Nicholas Watson in Prague -

Serbia's economy, like many others in the region, had appeared largely immune to the paralysing politics in its midst. With this week's election of an ugly nationalist as the parliament's new speaker and fresh general elections looking increasingly likely, that blessed situation could be about to come to an end.

Hopes of a new government being formed by the May 15 constitutional deadline receded over the past week as outgoing Prime Minister Vojislav Kostunica and President Boris Tadic failed to reach a deal to share power. Tadic has set a deadline of Friday to form a government; failure to do so would mean new elections, which would leave the ultra-nationalists, who won the largest share of the vote in January's polls, in prime position to take power.

A flavour of how that government might look came this week with the election to speaker of the leader of the ultranationalist Radical Party, Tomislav Nikolic, who received backing from PM Kostunica's party. A bad-mannered bully, Nikolic immediately set about demolishing Serbia's ostensible policy of forging closer ties with the EU.

Snubbing the EU

"Russia will find a way to bring together nations that will stand up against the hegemony of America and of the European Union," Nikolic told parliament. "I hope that a majority in Serbia will strive for membership in such an organization, not in the European Union."

Russian Ambassador Aleksander Alexeyev responded in kind, congratulating Nikolic on his victory and saying that Russia is "always ready to cooperate with Serbia and strengthen ties on all levels."

Nikolic's comments caused conniptions in European capitals. Germany, which holds the rotating presidency, said it "noted with concern" Nikolic's election and called on "all reform-oriented parties in Belgrade to use the period until May 15 to form a democratic, majority-based government that reaffirms the pro-European orientation of Serbian policy."

Yet Nikolic's elevation to speaker reflects a wider, rising anti-Western sentiment in Serbia, fuelled by the EU's decision last year to suspend pre-entry talks with Serbia over its failure to capture war crimes suspects and the possibility of the Serbian province of Kosovo gaining independence under a UN plan. Serbia inevitably has Russia's support in trying to prevent Kosovo's secession.

Speaking his mind

Even if a ultranationalist government wanted to restart talks with the EU about joining, the party's position on Kosovo and war crime suspects would prevent such a thing happening. Ksenija Milivojevic, general secretary of the European Movement in Serbia, said in a statement that while she didn't believe Serbia would become isolated like it was before the late dictator Slobodan Milosevic was overthrown in 2000, there is no doubt that "Serbia's European course, which has been halted for the past year, would definitely start going in a backward direction."

The economy is also beginning to suffer from a lack of government and worries about what a new one would look like. As a rule, the ultranationalists are anti-reform. "They're also utterly incompetent," sighs one Western banker in Belgrade.

Yet further reform is "essential for helping the economy to realise its potential, to improving labour market conditions and to running down quasi-fiscal deficits," says Sandor Gardo, an analyst at UniCredit's New Europe Research Network.

"The creation of a business-friendly environment, ongoing EU integration and the overhaul of the legal, administrative and judicial system are necessary to secure sustained [foreign investment] inflow," says Gardo. "A rapid formation of a stable, pro-Western democratic government, a coherent economic policy mix, which would remedy the current fiscal and monetary policy mismatch, and the renewal of the EU integration process are inevitable for maintaining and further strengthening macroeconomic stability."

This would be shame, because Serbia has made such huge strides over the past few years. News in March that Serbia had repaid early almost $1bn in loans to the IMF was yet more proof of how far the country has come since its international pariah status of the 1990s. Last year, the economy is reckoned to have grown around 5.7%, buoyed by high consumer spending and borrowing. The current account deficit has deteriorated sharply since 2004 to almost 10% of GDP as imports surge, though this gap has been ameliorated somewhat by a mass privatisation effort that has put about 80% of the country's banking system in foreign hands and raised over €4bn last year.

The macroeconomic outlook prompted ratings agency Standard & Poor's Ratings this week to affirm its 'BB' long-term rating for Serbia with a positive outlook, providing for the possibility of a rise in the ratings in the next 18 months.

However, S&P warned the political problems in the country could upset this positive trend. "Further delays in the forming of the government would cause delays in privatisation process, social security sector reforms, restructuring of companies and general economic reforms," S&P analyst Sladana Tepic told SeeNews. "The outlook will go back to stable in case of new elections, which will cause further delays in economic reforms and fiscal slippage."

Indeed, the political uncertainty is already having a negative effect on investment. Stojan Stamenkovic of the Economics Institute warns the country "is paying the price in terms of reduced investment, which is to say disinvestment, and this means a lower growth rate in the coming years."

For example, a Hungarian-US consortium, Biotech Energy, has had to postpone construction of its €400m bio-ethanol plant in Serbia because it's still waiting for a government to approve the documentation.

All this will be very worrying for those foreign banks who have paid very high multiples to buy into the country's expected development process. The highly acquisitive Greek bank EFG Eurobank last year completed its takeover of Nacionalna Stedionica, paying about 4.75 times book value for the bank.

"These banks have gone for increasingly high multiples, 3-5 times book value," says Oliver Roegl, chairman of the managing board at Raiffeisenbank in Belgrade. "When you see the prices, it's difficult to see how some investors will get their money back."

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