Serbia and Montenegro Business Forecast Report Q3 2009

We expect Serbia to experience a painful recession in 2009 and forecast real GDP to contract by 3.8% as both external and domestic demand collapses and foreign capital inflows fall. While the conclusion of a US$4.0bn Stand-By Arrangement will reduce external financing risks to the economy, we caution that the requirement that the government runs a fiscal deficit of no more than 3% of GDP will pose a threat to political stability. Social spending cuts and tax increases at a time of rising unemployment will likely be highly unpopular. We warn that further protests are likely, and policy continuity cannot be assured. We expect to see signs of a recovery in late 2010, and project real GDP growth of 3.5% in 2011 as external and domestic conditions improve. In terms of medium-term political risk, we expect the issue of Kosovan independence to remain a concern and caution that there is potential for flare-ups between the ethnic Albanian and ethnic Serb populations.

We have recently revised down our short-term political risk rating to 44.6 (from 47.5) due to concerns over the potential risk of increased social instability and threats to policy continuity as Serbia heads into recession. Specifically, we have revised down the 'policymaking process' subcomponent of our risk rating methodology to 60.0 (from 63.3), and the 'social stability' rating to 35.0 (from 40.0). We are concerned that an increase in the unemployment rate, a fall in real living standards, combined with fiscal spending cutbacks will pose elevated risks to Serbian political stability over the medium term.

Separately, we have revised down the 'security / external threats' component of our ratings to 33.3 (from 36.7) due to the uptick in tensions in northern Kosovo, specifically in the town of Mitrovica.

Economic growth slowed in the final quarter of 2008, expanding by 2.8% year-on-year (y-o-y), below the 8.5%, 6.0% and 4.9% seen respectively in the first three quarters. The fourth quarter figure is the lowest growth rate since Q403, and brings the annual figure for 2008 to 5.4% - in line with BMI's forecast. We recently revised down our 2009 growth forecast and now project a 3.8% contraction, compared with our previous forecast of -2.2%. Our revised forecast is lower than that of the National Bank of Serbia, which recently stated it still hoped growth could reach 1.5 -2.0%, and the government's view, outlined by Deputy Prime Minister Bozidar Delic in March that growth would be between -2.0% and 0%. We expect economic activity to continue to be negatively impacted by weak external and domestic demand, tighter access to global credit markets and a reduction in foreign investment.

Mobile operator Vip Mobile, a subsidiary of Telekom Austria, has warned that the additional 10% tax on mobile phone bills that the government has introduced will negatively impact both the industry and customers. The operator believes that the tax will hit investment plans and, consequently, the development of the mobile industry in Serbia. The new tax policy has been introduced as part of the government's fiscal adjustment package, which aims to reduce the budget deficit to 3% of GDP this year. Norwegian firm Telenor, one of the largest foreign investors in Serbia, has cautioned that the tax could damage the telecommunications industry, and could have feed-through effects to overall investment levels. In addition, passing this tax on to the consumer will also be unpopular, as Serbian living standards are already set to deteriorate in the face of the economic downturn.

International's 2008 Corruption Perception Index.