Serbia, Montenegro and Kosovo Business Forecast Report Q4 2012

Executive Summary – Serbia Core Views With the formation a new government imminent following May elections, the next government will have to contend with a large and widening fiscal deficit. We expect the next administration to tighten the fiscal accounts and return to the IMF programme abandoned in February. Having gained EU candidate status on March 1, Serbia has now embarked on the long process of EU accession. While we expect accession talks to provide an important policy anchor for the country, we do not expect Serbia to join the bloc before 2018. Major Forecast Changes We have revised our budget deficit forecast for 2012 down from 4.9% of GDP to 5.8% because of delays in forming a new government following the May elections. We expect the National Bank of Serbia to cut rates from 10.00% to 9.25% by the end of 2012 following the bank's 50-basis-point rate hike in June. Key Risks To Outlook If Serbia does not quickly embark on a more sustainable fiscal trajectory, borrowing costs could spike and the dinar could sell off further, inflating foreign-exchange-denominated public debt. The suspension of Serbia's IMF programme has already rattled investor confidence. Our sunnier view on Serbia's long-term prospects is grounded in EU accession providing a policy anchor for the Serbian government. This convergence story requires Serbia to gradually normalise its relationship with Kosovo. However, there is significant tension between the two, and we highlight the potential for unrest in the short term. Executive Summary – Montenegro Core Views As accession talks approach, Montenegro will need to adhere to the EU's acquis communitaire accumulated legislation which will require the incorporation and implementation of all EU norms and regulations into the country's legal system. Given the still substantial gap that needs to be bridged between the Montenegrin and EU legal systems, we expect that accession talks will last at least until the latter half of the decade. Although Montenegro's economy has not yet been hit by the recessionary headwinds originating in the eurozone, we highlight that the country faces a series of major downside risks. Due to a potentially looming balance of payments crisis, we believe that a rescue package from the IMF may be the last resort for Montenegro. Major Forecast Changes With 61.8% of exports bound to the eurozone, Montenegro is highly exposed to the macroeconomic headwinds mounting in the common currency bloc. In 2012, the current account deficit is expected to reach 22.1% of GDP and is currently forecast to remain above the 20% level until 2019. Key Risks To Outlook As volatility in the international financial bond markets is unlikely to ease over the course of 2012, we highlight the risk that Montenegro might have to pay a substantial premium to place its bonds and might, therefore, quickly slip into a debt spiral that would lock it out from global financial markets, preventing it from borrowing to finance the current account deficit, even in the short run. Despite not being part of the eurozone, Montenegro has adopted the euro as its currency since it went into circulation in 2002. As a consequence, the country is highly exposed to a potential disorderly breakdown of the eurozone. Although this is not our core scenario, we highlight that the dissolution of the currency bloc would leave Montenegro vulnerable to sharp capital outflows and soaring imported inflation, or the Central Bank of Montenegro could be forced to artificially fix its new exchange rate to a future core European currency. Executive Summary – Kosovo Core Views We do not see tensions abating between Serbia and Kosovo over the coming months, as key policy developments in 2012 are likely to further stir up divergence between the two countries. In particular, we highlight growing nationalist sentiment among the electorate in Serbia, which bodes ill for a conciliation between Serbia and Kosovo. We forecast Kosovan real GDP growth to slow in 2012 as the eurozone slips into recession. While the Kosovan economy faces significant challenges, there are tentative signs it is embarking on the EU accession process, which could boost long-term growth. Major Forecast Changes Given the current adverse macroeconomic environment, we expect a much weaker expansion path for the Balkan republic. We are currently forecasting growth to come in at 2.5% in 2012, picking up to 5.0% only towards the second half of the decade. Key Risks To Outlook We caution that failure to rein in spending or secure short-term financing from international lenders would result in a fiscal crisis for Kosovo, with substantial repercussions for economic and political stability in the region. Social unrest could lead to a fall of Prime Mininster Hashim Thaçi's government, drawing the country to yet another early election. A strong international military and diplomatic presence would prevent an escalation of violence, but the country's bid towards progressive political normalisation would face another blow.