka abstained. Despite the ease with which the government defeated the motion the BSP has announced that it will call another no confidence vote in July. Given that it is highly unlikely to be successful in achieving its aim of forcing early elections on this occasion either it can be assumed that these confidence votes are in fact aimed at uniting and/or motivating the Socialist Party base ahead of presidential and local elections scheduled for October 23.
The IMF's Executive Board has approved a US$106 mn, 3-year Extended Credit Facility (ECF). This enables an initial disbursement of US$15 mn. The deep political crisis last year pushed the existing IMF program off track as economic growth collapsed and the budget deficit swelled. Inflation also rose due to high global food and fuel prices. This new program is aimed at restoring macroeconomic stability. There will be a modest fiscal expansion this year to aid economic recovery and then from 2012 the government will set out on a path of fiscal consolidation to stabilize the public debt to GDP ratio. Monetary policy has already been tightened to deal with inflation. The crisis also exposed some weaknesses in the banking sector which need to be resolved and supervision will also have to be strengthened going forward.
Inflation in the Euro area ticked down from 2.8% y-o-y in April to 2.7% in May. Within the EU-27 inflation fell from 3.3% y-o-y to 3.2% over the same period. This small reversal of the upward trend in inflation is unlikely to stop the ECB hiking its policy rate by another 25bps in July following a similar move in April. Risks to the inflation outlook from rising food and fuel prices remain significant and it remains above target. Within Eastern Europe, the majority of countries saw a further rise in inflation in May. Only Hungary saw a fall (from 4.4% to 3.9%). Inflation remains highest in Romania (8.5%). However, it is also high in Estonia (5.5%), Lithuania (5.0%) and Latvia (4.8%). The Czech Republic (2.0%) and Slovenia (2.4%) have the lowest rates of inflation in the region.
Bosnia still has no government at the state level following elections held last October. Moreover, it may yet be some time before a government is formed. The Presidency of Bosnia this week elected Slavo Kukic as nominee for the position of Prime Minister. However, given the opposition of the Serb representatives in the House of Representatives it seems unlikely that he will be approved as Prime Minister in a vote expected tomorrow. The fundamental differences between the SDP/SDA-led grouping in parliament and the SNSD/HDZ-led bloc remain. The former was in a position to have Kukic nominated at the Presidency level. The latter (given ethnic voting rules) seems to be a position to block his approval. In this case, the Presidency would have to nominate a new candidate within eight days. However, without an underlying agreement between the two sides this process could continue for some time.
Industrial production (IP) rose by 5.2% y-o-y in April in the Euro area compared to 5.8% y-o-y in March. For the EU-27, IP rose 5.1% y-o-y in April compared to 5.8% in March. The March numbers were revised upwards by 0.5 percentage points. After a much stronger than expected Q1, growth in the European economy is expected to moderate in Q2 as these figures seem to confirm (IP rose by 6.6% y-o-y on average in Q1). Within Eastern Europe, Estonia (31.8%) and Latvia (13.7%) recorded the fastest IP growth in April. Most of the other economies in the region posted IP growth between 7% and 9%. The weakest outcomes were seen in Romania (5.3%) and Slovenia (6.8%).
The IMF has released a statement at the end of its Article IV Mission. The discussions with the authorities focused on ways to raise Russia's medium-term growth rate and make growth less prone to external shocks. The Mission sees medium-term growth at Russia at 4% but believes the implementation of certain reforms/policy steps could raise this by up to two percentage points. First, fiscal policy should be tightened and put into a more sustainable medium-term framework. The non-oil fiscal deficit at the end of the 2011-13 budget period will be about 10% of GDP whereas something closer to 5% is more sustainable. Second, monetary policy should be tighter to bring down inflation and put in a more comprehensive framework. Third, the financial sector could be regulated more effectively. Fourth, the business climate and corporate governance must be improved to raise productivity growth.
The IMF's Executive Board has issued an assessment of Hungary's Stand-By Arrangement with the Fund and developments since its conclusion. The program proved successful in stabilizing the economy during the worst of the global financial crisis but the recovery is weak and significant vulnerabilities remain (in the financial sector in particular). Unfortunately, much of the fiscal tightening achieved under the IMF program has been unwound by the new administration. The budget deficit overshot its target in 2010 and the underlying fiscal position is expected to weaken further this year. Having said that, the Fund broadly commends the Szell Kalman structural reform plan and the new constitutional debt limit. While the lack of details on both counts raises implementation risk, the government has committed to 3 percentage points of GDP in fiscal tightening over the 2012-13 period which would put the public debt to GDP ratio on a declining path.
An IMF Mission to Minsk has begun negotiations with the government on drawing up an economic program that could be supported by the Fund. It comes as little surprise that the Fund advises the government to address some of the policy errors (increased directed lending and outsized public sector wage increases) that led to the balance of payments crisis in the first place. The IMF recognizes that the authorities are taking some measures to stabilize the situation. The central bank has hiked rates, there has been a devaluation of the currency and the government is reducing the budget deficit. However, the Fund is calling for a move to a free floating currency, further rate hikes and the implementation of structural reforms as well tighter fiscal and incomes policies in order to sign off on a new program. These measures are necessary to bring down rising inflation and bring the current account deficit down to financeable levels in the medium-term.
Inflation fell from 14.7% y-o-y in April to 13.4% y-o-y in May. While this is little reason for celebration given that the upper-point of the end-year inflation target is 6% it does confirm the National Bank's view that inflation has peaked. Indeed, the May reading is somewhat lower than expected. A huge amount of the pick-up in inflation over the last twelve months has been due to sharp increases in food prices. If this year's agricultural prices move in line with seasonal norms a positive base effect will see inflation fall sharply in the second half of the year. It will likely drop below 10% but remain above the target. Any further increase in regulated prices this year would be an upside risk to this projection. Next year's inflation target is even more challenging (an upper-point of 5.5%). Hence the Bank should cut rates cautiously. Not least because lower interest rates will reduce demand for the dinar and could lead to a reversal of its recent strength.
Following his victory in presidential elections in early 2010, President Yanukovych formed an administration which secured a new US$15.1 bn IMF agreement last August. Some key reforms (such as a large increase in domestic gas prices) were implemented and helped to secure the completion of the first review of that program in December. However, the government's popularity has since fallen significantly mainly as a result of these policy changes. It appears that the appetite for reforms is weakening even though parliamentary elections are not due until October 2012. Further domestic gas prices increases (needed to improve the finances of Naftogaz) and a pension reform have been stalled. The IMF program has thus gone "off track". While Ukraine has ample FX reserves the price of gas it pays Russia is increasing sharply. Russia has, so far, failed to agree to another price discount. Hence, FX reserves could fall (and investor sentiment deteriorate) if the IMF program is not put back "on track" fairly quickly.
The deal reached in late April between coalition partners to defeat a vote of confidence in parliament tabled by the opposition has not put an end to instability within the government. Two Public Affairs (VV) ministers were removed from the cabinet at that stage during a cabinet reshuffle sparked by a corruption scandal. However, VV is now insisting that its regains two ministerial posts by the end of June or it will withdraw from the coalition. The other two parties (ODS and TOP 09) in the government have so far ignored this request. In theory, the potential withdrawal of VV from the coalition could be problematic. The government would no longer have a majority as it seeks to win the passage of key reform bills through parliament. However, the rating of VV has dropped sharply in the polls and it is unlikely to want to force early elections. Moreover, it has indicated that it will support key reform measures even if it is not in the government.
The National Bank of Serbia (NBS) has cut its key policy rate by 50 bps to 12.0%. The NBS had signaled in its May Inflation Report that further rate hikes were unlikely. Moreover, Governor Soskic had commented that rate cuts were likely as inflation started to fall. However, this move comes earlier than expected given that the last inflation reading was 14.7% y-o-y in April, way above the 6% upper-range of this year's target. The NBS is convinced that inflation will fall sharply in H2 2011 as positive base effects from last year's sharp rise in food prices take effect. Moreover, the dinar has been much stronger than expected this year on the back of previous rate hikes. This both helps the disinflation effort but undercuts the economic recovery. The NBS has started buying FX to stop the currency strengthening further. It may also have decided to unwind its latest rate hike for the same reason.
The European Parliament (EP) has decided that Bulgaria and Romania have met the technical conditions for joining the Shcengen zone. Both countries had hoped to join the zone in March but were not allowed to do so when it was judged that Bulgaria had not met the technical conditions due to issues relating to its border with Turkey. Now that these problems have seemingly been addressed both countries hope to enter the zone in the autumn. However, this remains far from certain. Some members of the zone believe that neither should be allowed entry until they have improved their performance under the EU's Co-operation and Verification Mechanism (CVM). This was set up to monitor the fight against corruption and organised crime but progress is considered to have been patchy at best. A regular CVM is due in July at which point it will be clearer how both countries are faring in this regard.
An inter-governmental conference on Monday saw the closure of the Fisheries chapter in Croatian EU Accession negotiations. What's more, the European Commission is expected to adopt its position on the outstanding four chapters later this week. If, as expected, the position is positive then Croatia will be very close to obtaining a potential date for EU entry. This date will most likely by July 2013. A positive Commission recommendation to the Council of Ministers could be accepted either at the end of this month (if the Hungarian presidency gets its way) or shortly afterwards. Either way, it appears that the Accession negotiations which started in 2005 are close to completion. This would be quite a success for the HDZ-led government which has had to make considerable efforts to convince the EU that the Competition and Justice/Fundamental Rights chapters in particular can be closed. However, the government's low popularity is unlikely to improve as a result of this and it appears destined to lose parliamentary elections this winter.
Results from Sunday's local elections show that the Communist Party remains the largest single political party in Moldova but that the Alliance for European Integration (AEI) - a coalition of three parties - can count on over 50% of the vote. The race for mayor of Chisinau will go to a second round with the Communist candidate getting 48% of the vote compared to 46.5% for the Liberal Party candidate. In the overall share of the vote in local council elections the Communists took 30% compared to 56% for the AEI. The AEI continues to be undermined by infighting between its respective parties as elections approach. There is little to suggest here that the constitutional impasse in Moldova can be resolved. The AEI has a majority in parliament but insufficient seats to elect a President of Moldova. Failing this, the risk of yet more early parliamentary elections remains high.
The Monetary Policy Committee (MPC) of the National Bank of Poland has hiked its key policy rate by 25bps for the third time this year taking it to 4.5%. The MPC noted that economic growth in Poland remains robust and led chiefly by domestic demand. Unemployment has started to fall although there is, as yet, no sign of a sustained pick-up in wage growth. Credit growth is also recovering. Headline inflation (at 4.5% in April) is well above target. Core inflation and inflation expectations are also relatively high. Rising global food and fuel prices have also had an adverse impact on inflation. With inflation likely to stay high in the next few months the MPC has decided to raise rates again to help bring inflation back down to target in the medium-term. Having moved aggressively to hike rates in the last three months a pause is now likely unless upside risks to inflation rise once more.
The Pahor-led government continues to battle for its survival. Having being reduced to a minority in parliament last month by the departure of DeSus and currently gaining only 14% in the opinion polls the government decisively lost a referendum on pension reform on Sunday. The reform, supported by the IMF as being the key to medium-term fiscal sustainability, envisaged a modest increase in the retirement age from 63 to 65. Voter turnout was low (40%) and 72% voted against the proposed reform. The opposition SDS is calling for early elections on the back of this significant defeat for the government. Prime Minister Pahor has pledged to continue in office and look for alternative measures to offset the impact of the blocked reform. He will have to secure a majority in parliament for passage of the 2012 budget if he is to do so. Elections are scheduled for autumn 2012.
Preliminary results show that the ruling VMRO-DPMNE won the most seats in parliamentary elections held on Sunday. It should, with its anticipated 53 seats, be able to reform a coalition with the ethnic Albanian (DUI) which is expected to get 14 seats. These two parties would then command a majority in the 123-seat parliament. At the same time, the opposition Social Democrats appear to have made some progress in this election. They seem to be on course to gain 43 seats compared to the 18 they held in the outgoing parliament. Elections were held early after an extended opposition boycott of parliament. International observers have generally issued a positive assessment of the conduct of the election. The OSCE described the elections as "competitive, transparent and well administered".
In its regular Article IV report, the IMF notes that the Slovenian economy is undergoing a gradual recovery after a deep recession. GDP grew by 1.2% in 2010 and is expected to expand at a modest 2% pace this year. Fiscal retrenchment, higher unemployment and a highly indebted corporate sector will limit the pace of domestic demand. Inflation is low and the current account deficit has fallen. The government hopes to bring the fiscal deficit down from 5.2% of GDP in 2010 to below 3% by 2013. However, delays to further pension and labour market reform could hamper competitiveness. Moreover, the crisis exposed the weaknesses in the Slovenian banking sector. Both profitability and loan quality deteriorated significantly. The sector will remain under-capitalized despite recently announced recapitalization efforts according to the Fund.
The IMF observes in its annual Article IV report that the Slovak economy continues to grow strongly if slightly slower than it did before the global economic crisis hit. Growth will be just under 4% this year and just above in the years to come. While headline inflation has accelerated core inflation remains low. The government is implementing a sizable fiscal adjustment this year (about 2.5 percentage points of GDP). This will stabilize the public debt to GDP ratio at a reasonable level (just over 40%). Credit growth is starting to restart. The key remaining challenge is to bring down the rate of unemployment. This has risen to 14%. It is substantially higher amongst lower-skilled workers and in the poorer regions of Slovakia. An increase in long-term unemployment is of particular concern. The authorities are trying to address this problem via lower social security contributions and higher in-job benefits.
Economic policies in Belarus have deteriorated significantly since its last program with the IMF expired last March. In the run-up to December presidential elections public expenditure and directed state lending were increased. This may have boosted growth in the short-term but sucked in more imports and therefore led to a balance of payments crisis. The central bank had to let the ruble depreciate significantly in response as it started to run out of FX reserves. The authorities requested a large loan from Russia to fill the financing gap. However, Russia is prepared to offer money less quickly than had been hoped. It has also attached conditions on the sale of Belarusian state assets to Russian firms which the authorities in Minsk find unacceptable. Hence, the government has now turned to the IMF for help, requesting a US$8 bn program. As a first step in securing this the central bank has hiked the refinancing rate by 200 bps to 16% to offset the impact of the devaluation on inflation.
The death of Sergei Bagapsh, President of the Republic of Abkhazia, necessitates the holding of a presidential election within the next three months. Until then, Vice President Aleksandr Ankvab holds the position on an interim basis. Abkhazia effectively broke away from Georgia following a war in 1992-93. Georgia still considers it part of its territory. The war between Russia and Georgia in August 2008 ended with Russia formally recognizing the independence of both Abkhazia and South Ossetia. However, few other countries have followed suit despite intense Russian pressure to do so. Bagapsh had previously been Prime Minister of Abkhazia and won his second term as President in an election held in December 2009.
The benchmark index of leading shares in Slovenia (SBI TOP) continued its poor performance in May. It fell by 2% relative to April and is now down 8.6% for the year as a whole. While Krka and Telekom Slovenija posted modest gains in May (up 1.3% and 1.2% respectively) bank NKBM fell by 11.4%. Of the six shares in this index only Mercator has recorded a gain in its share price so far this year (up 5.6%) while NKBM and Gorenje are both down over 20%. The economic recovery in Slovenia is slow and follows a severe recession. As a result of this, not only is demand for products relatively weak but corporate indebtedness is high. Major liquidity problems further worsen the operating environment.
The Serbian equity market continues to perform strongly this year. The benchmark index (BELEX-15) was up 10.5% in May and up 26.4% for the year as a whole. The strongest performers in May were oil company NIS (which jumped fully 55% after the publication of better than expected Q1 results), Aerodrom Nikola Tesla and Sojaprotein (both up 23.7%). A notable under-performer has been AIK Banka (down 3.6% in May after a weak April). Its strong momentum over the last year or so has been checked by a poor first quarter. However, the headline figure was worsened by one-off adjustments rather than a deterioration in underlying revenue performance. The Serbian market has underperformed many of its peers and so is due for some upward correction. However, the positive momentum also reflects the fact that these companies are posting decent profits despite still challenging economic conditions.
The Croatian equity market saw no upside in May. The benchmark index (CROBEX-10) fell by 0.6%. It is now up 7.3% in 2011 as a whole. The top performer in May was Ingra (up 31.7%) followed by Koncar (up by 11.8%). Meanwhile Ericsson Nikola Tesla fell by 9.3%. The vast proportion of this year's gain on the index (and indeed last year's 9.5% growth) has been due to a large jump in the price of INA - up 31.7% this year and accounting for 21.6% of the overall index weighting. However, INA shares have been suspended due to allegations that MOL has been trying to increase its holding in INA to above 50% contrary to the government's wishes. The CROBEX-10 is also not helped by the fact that Croatian economic indicators remain relatively poor - the economy contracted by 0.9% y-o-y in Q1 2011 while most other economies in the region are now growing once again.
The IMF's Executive Board has approved the completion of the fourth review of the Stand-By Arrangement (SBA). This makes a disbursement of EUR121 mn available. The Latvian economy has returned to growth after a severe recession. The government has undertaken a huge (and ongoing) fiscal adjustment to reinforce confidence in the fixed exchange rate regime and with the aim of meeting the Maastricht criteria in 2012 (in order to gain entry to the Euro by 2014). A fiscal responsibility law is being drawn up which would ensure appropriate budgets over the long-term. After some delays, bank restructuring appears to be progressing. Inflation is rising due to higher food and fuel prices but also tax increases. The Fund recommends, therefore, that reducing the budget deficit further should focus more on expenditure cuts than tax hikes.
The IMF notes in its annual Article IV report that the economic recovery in Croatia is one of the weakest in the region. The economy contracted last year by 1.2% and is expected to grow this year only by 1% according to the Fund. The current account deficit may have fallen and inflation is relatively low but Croatia has failed to take advantage of the global economic recovery to date due to a narrow export base and poor competitiveness. The fiscal deficit is high (over 5% of GDP) and public debt to GDP high and rising (58% of GDP including public guarantees). Wages are high by regional standards and the labour market inflexible. The public sector remains large and inefficient. The government has sought to tackle some of these structural weaknesses through its Economic Recovery Program. Some measures have been implemented but others have not due to strong opposition from social partners.
Negotiations with Russia for a loan to help stabilize the Belarusian economy have been underway for some time. Belarus has been hit by a balance of payments crisis due to inappropriate economic policies and its currency has devalued sharply as a result. Russia has made clear that such a loan would not come directly from it but via the Eurasian Economic Community (which consists of both Russia and Kazakhstan). It will also come with strict additions attached. Russia has long sought to buy Belarusian state assets in return for loans. The agreement is likely to be approved formally at the beginning of June and up to US$1.2 bn in cash may be available this year. It remains to be seen exactly what price (both in terms of interest payments and forced sales of state assets) will be negotiated by Russia in return for this bailout.
The strained relationship between government and opposition in Albania that has been evident for at least 12 months has been exacerbated by the recent local elections. Election day itself seemed to be relatively uneventful. However, a initial count of ballots for the race for Mayor of Tirana gave incumbent Edi Rama, leader of the opposition Socialists, a razor-thin victory. A recount of "stray ballots", however, gave victory to Democratic Party candidate Lulzim Basha. The Socialist party has appealed to the Central Election Commission against this decision. The electoral law appears to be too vague to define exactly what should happen in this situation. Both the OSCE and European Parliament Raporteur have expressed disappointment over the course of developments and urged restraint on both sides.
The IMF notes in its annual Article IV report that the Bulgarian economy is recovering. Strong exports should lead to GDP growth of 3% y-o-y in 2011 even though domestic demand remains weak. The current account deficit has been reduced and inflation is relatively contained. The Fund believes that both the National Reform Program and Financial Stability Pact should enhance the attractiveness of Bulgaria to foreign investors. Structural reforms are central to raising medium-term growth potential. A fiscal rule that saves excess budget revenues during an economic upswing would aid macroeconomic stability. The budget deficit for 2011 appears to be on track. However, the IMF urges the authorities to rebuild the fiscal reserve (which was used to finance part of the budget deficit during the recession) by accelerating privatization and issuing more debt when conditions are appropriate.
Demonstrations are being held in Tbilisi against the rule of President Saakashvili. While largely peaceful there have been some violent incidents. The protesters claim that Saakashvili, having come to power via the Rose Revolution of 2003, has shown authoritarian tendencies and they are seeking that he step down immediately. The demonstrations are unlikely to worry the government unduly or have the intended effect. The opposition is split with other parts of it distancing itself from these proceedings organized by its more radical elements. Much larger demonstrations two years ago, indeed, failed to unsettle the authorities. There are concerns in some quarters that Saakashvili may not step down at the end of his second term as president. Perhaps more realistic are fears that constitutional reforms that strengthen the role of parliament relative to that of the presidency may see him next seeking the position of Prime Minister.
An IMF Mission has arrived in Belgrade to review economic developments and discuss with the authorities the possibility of agreeing on a new, precautionary IMF program. The government successfully completed its Stand-By Arrangement with the Fund but a new program (expected by the autumn) would give more confidence that macro-economic stability will be maintained through parliamentary elections expected by March next year. Fiscal policy tends to loosen sharply in the pre (and post) -election period in Serbia. The establishment of a Fiscal Council and a new law restricting the ratio of public debt to GDP should help here but the Fund's oversight would add further weight to criticism of any populist measures. In immediate focus are a number of new subsidies intended to boost growth and employment but which may also risk an overshoot of the budget deficit target.
Eurostat data confirms that inflation in the Euro area rose from 2.7% y-o-y in March to 2.8% y-o-y in April. In the EU-27, it rose from 3.1% y-o-y to 3.2% y-o-y. Relatively strong GDP numbers in Q1 and rising inflation are likely to see the ECB hike rates for a second time in this cycle in Q3 even though a good part of the inflation pick-up has resulted from rising food prices rather than strong domestic demand. Monetary policy is exceptionally loose and will be slowly returned to a more neutral setting. Within Eastern Europe, inflation remains highest in Romania (8.4% y-o-y up from 8.1% in March) and Estonia (5.4% y-o-y up from 5.1%). Inflation should fall sharply in Romania in the summer as tax increases last year fall out of the base for calculation. In most countries in that region inflation is about 4% y-o-y while it is somewhat lower in the Czech Republic (1.6%), Slovenia (2.0%) and Bulgaria (3.3%).
The authorities have reached Staff-level agreement with the IMF on completion of the third review of the ECF/EFF programs. Executive Board approval of the completion of the review expected in July would lead to a US$77 mn disbursement. Economic growth is strong and the planned fiscal consolidation on track. The level of FX reserves has improved. Challenges remain however. Inflation is high and the current account deficit is growing. While tight fiscal and monetary policy will help here the implementation of structural reforms is also needed. The authorities have committed themselves to a program of economic liberalization intended to improve competitiveness and strengthen the export base. This should boost the sustainable level of economic growth in the medium to long-term.
The authorities have reached Staff-level agreement with the IMF on a new program. The Extended Credit Facility would amount to US$108 mn and is likely to be endorsed by the Fund's Executive Board in June. The political crisis that broke out last year derailed the then IMF program. A deteriorating security situation undermined economic growth and caused considerable damage. The Fund responded to the immediate financing pressures that this caused via a Rapid Credit Facility. Now that the situation has stabilized (both security and economic) the authorities wish to move to a longer-term arrangement. This would support an economic program focused on fiscal retrenchment (while securing funds for key social programs), improving the effectiveness of public expenditure and strengthening the supervision and regulation of the banking sector.
Local elections held at the week-end were closely monitored by international institutions. The OSCE's preliminary report stated that the elections were "competitive and transparent, but took place in an environment of high polarization and mistrust between parties in government and opposition". Some of the key election results remained too close to call at the time of writing. However, it appears that the opposition Socialist Party has taken a number of smaller municipalities formerly held by the ruling Democratic Party and may also win a higher share of the overall vote. Tensions between the two parties have been strained since close-run parliamentary elections in the summer of 2009. The opposition still contests the outcome of those elections and has regularly held demonstrations demanding a recount.
Some sort of compromise appears to be within reach as regards to whether the Republika Srpska (RS) holds a referendum on the legitimacy of the High Court and Prosecutor's Office of Bosnia. Milorad Dodik has volunteered to delay the referendum (scheduled for next month) hoping that discussions with EU officials will result in a review of the work of both institutions which he claims are biased against Serbs. Valentin Inzko, High Representative, and many countries within the international community consider such a referendum as an attempt to undermine Dayton institutions and have strongly criticized it. Russia, however, opposed the imposition of sanctions against certain individuals in the RS. A deal on this issue does not resolve the underlying tensions in Bosnia however. The Bosniaks are pushing for a more centralized state whereas both Serbs and Croats strongly resist this and seek to move in the opposite direction.
Eurostat figures show that industrial production (IP) growth was weaker in March on both a m-o-m and y-o-y basis than in February. IP fell by 0.2% m-o-m (seasonally adjusted) in the Euro area in March having grown by 0.6% m-o-m in February. Likewise, it contracted by 0.3% m-o-m in the EU-27 in March having grown by 0.4% m-o-m in the month before. On a y-o-y basis, IP growth slowed from 7.7% in February in the Euro area to 5.3% in March and from 7.5% to 4.6% in the EU-27. Within Eastern Europe, Estonia (32.7%), Latvia (9.8%) and Lithuania (14.5%) all enjoyed strong IP growth in March. There was significant deceleration in IP growth in March, however, in the Czech Republic (13% to 8.6%), Poland (9.7% to 4.9%), Slovakia (10.8% to 6.8%), Romania (12.9% to 7.0%) and Bulgaria (15.4% to 5.1%).
The Romanian authorities have reached Staff-level agreement with the IMF on the completion of the first review of the new Stand-By Arrangement (SBA). The Executive Board of the IMF is likely to approve completion of the review in June at which time a EUR475 mn disbursement would become available. The authorities, however, are treating this new SBA as precautionary and therefore do not intend to draw down this amount. Economic indicators are developing broadly in line with program targets: GDP growth is expected to be 1.5% this year and the budget deficit brought down to 4.4% of GDP. More fiscal adjustment will be needed to bring the deficit down to 3% of GDP next year as planned (in order to join EMU in 2014). The authorities must now move to reform and privatize loss-making state-owned enterprises.
The partial devaluation of the currency in Belarus started last month has now been completed. While the authorities allowed banks to buy US dollars at the (much weaker) free market rate last month they have now extended this to ordinary retail transactions. This, in effect, has meant that the exchange rate for the average citizen has been devalued from 3,100 to 4,000. A devaluation became inevitable when Belarus adopted expansive economic policies after the expiry of the IMF program. This led to a rising current account deficit and lower FX reserves. The devaluation will push up inflation sharply and cut into household spending power. The central bank may have to respond by raising its key interest rate further. The weaker currency will boost exports and reduce the demand for imports (other things equal) taking some pressure off foreign reserves.
The Serbian dinar has strengthened from 107 to the Euro last November to 99 today. The cause has been a sharp increase in the central bank's key interest rate (and related to that government paper) as it seeks to bring down inflation. A stronger currency gives some respite in the short-term to those indebted in Euros and receiving income in dinars. It also helps the disinflation process. However, it will be damaging for exporters in the medium-term. A nominal appreciation of the currency and much higher inflation in Serbia than in the Euro area represents a significant real appreciation. Moreover, this is not a reflection of improving productivity in the export sector but an inflow of short-term capital. The central bank may now pause in its rate hiking cycle. When inflation falls and rates eventually head downwards it will have to be wary that the dinar does not weaken sharply too.
Representatives of the junior party in the governing coalition (the SDP) left a cabinet meeting early last week and refuse to attend future ones until a dispute over the rebuilding of a church on Sveti Stefan is resolved. Local inhabitants have started renovations without the appropriate approval. A government decision to suspend building raised tensions and Prime Minister Luksic subsequently referred the matter to a Commission. The SDP is insisting that the cabinet's initial decision be implemented. He also threatened to replace any Ministers who fail to attend cabinet meetings. While one assumes that the government will not fall over such an issue the whole affair is being interpreted as a challenge to Luksic in his new position as Prime Minister. His authority may be challenged if the affair requires Djukanovic (still unchallenged leader of the DPS) to intervene.
Valentin Inzko, High Representative in Bosnia, has announced that he will cancel the holding of a referendum in the Republika Srpska (RS) approved by its National Assembly unless it is withdrawn. RS President Dodik is pushing for such a referendum to question the validity of the High Court and Prosecutors Office. Inzko notes that the RS is an Entity not a State and the Constitution does not provide for it to hold a referendum. Dodik is seemingly seeking confrontation with the international community over this issue to further boost his standing among nationalists. Inzko has also mentioned the possibility of sanctions being implemented against individuals seeking to destabilize Bosnia in such a fashion. Dodik has replied that if the referendum is canceled Serb representatives will boycott meetings of State-level institutions.
The Georgian authorities have reached Staff-level agreement with the IMF on the completion of the ninth and final review under the US$1.2 bn Stand-By Arrangement. The IMF's Executive Board is expected to approve completion of the review in June enabling the disbursement of a US$114 mn tranche (although the authorities may well not draw it down). Economic developments remain consistent with program parameters. In particular, growth is strong and fiscal consolidation on track. Despite retaining access to the international capital markets (as seen by the recent Eurobond issue) the authorities are looking for a successor IMF program. While FX reserve levels are already adequate this new program (whose details are still being negotiated) would serve as a positive signal to investors that economic reforms continue to be implemented.
A number of central banks in the Eastern Europe (EE) and Former Soviet Union (FSU) region followed the European Central Bank in hiking interest rates last month. This is hardly surprising given rising global food and fuel prices and signs that economic recoveries are becoming more solid and broad-based. Russia, Poland, Serbia and Armenia all hiked interest rates by 25 bps having already started to tighten monetary policy earlier this year (or in Serbia's case last autumn). The policy rate was hiked by fully 100 bps in Belarus in an attempt to offset the impact of a recent currency devaluation. Other countries such as Hungary that have hiked rates in previous months appear to think that they are at a satisfactory level for now. While expectations of a possible rate cut this year in Romania have evaporated as inflation has come in higher than expected.
The ODS-TOP09-Public Affairs coalition comfortably defeated a no confidence motion tabled by the opposition Social Democrats. This outcome was pretty much inevitable when the coalition managed to agree on a cabinet reshuffle a few days ago after a recent corruption scandal. 114 deputies voted against the motion in the 200 seat parliament. Three members of Public Affairs voted with the motion and have been expelled from the party. Hence, the government's majority has been reduced but still remains substantial. Nevertheless, it is clear that relations within the coalition remain strained. Moreover, the government's ratings in the opinion polls has dropped sharply due partially to coalition disunity but perhaps also to the painful fiscal tightening and structural reforms that it has pledged to implement starting to take effect.
Despite having received only one bid for the sale of 51% in Telekom Srbija (and that 40% below the asking price of EUR1.4 bn) the government continues to try to complete the sale. A new suggestion has been that Austria Telekom pays the government the EUR850 expected for the 31% stake of Telekom that it is selling. Then the Austrians would swap their VIP mobile network in Serbia for the 20% stake in Telekom Srbija that OTE is selling. This would give Serbia the money it was searching for, the Austrians 51% in Telekom Srbija and Deutsche Telekom (part-owner of OTE) a foothold in the Serbian mobile phone market. Whether this deal is viable remains to be seen. However, the government faces considerable scepticism at home that the money raised will be spent wisely rather than on a pre-election populist splurge. The government insists the money will be used to pay down external debt and to finance crucial infrastructure projects.
The opposition Social Democrats have chosen Radmila Shekerinska as their candidate for Prime Minister in June 5 parliamentary elections. Shekerinska served as Deputy Prime Minister in charge of European Affairs in the last Social Democrat government and is a senior party figure. Party leader, Branko Crvenkovski, has played up Shekerinska's European credentials as a reason for her to compete, most likely against incumbent Prime Minister Nikola Gruevski, in the elections. However, it is possible that with the governing VMRO-DPMNE leading by some way in the opinion polls Crvenkovski does not want to be directly associated with an expected election defeat as he tries to rebuild his party and overcome the VMRO-DPMNE's recent electoral dominance.
President Yanukovych is often presented as pro-Russian in the Western media. This impression was bolstered by the accords signed last year between Ukraine and Russia giving the former a more favorable gas import price in return for the extension of the lease of Sevastopol to the Russian Black Sea Fleet. And yet, the situation is not so clear cut with Ukraine resisting Russian demands for Gazprom to merge with Naftogaz and gain access to its pipeline infrastructure. Ukraine's desire to have good relations with both the European Union and Russia is demonstrated by its stance on trade negotiations. Ukraine is both negotiating a free trade treaty with the EU while Russia offers it cheaper gas if it joins the Russia-Belarus-Kazakhstan customs union. Despite the short-term gains to Ukraine from the latter it knows that the EU is a much larger market. Hence it is both continuing negotiations with the EU and seeking to join the Russian-led customs union on a 3 plus one basis.
The ruling Fidesz/Christian Democrat alliance has secured the two-thirds majority in parliament necessary to pass the new Constitution which will now come into force at the beginning of next year. The Socialist Party and LMP boycotted the vote while Jobbik voted against rather undercutting government claims that the new Supreme Law represents all the people. The government sees the new Law as finishing the process of democratization started in Hungary twenty years ago while many foreign observers see it in a less favorable light following on from issues relating to the media law and the watering down of the Fiscal Council etc. Foreign investors may welcome the aim to bring public debt down to 50% of GDP and the requirement to post a budget surplus if debt requirements are not met. However, it also depends whether such fiscal adjustment is done in a sustainable and non-discriminatory way which has not been the case so far with this administration.
Inflation in the Euro area rose from 2.4% y-o-y in February to 2.7% y-o-y in March. At the EU-27 level, inflation rose from 2.9% in February to 3.1% in March. Rising inflation has already persuaded the ECB to hike rates by 25bps (to 1.25%) and further increases are likely this year. Within the Eastern European countries covered by the data, inflation was highest in Romania (rising from 7.6% to 8%) but was also elevated in Estonia (falling from 5.5% to 5.1%), Bulgaria (remaining at 4.6%) and Hungary (rising from 4.2% to 4.6%). Estonia and Bulgaria have currency boards and therefore no independent monetary policy. Romanian and Hungarian central banks left rates on hold at their last MPC meetings but may have to consider rate hikes if inflation continues above expectations. Inflation was more muted in the Czech Republic (1.9%) and Slovenia (2.4%).
Leaders of the three parties in the coalition government have reached an agreement on a cabinet reshuffle following a recent corruption scandal that brought the government to the brink of collapse. Non-partisan figures will replace Public Affairs ministers at the Ministry of Transport and of the Interior. Public Affairs leader Radek John will stay in the new cabinet as Deputy Prime Minister. The opposition has called a vote of no confidence in the government which will be held early next week. This seems likely to fail. However, the opposition has a clear lead in the opinion polls and tensions between the coalition partners remain high. TOP 09 and Public Affairs are pushing for the removal of the Defense and Agriculture Ministers respectively and Prime Minister Necas of the ODS indicated that there may be further cabinet changes in the next few months. Even though the government has overcome the immediate problem, then, it is still becoming increasingly difficult for it to see through its ambitious economic reform program.
At the peak of the global economic crisis Belarus obtained (and largely implemented) an economic program with the IMF. After this expired last March and was not replaced economic policies started to deteriorate. The authorities sought to boost growth ahead of presidential elections in December by increasing spending and directed bank lending. This had the adverse effect of worsening an already large current account. As downward pressure on the level of FX reserves intensified the central bank first widened the trading band around the exchange rate basket from 2% to 10% and has now suspended the band completely for commercial transactions. The first step already meant a significant depreciation. The second step introduces a multiple exchange rate which effectively amounts to a further depreciation. In the meantime, the government is seeking a US$3 bn loan from Russia to help boost reserves.
The Peace Implementation Council (PIC) has strongly criticized the decision of the National Assembly of the Republika Srpska (RS) to hold a referendum on the legitimacy of the State Court and Prosecutor's Office of Bosnia. These institutions were created in 2002/2003 by then High Representative who is charged with the implementation of the Dayton Peace Agreement. Prime Minister of the RS Dodik has pushed for the referendum alleging that these institutions were "imposed" by the international community and are biased in their activities against Serbs. The PIC, however, notes that the High Representative has the sole authority to interpret Dayton and that the Bosnian national parliament approved the creation of both institutions overwhelmingly. The PIC emphasized that it strongly condemns any such attempt to "undermine" Dayton institutions. The RS proposes to hold the referendum within 45 days of the Assembly's decision.
The Latvian authorities have reached staff-level agreement with the IMF on the completion of the fourth review of the Stand-By Arrangement (SBA). The economy is now growing at a reasonable pace. The supplementary budget approved this week delivers more sustainable fiscal adjustment that makes the 4.5% of GDP budget deficit for 2011 feasible and will offer a reasonable starting point for the budget deficit being brought down to below 3% of GDP in 2012 as envisaged in the government's economic program. Further measures, however, will need to be identified to achieve this. Completion of the fourth review unlocks almost EUR1 bn in potential disbursements from the IMF, EU and bilateral creditors although the authorities have indicated that they will draw down only a small portion of this amount. The IMF's Executive Board is expected to meet either in late May or early June to finalize completion of the review.
The parliament in Macedonia has dissolved itself ahead of early elections set for June 5. The opposition Social Democrats have been boycotting parliament since January and agreed to early elections conditional on the implementation of electoral reforms. Early elections will be held anyway even though these reforms have not been implemented. The ruling VMRO-DPMNE and opposition had failed to agree on the exact nature of these during the course of the last two months. The VMRO-DPMNE is expected to win the elections according to the latest opinion polls. Indeed, the Social Democrats have yet to elect a candidate for Prime Minister. While it had seemed likely that party leader (and former President of Macedonia) Branko Crvenkovski would be the obvious choice he has recently suggested that the candidate will be elected at a party conference to be held at the end of April or early May.
The main opposition party in Serbia, the SNS, has held another protest rally in Belgrade calling for early elections. The SNS has recently established a lead in the opinion polls over the DS - the largest party in the current governing coalition. Despite recent political instability within the coalition most agree that elections will not be held before the EU decides on whether to accept Serbia's official candidature for membership in October/November. The SNS, along with some smaller opposition parties, is calling for the elections to be held in December. Elections, anyway, must be held by next May and would likely have been scheduled for March according to President Tadic irrespective of opposition demands. The coalition government has offered to bring these elections forward by a couple of months if the opposition takes a more constructive approach to the passage of legislation crucial for the EU Accession process.
Relations in the ODS/TOP 09/Public Affairs coalition government have been strained by a corruption scandal affecting the Public Affairs party. Two of its members have claimed that Vit Barta, Transport Minister and a senior party figure, had tried to buy their silence concerning the funding of the party. Barta has resigned claiming that he is innocent and asserting that he wishes to clear his name. Moreover, Prime Minister Necas has declared that other Ministers from the same party (Interior Minister Radek John and Education Minister Josef Dobes) would also be replaced in a cabinet reshuffle. Party Affairs leader Radek John has replied that he is prepared to accept these changes as long as other ministers that have been linked to potentially corrupt practices are also removed. Necas has made it clear that this is unlikely to happen suggesting the possibility of Public Affairs leaving the coalition in a minority.
An IMF post-program monitoring Mission has released its findings. These note that the economy is expected to grow at a modest 2.5% pace both this year and next. The fiscal balance is likely to record a surplus of 2% of GDP this year (largely thanks to one-off revenues from asset transfers from the recently dissolved second pension pillar). A more realistic assessment of the underlying fiscal position is that the Fund considers that a significant fiscal effort will be needed to keep the budget deficit in 2012 to less than 3% of GDP (the budget deficit target of 3.8% of GDP for 2010 was overshot by 0.5 percentage points). The government's recently announced Szell Kalman economic reform program is broadly welcomed although the IMF warns that more details are needed before a fuller assessment can be made. It may reduce growth in the short-term but boost it in the long-term. Fiscal savings are urgently required given high public debt to GDP and a challenging repayment schedule.
The IMF's Executive Board has approved the completion of the seventh and final review of the EUR2.9 bn Stand-By Arrangement. Although completion of the review enables the disbursement of a tranche of EUR353 mn the Serbian authorities have indicated that they will draw down only a fraction of this as FX reserves are already more than adequate. Implementation of the program is described by the Fund as satisfactory rather than good. This refers to the government having met its fiscal deficit targets but having delivered rather less in the implementation of structural reforms. The Fund notes that the public sector remains over-sized, that public enterprises need to be reformed and the business environment improved. These areas will form the core of a successor (non-disbursing) program that is expected to be negotiated in the summer. A new IMF program would help reassure investors to some extent that fiscal discipline will be maintained through parliamentary elections to be held in the next 6-12 months.
The recent Constitutional Court ruling that Behgjet Pacolli's election as President of Kosovo in February was unconstitutional raised the possibility of early parliamentary elections. For sure, his election as president in parliament was part of a deal with the PDK on forming a coalition government. Pacolli has accepted the Court's ruling and has stepped down from the presidency. However, instead of the collapse of the newly formed governing coalition a compromise appears to have been reached. For his part, Pacolli has said that he does not condition his party's participation in the government on his holding the presidential post. Moreover, the PDK has come to an agreement with the leading opposition party (the LDK) on the election of Alisete Jahjaga, Deputy Director of the KPS, as president in return for a deal ensuring constitutional changes to allow direct election of the president in an election to be held by 2013 at the latest.
Relations between Hungarian MOL on one side and INA and the Croatian government on the other remain rather strained. MOL has a 47.3% stake in INA while the Croatian government holds 44.8%. An attempt by MOL to increase its holding in December through a share offer did not prove very successful. Since the price of INA's shares have rocketed from around 1,700 last autumn to about 4,000 now speculation has arisen that MOL was attempting to raise its ownership through the 50% level via intermediaries. MOL has strongly denied these claims but the body regulating Croatian financial markets (HANFA) has suspended the trading of the shares pending an investigation and the government is considering changing legislation to make it illegal for any company to hold 50% or more of the Croatian oil company. Moreover, MOL has indicated that the profit generated by INA in 2010 should be reinvested while the government is expecting all profitable SOEs to pay a dividend.
The IMF's Executive Board has approved the second review of the Extended Credit Facility (ECF) and the Extended Fund Facility (EFF) programs. This means that a disbursement of US$79 million becomes available. The AEI government's economic program is being implemented well. This envisages fiscal consolidation but ear-marking a larger share of government revenues for investment and social assistance. The economy is rebounding strongly and the central bank has started to hike rates in anticipation of an increase in inflationary pressures. The banking sector is returning to profitability as the ratio of non-performing loans starts to stabilize. Structural reforms must also be implemented to improve Moldova's relatively weak export base and improve the business climate. These include removing barriers to trade and privatization. The energy sector must also be reformed to make it financially sustainable in the long-run.
President Medvedev last week announced that government officials should be removed from the boards of certain state-owned companies as one of a number of measures to improve the investment climate in Russia. Medvedev argues that there is an inherent conflict of interest in ministers who determine regulation of a particular sector being on the board of a state-owned company that operates in that same competitive sector. It was later detailed that this initiative would include Finance Minister Kudrin stepping down from his position at VTB and Deputy Prime Minister Sechin from his at Rosneft amongst others. While Medvedev is certainly right that there is indeed a conflict of interest here the move has also been interpreted (as ever) as a sign of growing conflict within the Putin-Medvedev tandem ahead of presidential elections in 2012 ( Putin, after all, while President encouraged the re-consolidation of the power of the state over big business). It seems unlikely, though, that such a large step could be taken without Putin's consent.
The attempt to unseat the newly formed government in the Federation seems to have failed. The SDP-led coalition which holds a majority of seats in parliament has recently formed a government and appointed a new President. However, those Croat parties (HDZ and HDZ 1990) that had failed to reach an agreement on joining the new administration tried to question the legitimacy of the new government on the basis that they had not sent their cantonal representatives to the Upper House of parliament. Although the Election Commission backed their appeal this decision was suspended by the High Representative awaiting a decision on the matter from the Constitutional Court. Before the Court ruled the appeal was withdrawn. While the Croat parties fulminate about the intervention of the international community on this matter it would seem that the new government can now concentrate on passing key legislation relating to the IMF program such as the recently approved budget for 2011.
The National Bank of Hungary (NBH) has released its March Inflation Report. In it it notes that inflation remains somewhat above the central bank's medium-term inflation target of 3%. Food and energy supply shocks have pushed inflation higher. However, core inflation remains more moderate given a loose labour market and weak domestic demand. The NBH concedes that inflation could rise further in the short-term (it was 4.2% y-o-y in February) but expects that average inflation in 2011 will be around 4%. These "cost-push" factors are expected to moderate and fall out of the basis for calculation further out. Hence, in H2 2012 inflation is expected to fall back towards the 3% target. The rate increases that the central bank has already implemented should also help to contain inflation expectations in the face of rising headline numbers. While recognising the risks inherent in the forecast this Report suggests that the NBH now has a neutral bias.
The IMF's Executive Board has approved a 24-month EUR3.5 bn Stand-By Arrangement (SBA) to replace the EUR13 bn SBA that has just successfully been completed. The new program will enable additional support of EUR1.8 bn to be drawn from the EU and the World Bank. However, the Romanian authorities have decided that the last EUR1 bn of the outgoing program and the funds that would become available (following good implementation) under the new one will be treated as precautionary. In other words, Romania has sufficient FX reserves and wants to use the new program to reassure investors that it can both service its debts and is carrying out agreed economic reforms. The new program envisages further fiscal consolidation and structural reforms with the aim of getting the budget deficit down to 3% of GDP by 2012. The Boc government has continued to push through with its tough economic policies despite widespread strikes and a sharp fall in its popularity.
Kosovo's Constitutional Court has declared that the election of Behgjet Pacolli as President of Kosovo in February was unconstitutional. Pacolli was only elected in the third round of voting. The opposition immediately filed complaints to the Court that they had left the parliament building by this stage and, therefore, that a quorum was not present and, indeed, that deputies were pressurized to vote for Pacolli in an illegal break between the voting before the decisive third round. The Court's decision could lead to some political instability. The new government was formed with a relatively small majority and includes Pacolli's New Kosovo Alliance. Pacolli only joined the government on the basis that he would be elected President but some members of the largest part (the PKR) were against this. A new election for President will now have to be held. If Pacolli is not re-elected then the stability of the government could be drawn into question.
When the SDP and SDA won most seats in parliamentary elections in the Federation last October it seemed a government could be formed relatively easily. They quickly came to an agreement that two smaller parties - the NSRzB and HSP - would join them in a coalition but also held out the possibility of the two largest Croatian parties (the HDZ and HDZ-1990) joining the new government also. However, talks with these two parties did not yield results after several months with failure to agree over cabinet allocations. In the end, the SDP and SDA went ahead with the formation of their new government which was approved last week in parliament. However, the HDZ and HDZ-1990 have challenged the legitimacy of this new administration. They claim that it is illegal on the basis that they have not yet submitted their candidates to the upper house. This dispute may prove long-running and further add to the sense of drift in Bosnia caused by the failure yet to agree an administration at the State level as well.
An IMF Mission in Kosovo monitoring progress towards the completion of the first review of the Stand-By Arrangement (SBA) has concluded without reaching agreement with the authorities. As anticipated, the large public sector wage increases promised by Prime Minister Thaci during the campaign for the December parliamentary elections are not consistent with the SBA program targets. With the economy growing at a fairly robust 5% plus pace such out-sized wage increases (of between 30% and 50%) in the public sector would not only push the budget deficit above target but risk adding to inflationary pressures. If the IMF program remains "off track" the government stands to lose budget financing not only from the SBA but also from other international financial institution disbursements. The government can "afford" to do this in the sense that it has a large deposit at the central bank but this is better used as a back-stop for potential problems in the banking sector than as current expenditure.
An IMF Mission conducting the annual Article IV review notes that the economy is returning to growth but the recovery is weak due to problems in the banking sector and over-indebted corporates. Large banks are weakly capitalized and profitability has been hit due to high exposure to problems in the construction sector and over-indebted financial holding companies. Bank capitalization and governance need to be strengthened according to the Fund. The fiscal deficit is due to narrow this year. However, adverse longer-term trends can only be addressed with an important pension reform which will both increase the retirement age and move indexation of benefits towards price rather than wage indexation. Wage growth must be contained and labour market flexibility improved if competitiveness is going to be sustained/regained in the context of membership of the Euro area. Larger inflows of FDI would improve productivity and probably growth in the medium-term.
The government has announced that it has received only one bid for the sale of a 51% stake in Telekom Srbjia. Even that bid, from Telekom Austria, was less than the required asking price of EUR1.4 bn. The Austrians offered to pay EUR950 mn for the stake and pledged another EUR450 mn in planned future investment. At one point seven companies had registered an interest in buying a 51% stake. The government subsequently decided to sell only a 31% stake when it became clear that OTE wished to sell its 20% stake in Telekom Srbija at the same time. Nevertheless the government had still been hoping for substantial revenues from the sale which is now likely to be cancelled or at least postponed. This does not necessarily have a major impact on budget financing for this year because the government is now likely to an issue a eurobond instead. The money from the sale was not intended for covering current expenditure but investment in infrastructure projects.
Parliament has approved the appointment of the final two new external members to the Monetary Policy Council (MPC). These are Janos Cinkotai and Gyorgy Kocziszky. This follows the appointment of two other new external MPC members on March 7. The term of the four outgoing external MPC members expired on March 1. They join the Governor and 2 Deputy Governors on the MPC. All of the new members are respected economists as Fidesz tries to counter claims that it has tried to water down the independence of the National Bank of Hungary by having changed the way in which MPC external members are selected. The net impact of the changes may still be to make the MPC slightly more dovish than before, however, despite the credentials of the new members given that they are now answerable more directly to parliament than they would otherwise have been under the old selection process.