June 11, 2007	Monday	Jamadi-ul-Awwal 25, 1428

Balkan economies

The Balkan economies continue to grow despite political risks and external shocks. Consumption is the main source of growth, with investments also increasingly contributing. High exports are accompanied by high imports and external balances remain strongly negative. Price and exchange rate stability, however, remain manageable because of strong growth of productivity and downward pressure on wages from excess supply of labour. The expectation of sustained growth is supporting growth of foreign investments in privatized assets but also increasingly in green-field projects.

Fast rising prices of assets and declining interest rates due to strong credit expansion are proving worrisome for the central banks, which fear asset bubbles and weaknesses in the banking sector. These challenges are met with a tightening of monetary policy, which has led to some moderation of growth rates. Overall prospects are positive for growth and stability in the short and medium run. The main risks to positive expectations emanate from remaining political problems and from doubts about the process of EU integration and accession.

The major political risk is connected with the upcoming decision on the Kosovo status. If that risk is managed well and if other political problems are addressed that will make it possible for all the countries in the region to either sign association agreements with the EU or continue or start negotiations on membership in the EU, rather positive economic news should be coming out steadily from the Balkans. That would also help the region to address the serious social risks, especially those connected with high or very high unemployment.

Overall, prospects for growth are good in the short and medium run and prospects for stability are risky in the short run and good in the medium run. The region as a whole should be included in the EU by 2015, except perhaps for Kosovo and Turkey.

Growth in Bulgaria and Romania (which joined the EU on 1 January 2007) was also accelerating throughout 2006. Everywhere, except Hungary, GDP growth has been driven predominantly by domestic demand. External trade, which significantly boosted GDP growth in 2005, has been losing significance and continues to be a drag on growth in Bulgaria and Romania. Growth forecasts in 2007 and 2008 are looking very good. It is expected that household consumption will continue to rise strongly. Rising employment and wages will be supportive. Rising remittances of migrant workers would be adding to fast rising consumer spending. Gross fixed capital investment is expected to remain strong. With the exception of Hungary, fiscal policies will not interfere with real growth. The slight deceleration of growth in the EU-15 expected in 2007 is not likely to restrict the growth of both exports and overall GDP too much as further gains on industrial unit labour costs are expected. Given the ongoing structural changes and quality improvements in production and exports, the NMS should continue to gain market shares even despite further currency appreciation.

However, growth in imports responding to growing domestic demand will be reducing the contribution of trade to GDP growth. In Bulgaria and Romania, the contributions of external trade to growth will be negative and large. These two countries will be running very high current account deficits and rely on rising private foreign debt in order to finance consumption and investments. The rates of inflation are quite low and firmly under control. Interest rate differentials versus the major international currencies are also low, falling, or even negative.

Incentives for potentially destabilizing speculative capital inflows (and outflows) are therefore weak. Nominal currency appreciation is likely to continue, signifying the economic strength rather than potential weakness. The estimates of GDP growth rates for Bulgaria and Romania may be less certain. Both countries are growing turbulently. But, as in the Baltic countries, their growth is to a large extent induced by booming household consumption which is credit-driven and fed by excessive imports.

Slovakia

In 2007 Slovakia will face the perhaps enviable problem of managing success, with economic growth set to accelerate towards 8per cent just when the authorities are aiming to meet the tough Maastricht criteria so as to adopt the euro on schedule. The main challenge on this front will be preventing buoyant growth from generating inflationary pressures. Nevertheless, the impact of any such demand-pull inflationary effects should be strongly counterweighed by falling energy prices and currency strength.

More positively, rapid GDP expansion will assist the government in bringing the budget deficit in below 3per cent of GDP, leading us to attach an increasing probability to Slovakia entering the eurozone in 2009 within our core view of 2009-2010.

Although domestic demand will remain strong in 2007, the drivers of growth will shift firmly to the export sector, as output is launched at the new car plants owned by Peugeot-Citroen and Kia. As exports take off and imports of capital goods used in the construction of the plants fall back, the current account deficit is set to narrow substantially from as much as 8per cent of GDP in 2006. Combined with ongoing foreign direct investment inflows, these strong growth and export fundamentals will underpin a continuing appreciation of the Slovak currency – potentially igniting concerns of locking into the eurozone at an overvalued rate.

BMI expects the business environment to remain favourable in 2007, with robust growth, macroeconomic stability and the prospect of becoming the first central European country to join the eurozone all supporting investor confidence.

Meanwhile, the risk of a substantial reversal under the new government of the previous administration’s liberal market reforms is expected to be low with, crucially, the 19per cent flat tax system having been largely left unchanged. Nevertheless, as wages continue to converge with Western European levels, Slovakia will face increasing competition for foreign direct investment from lower-cost new EU entrants, Romania and Bulgaria.

As with many CEE states, there has been a rapid run-up in Slovakia’s external debt in recent years, and we expect this to continue, so that obligations to non-residents reach US$48bn by the end of the decade However, we do not think that this poses a significant risk to macroeconomic stability Real GDP and export growth have been strong and the koruna has been appreciating – which has kept debt ratios in check – while at the same time the banking sector is highly robust

Eurozone growth made headlines in 2006, with the regional economy set to have expanded at its fastest pace since the start of the decade. The positive impact of strong eurozone performance is expected on the Central European (CE4) states: the Czech Republic, Poland, Hungary and Slovakia, and assess the outlook for 2007

Growth on the Slovakian automotive market is being led by commercial vehicle sales encouraged by high levels of capital investment in the industrial and transportation sectors BMI is forecasting a slowdown in growth from 5per cent in 2007 to 2per cent by 2010. The commercial vehicle market is likely to sustain double digit growth, which is forecast at 202per cent in 2010, down from an expected 325per cent in 2006. Due its small size and modest growth projection, Slovakia’s pharmaceutical market is not the most attractive in Central and Eastern Europe but a 37per cent growth is expected through to 2010.