Nicholas Watson in Prague -

While Kosovo will certainly grab the headlines this year, it's the more prosaic issues of inflation and current-account deficits that will probably concern investors most in the region, particularly in Bulgaria and Romania.

"I would say there is no direct spillover effect from Kosovo to the countries outside the former Yugoslavia, as these countries are all on their very own way of convergence with the level of the old European Union," says Sebastian Kahlfeld, senior fund manager of equities in emerging Europe at DWS Investment. "The main risk in the Balkans is the current account deficits, particularly in Romania and Bulgaria which are between 15-20%."

The other issue on investors' lips at the moment, the subprime crisis, isn't affecting the economies of the region, nor is there any evidence of a credit crunch so far. In fact, the stock markets in Bulgaria and Turkey recouped their early August losses and have since risen above the pre-crisis levels, suggesting that international investors do not perceive a significant threat to growth. The economies of emerging Europe continued to grow robustly in 2007 and are expected to continue on the same path in 2008, albeit at a slightly lower rate.

Balkans

Kosovo (or Kosova in Albanian) casts a long shadow over much of the Balkans. The latest situation is an uneasy stalemate, with the Kosovo Albanians preparing to declare unilateral independence, perhaps as soon as this month, while Serbia and its ally Russia mutter darkly about terrible consequences for the region.

Kosovo's two largest parties on January 7 signed an agreement to form a new government, over seven weeks after elections were held. The Democratic Party of Kosova (PDK) and the Democratic League of Kosova (LDK) had agreed in principle on December 26 to sit in government together, but failed to reach agreement on the allocation of ministries and the names of ministers. The PDK's 39-year-old leader, Hashim Thaci, will be prime minister and he promised unequivocally that unilateral independence would be declared if Serbia and Kosovo cannot agree a deal, which of course they haven't. Announcing that a new government has been agreed, Thaci said that, "The number-one commitment of this government and of all Kosova's citizens is to formalize Kosova as an independent, democratic state." According to local media, Thaci also reiterated that while he is determined to lead Kosovo to independence soon, he will coordinate his government's steps with the US and EU.

In the meantime, Serbia is set to hold presidential elections on January 20. President Boris Tadic is seeking re-election as the candidate of the pro-Western Democratic Party; his main rival will be Serbia's ultranationalist leader Tomislav Nikolic, who heads the country's largest political party. Some Tadic supporters say quietly it might be better for Tadic to lose, as it's better not to be at the helm when Kosovo is lost.

In keeping with Serbia's rather bipolar nature at the moment, the government hopes to soon sign a key deal with the EU, which would pave the way for the country to start accession talks with the bloc. Serbian Foreign Minister Vuk Jeremic told reporters after meeting with the EU's foreign-policy chief, Javier Solana, on January 8 that, "Serbia hopes that we are going to be able to sign the Stabilization and Association Agreement on January 28," though "full cooperation" with the International Criminal Tribunal for the former Yugoslavia remains a precondition set by the EU. That "full cooperation" is open to interpretation, with Serbia insisting it is doing so, while some in the EU argue that this condition won't be met until the Bosnian Serb wartime commander Ratko Mladic is in The Hague.

Despite the uncertainty that still surrounds the whole Kosovo issue, most believe it will be settled largely peacefully. According to EU officials, eventual membership of Serbia depends on whether it can peacefully settle the province's status and not even the nationalist bully Nikolic is advocating a war over the province. "We will not send our children to war," he told local media in January. However, he says Serbia should "cut all economic ties, transport, and flows of capital, goods and people from Albanian-controlled parts of Kosovo."

There remains the fear for the EU, therefore, that, let down by the West over Kosovo, Serbia will turn the other way toward its Slavic ally Russia, undoing much of the gains that have been made since the turn of the century. Though Serbia's per capita GDP was still a mere 4% of the OECD average in 2006, big economic changes have and are taking place in the country. The government is pressing on with privatising vast swathes of the economy after the successful privatisation of its banking sector. GDP growth is strong, rising 7.6% on year in the nine months of 2007 - though this is slowing: growth in the third quarter was 7.2% compared with 7.7% in the second quarter.

Inflation is more of a problem. The central bank revised up its inflation forecast for the end of 2007 and 2008. In its latest November inflation report, the bank revised core inflation up to 4.5% and 4.3% by the end of 2007 and 2008, respectively. Inflation is being fuelled by higher food and energy prices - factors that are afflicting the rest of the region. The higher energy prices are being exacerbated by the Kosovo problem, where many power plants are located but which are being badly administered by the local government.

Bulgaria

The biggest problems on the horizon for Bulgaria are much the same as those afflicting the other fast-growing new EU states: a ballooning current-account gap and soaring inflation.

The current-account deficit widened 75% on year to €3.675bn in the first nine months of 2007, which is equivalent to 13.1% of economists' GDP projections for the period. In 12-month rolling terms, the deficit expanded to 20.4% of GDP in September from 19.6% to August. The latest data suggests the deficit could reach 22-23% of GDP for 2007.

As worrying as that is, the good news for investors is that foreign direct investment (FDI) covered 100% of the deficit in the January-September period. Using FDI to cover a deficit is the most welcome and sound way of funding it, since it doesn't create debt or rely on portfolio investment that may be withdrawn rapidly. The overall balance of payments is also positive. Official foreign reserves grew €2.73bn in the first nine months of 2007, compared with just €1.03bn a year ago. These reserves create a buffer against a potential balance-of-payments shock.

Inflation poses a much greater problem to the country's future economic performance. Bulgaria is not immune to the global increase in food and fuel prices, however even before these two external forces began showing up in the statistics, inflation was a particular problem.

Excise duties on alcohol and tobacco were raised sharply in 2006, causing inflation to accelerate in the first part of that year. Following some weakening, prices again accelerated in late 2006 and early 2007, with January's yearly consumer price index growth standing at 7.1%. Any hopes that inflation would moderate in the course of 2007 were dashed by the severe drought in the summer that resulted in Bulgaria's CPI jumping to 13.1% in September as food prices rose 25.1% on year after a 24.1% increase the previous month. Even though inflation retreated slightly in October to 12.4%, few economists predict the rate for 2007 will fall below 8.0%.

The structural nature of the high inflation will prove to be the biggest stumbling block in Bulgaria's efforts to enter the Eurozone by 2010. The convergence programme calls for inflation to be reduced to 2.9% in 2009, but that is now regarded as fanciful. To pass the stability test for Eurozone entry, a country has to have average annual inflation no higher than the average of the three EU members with the lowest inflation plus 1.5 percentage points.

The stock market in Bulgaria is booming. Ask any analyst to summarise the performance of the Bulgarian Stock Exchange (BSE) in 2007 and they're certain to begin with IPOs - and with good reason. Recent research from Karoll Capital Management claims that Bulgaria now ranks only behind Poland and Russia in terms of IPOs so far this year, after doubling its 2006 IPO tally and the amount of revenue raised. Following Bulgaria's accession to the EU in January, 12 IPOs were been carried out on the BSE by the end of November, raising a total of €191m between them.

In contrast to the moribund trading on other regional stock exchanges, such as Budapest's, Sofia's exchange is fairly buzzing. A look at the statistics shows just how much:

--the market capitalization of BSE reached BGN20.78bn (€10.57bn) at the end of June 2007, an increase of more than 109% since the end of June 2006;

--in the first six months of 2007, the BSE recorded turnover of BGN2.72bn (€1.38bn), which was an 86.5% increase over same period in 2006. The turnover in May alone was BGN668.47m (€339.89m), which was the second highest in the entire history of BSE following the BGN705.16m (€358.45) peak hit in December 2006;

--the average daily turnover at BSE in the first half of 2007 stood at BGN21.78m (€11.07m) or 125 trading sessions, almost double the turnover in the first half of 2006.

Croatia

Croatia is standing at the gate of EU membership. According to EU Enlargement Commissioner Ollie Rehn, the accession talks could be over by the end of first half of 2009, meaning the country could enter the EU within this decade. There are of course qualifiers: as long as it undertakes the necessary economic and judicial reforms. "Croatia has the highest standards among the western Balkans, but corruption remains a key stumbling block," say analysts at Moody's Economy.com.

While Croatia has made great strides, it's sobering to note that it's still relatively poor; its per capita GDP was still a mere 18% of the OECD average in 2006. Even so, on the economic front the country has made huge inroads. In the first half of 2007, the Croatian economy grew 7.0% and 6.6% in the first and second quarter respectively, and may grow by an annual 6.3% according to the latest projections. The main driver is household consumption: retail trade accelerated in July-August to 8.2% annual growth from 7.7% in the first quarter, and thanks to increased government expenditure on households next year (above inflation wage hikes, pensioners debt repayment allowances etc.) there would appear to be further scope for advances.

However, the warnings signs are there: even though the government expects a budget deficit of 2.6% of GDP according to its revised budget plan, public debt rose by 4.1% on year by the end of August to a historic high approaching 50% of GDP. The current-account deficit will exceed 8% of GDP both in 2007 and 2008, though FDI coverage is near 60%.

On Monday, January 14, Croatian Prime Minister Ivo Sanader secured himself a second term in office after getting his new coalition government approved by parliament. The four coalition parties are Sanader's HDZ, HSS (Croatian Peasant Party), HSLS (Croatia Social Liberal Party) and SDSS (Independent Democratic Serbian Party).

Romania

Romania is flashing red as the economy overheats while the government does little to address the issue - in fact, it seems bent on exacerbating it.

The annual inflation rate in October hit 6.8%, the highest level since June 2006, a consequence of a severe drought this year and rising energy prices. The current-account deficit also widened to a record €11.8bn in the first nine months of 2007, which has pushed down the rate of the local currency against the euro. The Romanian leu, which until mid-2006 was among the world's top performers against the single currency, fell below the floor of RON3.6 to the euro, hitting an almost two-year low.

Against such an economic backdrop, the country's emergency doctor, National Bank of Romania Governor Mugur Isarescu, stepped in. Isarescu warned several times in November that the government has to get its act together by promoting more restrictive spending policies, especially on inflationary ingredients such as wages, and better planning over utility price increases. He also warned that if need be, the bank would use its powers to fine tune the rate of the leu.

Like so many times before during Romania's nearly 18-year-old post-communist transition, analysts say that Isarescu has no choice but to appear as the economy's saviour, as the politicians are too busy arguing in front of a disenchanted nation that could only muster a turnout of less than 30% for European Parliament elections held on November 25.

Observers urge the government to go back to work and develop some large infrastructure projects that the country desperately needs, but which have been put off for too long. Such projects would boost the amount of FDI needed to finance the ballooning current-account gap while also re-directing spending away from consumption and inflation. And last, but not least, it would bring in billions of euros from the EU accession money that Romania is entitled to but has so far failed to receive because the state is too ill-prepared to apply for it.

For 2008, the current-account deficit is now expected to exceed 14% of GDP, followed by a gradual improvement as the slowdown in consumption and the weakening leu are both conducive to a better trade performance. However, analysts say that more problematic than the size of the current-account deficit itself are the causes for Romania's external balances, which "give rise to genuine concern," says Ábel Bojár, economist at OTP Bank.

Looking at the net financing capacity of the three sectors of the economy - households, corporations and government - Bojár says the picture is rather gloomy compared to Bulgaria where the currency board requires the government to accumulate surpluses from year to year and households are net savers. The latest budget aims for a public deficit of 2.4% of GDP; pension and public wage hikes implemented at the end of 2007 year and early this year mean any significant deficit reduction is unlikely. As analysts point out, the main obstacle to fiscal consolidation is political in nature: the minority government depends on the outside support of the social democrats whose demands for public expenditure in education and healthcare pose fiscal risks. The public deficit is expected to range between 2.5% and 3% in 2008.

Turkey

Analysts and fund managers are cautiously optimistic for Turkey this year, though for several reasons they aren't as bullish as they are for that other regional heavyweight, Russia.

2008 will be challenging in terms of macroeconomic targets and economists expect year-end inflation to hit 6% rather than the central bank's target of 4%, given the expected increase in state-controlled energy prices, especially electricity. The consumer price index rose by 8.4% on year in November, compared with 6.9% growth in August.

The strengthening of the Turkish lira by 17% against the dollar and 8% against the euro in 2007 is partially offsetting the rise in food prices. Nevertheless, the continued rise in commodities, food and oil prices, as well as indirect tax hikes, will keep inflation high.

In contrast to the rest of the region, Turkey's current-account deficit is shrinking, down to 7.8% of GDP in the third quarter of 2007 compared with 8.6% of GDP at the end of 2006. Much of this can be attributed to the significant FDI inflows, which covered 65% of the deficit. The reelection of the reformist government of Prime Minister Recep Tayyip Erdoğan is expected to further this process.

Real GDP slowed to 3.8% on year in the first nine months of 2007 as a result of monetary policy tightening in 2006.

On the geopolitical front, there is still the risk of a wider war with the Kurdish rebels that infiltrate across the northern border of Iraq to carry out attacks on Turkish forces.

In a stepping up of the campaign against the militants, a group of about 300 Turkish troops crossed into Kurdish territory in northern Iraq in December and moved 2-3 kilometres deeper into Iraq. This followed air raids that have resulted in casualties on the ground. "Up to now, a large scale operation has been avoided due to the international diplomatic efforts. Nevertheless, the risk that a cross-border fight could emerge into a big regional crisis still exists," says Gikas Hardouvelis, head of research at Eurobank EFG.

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