Moldova and Montenegro Business and economic outlook

Quarterly update – July 2013Final analysis by Nenad Pacek

Contents

Moldova page 3Montenegro page 16

Moldova

Executive summary

• Real GDP fell by 0.8% last year (down from 6.8% growth in 2011), largely due to a severe drought

• Moreover, the fragile external environment spilled over into lower exports, while nearly all sectors struggled

• This year will post a rebound in economic activity (first quarter results were better than expected, driven largely by better household consumption), while the economy is forecast to expand by some 3.0% for the year as a whole

• Similar (or slightly better) GDP growth (3.5%) can be expected in 2014 • Inflation will remain within the target of 5.0% (with a variation of +/-1.5%)• The political crisis, which started earlier this year, was brought to an end with the

formation of a new (pro- European) coalition government in late May• However, the new government remains very fragile as it holds only a narrow

majority in parliament, while the emergence of inter-party tensions are possible – therefore, the risk of early elections still remains present

Important facts

• Population of 3.6m (declining by 1.0% annually) • GDP per capita (PPP) is $3,500 (one of the poorest countries in Europe)• GDP: €$7.5bn (sizeable unofficial economy)• Moldova is heavily dependent on donor money, exports of agricultural products and

workers’ remittances• The main export trading partners are the EU, Russia, Ukraine and Turkey• 54% of Moldova’s exports go to the EU (agro-products, clothing, textiles)• The country is vulnerable to weak growth in all major trading partner countries (except

Russia, which is still growing reasonably well)• In absolute terms the market remains small for all companies – average wages are just

€232 per month officially• Services account for some 65% of GDP, followed by industry (20%) and agriculture (15%)• The DCFTA – a free trade agreement between the EU and Moldova – is expected be signed

in late 2013• Reliance on just a few export products (mainly food and beverages) and a few export

partners keeps the country in a very unfavourable short- and medium-term position

Economic fundamentals

• Mixed: public debt is low at 27% of GDP, forex reserves are €1.8bn and cover 4.5 months of imports (sufficient)

• But foreign debt is too high at 85% of GDP, and deleveraging will hurt growth potential in the next two years (it rose by 12.7% in 2012)

• The current account deficit is high, indicating some currency overvaluation• A three-year $574m IMF deal is in place and progressing well – the latest

disbursement of $77m was approved in October 2012• The government has also contracted an additional $2bn in international donor

commitments for its Rethink Moldova programme, led by the EU and including funding by the IMF, World Bank, EBRD, EIB and UN

• Funds should flow to roads, agriculture, energy, health, regional development, and water developments

• This should offer many opportunities for business and companies should explore if and when the announced projects will go ahead

Growth prospects I

• After a horrible 2009 when GDP fell 6.0%, growth bounced back in 2010 to 6.9% and to 6.8% in 2011 – among the best rates in Europe, but from a very low base

• Real GDP fell by 0.8% last year • The agricultural sector underperformed strongly due to heavy drought and was the

main reason for the economic downturn • Catastrophic agricultural output coupled with the fragile external environment

spilled over into lower exports • Imports were weak as well, industry struggled, services decelerated, personal

consumption declined, and public consumption was also weak• Economic activity improved more than expected in the first quarter of this year (up

3.5% y-o-y), driven largely by good household consumption (remittances)• Construction, industry and better net exports (most export sectors improved,

particularly those exporting to CIS states) also contributed, while falling public consumption (-1.5%) had a negative effect on the growth figure

Growth prospects II

• Partial data indicate that the economy remained resilient during the last couple of months as well - domestic demand was ok ok, while industrial output increased strongly in April (good news for the industrial sector, whose output declined in 2012)

• The loan portfolio of commercial banks was positive too• The latest data indicate that imports have started to accelerate in the past three

months • We assume that such a trend is fuelled by good remittances and household

consumption • This is good news for companies exporting to Moldova, particularly those from the

consumer goods and food and beverages sector• Real GDP growth will reach 3.6% this year (upgraded since our last report) – it will

be heavily dependent on agricultural output• The agricultural sector showed some recovery signs in the first quarter of the year,

but a more notable rebound of the sector is expected in the second half of 2013

Currency and the current account I

• The currency (the leu) is currently trading at 16.3 to the euro – nearly unchanged since our last quarterly update, when it stood at 16.2 to the euro (it traded at an average of 15.6 to the euro in 2012 as a whole)

• The current account deficit stood at 11.3% of GDP in 2011 - it improved sharply last year and reached 7.0% of GDP (significantly better than expected)

• As mentioned in our last update, the narrowing current account deficit is a good sign for the domestic currency and will probably prevent a sharper depreciation, at least in the short-term, but executives should not forget that the leu is still subject to deeper depreciation and the risk will remain as long as the current account deficit does not reach sustainable levels of less than 4% of GDP or is fully covered by FDI

• Net FDI inflows declined last year and covered less than a third of the current account gap (equivalent to 2.2% of GDP), but the good news is that they rose by some $30m in first three months of 2013

Currency and the current account II

• Additionally, the current account gap narrowed in the first quarter of the year, driven largely by improved exports, and better current and income transfers

• It stood at 6.6% of GDP in the first quarter of 2013 • The lower current account gap and higher net FDI inflows provide some

support to the domestic currency, but these indicators will have to post a much higher improvement in order to secure a long-term stability of the leu

• Furthermore, it is less likely that the current account gap will continue to narrow more strongly (pressure is already stemming from the trade balance)

• Therefore, companies should be aware that the leu could still experience significant downward pressures, particularly if there are not enough capital inflows to cover the current account gap

• As a result of external imbalances, the country’s foreign debt rose by 12.7% in 2012 and reached 85% of GDP (too high by international standards)

Inflation and interest rates

• The inflation rate averaged 4.6% in 2012 (down from 7.6% in 2011)• It accelerated to 5.5% y-o-y in June (4.2% in our last update) • We expect inflation to ease slightly during the rest of the year• It should average 4.6% this year and 4.5% in 2014• The central bank’s inflation target is set at 5.0% (with a variation of +/-1.5%)• We expect the inflation rate to remain within the central bank’s target• The base interest rate was cut to 3.5% (4.5% in our last update)

Other economic and business issues

• The fiscal deficit narrowed to 2.1% of GDP in 2012 (vs 2.4% of GDP in 2011) due to fiscal consolidation and better state revenues coming from the re-introduction of corporate income tax and other measures

• A budget for 2013 was adopted in November 2012 – it is based on a 4% GDP growth forecast and includes much higher state revenues and exports, with a deficit target of 1.4% of projected GDP

• State revenues have been growing so far, thus reducing the budget deficit, which narrowed significantly in the period of Jan-April

• The EBRD will provide a loan worth €150m for road repairs • Negotiations with the EU on the DCFTA were concluded last month, but the

agreement still has to be finalized (probably in November this year)

Political update

• Following a no-confidence vote initiated by the opposition communists, the prime minister Vlad Filat and his government (a 3-party pro-EU coalition) resigned in March, which led to a political crisis in the country earlier this year

• A new (pro-European) coalition government was formed in late May, thus bringing the political instability to an end (at least for now), while the former foreign affairs minister Iurie Leanca was named prime minister

• The formation of the new government was welcomed by the international community, while the new government aims to focus on crucial reforms, particularly the fight against corruption, and push forward with the EU agenda

• In other words, they need to restore the confidence related to its EU integration path, which was heavily damaged by the recent political crisis

• However, the new government remains very fragile as it holds only a narrow majority in the parliament, while the emergence of inter-party tensions in the near future should not be excluded

• Therefore, the risk of early elections still remains present

Moldova – forecast table, selected indicators

Moldova: Macro indicators and forecasts 2010 2011 2012 2013 2014 2015

Real GDP (% change) 6.9 6.8 -0.8 3.6 3.9 4.5

Consumer prices, % (average) 7.4 7.6 4.6 4.6 4.5 4.7

Current account (% GDP) -7.7 -11.3 -7.0 -7.2 -7.1 -6.9

Lei/Euro (Average) 16.2 16.3 15.6 16.4 16.8 17.0

Montenegro

Executive summary

• After accelerating to 3.2% in 2011 from 2.5% in 2010, the economy contracted by 0.5% last year, with support coming largely from tourism

• Economic activity rebounded (better than expected, up 4.3% y-o-y) in the first quarter of 2013, driven mainly by higher electricity production and exports

• This year’s growth will hover around 1-1.5% on the back of strong tourism and good electricity exports (supported strongly by the low comparison base), which will partly offset the losses in other sectors (such as the currently negative manufacturing and mining sector)

• Austerity measures (higher VAT, crisis tax, etc) will continue throughout the rest of the year and in 2014, thus dampening consumer spending

• However, consumer goods companies will have a bit of relief during thr summer days as tourism brings in some extra revenues

• Local demand will stay quite weak in the next two years• Therefore, companies from all sectors will continue to struggle amidst a tough

sales environment, with a slight improvement in demand for B2C companies during the tourist season

Important facts I

• Population of 0.6m (declining by 0.5% annually)• GDP per capita (PPP) is $11,700• GDP: $4.4bn (sizeable grey economy)• Montenegro is one of the most unbalanced economies in the world, where

exports cover only one fifth of imports • The average official net wage is €490 per month• The country is uncompetitive, with a narrow export base centred on metals

(aluminium)• It is too dependent on such exports (almost half of the total) and its saviour

every summer is tourism • The country’s main export trading partners are Serbia, Greece, Italy, Hungary

and recently Croatia – mostly countries that are in economic trouble• Services account for 87% of GDP, industry accounts for 12% of GDP

Important facts II

• The tourism sector is strong and accounts for almost 20% of GDP • Its importance for the domestic economy will increase significantly in the

future • The unemployment rate is around 20% (many people do actually work in the

grey economy)• The EU began membership talks with Montenegro in June 2012 • The latest European Commission report in October 2012 revealed that

Montenegro has made very good progress towards meeting the criteria needed for EU accession

• One of the economy’s biggest problems is a lack of corporate liquidity • The effective average lending interest rate is currently around 9.4%

Economic fundamentals

• Public debt has risen to 69.6% of GDP – it has more than doubled since 2006 and has become quite a serious problem

• Foreign debt is 39% of GDP – relatively low by international standards• The current account deficit is chronically high - it was 17.9% of GDP in 2012• Such a current account deficit is unsustainable; in fact, it should not be higher than

4% of GDP and it clearly shows that the currency is too strong for Montenegro (sucking in too many imports and hurting exports)

• It also means that Montenegro will continue to build up foreign debt in the future (unless it attracts enough FDI to cover the gap)

• Besides, Montenegro has no monetary flexibility because it unilaterally adopted the euro years ago and because of that has built up large external imbalances (a hugely overvalued exchange rate sucked in too many imports and hurt exports)

• Banks are exposed to various real estate related loans (which fuelled pre-crisis growth) and the credit environment will remain very tight for several years

Growth prospects I

• After accelerating to 3.2% in 2011 from 2.5% in 2010, the economy slowed down sharply last year and, according to preliminary data, contracted by 0.5%

• Industrial production shrank by 7.1% -- manufacturing fell by more than 10%, while the mining and quarrying sector shrank by over 20% y-o-y

• Luckily, tourist arrivals were up by some 4.8%, which boosted services exports and partly compensated for a decline in goods exports – tourism revenues increased and currently account for some 20% of the country’s GDP

• However, total foreign trade dropped by 4% in 2012 as whole, while the import coverage ratio declined to 20% from 25% a year earlier

• Economic activity rebounded in the first quarter of 2013, when real GDP rose by 4.3% y-o-y (sectorial details are not yet available)

• Industrial output improved significantly -- up 9.1% in the period Jan-May 2013, driven solely by an increase of utilities (electricity) production -- as we expected

• Better electricity production led to surging exports of electrical energy, which kept foreign trade broadly positive in the first five months of 2013

Growth prospects II

• Total exports grew by 9.9%, while imports fell by 5.6% in the respective period• We assume that the first quarter GDP growth figure was driven mainly by strong

electricity production and rising exports • Unfortunately, manufacturing and mining continued the declining trend in the same

period and contracted by 28.3% y-o-y and 4.3% y-o-y respectively • The on-going financial problems with the major aluminium producer KAP continue to

impact (weak) base metals production, which has in turn been pulling down the manufacturing index

• A piece of good news is that tourist arrivals rose by 7.6% y-o-y in the period of Jan- May 2013, while the retail trade index remained resilient as well

• A strong tourism sector and better utilities production (helped by the low comparison base) will drive economic growth this year, but 2013 will remain challenging despite some positive movements reported in the first few months

• However, we should not forget that domestic electricity production is heavily dependent on hydropower generation and, as such, highly vulnerable to weather conditions – it is a downside risk

Growth prospects III

• In general, overall economic activity will remain rather weak, while the economy will have to rely on tourism (again) to make up for sluggish growth in other sectors

• Therefore, all companies will continue to struggle amidst a tough sales environment (with a bit of relief during summer for consumer goods firms, which can expect similar results as last year)

• Real GDP growth will reach 1.3% this year (revised upwards due to better-than-expected first quarter results) and accelerate to 1.9% in 2014

• Any significant improvement in export performance, particularly in metal exports, is likely to be absent this year and will remain very questionable in 2014 as well, but electricity exports will perform much better, which was already the case in the first five months of 2013

• The rising public debt will call for more austerity measures; government spending will remain sluggish and subject to cuts in the next couple of years, thus having a direct impact on all companies and the economy

Growth prospects IV

• Changes in personal income tax and the introduction of a crisis tax as one of the government’s austerity measures to control the budget gap will put a greater burden on household consumption

• Moreover, recent 2 percentage point VAT increase, to 19%, will deal another blow to consumer confidence

• Government consumption will not be a major growth contributor in the years to come

• Bank’ loan portfolios improved slightly (up by 5.3% compared to December 2012)• Deposits fell by some 1.5% in the same period• To some extent like Greece, the country now has to go through a real economic

adjustment (lower growth, lower domestic purchasing power) to correct its large macro imbalances

• This means that local demand will stay quite weak in the next two years, but with higher demand during the summer months as tourism brings in extra revenues

Currency, inflation and interest rates

• The annual average inflation rate stood at 4.1% in 2012 (it was 3.1% a year earlier)• Inflation decelerated to 3.0% y-o-y May (from 3.3% y-o-y in our last report) • We expect inflation to average 3.0% and 2.5% in 2013 and 2014 respectively• After narrowing in the period of 2009-2011, the current account deficit widened

slightly last year and reached some 17.9% of GDP (subject to revision) driven mainly by a wider trade gap

• As export performance improved during the first five months of 2013, both the current and the trade deficit narrowed in the same period

• Unfortunately, net FDI fell by some 11% y-o-y during the first four months of 2013 – net FDI actually increased by 16.6% back in 2012, when it covered some 77.3% of the current account deficit (up from 67.9% in 2011)

• In the future, the country will have to stabilize its exports and reduce its reliance on the tourism sector which, without a doubt, will gain in importance in the mid to long-term, but currently is too weak to steer the country’s economic prosperity

• The current account deficit will hover around 17% of GDP this and next year

Other economic and business issues

• The commercial court in Montenegro has launched bankruptcy proceedings at KAP (country’s main aluminium producer and a major employer)

• It remains to be seen whether this will lead to liquidation of the company, even though the CEO announced that the bankruptcy will be used to restructure the company (currently the company’s net value is negative)

• The IMF recently recommended KAP’s liquidation, but such a step is considered to be politically unpopular and would most likely raise the risk of social unrest

• The budget deficit in 2012 was 3.3% of GDP (down from 4.2% in 2011) • The budget for this year was adopted in December 2012 – it is based on a 2.5%

growth forecast and sets the deficit at 2.7% of the projected GDP • Public spending is lower while austerity measures are being implemented (temporary

crisis tax on personal income, VAT increase, etc) • Due to fiscal pressures and rising public debt (close to 70% of GDP), more austerity

measures are certain throughout this year and next• On the other hand, the strong grey economy (especially in tourism) will remain

dynamic as usual despite recent government efforts to fight it

Political update

• Filip Vujanović was re-elected president this April – it is his third term as president (but the second since the country’s independence from Serbia in 2006)

• Milo Djukanovic was named the prime minister in December 2012, after the European Montenegro coalition, which consists of three parties (DPS, SDP and LPCG), won the parliamentary elections in October 2012 - it is his seventh term as the prime minister and the DPS has been in power for the past 23 years

• The new government, with its alliances with minority groups, is a lot more diverse and thus fragile than it was in the past, and keeping it stable will remain a challenge in the future

Montenegro – forecast table, selected indicators

Montenegro: Macro indicators and forecasts 2010 2011 2012 2013 2014 2015

Real GDP (% change) 2.5 3.2 -0.5 1.3 1.9 2.0

Consumer prices, % (average) 0.5 3.1 4.1 3.0 2.5 2.0

Budget deficit (% GDP) -3.7 -4.2 -3.3 -3.0 -2.8 -1.8

Current account (% GDP) -22.9 -17.7 -17.9 -16.9 -17.0 -17.2

euro/dollar (average) 1.33 1.32 1.27 1.23 1.23 1.23

Disclaimer, copyright, sources

© 2013 CEEMEA Business Group* CEEMEA Business Group currently works with senior leaders of 340 large multinational companies operating in the Central Eastern Europe, Middle East and Africa regions, helping them understand economic and business outlooks globally, regionally and at country levels. Regional and global executives also receive regular advice and updates on best practices for expansion and success in emerging markets. Executive members of the CEEMEA Business Group can also attend regular peer group meetings held throughout Europe and in Dubai. Source: GSA Global Success Advisors GmbH and CEEMEA Business Group researchBasic data sources come from central banks, own intelligence network, CEEMEA Business Group corporate survey, governments and other public sources. Interpretation, views, forecasts, business quotes and business outlooks by GSA Global Success Advisors GmbH and CEEMEA Business Group.

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Contact: Nenad Pacek, President and Founder, GSA Global Success Advisors GmbH; Co-founder, CEEMEA Business GroupM: +43 676 646 0607 E: nenad.pacek@globalsuccessadvisors.eu www.ceemeabusinessgroup.com

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