Caucasus Business Forecast Report Q2 2008

Elections To Reaffirm Continuity We expect the upcoming presidential elections in Armenia and Azerbaijan, and the recently held presidential election in Georgia, to reaffirm policy continuity in both the political and economic spheres. This will continue to provide overall support to the internal stability within each country.

That said, the 'frozen conflict' foreign policy disputes remain a key risk for the region. While some progress has been made towards establishing a dialogue in 2007, we anticipate that a resolution to the disputes is unlikely in the medium term. Thus we believe that this issue will continue to threaten the normalisation of diplomatic relations and the opening of intra-regional trade for the foreseeable future. Nevertheless looking at the economy, we forecast that the key macroeconomic indicators for the Caucasus region will remain positive throughout 2008, and that all three countries will continue on their trajectories of robust economic growth. In particular, we expect that large foreign capital inflows, improving debt dynamics and the stabilisation of the local banking sector will provide key support for the economy. However, upside inflationary pressures remain a key risk, particularly as all three governments are facing increased domestic pressures from the population for improvements in living standards on the back of strong economic growth.

We maintain our view that the long-term outlook for all three Caucasus countries remains stable.

Indeed, while the public protests have continued since the snap presidential election held in Georgia on January 5 , which saw the incumbent President Mikhail Saakashvili re-elected, these are nowhere near the levels of discontent seen at the peak of November 2007. However, we expect that Saakashvili's National Movement-Democrats will see a reduction in support in the upcoming parliamentary election. We anticipate that the forthcoming presidential elections in Armenia and Azerbaijan will not see high levels of public protests, and that the incumbents (or their close allies) will win each election.

We expect that an improvement in the regulatory framework in the Armenian banking sector will be supportive of asset growth going forward. We anticipate that banking sector developments and robust economic growth, forecast to average 7 .7% of GDP each year until 2012, will have a reciprocal effect - boosting the growth of each other. Indeed, during our five-year forecast period, we expect that the demand for credit will continue to grow, although we caution that this may lead to an increase in non-performing loans.

Georgia's business environment continues to improve. We are particularly encouraged by the quality of the country's labour force and the flexibility of the labour market. Recent tax reforms have simplified the system and improved its efficiency. In addition, Georgia has become increasingly open to foreign business following the 'Rose Revolution' of 2003, making the country attractive to foreign investment. That said, the country's physical infrastructure requires further investment, and the military and political tensions with the separatist regions of South Ossetia and Abkhazia remain a concern.