Nicholas Watson in Prague -

Emerging Europe had a much better year than most countries to the west, and a combination of factors point to a repeat in 2011. For all that, the region is still facing a twin-speed recovery.

A major theme for 2011 in emerging Europe, as it is over much of the world, is a continuation of Keynesian re-flation giving way to Germanic fiscal restraint - and this fiscal tightening is, if anything, even stronger in the emerging markets. "We're all Germans now," states Mark Cliffe, chief economist at ING, in a take on the monetarist economist Milton Friedman's comment that, "We are all Keynesians now."

The reason why countries in emerging Europe are proving better able to push through deeper cuts more swiftly than are being attempted elsewhere on the continent is that it's much easier to tighten fiscally if you have strong economic growth - and that's exactly what emerging Europe has, unlike Western Europe.

With a variety of institutions, from the European Commission to the World Bank, continually issuing and updating GDP forecasts, it can be a little confusing, but all tell a similar story: the older EU member states will mostly either contract or grow slowly in 2011, while newer members and candidate countries will mostly grow relatively quickly - albeit at lower, but more sustainable, levels than before the global economic crisis hit.

In November, the World Bank said it now projects the EU as a whole to grow by 1.7-1.8% in 2010. The previous month, the European Bank for Reconstruction and Development (EBRD) put 2010 GDP growth for the emerging markets it covers at 4.2% - a significant improvement on the developed markets and an impressive turnaround from the 5.5% contraction the region suffered in 2009.

For 2011, the European Commission (EC) said in November that it now expects the Eurozone to grow 1.5% and the EU to grow 1.7%. In emerging Europe, only Romania and Croatia will fail to exceed the EU average, the EC says, with Turkey putting in the most growth at 5.5% (after surging 7.5% in 2009), followed by Estonia with 4.4% and Poland, the only EU country to avoid recession in 2009, with 3.9%.

As such, the region is facing a twin-speed recovery. While some economies will impress, others will be held back by the legacy of the last decade's credit bubble. "Turkey and Poland will continue to lead the way, followed by Slovakia and the Czech Republic," says Neil Shearing of Capital Economics. "Elsewhere, however, vulnerabilities are much greater... A combination of weak banks, competitiveness problems and hefty external financing requirements mean that the Balkans still face a long slog back to health."

Engine of the locomotive

The standout performer in the Eurozone in 2010 has been Germany, and the performance of the world's largest exporter has been key to the revival of the countries to its east.

The rebound in world trade has been particularly beneficial for the world's exporting economies. As such, the German economy recovered remarkably swiftly and vigorously from the crisis, posting six consecutive quarters of export-led growth that is above what many consider to be the economy's long-term output potential. The EC expects German GDP growth to come in at 3.7% in 2010 and 2.2% in 2011. That's good news for Central Europe, investing in which is sometimes referred to by fund managers as a "leveraged play on Germany."

The outlook for European exporters in 2011 could be improved further if, as many expect, there is a revaluation of Asian currencies over the coming months. With Germany a member of the euro, which is a freely floating currency, the bulk of the adjustment has to come from Asia, particularly China, whose renminbi, the US claims, is being kept artificially low.

Chinese manufacturing data for November suggest that GDP growth is accelerating, putting further upward pressure on inflation, which has already surged above 4%, meaning the government will miss its inflation target in 2010 and possibly also in 2011. "The bad inflation number could eventually contribute to easing tensions between China and the US, as it will increasingly be in China's own interests to let its currency appreciate to ease inflationary pressure," reckons Flemming Nielsen, a senior analyst at Danske Bank.

Though the signals are still weak, analysts believe the ground is being prepared by the Chinese for a sustained and significant appreciation of the renminbi over the next year or so, which should be particularly beneficial for Germany and other exporters in the Central and Eastern European region. "The Chinese are not arguing about the principle of revaluation, but the pace... and are probably trying to extract some political concessions along the way," ING's Cliffe told investors at the ING 13th Annual EMEA CEO/CFO Forum in Prague at the end of November. "This is good news for Europe, and especially Germany, as they try to penetrate these Asian markets."

With a continued cost advantage making it a magnet for foreign direct investment, CEE is, in the words of one Asian executive quoted recently by the Financial Times, "the factory of Europe, just as China is the factory of Asia."

The problems ahead for the region, therefore, are likely stem from success rather than failure.

Icebergs ahoy!

Timothy Ash, emerging markets economist at Royal bank of Scotland, argues we are in bubble territory: "We all know it - it feels like a bubble, it smells like a bubble and it probably is."

Certainly, the tide of money that has flowed into emerging markets, which only picked up as the US embarked on another round of quantitative easing (QE2), has been huge. The fund tracker EPFR reported that by November emerging market equity funds had taken in $84.3bn for the year, putting it ahead of last year's record-setting $83.3bn. "For the third year running, cash in the developed world is returning close to nothing. And this is turning into a significant problem because ageing populations in the rich world need income to supplement their falling retirement plans. Financial assets seeking income must now travel further afield," says Plamen Monovski, chief investment officer of Renaissance Asset Managers.

That of course has resulted in surging stock and bond markets, which brings with it risks as well as benefits. The MSCI Emerging Markets Index was trading around 1,130 on December 7, which is up about 140% from its low hit in the depths of the financial crisis in 2008. "Most of QE2 has gone to emerging markets, and this is not a short-term phenomenon but a long-term shift, and that causes a number of difficult policy implications," Dr Nouriel Roubini, professor of economics at New York University's Stern School of Business and the man who has acquired the nickname Dr Doom after predicting the financial collapse, grumbled to investors at the ING conference. "In some countries [price/earnings] ratios in emerging markets are very high and in some cases may not be justified by GDP differentials. In some countries currencies are already overvalued... and in some countries the reduction in credit spreads has been excessive and is unjustified."

Others dispute this, pointing out that the while the markets are certainly not as cheap as they once were, the MSCI EM Index is still well below its pre-crisis peak of 1,340 and these countries still have scope for export-led growth and an improved trade performance based not on undervalued currencies but rapid productivity growth capitalising on FDI inflows. "Look at the MSCI - we are not back to the peak despite strong economic growth, profit growth and strong fundamentals in the fiscal condition and fiscal reserves," says ING's Cliffe.

Perhaps, but few doubt that the capital markets will be volatile as long as the spectre of sovereign debt default hangs over the Eurozone, meaning that periodic setbacks from the developed markets should be a perennial problem throughout the year. The most bullish, of course, would argue that these setbacks present buying opportunities.

Roubini touches on another potential problem for some of the countries in emerging Europe, which is "reform fatigue." The region's countries have, by and large, put the Eurozone periphery to shame with their swift and decisive actions to cut spending to meet budget deficit ceilings imposed either by the International Monetary Fund (IMF) as part of a bailout plan or in the context of the EU's Maastricht Criteria for joining the euro. Even so, the EC forecasts have only six countries out of the 27 member states posting a deficit below the 3% ceiling required by the EU's Growth and Stability Pact. While none of the emerging European countries run deficits as high as Ireland, UK, Spain and Greece have, inflated deficits remain a big issue and further steps need to be taken. "The EC acknowledges the efforts undertaken by the Romanian authorities in the summer of 2010 to consolidate public finances, but at the same time sees substantial risk that some unpopular measures could be reversed," says Eugen Sinca of Banca Comerciala Romana.

So while the fundamentals of most of these emerging markets are sound, or at least sounder than those of the advanced economies, no country is an island and there are many risks - macro risk, sovereign risk - that will have a bearing on these markets throughout 2011. Those economies that have stronger macro, financial and policy fundamentals are going to do better than those in this region that display financial rigidities and macro-policy uncertainties, which will make them prone to greater corrections. "Over the next few quarters, investors in emerging markets have to ask tough questions: which of these economies are becoming overvalued in terms of their equity markets, fixed-income markets and currencies, and what are the risks that shocks coming from advanced economies have the potential for causing a correction in these emerging market economies," Roubini concluded.

With that in mind, the following is a look at the various countries in more detail:

A swift Turkey

Even though Turkey's third-quarter GDP growth announced in December was weaker than most economists had been predicting, at 5.5% on year this shows just how far the country is ahead of the rest of the pack in this region.

The third-quarter result followed a barnstorming 10.2% year-on-year growth rate in the second quarter, which prompted the EBRD to predict 8.0% growth for the whole of 2010. A slowdown from the post-recession bounce is always likely, so for 2011 most expect a continued moderation as per the third-quarter result, with the EBRD and Capital Economics putting growth at 5.0%. "Turkey has had a very good global crisis, proving itself above its EU peers in many respects. Half-year real GDP growth of just short of 11% puts it at the top of the regional growth pack," says RBS' Ash. "Turkish banks look in a robust state of health, able to expand now in Turkey and cross border into the region, the sovereign balance sheet also looks strong."

Even so, Ash and others worry about growing imbalances, evident in the ballooning current account deficit. Exports of goods and services actually fell by 0.2% on year in the third quarter (after rising by 11.6% in the second), while imports grew by nearly 17%. "This resurgence in imports has led to a renewed widening of the current account deficit throughout 2010 (a familiar vulnerability for Turkey). We expect this shortfall will swell to 6% of GDP next year - stretching the limits of what can be considered sustainable," says Capital Economics' Shearing.

What this means is that the central bank will remain loath to raise interest rates in the near term for fear of attracting further inflows of "hot money" - something that Turkey has seen a lot of as its stock market soared to a series of record highs over the summer - and widening the current account deficit even further. Capital Economics expects a first rate hike in mid-2011, although says there is a real risk that it will come later in the year.

Faced with a combination of strong capital inflows and rampant domestic demand, the central bank is going to need to get more creative with monetary policy. "Other forms of monetary tightening - particularly further hikes in banks' reserve requirements and possible limits to curb credit growth - are likely to play an increasingly key role in the policy mix in the coming months and quarters," Shearing predicts.

Romania still stuck in the shadows

The Romanian economy is still struggling to emerge from the shadow of the last decade's credit boom. After falling by 7.1% in 2009, GDP is on track to contract by a further 2.0% in 2010, followed by an anaemic 0.9% expansion in 2011, the EBRD predicts.

The EC notes that Romania entered the recession with a budget deficit of 5.4% of GDP and a current account deficit of 12.7%. "This vulnerable position created additional stress in local financial markets and limited the scope for any government stimulus to prop up the economy," the EC noted in its November report.

July's deep fiscal cuts - needed to meet the conditions of Romania's IMF-led loan programme - have taken a heavy toll on domestic demand and the economy as a whole. While those steps to consolidate public finances were welcomed, the EC and many others worry that the famously spineless and self-serving politicians in Romania will fall victim to what Dr Roubini describes as "reform fatigue" and reverse some of these unpopular measures.

The government survived a no-confidence vote at the end of October and agreements with the IMF and the European Commission have remained on track, but disbursement of new IMF funds has been delayed until parliament approves the new unitary wage law for the public sector, the new pension law and the budget plan for 2011. "This could happen the earliest in January 2011... so Romania could receive the next tranches from the IMF and the EC in January next year, at the earliest," says Ionut Dumitru, chief economist at Raiffeisen Bank International.

Under a scenario consistent with no reversal of the fiscal consolidation measures already implemented by the government, Erste reckons the budget deficit will decline to 4.9% of GDP in 2011 and 3.5% in 2012. But that's a big if.

With the country's banking sector amongst the most fragile in the region and domestic demand feeble (retail sales figures for October were down 7.6% on year), the consumer sector will stay weak for some time. Therefore, the pace of the recovery is highly dependent on the strength of external demand. On this front, a weaker leu should help, say economists, and with the political situation highly unstable, the currency should fall towards RON4.40 to the euro by the end of 2011. "But the industrial recovery has been sluggish so far and is overshadowed by the challenging outlook for key export markets in the Eurozone. Given the prevalence of forex-denominated debt in Romania, the weaker leu stiffens the headwinds for the domestic demand," says Shearing, adding that, "all told, policymakers face an increasingly tricky task."

Bulgaria's challenges

The worst of the crisis in Bulgaria has passed and the economy stabilised in 2010, but with the driving forces behind the economic turnaround being strong exports and the replenishing of inventories while households are still feeling the pinch, the country's GDP growth will continue to lag behind much of the rest of the region over the coming years. "All components of domestic demand are expected to have continued to contract in 2010," said the EC in its November report that predicts a 0.1% contraction in 2010, followed by 2.6% growth in 2011 and 3.8% in 2012.

According to Capital Economics, Bulgaria faces challenges on three fronts. First, with the budget deficit on course to hit 5% of GDP this year, the government plans a significant fiscal squeeze. Second, while the immediate threat of a meltdown in Greece appears to have receded, Bulgaria's banking sector remains the most exposed to that country in the region. Third, the lev's peg to the euro means that a prolonged period of sluggish wage and price growth is still needed to restore competitiveness lost during boom years.

Given the problems, the government is perhaps over-compensating by becoming too optimistic. In December, the Bulgarian parliament adopted a 2011 budget that sees economic growth picking up to 3.6% next year and the budget deficit narrowing to 2.5% of output. This will be difficult to achieve, says RBS' Ash, as credit growth remains moribund and consumer demand weak. "The danger herein is that the government will risk a repeat of 2009 whereupon original budget forecasts presented to the EC had to be subsequently revised up, damaging credibility in the process."

The country's problems with corruption and organised crime remain challenges, but overcoming these impediments to business and broader development remain structural and longer-term projects. Another longer-term question is whether the currency board arrangement (CBA) can deliver growth and development, or whether the lack of exchange rate flexibility will serve as a break on development. "Proponents of the CBA model will no doubt counter that for small, open economies closely tied to a large external trade partner such as the EU, it makes little sense to have an independent monetary policy," says Ash. "In the region, the interesting comparable is Serbia, which shares many similar characteristics to the Bulgarian economy, but runs a floating exchange rate with an inflation-targeting regime."

Slovenly growth in Slovenia

While critics of Slovenia's government are urging a political "reset", economists see a year of gradual recovery.

Slovenian economic growth is projected to come in at 0.9% in 2010, barely a turnaround from the 8.1% contraction suffered in 2009. However, Slovenes are about to wait at least one more year for a return to nearer the country's output potential: according to the Institute for Macroeconomic Development, GDP growth should reach 2.5% in 2011 and 3.2% in 2012; the EBRD puts growth at 2.1% in 2011.

The rise in the jobless rate, currently at 10.5%, should slow down as well. But with more dismissals and bankruptcies on the horizon, the figure is likely to keep increasing until 2012 at least. These moderately optimistic forecasts are largely dependent on economic growth continuing in the country's main trading partners Germany, Austria and Italy.

While the situation on the labour market and the difficulty of accessing finance are part of global challenges, many other variables could be dealt with within the country's political agenda. Questions such as whether or when to save existing jobs or create new ones are high on the list of policymakers.

The government's term is at the halfway point and many of its plans that could influence economic development are still waiting to be approved by legislators. These laws should in the first place boost the labour flexibility, enforce payment discipline and increase transparency.

The centre-left coalition of Social Democrats, two liberal parties - the Liberal Democrats and Zares - and the rather unusual Democratic party of Pensioners of Slovenia (Desus), continues to implement its strategy that was initially criticised for being a list of good intentions rather than providing solid ground for action. On the broader scale, the government led by Prime Minister Borut Pahor struggles with measures to deal with the crisis, his promise to safeguard social security and the inevitable pension reform, which was surprisingly pushed through in December (despite failing to get support from Desus). The concrete economic policies aim to boost technological development, competitiveness, investment friendliness and stimulate small to medium-sized enterprises.

The future of this internally wracked coalition is far from certain, as it has practically destroyed its credibility in a series of affairs. According to the latest polls, less than a quarter of the population still supports it. On the other hand, there are few signs that any other political force would fare significantly better. Each would have to deal with a series of recovery measures, as well as some burning strategic questions, such as how to modernise the railways, which are proving to be a bottleneck for logistics opportunities afforded by Slovenia's favourable location.

The longer-term economic outlook for Slovenia is moderately optimistic, but after the record growth of 7.2% in 2007 was followed by an equally deep crisis, nobody dares to speak about miracles anymore.

Croatian corruption

Croatia was making the headlines at the end of 2010 for all the wrong reasons: the former prime minister, Ivo Sanader, was picked up in Austria after fleeing the country as the authorities' investigations into high-level corruption closed in on him.

Sanader's farcical attempts to escape justice certainly make for good copy, but are indicative of a serious problem in Croatia - and one that threatens to derail the country's bid to become the 28th member of the EU in 2012 after completing its negotiations sometime in 2011. The European Commission's progress report on Croatia acknowledged that the country continues to make progress along the road to long-cherished EU membership, but also sent out a clear warning it still faces the prospect of missing out on membership in the next couple of years if it doesn't step up its efforts to implement judicial and administrative reforms, continue the fight against corruption and organised crime, and push through long-overdue changes to economic policy. As such, the report didn't give any definitive date for Croatia's elevation into Europe's politico-economic elite, prompting Croatian President Ivo Josipovic to warn that the country faces the danger of encountering further delays to its EU accession - already the longest of any EU candidate, having begun talks back in 2005 - and of missing out on billions of euros of EU funds if it fails to put its house in order.

And Croatia needs the investment. Its economy was hard hit by the global economic crisis, shrinking 5.8% in 2009, and has struggled to climb out of recession since. The latest government forecasts show the economy falling a further 1.8% in 2010, then growing 1.5% in 2011 and 2.1% in 2012. The EBRD's a bit more optimistic, predicting 2.0% growth in 2011.

Ironically, part of the economy is benefiting from the Eurozone's problems, namely that many tourists, particularly Germans and Austrians, avoided visiting Greece in the summer due to its problems and instead plumped for the Dalmatian coast, lifting tourism arrivals by 3% from 2009. Given Croatia relies on tourism for nearly a fifth of its GDP, that's a crucial boost.

Even so, the EC says Croatia needs to start making the difficult structural reforms that have been put off for far too long, especially with regard to the privatisation and restructuring of loss-making enterprises such as the country's shipyards, which have only survived the global economic downturn thanks to a steady drip-feed of direct and indirect subsidies that don't comply with EU competition legislation.

The EU also says the Croatian labour market remains highly rigid, with low employment and participation rates; the jobless rate has risen to 12.5% in 2010 from 9.0% before the crisis.

There's also trenchant criticism of the current government's fiscal policy, which has seen loose controls over public spending at the cost of a rising budget deficit that has only been supported by a rise in borrowing at increasingly expensive rates. The EU says that the rise in indebtedness, about 88% of GDP, remains a key vulnerability of the economy that needs to be urgently addressed. "With elections due at the end of 2011, a substantial fiscal tightening is unlikely to arrive anytime soon. But with firms still reluctant to hire and unemployment amongst the highest in the region, the household sector is likely to remain under intense pressure for some time. As a result, GDP growth will remain firmly below its potential rate of around 4% over the coming years," says Shearing.

Rest of the Western Balkans

With the modest recovery seen in 2010 expected to continue and pick up into 2011, Serbia has received plaudits for its response to the crisis. RBS' Ash visited Serbia in November and says he left "with a generally upbeat outlook."

Dusko Vasiljevic, an economist for the World Bank in Serbia, explains that the authorities in Serbia reacted quickly to deteriorating external conditions by initiating a programme with the IMF and undertaking a significant fiscal adjustment. The result is that the economy, helped by the exchange rate flexibility and low base period effects, as well as good FDI inflows, seems to be bouncing back more robustly than its peers, with the EBRD predicting 1.6% growth for 2010 and 2.9% for next year.

Vasiljevic notes a "welcomed re-balancing of growth sources," adding that "exports are recovering vigorously, indicating that the economy may be moving away from consumption-driven growth. Going forward, growth will have to rely much more on exports and investments, as opposed to consumption financed by foreign capital inflows, as in the pre-crisis period."

To capitalise on this momentum, Vasiljevic calls for structural reforms, "including expenditure reprioritization and a reduction of current expenditures over the medium term...[plus] reforms to facilitate the growth of Serbia's private and financial sectors, including through enhancing the business environment, improving competition on the domestic markets, strengthening financial discipline and building a more efficient and stable financial sector."

For now, the IMF seems happy with the way the government is handling matters. On November 30, the parliament adopted a revised 2010 budget, widening the budget deficit to 4.8% of GDP, an increase Serbia agreed with the IMF in May to allow for the impact on the region of the Greek financial crisis. The earlier target was 4.0%. Serbia signed a €3bn deal with the IMF in 2009.

The current account deficit and inflation remain the thorns in Serbia's side. Inflation, which dropped to a low of just 3.7% in May 2009, has spiked over the past few months. The consumer price index rose 9.6% on year in November, faster than the 8.9% growth seen in the previous month, thus moving outside of the National Bank of Serbia (NBS) targeted range in November. "The recent key rate hike of 100 basis points [making it Europe's highest benchmark interest rate] is a kind of anxious move by the NBS Executive Board that is resigned to the fact that this year's CPI target won't be hit, but being much concerned on hitting the 2011 CPI target," says Raffeisen. "In a move to stabilize the agriculture and food market, the prime minister and the NBS governor agreed on defining new measures to curb food price inflation - the introduction of a commodity reserve system, efficient anti-monopoly policy measures which we welcome but are cautious whether the move would in fact curb the speeding inflation, given still rather volatile dinar movements and high inflationary expectations."

The current account deficit reached a peak of 17.6% of GDP in 2008, before moderating to 6.7% of GDP in 2009, but has since risen back to a forecast level of 9% of GDP in 2010.

Serbia's perennial problem has been its volatile politics, which has seen too many elections come and too many governments go. Those problems appear to have eased somewhat, with the current pro-European coalition led by the president's Democratic Party proving much more durable than had been previously assumed; it could even endure until parliamentary elections due by May 2012, which would be something of an achievement.

The coalition could go into those elections with the extra boost of an EU agreement to begin accession negotiations. The EC is expected to produce an "opinion" by November 2011 as to whether formal accession negotiations should begin with Serbia, which will then be subject to a decision of the European Council. Key issues remain the normalisation of relations between Serbia and Kosovo, as well as the festering issue of the alleged war criminals still at large, chiefly General Ratko Mladic.

However, Serbia is another prime candidate for Roubini's "reform fatigue." There's mounting union opposition to legislation lowering pensions and raising the retirement age, and there are fears that Serbia's economic restraint may begin to fray in the face of such pressures, particularly in the run-up to the parliamentary elections in 2012. However, the planned sale of a 51% stake in Telekom Srbija, the national telephone company, in the first quarter of 2011 - which is expected to raise around €1.4bn - may provide the government with an opportunity to solve the deficit problem without political confrontation, though at the expense of much-needed capital investment.

Other challenges remain on the horizon. For Serbia, this includes getting the growth to translate into more jobs, as over 10% of jobs were lost since the crisis started.

Bosnia-Herzegovina, too, has suffered a jobless recovery, while also being praised for the steps taken in the face of stark economic realities, even though it was facing important elections of its own in October. The economy shrank 2.8% in 2009, but has stabilised in 2010. The EBRD predicts GDP to grow 0.8% in 2010, picking up to 2.2% in 2011.

A recent IMF mission to Bosnia concluded that the country's performance under the three-year stand-by agreement remains broadly on track. The mission's head, Costas Christou, said in his concluding statement that following the decline in economic activity in 2009, an export-led recovery has been advancing. Other encouraging signs include acceleration in indirect tax collections and gains in manufacturing production. As of the end of September, the country looks likely to achieve the end-2010 fiscal targets, including the consolidated general government deficit of 4.5% of GDP.

Even so, Damir Cosic, an economist for the World Bank in Bosnia, cautions that the economic recovery remains fragile and dependent on external conditions.

In November, Montenegro secured long-cherished EU candidate status and with forecasts of growth of 2.6% in 2011 after the economy stabilised in 2010, the government has been busy touting the country as the next frontier-market play with international investors.

Prime Minister Milo Dukanovic has declared that the worst of the economic crisis in Montenegro is over and the country is on the road to recovery. Part of that optimism is based on a successful tourist season, with the tourism minister reporting in October that tourism revenues so far this year had reached €638m, beating the planned annual figure of €620m.

Meanwhile, PM Dukanovic is hopeful that work on a number of major projects that will be key drivers of future economic growth will start in the first quarter of 2011. These include the Porto Montenegro project in Tivat, a tourism complex development in Lusica, and the Bar-Boljare motorway project.

At a time when investors are shying away from heavily indebted countries, Montenegro boasted a relatively unleveraged profile. State debt/GDP was a modest 34.8% at €1.115bn at the end of June, with internal debt at €377.5m, or 11.8% GDP, while external debt was at €737.8m, or 23% of GDP.

Montenegro also seems to be making major strides in improving its competitiveness. In the World Economic Forum's 2010-2011 Global Competitiveness Index report, Montenegro recorded the biggest year-on-year rise of any European country, rising 13 places to number 49 out of 139 countries in the survey.

However, after two years of tourism and real estate-driven growth after independence from Serbia in 2006, Standard & Poor's (S&P), which cut Montenegro's credit rating to 'BB' from 'BB +' in March, has warned that the recession is putting pressure on government finances. "In our view, Montenegro's government continues to be vulnerable to indirect and contingent risks associated with the significant pressure on its real economy and banking system, and deteriorating asset quality. The Montenegrin economy is suffering a hard landing," noted S&P analyst Marko Mrsnik.

In December, Macedonia reached an agreement with the IMF for a two-year precautionary credit line worth €480m, becoming the first country to use the IMF's new credit line, designed to provide support for countries but without the conditionality associated with other IMF loans. In its statement, the IMF noted Macedonia's "history of sound economic policies," and that the deal was based on the government's economic programme which is projecting a fiscal deficit of 2.5% of GDP in 2011 and ongoing commitments to support the exchange rate regime.

Indeed, Macedonia fared relatively well during the global recession compared to regional neighbours, with GDP only shrinking by 0.8%. The EBRD puts growth at 2.3% in 2011. On the downside, tax revenues are expected to come in below expectations in 2010, while a recovery in the country's export-orientated metals industry is still struggling to gain pace.

The EC also remains fairly unimpressed; in November, it identified Macedonia as a laggard in the reform process and urged the state to step up judicial and public-sector reforms and encourage greater political dialogue and media freedom, while doing more to clamp down on political and economic corruption.

Albania was one of only three European countries to avoid recession in 2009 (Poland and Belarus were the other two) and some argue this might be going to its head.

The finance ministry's draft budget unveiled in December showed the government expects the economy to grow 5.5% in 2011, far more than forecast by the IMF, and also plans a higher budget deficit than the Fund has recommended. The IMF sees 3.5% growth in 2011 and has recommended Tirana target a budget deficit of 2.5% in 2011, arguing it would help start lowering public debt from 60% of GDP to 54%in 2013. The draft budget sees the deficit at 3.5% at the end of 2011.

In November, the EC dealt a blow to Albania's hopes of joining the EU in the near future when it stated the country had failed to meet the Copenhagen criteria on political development. Commenting on the decision, the enlargement commissioner, Stefan Fule, said: "What is needed is the stability of institutions guaranteeing democracy and the rule of law. I urge Albania to make the necessary efforts to build on efforts so far." Fule added that he hoped to be able to recommend Albania for EU membership candidacy status in 2011.

At the heart of the rejection is the lack of dialogue between Prime Minister Sali Berisha's administration and the opposition following the fiercely contested parliamentary elections in June 2009, which saw Berisha's Alliance for Change centre-right coalition narrowly defeat the leftwing Socialist Party opposition, who cried foul at the election result, alleging widespread fraud. In its report, the Commission noted: "Political dialogue is confrontational and unconstructive, not least because of the political stalemate since the June 2009 elections. This obstructs parliamentary work and prevents necessary policy reforms based on consensus."

Speaking ahead of the EU's rejection, Berisha told bne that he had already reached out to the opposition with regard to implementing electoral reforms that would enable Albania to convince the international community that the country is capable of holding truly free-and-fair elections. "I believe that last election met most of the principles of a free and fair election according to the OSCE," Berisha said, adding that he had told Edi Rama, chairman of the Socialist Party and mayor of Albania's capital Tirana, to draft changes to the country's election legislation that it would pass onto Europe's regional security organisation, the OSCE, without comment or amendments. "It's the biggest compromise I've made in more than 20 years in politics," said Berisha, who after the fall of communism served as Albania's president from 1992 to 1997 until his government fell in the wake of the collapse of series of pyramid schemes, which led to widespread civil unrest. After eight years in opposition, he returned to power in 2005 as prime minister.

Berisha said that Albania's integration into the EU remains the top priority of his current mandate, which runs until 2013. He also noted that in terms of the fight against corruption and organised crime, Albania can point to substantial progress. In the latest corruption listings published by anti-graft body Transparency International (TI) at the end of October, Albania rose eight places compared with 2009 to rank 87th out of 178 countries. When Berisha came to power in 2005, Albania ranked 125th out of the 158 countries surveyed by TI at the time. "We are doing our best to increase transparency in all government sectors," said Berisha, adding that Albania is the first country in the world to introduce 100% digital public procurement.

Kosovo held its first post-independence elections in December, which saw the Prime Minister Hashim Thaci's Democratic Party of Kosovo (PDK) emerge the strongest force, but saw its support decline as voters expressed their anger at corruption and lack of economic progress.

Despite some €4bn in aid, the country still has an estimated 48% unemployment rate. However, Gani Gerguri, the acting central bank Governor of Kosovo, told Bloomberg in November that Kosovo's GDP is forecast to expand an annual 5.9% in 2011, the fastest pace in the Balkans, after an estimated 4.6% growth in 2010 and 4% in 2009.

What Kosovo really needs is investment, but the country's a hard sell as long as institutions remain dysfunctional, the economy a basket case and corruption rampant. "The economy of Kosovo is about to collapse," Musa Limani, an economy professor at the University for Business and Technology in Pristina, told Reuters. "No politicians have worked for the interests of Kosovo. They were eager to get richer and some people got rich overnight."

As IHS Global Insight notes: "The status quo has angered the electorate and served to alienate the already low levels of international investment – a real problem given the country's ambitious privatisation plans. Improving this situation will be a top priority given its importance for the third item on the future government's agenda: economic development."

More of the same in Moldova

Moldovans had a chance in November to finally put an end to the political impasse that has plagued the country, but sadly the three-fifths super-majority needed in the unicameral parliament to elect a president proved again elusive after the country's third parliamentary election in two years: with all the votes counted, Moldova's Communist Party took 39.3% of the ballots and 42 of the 101 seats, while the three-member governing coalition Alliance for European Integration (AEI) took 52.1% of the vote and 59 seats, just shy of the 61 needed to elect the president.

By mid-December, there was still no resolution to the vote's outcome, which will inevitably have a damaging impact on the already fragile economic recovery as well as leading to voter fatigue. "Currently, Moldova is dangerously close to a systemic failure of the current parliamentary system if the election fails to end the political stand-off. The inability to govern the country in full and pursue necessary structural reforms is likely to result in the further exodus of the young and able population, further weakening Moldova's prospects of political, societal and economic development," says IHS Global Insight.