October-16 * SE

SEE Quarterly FISCAL EASING?

GDP growth forecasts

Source: Focus Economics, Addiko Reasearch 3,5 February forecasts 0,5 October forecasts Percentange points change (rhs) 3,1 0,3

2,7 0,1

2,3 -0,1

1,9 -0,3

1,5 -0,5 CRO SLO SRB B-H MNE SEE average

Slovenia: Reassuring, But Not Without Risks page 5

Croatia: More Than an Economic Recovery? page 11

Serbia: After Elections, Ready for Reforms? page 17

Bosnia and Herzegovina: After IMF, Politics Takes the Spotlight page 23

Montenegro: Capex Delays Harming Growth page 27 SEE MACROECONOMIC OUTLOOK

EXECUTIVE SUMMARY

BOTTOM LINE: We have upgraded growth outlook for both Slovenia and Croatia in 2016 with the latter owing to the strong tourism season and private consumption recovery. In Serbia, as our initial assumptions stayed largely in place we have kept our growth outlook unchanged while in Montenegro and Bosnia weaker macro performance ydt and more cloudy outlook in the period ahead forced us to downgrade this year growth expectations. In 2017, we upgraded Croatian and Serbian growth and made minor downward correction in Montenegro while keeping forecasts unchanged in Bosnia and Slovenia. However, we do admit certain downside pressures that arise from deteriorating euro zone outlook on weaker trade with the UK, tightening in financial conditions and in general elevated uncertainty and its impact on investment decisions. As for prices, fading direct effects from past commodity prices declines and the recent energy inflation normalization suggest some recovery of inflation in the near term while in 2017 commodity price recovery and higher processed food prices should pull inflation higher.

3-month view Government yields FX vs EUR Monetary policy Slovenia ▼ ▼* easier Croatia ▼ ▲ easier Serbia ▼ ▲ easier Bosnia and Herzegovina ◄► ◄► easier Montenegro ▲ ▼* unchanged *vs USD

KEY POINTS:

1. In Slovenia, despite stronger domestic demand, we kept our 2.0% GDP growth forecast on deteriorating euro zone outlook and tightening in financial conditions. In Croatia, reduced policy uncertainty, further easing in funding conditions along with EU funding and durable consumer as well capex recovery lift our 2017 GDP growth forecast to 2.25%. In Bosnia, with our assumptions staying in place we kept our 2017 growth expectations at 2.1% and 3.0% respectively, while admitting certain downside risks in Bosnia stemming from ongoing political uncertainties. In Montenegro, current macro underperformance combined with the expected slowdown next year led us to reduce 2017 growth expectations by 0.6pp to 3.2%.

2. In Croatia, with the strong fiscal performance ytd and revenues driven by strong PIT and CIT intake, EU transfers and soaring VAT amid terrific tourist season we will likely end up with stronger than expected consolidation this year, with the deficit closer to 2.0% of GDP. In Slovenia, the planned 0.6pp consolidation in 2017 largely rests on the ongoing domestic demand strength and lower interest outlays after USD to EUR market debt swaps, but we see just a 0.2pp deficit correction to 2% of GDP. In Serbia, we see 2017 budget deficit slightly higher around 3% of GDP on minimum wage and pension hikes, further severance payments and higher public capex.

3. As for inflation, in Slovenia we expect CPI inflation to pick up to 1.0% on average in 2017, just below the euro area average, and with a neutral impact on competitiveness. With the underlying inflation pressures weak, we think further ECB expansionary measures remain on the agenda. In Croatia, we expect 2017 CPI inflation to pick up to 0.7% on average on commodity price recovery and higher processed food prices. In Serbia we see inflation entering NBS target band in the 1H17 and increasing by 3.1% on average in 2017.

4. Notwithstanding the recent ECB QE taper speculation, we think that given the disappointing inflation trend, and a number of downside risks to growth, the ECB will launch a further round of monetary easing in December. In our view, In Croatia reduced policy risks upon elections, ECB-driven risk appetite, local fiscal risk mitigation, high C/A surplus and record banks' net foreign assets allow further CNB easing in 1Q17, mainly directed at getting the current tentative lending rebound going. That being said, there is relatively strong case for Croatian CDS spreads tightening by 50-75bp over a six month horizon, followed by the yield curve flattening. Serbia, we see the NBS’ wait and see stance in order to get more clarity on the future monetary policy stance of main central banks but with net- net further global monetary easing, stable dinar, ongoing inflation undershooting and strong risk appetite, we see further 25-50bp rate cut(s) over the next three to six months.

Page 2 October-16 Page 2 SEE MACROECONOMIC OUTLOOK

SEE data trends

Real GDP growth (%) CPI inflation (average, %, YoY)

2015 4 3,0 2016F 2015 2017F 2016F 3 2018F 2017F 2018F 2 1,5

1

0 0,0

-1

-2 -1,5 SLO CRO SRB B-H MNT SEE SLO CRO SRB B-H MNT SEE

Unemployment rate (ILO, average, %) Current account balance (% of GDP)

10 30 2015 6 2016F 25 2017F 2 2018F

20 -2

-6 2015 15 2016F -10 2017F 2018F 10 -14

5 -18 SLO CRO SRB B-H MNT SEE SLO CRO SRB B-H MNT SEE

Government balance (% of GDP) Gross foreign debt (% of GDP)

0 150

135 -2 2015 2016F 120 2017F -4 2018F 105

-6 90 2015 2016F 75 -8 2017F 2018F 60

-10 45 SLO CRO SRB B-H MNT SEE SLO CRO SRB B-H MNT SEE

Source: National sources, Addiko research

Page 3 October-16 Page 3 SEE MACROECONOMIC OUTLOOK

SEE banking sector trends

Gross loans (% of GDP) Loan-to-deposit ratio (%) 2015 120 90 2015 2016F 2016F 2017F 80 2017F 2018F 110 2018F

70 100

60

90 50

80 40

30 70 SLO* CRO SRB B-H MNT SEE** SLO* CRO SRB B-H MNT SEE**

Net interest margin (%) Cost-to-income ratio (%)

5 70 2015 2015 4 2016F 65 2016F 2017F 2017F 2018F 60 2018F 3

55 2 50

1 45

0 40 SLO CRO SRB B-H MNT SEE SLO CRO SRB B-H MNT SEE

NPL ratio (%) Capital adequacy ratio (%)

28 25 2015 2015 2016F 2016F 2017F 25 2017F 21 2018F 2018F 22 17

19

13 16

9 13

10 5 CRO SRB B-H MNT SEE** SLO CRO SRB B-H MNT SEE

*Net loans; **Slovenia excluded; Source: central banks, Addiko research

Page 4 October-16 Page 4 SEE MACROECONOMIC OUTLOOK SLOVENIA

Reassuring, But Not Without Risks We hold our 2.0% GDP growth forecast for 2017 on deteriorating euro zone outlook on weaker trade with the UK, slower global growth and elevated political uncertainty in its impact on investment decisions. Upside risks stem from the co-ordinated euro-area-wide fiscal easing, additional Slovenian rating upgrades, productivity-enhancing reforms and privatization. Further and possibly stronger ECB purchases and further restructuring of the yield and maturity profile ahead might result in additional credit upgrades, adding to the current bullish tone.

Q2 GDP surprised on The Q2 GDP (+0.5% qoq, 1.9% yoy s.a., vs prev 2.1% yoy) surprised on the upside, equally driven by the upside private spending and net exports, adding 0.9pp and 0.8pp, respectively. Stronger-than-expected consumer momentum is supported by soaring car sales, solid private hiring, stronger real incomes and housing credit. And net exports reflect larger-than-anticipated pick-up in the euro zone's demand, price competitiveness outperformance of the euro area, higher degree of export market differentiation and product specialization. Encouragingly, private equipment capex has offset public capex slump courtesy of a dearth of EU-funded projects. The EC sentiment bodes well for the ongoing 0.5% qoq GDP growth in 2H16, making our FY16 forecast pushed again to 2.2% not least due to more constructive euro zone outlook after the Brexit than initially feared. While we still see external demand slowing in H2 as the euro area is cyclically challenged, domestic demand is holding pretty well.

Slovenia: contributions to quarterly changes in real GDP (in pps)

11 Household General Government GFCF Net trade

5

-1

-7

Source: SORS, Addiko research -13 1Q05 4Q06 3Q08 2Q10 1Q12 4Q13 3Q15

We hold our 2.0% GDP Despite stronger domestic demand, we hold our 2.0% GDP growth forecast for 2017 on deteriorating forecast for 2017 euro zone outlook on weaker trade with the UK, slower global growth and elevated political uncertainty in its impact on investment decisions. Although the ECB is happy about monetary transmission, concerns about bank-based financial conditions are intensifying in response to, among other reasons, high NPLs in periphery countries and persistently low profits, and the persistent lack of capex drags on productivity, reducing the incentive to invest. Thankfully, we see investments as the key growth driver given rising capacity utilization, stronger corporate cash flows, better funding conditions and stronger EU funding next year. We also see private consumption growth at 2%-alike pace thanks to ongoing decent employment gains (showing higher elasticity to GDP growth) in private firms and stronger retail credit, albeit the recent subdued wage growth (mirroring weak productivity gains) bears watching. While the risks to our forecasts are pretty balanced, hard Brexit case and other idiosyncratic political events, protectionism in international trade as a drag on foreign demand and ongoing local private-sector de-leveraging needs are the main risks to the downside. Upside risks stem from the co-ordinated euro-area-wide fiscal easing, additional Slovenian rating upgrades, productivity- enhancing reforms and privatization. CPI inflation stabilized The recent normalization in energy prices, including that of oil, transport tariffs, as well as service in positive territory prices have stabilized CPI inflation in positive territory. What's more, oil prices in dollar terms remain higher than the monthly averages we saw at the very end of last year, and throughout 1H16. Hence, despite the recent euro strength, which mitigates some of these upward pressures on energy prices, we still see inflation accelerating to about 1.5% by end-1Q17. Next year, we expect consumer demand, rising unit labor costs, commodity price recovery and higher processed food inflation driving inflation going forth as indirect effects from commodity cost declines and low spot inflation fade. All said, after -0.1% on average in 2016, we expect CPI inflation to pick up to 1.0% on average in 2017, just below the euro area average, and with a neutral impact on competitiveness. With the underlying inflation pressures weak, we think further ECB expansionary measures remain on the agenda.

Page 5 October-16 Page 5 SEE MACROECONOMIC OUTLOOK SLOVENIA

Steady external A strong increase in C/A surplus owes to steady external demand and subdued imports amid a demand and subdued temporary EU-funded public investment slowdown. Such positive developments are offset by imports increasing C/A temporarily lower EU-related transfers and the worsening of the general government position. With a surplus renewed strengthening of domestic (import-) demand and commodity price normalization, we expect C/A surplus to level off in 2017 onwards as the C/A balance becomes increasingly 'structural'. As long as net external liabilities decline, we likewise see a further decrease in the net international investment position toward -35% of GDP, which is below the Baa3 median of -41.3% of GDP last year.

With record surpluses and about 18% of GDP fiscal reserve upon further dollar bond buybacks via 19Y EUR1bn bond issue, Slovenian funding position is on extremely firm footing. With further ECB easing likely by end-year, the MinFin may engage in further USD bond repurchases and prefund for 2017. After this year's sale of NKBM bank, privatization has stalled since the political context (MoF Mramor's departure, elections in the summer 2018) and the government's plan to keep 25%+ share in the largest state NLB bank do not help to attract investors. That said, removing restrictions on holding higher stakes in strategic SOEs and competitiveness reforms are needed to attract FDI and reduce public debt as a prolonged period of low interest rates requires state-owned banks to adapt business models.

Slovenia: fiscal deficits (% of GDP) Source: European Commission, Addiko research 0

-3

-6

2010 2016 -9 EST CZE LAT LIT B-H HUN BG SLO POL CRO ROM SRB

We expect to see 'only' A 29.7% yoy lower budget deficit (EUR670m) in the year to August is driven by a -5.2% yoy spending cuts 0.2pp deficit cut to and sound tax performance, despite PIT cuts. Notwithstanding public wages, pensions and social 2.0% of GDP this year transfer hikes, refugee-related spending, and recently higher interest outlays, spending cuts largely reflect lower capital investments and subsidy cuts. While consolidation goes as planned, with upside risks to tax-rich domestic demand and the budget gap indeed within the MinFin-eyed 2.2% of GDP in 2016, we still do not rule out stronger-than-expected impact from BAMC activity, whereby Slovenia seeks ways to exclude it from the budget given unpredictability of every BAMC transaction. Looking ahead, politics are not supportive for larger consolidation in 2017-2018 when structural balance will deteriorate to -3% of GDP, and public capex cuts will be reversed to 2013-alike levels, which together with higher entitlement spending leads to marginal fiscal easing. We also doubt the government including the pensioner party DeSUS will bring any meaningful pension reform to address the area which largely explains fiscal sustainability gaps. While the planned 0.6pp consolidation in 2017 largely rests on the ongoing domestic demand strength and lower interest outlays after USD to EUR market debt swaps, we see just an 0.2pp deficit correction to 2.0% of GDP.

Public debt expected Following an increase to 83.5% of GDP on strong prefunding, we expect public debt to drop over 2017- to drop over 2017- 2018 thanks to successively lower deficits and state bond redemptions partly covered by the reduction 2018 of the ample cash buffer, totaling nearly 18% of GDP. The assumed drawdown in the latter by EUR1bn and EUR0.5bn in 2017 and 2018, respectively, will in our view enable a reduction in the gross government debt to 80% of GDP this year and 74.5% of GDP by the end of this decade, in line with the EC-enshrined MIP's requirement of the debt reduction by 1.2pp of GDP annually. Moreover, the pace of public debt reduction could be faster in case of stronger authorities' push for a reform-driven budget gap reduction, resumption of privatization deals (generating EUR400m in 2014-2015), sale of BAMC assets (EUR300m last year), and also adherence to a zero-budget deficit rule. When it comes to the latter an the overall reform content, the real estate tax implementation (bringing EUR200-300m), tax base expansions and the assumed EUR200m savings out of healthcare reform are the main options with an eventual larger fiscal impact. Further bank and firms' (both SOE and private ones) restructuring, with an overall ambitious NPL reduction targets, are equally important to reduce the risk to public finances over the medium term.

Page 6 October-16 Page 6 SEE MACROECONOMIC OUTLOOK SLOVENIA

Slovenia bonds Not only Slovenian bonds outperformed CEE ones in the past months, but they also outdid periphery outperformed issuers Italy and Spain under pressure from growing political and fiscal concerns. The abrogation of the EDP, further improvement in the fiscal accounts, including the reversal in public debt trajectory and further restructuring of the debt profile into lengthier euro curve, further hefty ECB QE purchases and the subsequent rating upgrades by Fitch and Moody's have all driven yields down. Slovenia also found itself among top 10 performing EU bond indices, with the sovereign's total return of 3.2% and 6.1% on 3M and year-to-date horizons, respectively. Further and possibly stronger ECB purchases and further restructuring of the yield and maturity profile ahead (i.e. even lower interest payments) might result in additional credit upgrades, adding to the current bullish tone.

Slovenian spreads in tandem with peers

470

410 Source: Bloomberg, Addiko research Slovenia USD 2022 Romania USD 2022 350 Hungary USD 2021 290

230

170

110 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16

The ECB set to launch a Notwithstanding the recent ECB QE taper speculation, we think that given the disappointing inflation further round of trend, and a number of downside risks to growth, the ECB will launch a further round of monetary monetary easing in easing in December. That said, the markets expect the ECB to announce the extension of QE purchases December by minimum six months beyond March 2017, expand portfolio of bonds eligible for purchase, change the issuer share limit or move away from the key capital ratios (positive for periphery issuers) as well as another depo/refi rate cut. Additional easing next year cannot be excluded when the central bank would venture into buying riskier assets, including equities. In such case, we'd expect additional drop in Slovenian yields. While the ECB backstop via QE purchases is an important market support in the wake of the growing pressure on peripheral spreads ahead of the upcoming constitutional referendum in Italy and continued political/fiscal uncertainty in Spain and Portugal, the almighty facility is unlikely to be enough to stop 20-50bp widening episodes, in our view. We see Slovenian bonds outperforming as long as the sovereign fares better on the growth and fiscal metrics and does not face political uncertainty, unlike most peripherals. We'd also expect upside pressures on peripheral and Slovenian yields should the ECB start tapering QE program in 1H17, when a broader systemic prices slump would be unavoidable.

Page 7 October-16 Page 7 SEE MACROECONOMIC OUTLOOK SLOVENIA

Slovenia's data trends

Real GDP growth (% YoY) Economic confidence vs. GDP growth

Economic Sentiment Index (lhs) 4 120 12 GDP growth, 3m lag (yoy, rhs) 2 110 8

0 100 4 -2 90 0 -3

80 -4 -5

70 -8 -7

-9 60 -12 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F 1Q02 2Q05 3Q08 4Q11 1Q15

CPI inflation dynamics (% YoY) Business sentiment in manufacturing

9 20 Slovenia Euro area

7 0

5 -20

3 -40

1 -60 Confidence indicator Export order-books Overall order-books -1 -80 Jul-01 Jun-04 May-07 Apr-10 Mar-13 Feb-16 Aug-04 Jul-08 Jun-12 Sep-16

PMI vs Industrial production - Slovenia Unit labour cost for the total economy 65 12 10

8 60 5 4 0 55 0 -5 50 -4 -10 45 -8 -15 -12 40 Germany mnfg PMI, (lhs) -20 -16 Italy mnfg PMI, (lhs) 1Q96-1Q16 35 Slovenian industrial production, 3mma, -20 -25 (YoY, w-d-a, rhs) 30 -24 -30 Jan-07 Apr-09 Jul-11 Oct-13 Jan-16 LUX GRE ITA SLO ESP FIN NL BEL FRA AT IRE GER

Source: Slovenian National Bank, Statistical office of the Republic of Slovenia, Ministry of Finance, ECB, European Commission, Bloomberg, Addiko research Page 8 October-16 Page 8 SEE MACROECONOMIC OUTLOOK SLOVENIA

SELECTED ECONOMIC FORECASTS 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Activity Nominal GDP (EURbn, current prices) 36,3 36,9 36,0 35,9 37,3 38,5 39,4 40,2 41,1 Nominal GDP (USDbn) 48,1 51,4 46,3 47,7 49,6 42,7 43,6 41,8 44,0 GDP per capita (EUR) 17.693 17.972 17.496 17.431 18.091 18.665 19.042 19.389 19.837 GDP per capita (USD) 23.471 25.028 22.499 23.150 24.034 20.701 21.079 20.164 21.225 Real GDP (constant prices YoY, %) 1,2 0,6 -2,7 -1,1 3,1 2,3 2,2 2,0 2,5 Private consumption (YoY, %) 1,1 0,0 -2,4 -4,1 1,9 0,4 2,3 1,9 2,1 Fixed investment (YoY, %) -13,3 -4,9 -8,8 3,2 1,4 1,0 -1,2 3,6 3,7 Industrial production (YoY, %) 7,1 1,3 -1,1 -0,7 2,2 4,6 6,5 4,5 5,0 Unemployment rate (ILO, average %) 7,3 8,2 8,9 10,1 9,7 9,0 8,5 8,0 7,6

Prices CPI inflation (average % YoY) 1,8 1,8 2,6 1,8 0,2 -0,5 -0,1 1,0 1,3 CPI inflation (end-year % YoY) 1,9 2,3 2,7 0,7 0,2 -0,5 0,3 1,0 1,4 PPI inflation (average % YoY) 2,1 4,5 0,9 0,3 -0,6 -0,2 0,6 1,5 0,0 Net wage rates (% YoY, nominal) 3,9 2,1 0,4 0,6 0,8 0,7 1,7 2,0 1,4

Fiscal balance (% of GDP) State budget balance (ESA-95) -5,7 -6,7 -4,1 -15,0 -5,0 -2,9 -2,3 -2,0 -1,6 Public debt 38,0 46,6 53,9 71,0 81,0 83,2 80,2 78,1 77,4 Gross public funding needs 7,0 10,5 8,2 19,5 14,6 6,4 8,1 9,7 9,2

External balance Export of goods and services (EURbn) 23,285 25,948 26,363 27,010 28,520 30,064 31,236 32,298 33,429 Import of goods and services (EURbn) 22,823 25,516 24,934 24,569 25,641 26,547 27,503 28,724 29,672 Merchandise trade balance (EURbn) -0,748 -0,974 -0,081 0,708 1,181 1,498 1,593 1,634 1,817 Merchandise trade balance (% of GDP) -2,1 -2,6 -0,2 2,0 3,2 3,9 4,0 4,1 4,4 Tourism receipts (EURbn) 1,925 1,975 2,008 2,043 2,060 2,257 2,144 2,209 2,272 Current account balance (EURbn) -0,043 0,068 0,930 1,732 2,325 1,998 2,599 2,490 2,592 Current account balance (% of GDP) -0,1 0,2 2,6 4,8 6,2 5,2 6,6 6,2 6,3 Net FDI (EURbn) 0,1 0,6 0,5 0,0 0,6 1,2 1,0 1,2 1,4 FDI (% of GDP) 0,3 1,7 1,3 0,1 1,6 3,2 2,6 3,0 3,4 FDI cover (%) n/a n/a n/a n/a n/a n/a n/a n/a n/a Gross international reserves (EURbn) 0,803 0,767 0,722 0,669 0,837 0,760 0,760 0,760 1,760 Import cover (months of imports) -0,4 -0,4 -0,3 -0,3 -0,4 -0,3 -0,3 -0,3 -0,7

Debt indicators Gross external debt (EURbn) 42,123 41,669 42,872 41,658 46,314 44,954 44,554 44,404 44,934 Government (EURbn) 8,190 8,748 11,092 15,459 22,416 23,169 23,819 24,419 24,919 Private (EURbn) 30,273 28,534 25,709 23,457 21,815 20,385 19,335 18,785 18,815 Gross external debt (% of GDP) 116,2 112,9 119,1 116,0 124,2 116,6 113,1 110,6 109,2 Gross external debt (% of exports) 180,9 160,6 162,6 154,2 162,4 149,5 142,6 137,5 134,4

Exchange rates and money growth EUR/USD (end-year) 1,34 1,30 1,32 1,38 1,21 1,09 1,05 1,07 1,09 EUR/USD (average) 1,33 1,39 1,29 1,33 1,33 1,11 1,11 1,04 1,07 Money supply M1 (% YoY)* 13,5 1,5 4,4 0,1 18,5 24,9 8,5 6,2 5,3 Broad money M3 (% YoY)* 2,4 3,5 -1,4 -1,3 6,1 4,6 3,2 2,9 2,4 Domestic credit (% YoY) 1,6 -4,6 -5,8 -21,4 -11,5 -5,9 -3,5 2,1 2,6 ECB reference rate (end-year %) 1,00 1,00 0,75 0,25 0,05 0,05 -0,20 -0,25 -0,25 EURIBOR 3M interest rate (average %) 0,81 1,39 0,58 0,22 0,21 -0,02 -0,29 -0,40 -0,40 SLO 5Y yield (average %) 3,03 3,96 4,55 4,35 2,14 0,84 0,10 0,05 0,25 SLO 10Y yield (average %) 3,84 4,98 6,01 5,87 3,28 1,67 1,05 0,75 1,00

* Since 2007 ECB data

Source: Slovenian National Bank, Statistical office of the Republic of Slovenia, Ministry of Finance, IMF, Addiko Research

Page 9 October-16 Page 9 SEE MACROECONOMIC OUTLOOK SLOVENIA

SELECTED BANKING SECTOR DATA 2010 2011 2012 2013 2014 2015F 2016F 2017F 2018F Balance sheet Assets (EURm) 50.319 48.748 46.125 40.344 38.714 37.383 36.603 36.786 37.154 Assets (%, YoY) -2,5 -3,1 -5,4 -12,5 -4,0 -3,4 -2,1 0,5 1,0 Assets (% of GDP) 138,8 132,1 128,2 112,4 103,8 97,0 93,0 91,6 90,3 Net loans (EURm) 34.450 32.875 30.964 24.338 21.540 20.275 19.569 19.976 20.491 Net loans (%, YoY) 1,6 -4,6 -5,8 -21,4 -11,5 -5,9 -3,5 2,1 2,6 Net loans (% of GDP) 95,0 89,1 86,0 67,8 57,7 52,6 49,7 49,7 49,8 Deposits (EURm) 23.507 24.170 23.856 22.550 24.426 25.140 25.692 26.487 27.281 Deposits (%, YoY) -0,3 2,8 -1,3 -5,5 8,3 2,9 2,2 3,1 3,0 Deposits (% of GDP) 64,8 65,5 66,3 62,8 65,5 65,2 65,2 66,0 66,3 Loan-to-deposit ratio (%) 146,6 136,0 129,8 107,9 88,2 80,6 76,2 75,4 75,1 Capital adequacy ratio (%) 11,3 11,6 11,9 14,0 16,7 17,2 18,5 18,5 19,3 Performance Net interest income (EURm) 1.038 1.018 886 708 832 718 677 644 725 Net interest income (%, YoY) 11,3 -2,0 -12,9 -20,1 17,5 -13,7 -5,7 -4,9 12,5 Total operating income (EURm) 1.474 1.447 1.566 1.091 1.233 1.074 1.021 985 1.068 Total operating income (%, YoY) 3,4 -1,9 8,2 -30,3 13,0 -12,9 -4,9 -3,5 8,5 Pre-provision profit (EURm) 709 670 823 370 547 479 456 437 537 Pre-provision profit (%, YoY) 7,3 -5,4 22,8 -55,0 47,7 -12,4 -4,8 -4,2 22,8 Provision charges (EURm) 810 1.207 1.599 3.809 614 325 240 202 203 Profitability and efficiency Net interest margin (%) 2,0 2,1 1,9 1,6 2,1 2,0 2,0 2,0 2,0 Pre-tax ROAA (%) -0,2 -1,1 -1,6 -8,0 -0,2 0,4 0,6 0,6 0,9 Pre-tax ROAE (%) -2,4 -13,3 -20,3 -92,9 -1,7 3,6 4,8 5,0 6,7 Cost-to-income ratio (%) 51,9 53,7 47,4 66,1 55,7 55,4 55,3 55,7 49,8 Operating expense (% of assets) 1,5 1,6 1,6 1,7 1,7 1,6 1,5 1,5 1,4 Credit quality and provisioning NPA ratio (%) 7,3 11,4 15,0 13,7 11,5 9,9 7,0 6,5 6,5 NPA coverage (%) 65,7 58,6 60,4 91,6 80,0 98,4 101,0 102,8 105,1 Provision charges (% of loans) 1,6 2,4 3,4 8,8 1,6 0,9 0,7 0,6 0,6 Provision charges (% of PPP) 114,3 180,1 194,3 1.029,2 112,3 67,8 52,7 46,2 37,9

Source: BSI, Addiko research

De-leveraging slowdown, De-leveraging has eased in 8M16 from 5.9% yoy in 2015 to 3.2% with the strongest negative contribution growth in retail loans arising from 6.5% ytd lower corporate credit activity, but also due to 6.1% lower public sector and 19.8% lower other sector loans. On a more positive note, not only retail loans positive performance that started in January continued but has also speeded up to 4.5% in 8M16 on the back of record low interest rates and strong consumer momentum as private hiring and real incomes remain on solid levels. Looking ahead, we expect for 2016 to be another year of de-leveraging with overall loans dropping by roughly 3.5% as corporate lending activity remains poor and public sector continues to de- leverage strong given the cheaper sources of funding abroad. However, in 2017 we expect lending to enter green territory as interest rates will decline further and we see investments as the key growth driver on the back of rising capacity utilization and stronger corporate cash flows. As for NPL’s, the ongoing sale of bad loans and increased write-offs lowered the ratio to 6.7% in August from 9.9% at the end of 2015 and we expect to see it around 7% at the year end.

Deposit collection As for funding, after deposits entered negative territory in May, they managed to recover somewhat recovering somewhat increasing 1.4% ytd in 8M16 with the strongest positive contribution coming from 6.0% ytd stronger retail deposits intake, followed by 4.8% stronger collection of corporate deposits. However, public sector deposits decline not only continued but has speeded up from -10.3% at the end of 2015 to as much as 45.3% in 8M16. Looking ahead, we expect to see a 2.2% deposit growth in 2016 as we see retail continuing its solid deposit placing given the strong labour market, corporate deposits are supported with solid cash flows and we see some potential upside pressures stemming from public sector if the sovereign decides to use favorable market conditions for prefunding. As for profits, after several years of losses 2015 brought a positive net result. In 2016, we see NII pressured with lower active interest rate, but with expected further decline of provision charges we see a solid 10%-alike pre-tax profit growth.

Page 10 October-16 Page 10 SEE MACROECONOMIC OUTLOOK CROATIA

More Than an Economic Recovery? September's elections brought about a stronger working majority led by the centre-right HDZ, enabling policy continuity. Marking better H1 outturn to market alongside stellar tourist season moved 2016 GDP growth forecast to 2.7%, as consumer recovery has legs on rosier employment outlook, falling savings rate and further PIT cuts. Our constructive medium-term view on Croatian bonds rests on improving macro/fiscal story, political stability and subsequent rating upgrade prospects, which alongside CNB/ECB easing allows CDS spread tightening by 50-75bp in six months.

Upgradin GDP growth The economy has proved more resilient than expected to the prolonged period of political stalemate, in 2016-2017 on driven by external cyclical recovery, tourism, resurgent private consumption, better funding tourism and private conditions and employment. Marking better H1 outturns to market alongside stellar tourism earnings consumption and still decent external tailwinds after the Brexit hence lifts our 2016 GDP growth forecast to 2.7%. That said, private consumption is not only the darling of the tourist season (its boost to summer retailing and citizens' real incomes), but consumers benefit from rosier employment outlook, persistent deflation, stronger non-purpose cash loans, declining savings rate, and further PIT cuts in the pipeline. Higher EU funding, improving bank loan availability and better exporters' morale also drive investments. With goods exports expected to slow in response to the weaker euro zone activity, strong domestic demand and commodity price normalization, net trade will contribute negatively.

Croatia: contributions to GDP (in pps) 12 8 4 0 -4

-8 Source: CBS, HAAB research -12 -16 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 HOUSEHOLDS STATE INVESTMENT STOCKS NET TRADE GDP DOMESTIC DEMAND

Political restart: Will The outcome of September's elections is a stronger working majority led by the centre-right HDZ, This Time Be Different? allowing a swift return to reforms laid out by the outgoing government. Among the first steps of the new cabinet will be 2017 budget, tax reforms and incentives for NPL sales as part of the dealing with the consequences of forced CHF loan conversions. The recent policy communiqué and the former government's moves show greater acceptance of public sector right-sizing, privatization and productivity-enhancing reforms. Reduced policy uncertainty, further easing in funding conditions (see next pages) along with EU funding and durable consumer as well as capex recovery lift our 2017 GDP growth forecast to 2.25%. The expected slowdown in 2017 reflects the reversal of deflation (suppressing real incomes) and the last two years' record tourism delta, as the elevated political uncertainty in the EU hits demand, notably already weak investments. The main risk are the external environment and delays in meaningful reforms this side of regional elections in spring 2017, dumping already low potential growth while also increasing risk aversion for Croatian assets. We are also concerned about longer-term risks lurking beneath the surface; demographic trends, rising populism and balance sheet adjustments. Possible upside risks stem from a stronger impact of policy measures and looser fiscal policy on business optimism and domestic demand.

Inflation grinds slowly The recent deflationary development reflects the renewed supply-side shocks and clothing price higher over the coming discounts in the absence of significant administrative price hikes. Despite strong real wage growth and years better labour market situation, deflationary pressures owed to stronger imported deflation pass- through given the increased trade openness, ongoing retailers' price wars launched upon the EU entry and household de-leveraging. While fading direct effects from past commodity price declines and the recent energy inflation normalization suggest some recovery in inflation in the near term, attention also turns to the recovery potential of ex-energy inflation. Namely, processed food inflation is seen recovering progressively in 2017-2018 on stabilizing agricultural prices and stronger domestic demand. And with the ongoing decent real wage growth in response to PIT cuts, and EU demand not slowing as feared, the labour market may start supporting inflation. All said, after -1.4% in 2016 (one of the lowest in the EU), we expect CPI inflation to pick up to 0.7% on average in 2017.

Page 11 October-16 Page 11 SEE MACROECONOMIC OUTLOOK CROATIA

C/A surplus stays Slower euro zone investment and consumer demand given the elevated political uncertainty forebode a elevated around slowdown in goods exports growth next year. Low sophistication in many sectors, insufficient size 4%/GDP distribution and poor risk management do not help either, leaving further price competitiveness gains subject to the forthcoming tax reforms. Meanwhile, stronger consumer demand, private capex, corporate credit recovery and stabilizing commodity prices lead to stronger imports as well, leading to slightly higher goods trade deficit and equally C/A surplus moderation compared to 2016. Despite that, we expect stable tourism FC receipts and higher EU transfers to keep C/A surplus at solid 3.5% of GDP. Consequently lower foreign borrowing needs, alongside the record banks' net external position (EUR3.8bn) and their external de-leveraging (as part of balances restructuring and NPL sales), and decent portfolio inflow will see an improvement in net international investment position and in turn external debt slump.

Croatia: merchandise exports (seas.adj. 6mma, %, yoy)

30

.20

10

0

-10 Source: Eurostat, CBS, HAAB research -20 Croatia CE4 average CEE average

-30 Jan-04 Jun-06 Nov-08 Apr-11 Sep-13 Feb-16

The CNB feels In our view, reduced policy risks upon elections, ECB-driven risk appetite, local fiscal risk mitigation, vindicated in its high C/A surplus and record banks' net foreign assets allow further CNB easing in 1Q17, mainly directed monetary stimulus at getting the current tentative lending rebound going. Ample interbank excess liquidity provision magnified by 4Y reverse REPO facility has anchored kuna yields and volatility at record lows, which helps turn lending flows back, stabilize FX, and makes the CNB's life easier. This alongside likely 4Y REPO rate cuts and the commitment to low single-digit mandatory reserve rate by 2020 shows the CNB cares about funding costs and pent-up demand for kuna credit, whereby the wider net interest spread helps banks restore profits. To promote 4Y REPO the CNB offers a genuine cross-FX-swap platform by widening its collateral pool to FC bonds, increasingly bought by local banks to close short FC position (amid FC-linked credit de-leveraging) and get cheaper kuna funds. Structural banks' demand for FC bonds helps Croatian spreads tightening increasingly driven by fundamentals. Even then, the CNB faces imperfect monetary transmission, leaving the authorities to cooperate on risk cost cuts - from incentives for NPL sales and capital hikes to risk-sharing credit schemes and de-leveraging benefits to banks and customers. If these issues (e.g. faster bankruptcy settlements, tax dilemmas) are not dealt properly, private sector de-leveraging will take time.

Kuna moves in seasonal Stronger than usual kuna mainly reflects hefty FC inflow out of another record tourist season, and fashion from strong supportive goods trade trends. Strong fiscal outperformances, high C/A surplus, record banks’ net levels foreign assets and increasingly important kuna lending have also underpinned the kuna. Short-end rates exhibited a bout of volatility as the MinFin beefed up local issuance (EUR1.5bn 15M bills) given the delayed Eurobond before returning to record lows thanks to constructive FX development, HRK6bn-alike excess interbank liquidity, CNB easing and the MinFin covering ~80% of 2016 financing needs. Croatian bonds outperformed recently on macro overperformance and improved risk perception, as political strains also eased. Meanwhile, global EM bonds sell-off didn’t materialize after the Brexit vote, as key central banks turned even more dovish and bond yields sank in response, propping up risk assets.

Notwithstanding supportive C/A trajectory and favorable external position in many aspects, we see the EUR/HRK gradually rising from here. Namely, depreciation pressures may arise from the worsening goods trade trends and some nervousness about the hawkish FOMC and EU-wide political instability combined by the regional FX aversion. Furthermore, speculative USD forward buying may also occur given the bets on the renewed USD strength. Given rather comfortable CNB position as far as FX reserves (120%+ of gross external funding needs), interest rate differential and accommodative stance are concerned, and the new Eurobond prospects, we do not stronger FX volatility for the time being. The recent period has also displayed a bit more REER adjustment, implying little concerns over competitiveness.

Page 12 October-16 Page 12 SEE MACROECONOMIC OUTLOOK CROATIA

Croatia: 5Y CDS spreads and EUR/HRK

650 5Y CDS spread EUR/HRK 7,73 550 7,59 450 7,45 350

250 7,31 Source: CNB, Blomberg, HAAB research 150 7,17 Jan-09 Jul-10 Jan-12 Jul-13 Jan-15 Jul-16

We see Croatian CDS The CNB liquidity provision and further easing (prospects), timid credit activity and stable FX spreads tightening by combined, we see short-end rates record low. Despite pent-up demand for bank kuna lending and 50-75bp in six months refinancing of FX-linked loans, new credit volumes are still insufficient to push rates up. With 2016 funding needs almost closed, the expected EUR1-1.5bn bond pre-funding high foreign debt redemptions in 2017 (~4% of GDP), significant (re)financing operations (incl off-market funding) in pipeline and favorable conditions for kuna bond issuance, Croatian spreads continue to tighten, in our view. Our constructive medium-term view on bonds rests on improving macro/fiscal story, greater political stability, 5pp/GDP lower gross funding needs and the subsequent rating upgrade prospects in the wake of the expected EDP exit next spring and diminishing gaps behind peers, which alongside the CNB's incentive to hold state bonds and ECB-driven risk appetite triggers more positive market response than imagined before elections. All being said, there is relatively strong case for Croatian CDS spreads tightening by 50-75bp over a six-month horizon, followed by the yield curve flattening. The major disruptor to our baseline would be riskier EM backdrop amid potential ECB tapering (not our baseline though), US' Trump presidency and other idiosyncratic events.

Deficit set to decrease Fiscal accounts saw a strong performance in 7M16, with the consolidated government gap down 62.0% close to 2% of GDP yoy to just HRK2.2bn (0.6% of GDP) thanks to sound revenue performance and lower-than-planned outlays. That said, revenues are driven by strong PIT and CIT intake and EU transfers in 7M16, and soaring VAT in August and September amid terrific tourist season. Cost containment is largely due to a temporary freeze in subsidies, material costs and public capex due to a political deadlock, and also lower interest cost outlays, despite the lack of the reform content on the expenditure side of the budget. All said, we will likely end up with stronger than-expected consolidation this year, with the deficit closer to 2% of GDP. Looking ahead, further PIT relief, CIT cuts for SMEs and social VAT rates, without mention on how this will be financed (apart from very classic determination to spending containment), and higher public capex will result in deficit re-widening. Thankfully not above 3% of GDP as better interest cost management out of cheaper (re)financing options, broadening of the tax base and ESA 2010-exempt ways of public capex financing provide some flexibility. All said, the biggest elephant in the room is a potential HRK1.95bn (annualized) public wage unfreezing allowed 2%+ GDP growth. Stronger nominal GDP growth in combined by one of the strongest fiscal deficit reduction in two years in CESEE has brought about quicker-than-expected stabilization in public debt, paving the way for ratings upgrade.

...the trade-off Cognizant of the automatic pensions, public wage et al indexation, higher EU-funded project co- between political funding, and already used space for tax-driven consolidation, stability of public finances hinges on stability and spending entitlements (healthcare!), public administration and judiciary reforms (notably in the area of NPLs cuts needs some fiscal resolution). In all the areas above, plus public investments, reforms should not focus only on cost cuts relaxation... but on improving the efficiency of the programs, and systematic evaluation of investment projects rigorously on economic value. In that way policymakers can only show the awareness of the complex challenges faced by Croatia, which is crucial in earning investor confidence. Clearly, the trade-off between political stability and spending cuts needs some fiscal relaxation to 'grease the wheels' to avoid a rebellion by vested interests and unions, in line with the full use of the SGP's newly found leeway (if you reform, we will let you get away with fiscal drift'). All of it with the aim to build 5%+/GDP primary surplus in the next years to deal with one of the EU's highest interest rate expenditure (~3.5% of GDP) and lower public debt. The new focus on competitiveness of private firms to pave the way for higher potential growth should tackle multiple key aspects: (i) enhancing productivity via further labour flexibility and education reforms, (ii) boosting capex via better access to multiple sources of funding, and incentives for innovation, and (iii) improving the business environment through an efficient public sector, justice system and product and market liberalization.

Page 13 October-16 Page 13 SEE MACROECONOMIC OUTLOOK CROATIA

Croatia's data trends

CRO underperforms CESEE in growth terms Industrial production, 2010=100

10 Croatia 120 Original indicies (ls) 114 Slovenia 8 115 Seasonally adjusted (ls) Serbia Trend (rs) 6 CESEE 110 105 4 105

2 100 96

0 95

-2 90 88

-4 85

-6 80 79

-8 75

-10 70 70 1Q08 1Q10 1Q12 1Q14 1Q16 Jan -00 Apr -03 Jul -06 Oct -09 Jan -13 Apr -16

Merchandise import cover (% 3mma) Change in export shares vs EU countries, 2014-2008, (%)

70 32 28 67 24 20

64 16 12

61 8 4 0 58 2014 2015 -4 2016F -8 55 jan feb mar apr may jun jul aug sep oct nov dec

Budget balance and public debt (%/GDP) Spread on CRO USDs vs peers (bp)

100 160 95 -1 130 90 100 85 -3 80 70 75 40

-5 70 10 65 -20 60 -6 -50 BUDGET BALANCE (LS) 55 -80 PUBLIC DEBT (RS) 50 CRO -ROM CRO -HUN CRO -SRB CRO -SLO -8 45 -110 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Dec -13 Aug -14 Apr -15 Dec -15 Aug -16

Source: Croatian National Bank, Central Bureau of Statistics, Ministry of Finance, European Commission, Bloomberg, Addiko research Page 14 October-16 Page 14 SEE MACROECONOMIC OUTLOOK CROATIA

SELECTED ECONOMIC FORECASTS 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Activity Nominal GDP (HRKbn, current prices) 328,0 332,6 330,5 329,6 328,4 334,2 340,4 352,3 368,7 Nominal GDP (EURbn) 45,0 44,7 44,0 43,5 43,0 43,9 45,0 46,5 48,6 Nominal GDP (USDbn) 59,6 62,2 56,5 57,8 57,2 48,7 50,0 48,4 52,0 GDP per capita (EUR) 10.191 10.453 10.300 10.225 10.157 10.364 10.614 10.966 11.471 GDP per capita (USD) 13.882 14.542 13.233 13.571 13.488 11.492 11.781 11.405 12.274 Real GDP (constant prices YoY, %) -1,7 -0,3 -2,2 -1,1 -0,4 1,6 2,7 2,2 2,5 Private consumption (YoY, %) -1,5 0,3 -3,0 -1,9 -0,7 1,2 2,7 2,4 2,5 Fixed investment (YoY, %) -15,2 -2,7 -3,3 1,4 -3,6 1,6 5,4 5,0 4,8 Industrial production (YoY, %) -1,4 -1,2 -5,5 -1,8 1,2 2,7 3,8 3,6 4,0 Unemployment rate (ILO, average %) 11,6 13,7 15,9 17,3 17,3 16,3 15,2 14,6 14,0

Prices CPI inflation (average % YoY) 1,1 2,3 3,4 2,2 -0,2 -0,5 -1,4 0,7 1,6 CPI inflation (end-year % YoY) 1,8 2,1 4,7 0,3 -0,5 -0,6 -0,8 1,2 1,7 PPI inflation (average % YoY) 4,3 6,4 7,0 0,5 -2,7 -3,9 -4,4 1,2 1,8 Net wage rates (% YoY, nom., €) 1,3 -0,2 -0,4 -0,1 -0,4 3,4 1,0 1,1 1,2

Fiscal balance (% of GDP) State budget balance -6,0 -7,5 -5,3 -5,3 -5,5 -3,2 -2,2 -2,5 -1,8 Public debt 57,0 63,7 70,7 82,2 86,5 86,7 87,2 87,7 87,5 Gross public funding needs n/a n/a n/a 16,3 19,9 19,8 16,4 19,7 18,7

External balance Export of goods and services (EURbn) 17,007 18,110 18,315 18,764 19,978 21,991 23,230 23,902 24,599 Import of goods and services (EURbn) 17,158 18,297 18,097 18,573 19,106 20,757 21,363 22,304 23,297 Merchandise trade balance (EURbn) -5,924 -6,382 -6,296 -6,587 -6,355 -6,635 -6,689 -7,099 -7,560 Merchandise trade balance (% of GDP) -13,2 -14,3 -14,3 -15,1 -14,8 -15,1 -14,9 -15,3 -15,5 Tourism receipts (EURbn) 6,230 6,617 6,858 7,202 7,402 7,961 8,451 8,574 8,767 Current account balance (EURbn) -0,488 -0,316 -0,021 0,443 0,368 2,293 1,802 1,602 1,428 Current account balance (% of GDP) -1,1 -0,7 0,0 1,0 0,9 5,2 4,0 3,4 2,9 Net FDI (EURbn) 0,8 1,1 1,2 0,8 1,3 0,1 0,8 0,9 2,0 FDI (% of GDP) 1,80,0 2,50,0 2,70,0 1,90,0 3,10,0 0,30,0 1,90,0 2,00,0 4,00,0 FDI cover (%) 167,8 352,4 5.775,5 n/a n/a n/a n/a n/a n/a Gross international reserves (EURbn) 10,660 11,195 11,236 12,908 12,688 13,707 14,224 14,994 15,764 Import cover (months of imports) 7,5 7,3 7,5 8,3 8,0 7,9 8,0 8,1 8,1

Debt indicators Gross external debt (EURbn) 46,908 46,397 45,297 45,958 46,664 45,534 44,471 45,577 47,025 Government (EURbn) 11,096 11,449 12,705 14,647 15,841 18,049 17,806 18,806 19,406 Private (EURbn) 35,812 34,949 32,592 31,312 30,823 27,485 26,665 26,771 27,619 Gross external debt (% of GDP) 104,2 103,7 103,0 105,6 108,4 103,7 98,8 98,0 96,7 Gross external debt (% of exports) 275,8 256,2 247,3 244,9 233,6 207,1 191,4 190,7 191,2

Exchange rates and money growth USD/HRK (end-year) 5,57 5,82 5,47 5,55 6,30 6,99 7,28 7,15 7,03 USD/HRK (average) 5,50 5,34 5,85 5,71 5,75 6,86 6,82 7,29 7,08 EUR/HRK (end-year) 7,39 7,53 7,55 7,64 7,66 7,64 7,64 7,65 7,66 EUR/HRK (average) 7,29 7,43 7,52 7,57 7,63 7,61 7,56 7,58 7,58 Money supply M1 (% YoY) 1,7 7,3 0,9 11,5 9,6 11,4 6,0 5,8 5,5 Broad money M4 (% YoY) 1,92 4,75 3,58 3,52 2,76 3,10 2,80 2,60 2,40 Domestic credit (% YoY, euros) 6,09 4,01 -2,55 -0,36 -2,61 -1,68 -0,85 2,32 2,51 ZIBOR 3M interest rate (average %) 2,58 3,19 3,55 1,54 0,99 1,27 0,81 0,29 0,14 HRK 1Y yield (average %) 4,19 3,72 3,93 2,54 1,86 1,50 0,95 0,50 0,35 HRK 10Y yield (average %) 6,34 6,68 6,67 5,78 5,14 4,09 3,67 3,21 3,04

Source: Croatian National Bank, Central Bureau of Statistics, Ministry of Finance, Addiko research Page 15 October-16 Page 15 SEE MACROECONOMIC OUTLOOK CROATIA

SELECTED BANKING SECTOR DATA 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Balance sheet Assets (EURm) 53.386 55.395 54.123 54.564 54.719 54.512 54.512 54.784 55.332 Assets (%, YoY) 4,2 3,8 -2,3 0,8 0,3 -0,4 0,0 0,5 1,0 Assets (% of GDP) 118,6 123,8 123,1 125,4 127,1 124,1 121,1 117,8 113,8 Gross loans (EURm) 37.173 38.665 37.678 37.543 36.561 35.946 35.640 36.468 37.383 Gross loans (%, YoY) 6,1 4,0 -2,6 -0,4 -2,6 -1,7 -0,9 2,3 2,5 Gross loans (% of GDP) 82,6 86,4 85,7 86,3 84,9 81,8 79,2 78,4 76,9 Deposits (EURm) 29.215 29.139 30.001 31.014 31.881 33.666 35.733 36.893 38.042 Deposits (%, YoY) 0,3 -0,3 3,0 3,4 2,8 5,6 6,1 3,2 3,1 Deposits (% of GDP) 64,9 65,1 68,2 71,3 74,1 76,7 79,4 79,3 78,2 Loan-to-deposit ratio (%) 127,2 132,7 125,6 121,0 114,7 106,8 99,7 98,8 98,3 Capital adequacy ratio (%) 18,5 19,2 20,6 21,0 21,0 18,8 20,3 20,1 19,9 Performance Net interest income (EURm) 1.485 1.540 1.449 1.360 1.366 1.404 1.417 1.370 1.328 Net interest income (%, YoY) 13,6 3,7 -5,9 -6,2 0,5 2,7 1,0 -3,4 -3,0 Total operating income (EURm) 2.204 2.249 2.015 1.923 1.922 1.908 2.001 1.954 1.917 Total operating income (%, YoY) 5,3 2,0 -10,4 -4,5 0,0 -0,7 4,8 -2,3 -1,9 Pre-provision profit (EURm) 1.093 1.127 972 920 934 917 1.020 973 936 Pre-provision profit (%, YoY) 3,1 3,1 -13,7 -5,4 1,6 -1,8 11,1 -4,5 -3,8 Provision charges (EURm) 510 500 501 780 645 1.533 716 685 665 Profitability and efficiency Net interest margin (%) 2,8 2,8 2,6 2,5 2,5 2,6 2,6 2,5 2,4 Pre-tax ROAA (%) 1,1 1,2 0,9 0,3 0,5 -1,1 0,6 0,5 0,5 Pre-tax ROAE (%) 8,0 8,4 6,2 1,9 3,9 -8,7 4,3 3,9 3,7 Cost-to-income ratio (%) 50,4 49,9 51,7 52,2 51,4 51,9 49,0 50,2 51,2 Operating expense (% of assets) -4,2 -4,1 -3,7 -3,5 -3,5 -3,5 -3,7 -3,6 -3,5 Credit quality and provisioning NPL ratio (%) 11,2 12,4 13,9 15,7 17,1 16,7 14,7 14,4 14,1 NPL coverage (%) 38,8 41,4 42,6 46,2 51,0 71,4 91,4 100,2 108,7 Provision charges (% of loans) 1,4 1,3 1,3 2,1 1,7 4,2 2,0 1,9 1,8 Provision charges (% of PPP) 46,7 44,4 51,5 84,8 69,0 167,0 70,2 70,4 71,0

Source: CNB, Addiko research

Corporate lending Credit de-leveraging accelerated (-2.4% ytd in 8M16 vs. -1.7% yoy in 2015) with the strongest negative showing signs of revival contribution coming from retail sector that faced -3.9% ytd loss on the back of CHF loans conversion and the subsequent loan stock adjustment. However, corporate lending is showing signs of revival as it faced stagnation in 8M16 (+0.1% ytd) contrary to the previous year strong decline of 4.8% yoy, in line with the ongoing private investment recovery. Meanwhile, the public sector entered de-leveraging at the beginning of the year and is facing a 2.9% ytd drop in 8M16 which is not surprising given the recent T-bills and bonds yield decline and possibility of cheaper funding abroad. Looking ahead, we still expect to see kuna interest rates compression in the period ahead as the CNB will maintain its easing bias, thus boding well for the lending activity recovery. That said, we have adjusted our 2016 loan growth expectations downwards by 0.6pp to -0.9% given the expected further corporate NPL sales and the fact that in spite of declining interest rates retail loans are expected to stay pressured by unfavorable FX comps. In 2017 we expect overall lending activity to enter green territory on the back of low base and solid macroeconomic environment with the expected loan growth of roughly 2%.

Deposits continue to see On funding side, deposits continue to see solid growth (+5.3% ytd in 8M16 vs. 5.6% yoy in 2015) with the solid growth strongest positive contribution coming from corporate deposits that have faced a 12.2% ytd increase in 8M16 on the back of another record tourist season. Furthermore, all other categories contributed positively whereas household deposits have increase by 2.1% ytd and public ones as much as 23.4% ytd in 8M16. Looking ahead, we have upgraded our 2016 expected deposit growth by 2pp to 6.1% on the back of the expected EUR400-500m stronger intake of tourist deposits with certain downside risks stemming from negative impacts on exporters’ revenue due to slower EU consumer demand. On profits, net interest income (NII) increased 1.7% yoy in 1H16, thanks to 23.4% yoy lower interest expenses amid declining funding costs that managed to offset 9.2% yoy lower interest income and we expect to see similar performance through the rest of the year. Finally, NPLs declined to 15.0% in 2Q16 from 16.6% at the end of 2015 and we expect to see it around current levels in the rest of the year as well.

Page 15 October-16 Page 16 SEE MACROECONOMIC OUTLOOK SERBIA

After Elections, Ready for Reforms?

We keep our 2016 GDP growth forecast at 2.5% intact, with private and public consumption, and investments largely behind the acceleration relative to 2015. We also lift our 2017 GDP growth forecast to 2.5%. We see inflation increasing slightly in 4Q16 and then crawling back into the NBS' target band in 1H17 from a low base, and due to commodity price normalization, 3.8% electricity price hike in October and still decreasing negative output gap. Successful SOE restructuring and public administration reform remains the key in stabilizing public finances in the medium term given the rising public debt.

GDP slowing down in Serbia's 2Q16 GDP rose 2.0% yoy (vs. +3.8% yoy in Q1), with the slowdown owing mainly to net 2Q on net export export deterioration. That said, although export growth stayed in double-digits (+10.0% yoy after deterioration +11.6% yoy in Q1), soaring imports (+12.3% yoy vs. prev +4.7% yoy in Q1) on the back of domestic demand recovery saw net exports contributing negatively (-2.5pp). Furthermore, investments growth faced slowdown as well (+4.9% yoy vs. +8.4% yoy in Q1) given the high base effect. On the other hand, bearing in mind the ongoing fiscal consolidation and the late cabinet formation, public spending surprised on the upside (+4.6% yoy), and household consumption growth accelerated to 1.3% yoy thanks to private employment gains and moderate wage hikes.

Serbia: contributions to GVA (pps, %) 10 Agriculture Manufacturing Wholesale/retail trade/transport Construction 10 GDP (rhs) 6

5 2

0 -2 Source: SRS, Addiko research -6 -5 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16

We lifted our 2017 We keep our 2016 GDP growth forecast at 2.5% intact, with private and public consumption, and GDP growth forecast investments largely behind the acceleration relative to 2015. We also lift our 2017 GDP growth to 2.5% forecast to 2.5%. Namely, while many still guesstimate the Brexit effects, the recent trends suggest the consequences will be not as harsh as feared. Despite the expected slowdown of the main trading partners, exports benefit from the ongoing investments into tradable sectors (Hesteel, car parts Yazaki and Mei Ta, Toennies et al), increasingly important as they compensate for lower Fiat car exports lacking new models. Private capex will be beefed up with public infrastructure projects including the road corridor 11 and five railway projects (together worth 1% of GDP). In addition, private sector has offset public sector layoffs and also generated solid wage growth, which together with some fiscal impulse going forth (in 2017) favours further domestic demand recovery. We see downside risks in any Hard Brexit scenario, stronger market reaction to Fed tightening or dampened investor confidence in case the cabinet won’t deliver the long overdue reforms regarding SOE privatization and public administration.

C/A deficit narrowing The C/A deficit narrowed by 20.0% yoy to EUR664m in the year to July on the back of goods and further services balance improvement. That said, goods deficit decreased by 12.1% yoy in the year to July as export-oriented sectors continue to benefit from increased FDI inflows, while services surplus soared 40.5% at the same time. However, primary income contributed negatively as deficit increased by 10.6% yoy, while secondary income surplus decreased by 7.1% yoy in the same period. However, unlike in previous months when the economy has witnessed relatively strong de-leveraging (-EUR594.4m in 1H16), July saw a halt in that respect.

Page 17 Page 17 October-16 SEE MACROECONOMIC OUTLOOK SERBIA

C/A deficit set to Looking into financial accounts, FDI inflows continued their solid performance by growing 12.6% yoy decrease by 0.5pp to in the year to July, whereby the FDI structure has become more broad-based recently and more 4.3% of GDP in 2016 destined to tradable sectors. Furthermore, contrary to previous months, July’s data show higher net inflow of carry trades (+EUR34.1m vs. –EUR252.2m in June), that was also reflected in the recent dinar stability and can be explained with better EM risk perception and investors in yield-hunting mode. All in all, we keep our view of 0.5pp C/A deficit decrease to 4.3% of GDP in 2016, and see further narrowing in 2017 amid still low interest expenses, solid risk appetite and export growth on the heels of ongoing investments into tradable sector.

Inflation set to crawl Slow recovery of commodity prices, still contained if stabilizing domestic demand and the excellent back into the NBS agricultural season are the main factors for inflation staying below the NBS’ lower target band (2.5%) target band in 1H17 in the course of this year. That said, 1.0% yoy average inflation in the year to August suggests there is still a long way before re-entering the NBS target band (4+/-1.5%). Looking ahead, we see inflation increasing slightly in 4Q16 and then crawling back into the NBS' target band in 1H17 from a low base, and due to commodity price normalization, 3.8% electricity price hike in October and still decreasing negative output gap. However, downside pressures continue to arise from better-than-expected agricultural season and consequently lower food prices, while domestic demand is still not pulling up inflation. All in, we expect 1.4% average inflation in 2016 and further recovery to 3.1% in 2017.

Serbia CPI inflation and NBS policy rate 18 115

15 Source: NBS, SORS, Addiko research 112

12 109

9 106

6 103 NBS policy rate (%, lhs) CPI (%, yoy, rhs)

3 100 Jan -07 Dec -08 Nov -10 Oct -12 Sep -14 Aug -16

NBS has room for Unlike in 1H16, when we saw higher net outflow of carry trade and depreciation pressures that another rate cut(s) prompted the NBS to sell EUR795m, the Q3 displayed different picture. That said, better EM risk perception combined with low/negative ‘core’ yields led investors once again into yield-hunting mode. In such circumstances, the NBS hasn’t once been forced to intervene through FX sales, but rather bought EUR520m since early July and stabilized FX reserves around EUR9.5bn (six months import cover), following a sharp decrease since 4Q15.

Following a 25bp policy rate cut in July, the NBS decided to play safe in the last months and kept its key rate unchanged at 4.0%, citing the effects of past rate cuts, subdued inflation outlook, persistent uncertainty in the global markets and its potential impact on inflation and EM flows. All in all, we see the NBS’ wait and see stance in order to get more clarity on the future monetary policy stance of main central banks. However, we see the ECB postponing rather than quit from stronger QE and do not expect too strong impact from the expected Fed’s 25bp tightening on EM debt. With net-net further global monetary easing, stable dinar, ongoing inflation undershooting and strong risk appetite, we see further 25-50bp rate cut(s) over the next three to six months, followed by the NBS’ pausing during most of 2017-2018 thanks to the prolonged period of monetary easing of core central banks and the expected slow pace of Fed hikes.

Page 18 Page 18 October-16 SEE MACROECONOMIC OUTLOOK SERBIA

Dinar's recent The dinar recent stability owes not only to improved EM risk perception, but also solid GDP growth, stability expected to fiscal outperformance and the ongoing C/A deficit narrowing as well as stable political situation upon be maintained in short the government formation. That said, following roughly 1.5% nominal depreciation ytd, we expect term period the dinar’s recent stability to be maintained in short term period while certain downside risks stem from potential portfolio outflows in case of the renewed global risk aversion episodes (China slowdown, Brexit et al). In such circumstances, the NBS is expected to keep an active stance at interbank market via FX interventions and liquidity management through REPO. In 2017 and 2018, we see the dinar following similar pattern, i.e. depreciating roughly 2% in nominal terms given still significant external imbalances and investors likely shifting to other investment opportunities on the back of Fed’s policy normalization.

Serbia: T-bill/notes yields

17,5%

15,0%

12,5%

10,0%

7,5% 91 days 182 days 365 days 5,0% 53 weeks 18 months 2 years 3 years NBS policy rate 2,5% Mar-09 Dec-10 Nov-12 Oct-14 Sep-16

Fiscal consolidation on The MinFin’s 8M16 data show a RSD8.5bn budget surplus vs. a RSD44bn gap in 8M15. Such track but SOE performance owes to 9.9% yoy stronger revenues, offsetting 4.9% yoy spending growth. On revenues, developements remain the strongest positive contribution came from 22.0% yoy stronger excise tax intake, followed by a conceirn 10.6% yoy stronger VAT intake on account of better GDP growth and tax compliance. Revenues are also boosted by 9.8% yoy stronger non-tax revenues reflecting large SOEs’ dividend payments and the sale of 4G licences. The increase in expenditures is driven by 36.2% yoy stronger public capex and 12.8% yoy higher purchase of goods and services amid ongoing infrastructure works, which given the simultaneous wage and subsidy cuts improves the structure of state spending. In all, we further cut our 2016 budget gap forecast to 2.8% of GDP on strong revenue performance in the year to August, which would also lower public debt slightly. In 2017, we see budget deficit slightly higher around 3% of GDP on minimum wage and pension hikes, further severance payments and higher public capex.

Solid appetite for Solid risk appetite and yield hunt allowed the MinFin to increase T-bill/T-bond stock by RSD52bn Serbian debt expected from the beginning of July at lower costs. The MinFin is also lengthening its debt maturity by to stay in place lowering the stock of <2Y debt and increasing debt in the 2-7Y region. That said, we see solid appetite for Serbian debt for the time being due to a plethora of reasons. Firstly, with the Fed tightening forecasts of 25bp in 2016 and 50bp in 2017 largely priced in, we do not expect stronger turbulence on the markets but rather gradual upward yield movements. Furthermore, the ECB and BoJ are expected to ease further, and last but not least, Serbia continues to offer solid yield/risk ratio, especially given the strong macro and fiscal performance recently and the ongoing external imbalances reduction. In such circumstances, we see solid interest for the expected Eurobond in late 2016 or early 2017. We also think it would be wise to use the current low interest rate environment and consider USD bonds buyback and cheaper refinancing.

Favourable Serbian spreads have tightened by roughly 100bp to date on the back of better-than-expected macro risk/reward ratio story, rating upgrades, IMF backstop and the recent pro EU/IMF government formation, allowing assures decent policy continuity. In such circumstances, we see further spread compression in the near term but investor interest only if the new government pressed ahead with structural reforms. Namely, investors will watch the time and pace of the expected privatization processes, further public sector rationalization as well as EU talks currently rather slow and dependent on Serbia solving the Kosovo question that is still considered as Serbian province in the constitution. In such circumstances, we see value in revisiting Serbian asset with a potential further 20-40bp tightening in the next 3 to 6 months.

Page 19 Page 19 October-16 SEE MACROECONOMIC OUTLOOK SERBIA

Serbia's data trends

Budget and current account gaps (% of GDP) CPI contribution - key categories (pps ) vs. real GDP growth (%) Recreation and culture Transport 19

0 6 Health Housing, water, electricity, gas 16 Alcoholic beverages, tobacco Food and non -alchoholic beverages 4 13 -4

10 2 -8 7 0 4 -12 -2 BUDGET DEFICIT (LHS) 1 CAD (LHS) GDP (RHS) -16 -4 -2 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Jan -07 Jun -08 Nov -09 Apr -11 Oct -12 Mar -14 Aug -15

NBS active in the market NBS buys Size of the bubble shows total trade share, euros (X+M)/GDP NBS interventions 123,8 2 70 (EURm, lhs) ITA EUR/RSD (rhs)

45 1,6 GER 122

RUS 1,2 CHI 20 120,2

-5 0,8 HUN 118,4 ROM B-H -30 0,4 116,6 Import ( goodsImport of in EURbn, 8M16) -55 NBS sells 0 euros -0,1 0,2 0,5 0,8 1,1 1,4 Exports of goods ( in EURbn, 8M16) -80 114,8 Jan -14 Jul -14 Dec -14 Jun -15 Nov -15 May -16

Consolidated government budget balance (RSDbn) Corporate external de-leveraging comes to a halt? (EURbn) 40 20 25 Public 0 Corporate -20 Banks -40 20 -60 -80 -100 15 -120 2016 -140 2013 10 -160 2014 -180 2015 -200 5 -220 -240 -260 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan -05 Mar -07 May -09 Jul -11 Sep -13 Nov -15

Source: National Bank of Serbia, Statistical Office of the Republic of Serbia, Ministry of Finance, Consensus Economics, Bloomberg, Addiko research

Page 20 Page 20 October-16 SEE MACROECONOMIC OUTLOOK SERBIA

SELECTED ECONOMIC FORECASTS 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Activity Nominal GDP (RSDbn,current prices) 3.067 3.408 3.584 3.876 3.908 3.982 4.126 4.375 4.620 Nominal GDP (EURbn) 29,8 33,4 31,7 34,3 33,3 33,0 34,5 34,7 36,0 Nominal GDP (USDbn) 39,4 46,5 40,7 45,5 44,1 36,5 36,8 36,1 38,4 GDP per capita (EUR) 4.082 4.620 4.401 4.783 4.666 4.614 4.829 4.873 5.049 GDP per capita (USD) 5.400 6.423 5.650 6.353 6.177 5.114 5.144 5.068 5.388 Real GDP (constant prices YoY, %) 0,6 1,4 -1,0 2,6 -1,8 0,7 2,5 2,5 2,0 Private consumption (YoY, %) -0,6 0,9 -2,1 -0,4 -1,3 -0,5 0,8 1,1 1,5 Fixed investment (YoY, %) -6,5 4,6 13,2 -12,0 -3,6 8,1 5,6 5,6 3,5 Industrial production (YoY, %) 1,2 2,5 -2,2 5,5 -6,5 8,4 4,1 4,1 3,2 Unemployment rate (ILO, average %) 19,2 23,0 23,9 22,1 19,2 17,7 18,2 17,7 17,1

Prices CPI inflation (average % YoY) 6,5 11,0 7,8 7,8 2,1 1,4 1,4 3,1 3,3 CPI inflation (end-year % YoY) 10,2 7,0 12,2 2,2 1,7 1,5 2,4 3,1 3,0 PPI inflation (average % YoY) 12,7 14,2 5,6 3,6 0,7 0,2 -0,1 4,9 4,5 Net wage rates (% YoY, nominal, euros) -1,8 12,3 -1,8 6,1 -2,9 -2,5 2,2 2,0 2,0

Fiscal balance (% of GDP) State budget balance -2,2 -2,8 -3,7 -5,5 -6,6 -3,7 -2,8 -3,2 -2,2 Public debt 40,8 44,2 55,9 58,8 68,3 76,5 73,4 82,7 40,8 Gross public funding needs 10,2 11,3 12,3 16,1 17,6 17,0 16,5 19,3 10,2

External balance Export of goods and services (EURbn) n/a n/a 11,498 13,937 14,451 15,618 16,385 16,970 17,432 Import of goods and services (EURbn) n/a n/a 16,993 17,782 18,096 18,899 19,517 19,940 20,582 Merchandise trade balance (EURbn) n/a n/a -5,634 -4,159 -4,111 -4,006 -3,987 -3,861 -4,074 Merchandise trade balance (% of GDP) n/a n/a -17,8 -12,1 -12,3 -12,2 -11,6 -11,1 -11,3 Remittances, net (EURbn) n/a n/a 1,989 2,217 1,931 2,155 2,306 2,329 2,348 Current account balance (EURbn) -2,082 -3,305 -3,640 -2,098 -1,985 -1,590 -1,429 -1,332 -1,394 Current account balance (% of GDP) -7,0 -9,9 -11,5 -6,1 -6,0 -4,8 -4,1 -3,8 -3,9 Net FDI (EURbn) n/a n/a 0,7 1,3 1,2 1,8 1,9 2,0 1,2 FDI (% of GDP) n/a n/a 2,1 3,8 3,7 5,5 5,5 5,9 3,3 FDI cover (%) n/a n/a 18,4 61,9 62,3 113,2 132,9 153,8 84,7 Gross international reserves (EURbn) 10,002 12,058 10,915 11,189 9,907 10,317 10,687 11,443 13,830 Import cover (months of imports) n/a n/a 7,7 7,6 6,6 6,6 6,6 6,9 8,1

Debt indicators Gross external debt (EURbn) 23,786 24,125 25,645 25,747 25,741 26,358 26,158 26,098 27,748 Government (EURbn) 9,076 10,773 12,185 13,166 14,198 15,289 15,389 15,389 16,589 Private (EURbn) 14,710 13,352 13,460 12,581 11,543 11,069 10,769 10,709 11,159 Gross external debt (% of GDP) 79,9 72,2 80,9 75,1 77,2 79,9 75,8 75,2 77,2 Gross external debt (% of exports) n/a n/a 223,0 184,7 178,1 168,8 159,6 153,8 159,2

Exchange rates and money USD/RSD (end-year) 79,28 80,87 86,18 83,13 99,46 111,64 118,95 118,97 118,39 USD/RSD (average) 77,91 73,34 88,12 85,17 88,54 108,94 112,23 121,23 120,43 EUR/RSD (end-year) 105,5 104,6 113,7 114,6 121,5 121,8 125,0 127,4 129,7 EUR/RSD (average) 103,0 102,0 113,1 113,1 117,2 120,8 119,5 126,1 128,5 Money supply M1 (% YoY) -10,9 16,9 -3,3 24,8 5,2 16,4 13,0 8,0 7,0 Broad money M3 (% YoY) 2,59 11,17 0,69 3,73 2,98 6,60 7,00 5,40 3,50 Domestic credit (% YoY, euros) 15,33 8,91 0,79 -5,21 -2,32 2,36 3,72 5,05 5,38 NBS policy rate (average %) 9,13 11,54 10,14 11,00 8,79 6,08 4,09 3,75 4,02 NBS policy rate (end-year %) 11,50 9,75 11,25 9,50 8,00 4,50 3,75 3,75 4,25 6M BELIBOR interest rate (average %) 11,00 13,13 12,00 10,40 8,53 6,43 3,58 3,53 4,25

Source: National Bank of Serbia, Statistical Office of the Republic of Serbia, Ministry of Finance, Addiko research Page 21 October-16 SEE MACROECONOMIC OUTLOOK SERBIA

SELECTED BANKING SECTOR DATA 2010 2011 2012 2013 2014 2015F 2016F 2017F 2018F Balance sheet Assets (EURm) 24.015 25.211 25.322 24.827 24.545 27.202 28.194 29.043 30.206 Assets (%, YoY) 6,6 5,0 0,4 -2,0 -1,1 10,8 3,6 3,0 4,0 Assets (% of GDP) 80,7 75,4 79,9 72,5 73,6 82,5 81,7 83,7 84,0 Gross loans (EURm) 15.621 17.013 17.148 16.255 15.879 16.253 16.864 17.717 18.670 Gross loans (%, YoY) 15,3 8,9 0,8 -5,2 -2,3 2,4 3,8 5,1 5,4 Gross loans (% of GDP) 52,5 50,9 54,1 47,4 47,6 49,3 48,9 51,1 51,9 Deposits (EURm) 11.897 13.099 13.310 13.634 13.967 14.787 15.560 16.300 17.110 Deposits (%, YoY) 4,0 10,1 1,6 2,4 2,4 5,9 5,2 4,8 5,0 Deposits (% of GDP) 40,0 39,2 42,0 39,8 41,9 44,8 45,1 47,0 47,6 Loan-to-deposit ratio (%) 131,3 129,9 128,8 119,2 113,7 109,9 108,4 108,7 109,1 Capital adequacy ratio (%) 19,9 19,1 19,9 20,9 20,0 20,9 17,7 17,9 16,7 Performance Net interest income (EURm) 1.052 1.131 1.025 1.044 1.063 1.075 1.114 1.229 1.278 Net interest income (%, YoY) -1,7 7,6 -9,4 1,9 1,8 1,1 3,6 10,3 4,0 Total operating income (EURm) 1.541 1.590 1.484 1.435 1.489 1.520 1.579 1.772 1.841 Total operating income (%, YoY) -3,5 3,2 -6,7 -3,3 3,8 2,1 3,9 12,2 3,9 Pre-provision profit (EURm) 563 617 571 504 529 574 605 781 849 Pre-provision profit (%, YoY) -5,8 9,6 -7,5 -11,6 4,8 8,6 5,4 29,1 8,7 Provision charges (EURm) 316 313 339 510 490 494 514 640 728 Profitability and efficiency Net interest margin (%) 4,5 4,6 4,1 4,2 4,3 4,2 4,0 4,2 4,2 Pre-tax ROAA (%) 1,1 1,2 0,9 -0,1 0,1 0,3 0,3 0,5 0,4 Pre-tax ROAE (%) 5,1 5,9 4,3 -0,3 0,6 1,6 1,8 2,7 2,3 Cost-to-income ratio (%) 63,5 61,8 66,1 65,3 64,7 62,2 61,7 55,9 53,9 Operating expense (% of assets) 4,2 4,0 3,6 3,7 3,9 3,7 3,5 3,5 3,3 Credit quality and provisioning NPL ratio (%) 16,9 19,0 18,6 21,4 21,5 21,6 21,0 19,8 19,2 NPL coverage (%) 47,2 51,0 50,0 50,9 56,7 63,0 63,1 63,8 66,6 Provision charges (% of loans) 2,2 1,9 2,0 3,1 3,1 3,1 3,1 3,7 4,0 Provision charges (% of PPP) 56,2 50,7 59,4 101,1 92,8 86,0 85,0 81,9 85,7

Source: NBS, Addiko research

Loan growth forecast Overall loans grew 0.8% ytd in 8M16 mostly on the back of the 6.1% ytd higher retail loans, while for 2016 upgreded to other loans had slight positive contribution as well with 16.0% ytd gain. Household loans were 3.8% supported by modest wage and employment growth in private sector as well as the record low interest rates whereby average household interest rate (both RSD and FX-linked) fell to 9.5% in August (vs 10.3% at YE15). On the other hand, corporate loans were down by 1.3% ytd, while public lending fell 10.7% ytd. Looking ahead, we upgraded our overall loan growth forecast in F16 by 1.1pp to 3.8% yoy largely supported by the retail sector due to solid indicators from the labor market, low interest rates and expected price fall on real estate market, while we see corporate lending entering positive territory until the end of the year given the looser lending conditions and stronger private investments. However, negative contribution could arise from public sector as planned euro bond issue might result with closing of more expensive domestic credit lines.

On funding, deposits recorded 2.8% yoy growth in 8M16 with the strongest positive contribution Strong rise of corporate deposits coming from 3.1% ytd stronger retail collection, while public deposits went up by as much as 12.1% ytd. After being in red since the beginning of the year, corporate deposits managed to enter positive territory in August as they recorded 1.0% yoy gain in 8M16. Looking forward, we expect to see 5.2% yoy deposit growth on the back of the private sector collection where we see household deposits supported by aforementioned employment growth and net wages, while we see upside risk stemming from public sector as government plans to issue an euro bond later this year or in early 2017. On profits, TOI fell 6.8% yoy in 1H16, while pre-tax profit rose 19.1% thank to lower impairments. However we expect TOI to recover in the second half of the year to 3.9% yoy growth given the stronger lending activity expected, while we see 13.0% yoy pre-tax profit growth. As for NPLs, at the end of 2Q16 NPL ratio stood at 20.2% and we see the ratio increasing towards 21.0% in 2016 amid public sector layoffs as well as possible write-off in manufacturing sector due to initiation of the bankruptcy proceedings.

Page 22 October-16 SEE MACROECONOMIC OUTLOOK BOSNIA AND HERZEGOVINA

After IMF, Politics Takes the Spotlight

We downgraded our GDP growth forecast by 0.2pp to 2.9% in 2016 due to slowdownin 1H and political uncertainties. Meanwhile, new IMF deal is sealed and the first tranche arrived in B-H. We expect higher export and remittances will bring C/A deficit lower while inflation will stay in red in 2016.

GDP growth decelerated After 3.2% yoy growth in 2015, GDP growth slowed down to 1.7% yoy on average in 1H16. High in 1H16 frequency data also suggest the economy is somewhat losing momentum in the course of the year. On one hand, industrial production growth accelerated to 3.9% yoy on average in 8M16 (vs +3.1% yoy in 2015), driven by food processing and fabricated metal output. However, such performance has not fully translated into trade numbers as the volatile export growth decelerated to 2.2% yoy in 8M16 (vs +3.5% yoy in FY15). Nevertheless, flattish import (-0.2% yoy in 8M16) pulled the import cover up by 130bp yoy to 57.2% in August (on a 3mma basis). Stronger employment (+1.9% yoy in 7M16) and 1.6% yoy higher real net wage in 7M16 increased 8M16 retail trade by 6.6% yoy (vs +7.8% yoy in FY15).

GDP growth forecast Bearing in mind the GDP slowdown and political uncertainty, we reduce our FY16 GDP growth for FY16 reduced by forecast slightly to 2.9% yoy. Despite that, we still expect pick up in investments in 2H16 on road 0.2pp to 2.9% yoy construction and energy projects. Additionally, lower government spending amid fiscal consolidation will also weigh on GDP growth. As for consumption, we see it supported by stronger employment and remittances, and persistent deflationary pressures boosting purchasing power. Downside risk stem from employment growth that is largely supported by low-wage sectors and high youth unemployment, which forces emigration. Despite highly volatile international trade, we see export growth in 2016 around the current levels, which along flattish imports should have somewhat positive impact on economic growth. We keep our 3.0% GDP growth forecast for 2017 supported by accelerated investment activity and private consumption, with certain downside risks stemming from ongoing political uncertainties.

This year’s budget Strong fiscal consolidation in 2015 led to an 0.7%/GDP budget surplus. Meanwhile, 1H16 data deficit at around indicate 6.4% yoy lower budget surplus of EUR142m (0.9% of 2016e GDP), despite 2.0% yoy revenue 0.7%/GDP growth as 2.1% yoy higher expenditures were driven by surge in other expenses due to local elections in October. Although the general B-H government budget is lagging behind the plan, consolidated budget of B-H Federation saw a solid 5.2% yoy increase in tax revenue. In September, B-H Federation got EUR40m by selling stakes in FDS and Bosnalijek to meet obligations from the Reform Agenda, while privatization of Sarajevo Osiguranje is not yet complete. R-S consolidated budget has struggled on revenues (-2.4% yoy in 1H16), although fiscal consolidation seems to continue with 2.0% yoy lower expenditures. In detail, R-S budget is in constant struggle with liquidity and the debt service swallows more than 40% of the budget. Due to local elections and postponed IMF tranche, we see budget deficit at 0.7% of GDP this year and around same levels in next year as we expect investment expenditures to intensify. The IMF loan has finally been approved and B-H got the first tranche, with remaining tranches depending on implementation of the IMF-enshrined reforms.

Referendum and local In October, B-H held the local elections whereby, unsurprisingly, nationalist parties almost election were in focus completely defeated non-nationalist rivals. The focus was mainly on RS’ election, where pro-Russian separatist party (SNSD) defeated a pro-European Union coalition, campaigning on RS' secession from Bosnia. Namely, Dodik managed to shift Serb voters' attention away from the corruption accusations by holding a referendum in RS over a disputed holiday celebrated in that region, a week before the elections. Referendum received the international attention as it indirectly violates the Dayton Agreement whereby western countries clearly condemned the holding of the referendum and even Serbian government opposed it, probably under the pressure from the EU. In our view, Dodik has nevertheless strengthened his position in RS, encouraging him to continue with radicalization that paid him off recently. Elections brought the certain downside risks to institutional development in the moment when the country is set to start EU talks and launch EU-demanded reforms.

Inflation still in red in After CA deficit significantly reduced in 2015 to 5.7%/GDP, this year we see deficit narrowing 2016, C/A deficit lower towards 5.2%/GDP due to higher remittance inflow and slight improvement in G&S balance. In 2017, C/A deficit will probably re-widen due to import recovery, while in the medium term we see further fall in CA deficit. A for CPI, lower oil and food prices led to the -1.3% average inflation in 8M16. Given the currency board arrangement and B-H sensitivity to low inflationary pressures from euro zone, as well as shy pick up in net wages, we once again cut our inflation expectations in FY16 by 0.6pp to -1.0%. In coming years we see inflation lifting into positive territory given the expected stabilization of oil prices, inflation recovery in the euro zone as well as acceleration of net wages. Page 23 Page 23 October-16 SEE MACROECONOMIC OUTLOOK BOSNIA AND HERZEGOVINA

Bosnia and Herzegovina's data trends

Real GDP growth (% YoY) Industrial production (%, yoy, s-a, 3mma)

4 140 Intermediate Non -durable goods 3 130 Energy Industry Total

2 120

1 110

0 100

-1 90

-2 80

-3 70 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Mar -07 Jul -09 Nov -11 Mar -14 Jul -16

Key CPI contributions (pp) Merchandise import cover (%, 3mma) 65 9,8

8,3 60 Food Housing Transport 6,8 55 5,3

3,8 50

R² = 0,6605 2,3 45

0,8 40 -0,7

-2,2 35 Jan -07 Dec -08 Nov -10 Oct -12 Sep -14 Aug -16 Jan -08 Sep -09 May -11 Jan -13 Sep -14 May -16

Private credit dynamics (%, YoY) Budget and current account gaps (% of GDP) vs. real GDP growth 34

0 28 3

Corporate 22 Retail -3

16 1

-6 10

4 -1 -9 BUDGET DEFICIT (LHS) -2 CAD (LHS) GDP (RHS) -8 -12 -3 Jan -05 Jan -07 Jan -09 Jan -11 Jan -13 Jan -15 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F

Source: Central Bank of Bosnia and Herzegovina, The Agency for Statistics, IMF, Ministry of Finance, Addiko research Page 24 Page 24 October-16 SEE MACROECONOMIC OUTLOOK BOSNIA AND HERZEGOVINA

SELECTED ECONOMIC FORECASTS 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Activity Nominal GDP (BAMbn, current prices) 25,3 26,2 26,2 26,7 27,3 28,5 29,1 30,2 31,6 Nominal GDP (EURbn) 13,0 13,4 13,4 13,7 14,0 14,6 14,9 15,4 16,1 Nominal GDP (USDbn) 17,2 18,7 17,2 18,2 18,5 16,2 16,5 16,0 17,3 GDP per capita (EUR) 3.310 3.432 3.430 3.507 3.634 3.798 3.868 4.014 4.200 GDP per capita (USD) 4.404 4.789 4.431 4.682 4.785 4.088 4.293 4.174 4.494 Real GDP (constant prices YoY, %) 0,8 0,9 -0,9 2,4 1,1 3,2 2,9 3,0 3,2 Private consumption (YoY, %) -0,8 1,6 2,2 2,6 3,0 2,7 2,6 2,9 3,0 Fixed investment (YoY, %) -16,3 6,8 6,3 -2,4 9,5 -2,2 6,0 6,2 4,5 Industrial production (YoY, %) 1,6 5,9 -5,3 6,6 0,3 3,1 4,9 5,0 5,0 Unemployment rate (ILO, average, %) 27,2 27,6 28,0 27,4 27,5 27,7 26,3 25,7 24,9

Prices CPI inflation (average % YoY) 2,1 3,7 2,1 0,1 -0,9 -1,0 -1,0 0,7 1,4 CPI inflation (end-year % YoY) 3,1 3,1 1,8 -1,2 -0,4 -1,3 0,1 0,7 1,2 PPI inflation (average % YoY) 0,9 3,8 1,5 -2,2 -0,5 0,6 -2,0 1,0 1,3 Net wage rates (% YoY, nominal) 1,3 2,0 1,2 0,1 0,4 0,0 0,9 1,6 1,5

Fiscal balance (% of GDP) State budget balance -2,4 -1,2 -2,0 -2,2 -2,0 0,7 -0,7 -0,7 -1,3 Public debt 42,8 42,6 44,3 43,5 44,0 44,7 44,5 44,0 43,2

External balance Export of goods and services (EURbn) 3,851 4,297 4,312 4,597 4,733 5,043 5,162 5,446 5,664 Import of goods and services (EURbn) -6,649 -7,484 -7,483 -7,414 -7,943 -7,813 -7,939 -8,233 -8,521 Merchandise trade balance (EURbn) -3,797 -4,131 -4,091 -3,741 -4,142 -3,810 -3,838 -3,987 -4,057 Merchandise trade balance (% of GDP) -29,3 -30,8 -30,5 -27,4 -29,7 -26,1 -25,8 -25,9 -25,1 Remittances (EURbn) 1,015 1,027 1,070 1,097 1,163 1,210 1,247 1,269 1,292 Current account balance (EURbn) -0,783 -1,270 -1,168 -0,773 -1,057 -0,833 -0,775 -0,851 -0,870 Current account balance (% of GDP) -6,0 -9,5 -8,7 -5,7 -7,6 -5,7 -5,2 -5,5 -5,4 Net FDI (EURbn) 0,3 0,3 0,3 0,2 0,4 0,2 0,4 0,5 0,5 FDI (% of GDP) 2,1 2,6 1,9 1,6 3,0 1,4 2,7 2,9 3,0 FDI cover (%) 34,8 27,1 22,3 29,1 40,0 24,7 51,6 52,9 56,5 Gross international reserves (EURbn) 3,302 3,285 3,328 3,614 4,001 4,400 4,832 4,795 4,796 Import cover (months of imports) 6,0 5,3 5,3 5,8 6,0 6,8 7,3 7,0 6,8

Debt indicators Gross external debt (EURbn) 6,687 7,183 8,410 8,491 7,818 8,610 8,916 8,980 9,060 Government (EURbn) 3,217 3,407 3,687 3,867 4,316 4,444 4,524 4,584 4,499 Private (EURbn) 3,471 3,776 4,723 4,624 3,501 4,166 4,261 4,396 4,561 Gross external debt (% of GDP) 51,6 53,6 62,8 62,1 56,0 59,0 60,0 60,3 58,3 Gross external debt (% of exports) 173,6 167,2 195,0 184,7 165,2 170,7 172,7 164,9 160,0

Exchange rates and money growth USD/BAM (end-year) 1,46 1,51 1,48 1,42 1,61 1,79 1,86 1,83 1,79 USD/BAM (average) 1,47 1,40 1,52 1,47 1,47 1,76 1,76 1,88 1,83 EUR/BAM (end-year) 1,96 1,96 1,96 1,96 1,96 1,96 1,96 1,96 1,96 EUR/BAM (average) 1,96 1,96 1,96 1,96 1,96 1,96 1,96 1,96 1,96 Money supply M1 (% YoY) 7,9 6,5 6,5 7,2 6,0 5,1 6,1 6,6 6,6 Broad money M2 (% YoY) 7,22 5,80 3,41 7,94 7,30 7,98 7,19 6,65 6,50 Domestic credit (% YoY) 3,51 5,28 4,12 0,53 2,79 2,39 2,16 3,46 3,93 EURIBOR 3M interest rate (average %) 0,81 1,39 0,58 0,22 0,21 -0,02 -0,29 -0,40 -0,40

Source: Central Bank of Bosnia and Herzegovina, The Agency for Statistics, IMF, Ministry of Finance, Addiko research Page 25 October-16 SEE MACROECONOMIC OUTLOOK BOSNIA AND HERZEGOVINA

SELECTED BANKING SECTOR DATA 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Balance sheet Assets (EURm) 10.828 11.196 11.414 11.794 12.299 12.756 13.147 13.848 14.615 Assets (%, YoY) 0,8 3,4 1,9 3,3 4,3 3,7 3,1 5,3 5,5 Assets (% of GDP) 83,6 83,5 85,2 86,3 88,1 87,4 88,5 89,8 90,6 Gross loans (EURm) 7.436 7.828 8.151 8.194 8.423 8.624 8.810 9.114 9.473 Gross loans (%, YoY) 3,5 5,3 4,1 0,5 2,8 2,4 2,2 3,5 3,9 Gross loans (% of GDP) 57,4 58,4 60,9 59,9 60,3 59,1 59,3 59,1 58,7 Deposits (EURm) 6.407 6.643 6.814 7.285 7.861 8.452 9.025 9.565 10.107 Deposits (%, YoY) 3,6 3,7 2,6 6,9 7,9 7,5 6,8 6,0 5,7 Deposits (% of GDP) 49,4 49,6 50,9 53,3 56,3 57,9 60,7 62,0 62,6 Loan-to-deposit ratio (%) 116,1 117,8 119,6 112,5 107,1 102,0 97,6 95,3 93,7 Capital adequacy ratio (%) 16,2 17,1 17,0 17,8 16,3 14,9 14,8 14,2 13,8 Performance Net interest income (EURm) 366 396 389 385 383 398 419 429 463 Net interest income (%, YoY) 1,1 8,2 -1,8 -1,0 -0,5 3,9 5,3 2,4 7,8 Total operating income (EURm) 609 620 610 618 623 642 676 699 747 Total operating income (%, YoY) 4,8 1,8 -1,5 1,2 0,8 3,1 5,3 3,5 6,9 Pre-provision profit (EURm) 220 209 207 184 213 206 217 230 267 Pre-provision profit (%, YoY) 15,7 -5,1 -0,8 -11,1 15,8 -3,6 5,7 5,8 16,0 Provision charges (EURm) 275 125 130 192 117 157 105 152 149 Profitability and efficiency Net interest margin (%) 3,4 3,6 3,4 3,3 3,2 3,2 3,2 3,2 3,3 Pre-tax ROAA (%) -0,5 0,8 0,7 -0,1 0,8 0,4 0,9 0,6 0,8 Pre-tax ROAE (%) -4,4 5,9 4,8 -0,5 5,6 2,7 6,0 3,9 5,7 Cost-to-income ratio (%) 63,9 66,3 66,0 70,2 65,7 67,9 67,8 67,1 64,3 Operating expense (% of assets) -3,6 -3,7 -3,6 -3,7 -3,4 -3,5 -3,5 -3,5 -3,4 Credit quality and provisioning NPL ratio (%) 11,4 11,8 13,5 15,1 14,2 13,7 12,2 12,0 11,6 NPL coverage (%) 43,7 66,3 65,9 66,7 69,7 71,2 66,5 63,4 61,6 Provision charges (% of loans) 3,8 1,6 1,6 2,3 1,4 1,8 1,2 1,7 1,6 Provision charges (% of PPP) -124,8 -60,0 -62,8 -104,1 -55,1 -76,2 -48,1 -66,2 -55,8

Source: CBBH, banking agencies, Addiko research

Private lending in green Loans managed to end 8M16 in green (+0.6% ytd) as household and corporate loan growth (+2.1% ytd and +0.7% ytd, respectively) successfully offset public and other loans drop of 8.7% ytd and 14.0% ytd, respectively. That said, we see retail loans growth boosted with solid employment and remittances growth, although housing loans still count for only around 20% of total loans implying that increasing lending in B-H does not support investment activity, and it is still dominantly used for non-purpose spending. After being in red for some time, positive economic developments led to corporate lending recovery which would have been even more pronounced if it has not been for loans write off in May due to Banka Srpska liquidation. Looking forward, we lowered our FY16 credit growth by 1.7pp to 2.2% solely on the back of significant decline in public lending. Additionally, upside risk is looming from negative interest rate introduced by central bank since 1st of July, which in only two months forces commercial bank to pay almost EUR360m penalties, making unused cash rather expensive. In such circumstances we see potential for further interest rate decline as well as lending activity recovery. NPL ratio declined further towards 12.1% in 1H16 (vs. 13.7% at YE15) which allows us to adjust the FY16 NPL ratio projections to 12.0%.

Deposit collection In terms of funding, deposit collection increased by 4.1% on ytd level in 8M16 mostly driven by growth accelerated private sector deposit growth. Namely, retail deposits increased by 3.6% ytd, while corporate deposits recorded 4.8% ytd growth whereby strong deposit growth in recent years implies the security and stability of the entire banking sector. Finally, public deposits entered positive territory with 4.5% ytd gain after being in red throughout the year. That said, based on available data we expect to see this year’s deposit growth around 6.8% with downward pressure steaming from further decline in interest rates. Such expectations are implying LDR ratio of 98% at the end of 2016 and further decline in coming years. On profits, banks saw 0.8% yoy decline in pre-provision profit in 1H16 due to higher opex. As for 2016, we expect pre-tax profit to return to FY14 levels amid stable TOI growth and lower provisioning.

Page 26 October-16 SEE MACROECONOMIC OUTLOOK MONTENEGRO

Capex Delays Harming Growth

We have lowered our 2016 growth expectations by 0.7pp to 3.5% of GDP as tourism growth came somewhat lower than expected and industrial production continues to face drop. Meanwhile, due to delays in highway construction we lowered our 2016 deficit expectations by 2.2pp to 7.3% of GDP. We see inflation barely in green, while C/A deficit widening.

Economic data suggest After barely increasing 1.1% yoy in Q1, Montenegrin economy faced a solid growth of 2.7% yoy in mixed performance Q216 with soaring investments related to the highway construction being the main culprit as seen in as much as 32.1% yoy stronger construction activity in Q2. However, other hard indicators are not painting such a rosy picture. To be precise, following a -4.5% yoy drop in 1H16, industrial production decreased by further 3.7% yoy from July to August. In addition, due to previous year high base foreign tourist arrivals managed to saw a minor decline of 0.7% yoy from July to August but with retail sales growing rather solid 4.1% yoy in the same period as employment rises modestly and wages are seeing a solid growth (+4.5% yoy growth in August on a 3mma). However, highway construction combined with recovering domestic demand increased import by 11% yoy from June to August with the 21% yoy stronger export in the same period not being enough to offset it, all of which resulted in 19% yoy higher trade balance deficit.

GDP growth That said, we have lowered our 2016 growth expectations by 0.7pp to 3.5% of GDP as tourism downgraded to 3.5% in growth came somewhat lower than expected and industrial production continues to face drop. In 2016 line with that and the expected slowdown in 2017 we have lowered our 2017 growth expectations by 0.6pp to 3.2%. Elsewhere, we see growth supported with the ongoing personal consumption pick up on the back of public wage hike and pensions and certain social benefits increase. The latter is also one of the factors that will continue to pump government consumption, also supported with the usual higher spending in the pre-election period and infrastructural projects. Meanwhile, goods trade deficit is set to deepen further as import will be boosted by domestic demand recovery and highway construction while decrease in industrial production suggests not much can be expected from the export.

Fiscal metrics remain Public finances continue to be one of the main cause of the concern in Montenegro. However, a cause of concern looking at the performance in the year to July, budget revenues managed to increase 6.1% yoy but are still 0.8% lower compared to the plan. The strongest positive contribution thus came from 5.6% stronger VAT intake as well as 26.4% higher collection of income tax on better tax compliance and solid macro performance. As for the expenditure side, the outlays decreased 11.2% yoy in the year to August and are 14.1% lower compared to the plan with the difference almost solely arising from as much as 90.7% lowered capex than initially planned. In such circumstances, budget deficit decreased by 58.7% yoy and is halved compared to the plan but still standing at 2.9% of GDP already in July. However, we attribute such performance mainly to the delays in highway construction as seen in capex decrease and see those outlays back loaded into the second part of the year and further into 2017. That said, we have lowered our 2016 deficit expectations by 2.2pp to 7.3% of GDP, thus being in line with government plan while in 2017 we keep our view of 8.7% of GDP deficit intact for now. Public debt is thus set to increase by2.6pp to 69% of GDP in 2016 and further to 73.9% of GDP in 2017.

Inflation in 2016 As for prices, following 5 months of deflation the prices managed to face stagnation in August. barely in green Recent inflation dynamics surprised us largely on the downside with the strong decline of food prices being the main culprit together with slower than initially assumed recovery of oil prices. In such circumstances and with overall average stagnation of prices in the year to August we have lowered our 2016 inflation expectations by 0.9pp to 0.4%. However, with the normalization of oil prices on the way and recent public wage hike and pensions increase that boosts domestic consumption, we see a case for a modest price recovery in the 4Q16 and further into 2017 with an expected 2017 average inflation of 1.8%.

We see this year 1H16 current account gap increased by as much as 35.7% yoy with a 13.2% stronger import of goods current account deficit caused by highway construction and domestic demand recovery being the main reason. widening Furthermore, export has faced a 1% yoy drop in the same period while tourism receipts increased by less than expected 7.3% yoy. Looking into capital and financial account, net direct investments dropped 47.7% yoy while portfolio investments faced 92.4% drop. The mentioned is particularly concerning when bearing in mind that the investors will stay cautious in the period ahead as well given Montengros significant external imbalances and that the significant tax deductions have already been done to attract investments, not leaving much of maneuver space in the period ahead. All in all, with all the mentioned factors staying in place for the time being we see this year current account deficit widening by 1.6pp to 15.2% of GDP and then see further increase to 16.0% of GDP in 2017.

Page 27 Page 27 October-16 SEE MACROECONOMIC OUTLOOK MONTENEGRO

Montenegrin data trends

0,5 Balance of payments (%, yoy) Capital Account Industrial production (%, yoy) 0,4 Errors Omissions Change in Reservs (+ is decrease) 60 Industrial production Other 0,3 Portfolio Investment Manufacturing Net FDI 40 Current Account Deficit

0,2 20

0,1 0

0 -20

-0,1 -40

-0,2 -60 2009 2010 2011 2012 2013 2014 2015 Jan -11 Nov -11 Sep -12 Jul -13 May -14 Mar -15 Jan -16

CPI by key contributions (pps) Merchandise import cover (%, 3mma) 6 Food Alcoh. beverages, tobacco 32 5 Transport Housing Headline CPI 4 27

3 23 2

1 19

0

14 -1

-2 Jan -09 Jul -10 Jan -12 Jul -13 Jan -15 Jul -16 10 Mar -09 Aug -10 Jan -12 Jun -13 Nov -14 Apr -16

mil. € Tourism Budget revenue movements 170 900 11.000

800 10.000 155 9.000 700 140 8.000 600 7.000 125 500 6.000 110 400 Moving 4Q Net 5.000 Tourism Revenues 4.000 EURm (lhs) 95 300 2014 Moving 4Q Foreign 3.000 2015 80 2016 - plan 200 Overnights, in 000 2.000 (rhs) 100 1.000 65 1Q05 3Q06 1Q08 3Q09 1Q11 3Q12 1Q14 3Q15 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Source: Montenegrin National Bank, MONSTAT, Ministry of Finance, IMF, Addiko research Page 28 Page 28 October-16 SEE MACROECONOMIC OUTLOOK MONTENEGRO

SELECTED ECONOMIC FORECASTS 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Activity Nominal GDP (EURbn,current prices) 3,1 3,2 3,1 3,3 3,4 3,6 3,7 3,9 4,1 Nominal GDP (USDbn) 4,10,0 4,50,0 4,00,0 4,40,0 4,50,0 3,90,0 4,10,0 4,00,0 4,40,0 GDP per capita (EUR) 5.011 5.211 5.062 5.359 5.460 5.715 5.936 6.237 6.555 GDP per capita (USD) 6.648 7.257 6.510 7.117 7.253 6.339 6.571 6.486 7.014 Real GDP (constant prices YoY, %) 2,5 3,2 -2,7 3,5 1,5 3,2 3,5 3,2 3,0 Private consumption (YoY, %) 4,2 7,0 -0,7 3,1 1,5 1,9 2,3 2,5 2,5 Fixed investment (YoY, %) -21,2 -9,6 -1,8 10,1 3,5 17,0 12,2 12,0 7,2 Industrial production (YoY, %) 17,50,0 -8,70,0 -6,20,0 10,70,0 -10,50,0 9,20,0 -3,00,0 3,50,0 3,70,0 Unemployment rate (ILO, average %) 19,70,0 18,10,0 20,60,0 19,50,0 18,10,0 17,90,0 17,90,0 17,70,0 17,50,0

Prices

CPI inflation (average % YoY) 0,5 3,3 4,0 1,8 -0,5 1,4 0,4 1,8 2,0 CPI inflation (end-year % YoY) 0,70,0 3,00,0 4,40,0 0,40,0 -0,60,0 1,70,0 1,82,1 2,00,0 2,10,0 PPI inflation (average % YoY) -0,70,0 3,20,0 1,80,0 1,70,0 0,20,0 0,30,0 0,50,0 0,90,0 1,20,0 Net wage rates (% YoY, nominal) 3,50,0 1,00,0 0,70,0 -1,70,0 0,10,0 0,70,0 8,20,0 0,70,0 1,10,0

Fiscal balance (% of GDP) State budget balance (ESA-95) -4,9 -6,7 -5,8 -6,3 -3,1 -8,5 -7,3 -8,7 -5,1 Public debt 40,7 45,6 53,4 55,2 59,9 66,4 69,0 73,9 71,5 Gross public funding needs n/a n/a n/a 6,0 8,8 20,4 22,2 18,4 9,6

External balance

Export of goods and services (EURbn) 0,0001,158 1,3830,000 1,3890,000 1,3900,000 1,3880,000 1,5390,000 1,6470,000 1,7220,000 1,7790,000 Import of goods and services (EURbn) -1,961 -2,100 -2,166 -2,066 -2,074 -2,213 -2,404 -2,538 -2,618 Merchandise trade balance (EURbn) -1,267 -1,306 -1,389 -1,329 -1,376 -1,463 -1,637 -1,767 -1,818 Merchandise trade balance (% of GDP) -40,8 -40,4 -44,1 -39,9 -40,6 -41,2 -44,4 -45,6 -44,6 Tourism receipts (EURbn) 0,552 0,619 0,643 0,666 0,682 0,813 0,911 0,983 1,013 Current account balance (EURbn) -0,710 -0,573 -0,588 -0,487 -0,526 -0,482 -0,562 -0,619 -0,639 Current account balance (% of GDP) -22,9 -17,7 -18,7 -14,6 -15,5 -13,6 -15,2 -16,0 -15,7 Net FDI (EURbn) 0,6 0,4 0,5 0,3 0,4 0,6 0,6 0,6 0,6 FDI (% of GDP) 17,80,0 12,00,0 14,70,0 9,70,0 10,40,0 17,40,0 16,80,0 15,50,0 14,70,0 FDI cover (%) 77,7 67,9 78,5 66,6 67,3 128,5 110,2 96,9 93,9 Gross international reserves (EURbn) 0,3860 0,2730 0,3180 0,3950 0,5140 0,6410 0,7720 1,5080 2,0700 Import cover (months of imports) 2,4 1,6 1,8 2,3 3,0 3,5 3,9 7,1 9,5

Debt indicators Gross external debt (EURbn) 3,585 3,803 3,986 4,282 4,510 4,884 5,342 6,097 6,698 Government (EURbn) 0,4980,000 0,5290,000 0,5540,000 0,5950,000 0,6520,000 0,7590,000 0,7670,000 1,0200,000 1,1750,000 Private (EURbn) 3,0870,000 3,2750,000 3,4320,000 3,6870,000 3,8570,000 4,1260,000 4,5760,000 5,0780,000 5,5220,000 Gross external debt (% of GDP) 115,50,000 117,60,000 126,60,000 128,70,000 132,90,000 137,50,000 144,80,000 152,80,000 157,40,000 Gross external debt (% of exports) 309,7 275,1 286,9 308,0 324,9 317,3 324,4 354,1 376,4

Exchange rates and money growth EUR/USD (end-year) 1,34 1,30 1,32 1,38 1,21 1,09 1,05 1,07 1,09 EUR/USD (average) 0,0001,33 0,0001,39 0,0001,29 0,0001,33 0,0001,33 0,0001,11 0,0001,11 0,0001,04 0,0001,07 Money supply M1 (% YoY)* n/a n/a n/a n/a n/a n/a n/a n/a n/a Broad money M3 (% YoY)* n/a n/a n/a n/a n/a n/a n/a n/a n/a Domestic credit (% YoY) 0,0000-4,8 0,0000-6,3 0,0000-0,7 0,00003,1 0,0000-1,9 0,00000,8 0,00003,7 0,00003,2 0,00003,0 ECB reference rate (end-year %) 0,00001,000,0000 1,000,0000 0,750,0000 0,250,0000 0,050,0000 0,050,0000 -0,200,0000 -0,250,0000 -0,25 EURIBOR 3M interest rate (average, %) 0,00000,81 0,00001,39 0,00000,58 0,00000,22 0,00000,21 0,0000-0,02 0,0000-0,35 0,0000-0,45 0,0000-0,10

Source: Montenegrin National Bank, MONSTAT, Ministry of Finance, IMF, Addiko research Page 29 October-16 SEE MACROECONOMIC OUTLOOK MONTENEGRO

SELECTED BANKING SECTOR DATA 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F Balance sheet Assets (EURm) 2.944 2.810 2.808 2.959 3.136 3.472 3.629 3.774 3.925 Assets (%, YoY) -2,7 -4,5 -0,1 5,4 6,0 10,7 4,5 4,0 4,0 Assets (% of GDP) 94,8 86,9 89,2 88,9 92,4 97,3 96,3 94,6 96,3 Gross loans (EURm) 2.518 2.359 2.342 2.414 2.367 2.386 2.475 2.554 2.630 Gross loans (%, YoY) -4,8 -6,3 -0,7 3,1 -1,9 0,8 3,7 3,2 3,0 Gross loans (% of GDP) 81,1 72,9 74,4 72,6 69,8 66,8 65,7 64,0 64,5 Deposits (EURm) 1.790 1.817 1.981 2.098 2.308 2.625 2.838 3.002 3.171 Deposits (%, YoY) -1,9 1,5 9,0 5,9 10,0 13,7 8,1 5,8 5,6 Deposits (% of GDP) 57,7 56,2 62,9 63,0 68,0 73,5 75,3 75,2 77,8 Loan-to-deposit ratio (%) 140,7 129,8 118,2 115,1 102,6 90,9 87,2 85,1 82,9 Capital adequacy ratio (%) 15,9 16,5 14,7 14,4 16,2 16,0 13,4 12,9 12,5 Performance Net interest income (EURm) 111 106 106 104 111 117 126 131 137 Net interest income (%, YoY) -8,2 -4,8 -0,1 -1,6 6,6 5,3 7,7 4,2 4,0 Total operating income (EURm) 155 221 178 156 158 171 183 191 198 Total operating income (%, YoY) -4,4 42,6 -19,5 -12,0 1,2 8,3 6,7 4,2 4,0 Pre-provision profit (EURm) 53 114 65 48 46 52 55 53 51 Pre-provision profit (%, YoY) -13,0 114,7 -43,2 -26,7 -2,6 11,5 5,6 -2,7 -4,3 Provision charges (EURm) 148 124 121 44 21 53 43 45 46 Profitability and efficiency Net interest margin (%) 3,7 3,7 3,8 3,6 3,6 3,5 3,6 3,6 3,6 Pre-tax ROAA (%) -3,2 -0,3 -2,0 0,1 0,8 -0,1 0,3 0,2 0,1 Pre-tax ROAE (%) -30,0 -3,2 -18,7 1,0 6,0 -0,4 2,4 1,8 1,0 Cost-to-income ratio (%) 65,6 48,2 63,5 69,6 70,7 69,8 70,2 72,1 74,4 Operating expense (% of assets) 3,4 3,7 4,0 3,8 3,7 3,6 3,6 3,7 3,8 Credit quality and provisioning NPL ratio (%) 21,0 15,5 17,6 17,5 15,9 12,5 12,0 11,7 11,1 NPL coverage (%) 28,6 27,6 32,7 44,7 46,0 49,6 40,4 31,9 24,0 Provision charges (% of loans) 5,7 5,1 5,1 1,9 0,9 2,2 1,8 1,8 1,8 Provision charges (% of PPP) 277,2 108,5 185,7 92,5 45,6 103,2 79,5 84,6 91,1

Source: CBCG, Addiko research

We keep our 2016 loan Overall loans rose 4.3% ytd in 8M16 whereby the strongest positive contribution came from private growth intact sector. That said, retail loans soared 7.7% ytd supported by the higher public sector wages, PIT relief and solid tourist season, while corporate lending recorded 2.2% ytd increase. Public and other loans ended 8M16 in positive territory as well with 2.6% ytd and 2.4% ytd loans growth, respectively. That said, we keep our FY16 total loan growth expectations intact at 3.7% as we expect to see usual gradual slowdown in lending activity in the rest of the year. Certain downside risk is stemming from public sector where government outlays are much lower compared to the plans in year to August and there are no indications of funding needs in the rest of the year. Meanwhile, NPL ratio fell to 11.7% at the end of the June as banks in Montenegro are transferring NPLs to mother banks, increasing debt collection activities and demanding subsequent collaterals and therefore we cut our NPL ratio expectations for FY16 by 0.8pp to 12.0%, while in coming years we see further NPL decline with upside risks coming from rotten real estate market.

Private deposits rose on Total deposits rose 6.8% ytd in 8M16 where only negative contribution came from other deposits the back of the tourist whose collection fell 26.4% ytd. On the other hand, corporate deposits soared 13.4% ytd, while retail season saw 2.5% ytd increase, both supported by the solid tourist season despite modest stagnation in tourist arrivals in July to August. Finally, public sector deposit collection also surged +22.9% ytd. That said, we are comfortable with our 8.1% growth forecast as available data shows that our expectations are in the place. Meanwhile, LTD ratio fell to 89% in 8M16 (vs 91% at YE15) and we expect it to fell towards 87% as the downward trend continues. On profits, pre-tax profit rose 68.3% yoy in 1H16 on the back of 8.6% yoy higher TOI and 3.7% yoy lower G&A expenses. As for 2016, we expect to see pre-tax profit back in green territory on the back of 7-alike TOI increase and lower provisioning.

Page 30 October-16 SEE MACROECONOMIC OUTLOOK

ABBREVIATIONS

AUM AssetUnderManagement BAMC BankAssetsManagementCompany BRICS Brazil,Russia, India,China,South Africa CAD CurrentAccountDeficit CAR Capital Adequacy Ratio CARDS Community Assistance for Resconstruction, Development and Stabilization CBS CentralBureauofStatistics CEE Central Eastern Europe CIR Cost-to-income ratio CIT Corporate Income Tax CNB CroatianNationalBank CPI ConsumerPriceIndex EC European Commission ECB EuropeanCentralBank EE Eastern Europe EMU European Monetary Union EU European Union FC ForeignCurrency FDI ForeignDirectInvestment Fed FederalReserve FX Foreign Exchange GDP Gross Domestic Product GFCF GrossFixedCapitalFormation IEA International Energy Association IFI InternationalFinancialInstitution IFRS InternationalFinancialReporting Standards IMF InternationalMonetaryFund IP Industrial Production IPO Initial Public Offering ISPA Instrument for Structural Policies for Pre-Accession LDR Loan-to-Deposit Ratio M&A MergersandAcquisitions M1, M4 Monetaryaggregates(the narrowest and the broadest, respectively) MinFin Ministryof Finance MM MoneyMarket MoM month-on-month NII NetInterestIncome NIM NetInterestMargin NPA Non-Performing Assets NPL Non-Performing Loans (Impaired Loans) OECD Organization for Economic Co-operation and Development OPEC Organization of the Petroleum Exporting Countries PER Price vs. Earnings Phare Pologne et Hongrie - Aide á Restructuration Economique PPI Producer Price Index PPP Pre-Provision Profit / Public-Private Partnership PSE Public Sector Entity REER Real Effective Exchange Rate SAPARD Special Association Program for Agriculture and Rural Development S-D gap Supply-Demand gap SPO Secondary Public Offering T-bill Treasury bill TOI Total Operating Income VAT Value Added Tax YE yearend yoy year-on-year ytd year-to-date ZIRP Zero Interest Rate Policy

Page 32 Page 32 October-16 SEE ECONOMIC RESEARCH

Disclosures Appendix

ANALYST CERTIFICATION

The information and opinions in this report were prepared by Addiko Bank d.d.. and/or one or more of its subsidiaries/affiliates (collectivelly, Addiko Bank '). The research analyst or analysts who prepared this report hereby certifies that: (1) the views expressed in this report accurately reflect their personal views about the subject securities or issuers and/or other subject matter as appropriate; and, (2) no part of his or her compensation was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this report. On a general basis, the efficacy of recommendations is a factor in the performance appraisals of analysts.

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Securities prices : Prices are taken as of the previous day’s close on the home market unless otherwise stated.

Conflicts of interest policy . Addiko Bank manages conflicts of interest arising as a result of the preparation and publication of research through its use of internal databases, notifications by the relevant employees and Chinese walls as monitored by Addiko Bank Compliance and Security Department. For further details see our research policies page at http://www.hypo-alpe-adria.com.

Addiko Bank is involved in many businesses that may relate to companies, issuers or instruments mentioned in this report. These businesses include market making, providing liquidity and specialized trading and other proprietary trading, fund management, investment services and investment banking. Addiko Bank trades as principal in the securities/instruments that are the subject of this report. Addiko Bank may have a position in the debt of the Company or instruments discussed in this report, and may trade them in ways different from those discussed in this report.

POTENTIAL CONFLICTS OF INTEREST

Addiko Bank and/or affiliate (pursuant to relevant domestic law) acts as a market maker in government bonds issued by the Croatian Ministry of Finance (Treasury).

DISCLAIMER

Addiko Bank does not undertake to advise you of changes in its opinion or information. Any opinions and estimates contained herein reflect the current judgement of the author(s), and do not necessarily reflect the opinion of Addiko Bank or any of its subsidiaries and affiliates. It has not been determined in advance whether and in what intervals this report will be updated. Addiko Bank and others associated with it may make markets or specialize in, have positions in and effect transactions in securities of companies mentioned and may also perform or seek to perform investment banking services for those companies.

This report is based on information available to the public. While reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of publication Addiko Bank d.d. makes no representation or guarantee with regards to the accuracy, completeness or suitability of the data. Additional information is available upon request. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other Addiko Bank business areas, including Investment banking / Treasury / Corporate personnel.

This report is not investment advice or an offer or solicitation for the purchase or sale of any security/financial instrument or to participate in any trading strategy. Neither Addiko Bank Croatia d.d. nor its subsidiaries/affiliates accept any liability for any direct or consequential loss arising from any use of this publication or its contents. Clients should contact and execute transactions through Addiko Bank d.d. or group entity in their home jurisdiction unless local regulations permit otherwise. Copyright and database rights protection exists in this publication and it may not be sold, reproduced, distributed or published by any person for any purpose without the prior express consent Addiko Bank . Please cite source when quoting.

Addiko Bank d.d. is regulated by the Croatian Financial Services Supervisory Agency (HANFA) for the conduct of designated investment business in Croatia.

Any investments referred to herein may involve significant risk, are not necessarily available in all jurisdictions, may be illiquid and may not be suitable for all investors. The value of, or income from, any investments referred to herein may fluctuate and/or be affected by changes in exchange rates. Past performance is not indicative of future results. Estimates of future performance are based on assumptions that may not be realized. Investors should make their own investment decisions without relying on this publication. Only investors with sufficient knowledge and experience in financial matters to evaluate the merits and risks should consider an investment in any issuer or market discussed herein and other persons should not take any action on the basis of this publication.

This report may include research based on technical analysis. Technical analysis is generally based on the study of trading volumes and price movements in an attempt to identify and project price trends. Technical analysis does not consider the fundamentals of the underlying issuer or instrument and may offer an investment opinion that conflicts with other research generated by Hypo Alpe-Adria-Bank. Investors may consider technical research as one input in formulating an investment opinion. Additional inputs should include, but are not limited to, a review of the fundamentals of the underlying issuer/security/instrument.

This report is diseminated and available primarily electronically to professional investors, who are expected to make their own investment decision without undue reliance on this publication, and may not be redistributed, reproduced or published in whole or in part for any purpose. Additional information is available on request. SEE ECONOMIC RESEARCH

Hrvoje Stojic, Economic Research Director (+385-1-603-0509) Tajana Striga, Junior Analyst (+385-1-603-3522) Ines Antic, Junior Analyst (+385-1-603-3657)

Addiko Bank d.d. Slavonska avenija 6, 10000 Zagreb [email protected] phone: +385-1-603-3522 fax: +385-1-604-6522