Out of proportion

The downturn hit eastern Europe and prompted investor scrutiny and weakening sentiment, but the region comprises many economies, some of which are more affected that ­others. Tomas Hirst examines the prospects for the region.

Eastern Europe has featured prominently in recent headlines as the region’s developing economies come under scrutiny over their exposure to the broadening financial crisis.

The problem with discussions on the region as a whole is that journalists, as well as economists and politicians, can easily fall into the fallacy of treating it as a single unit rather than as a collection of individual states. As a result of this indiscriminate analysis the intricacies of the impact of the crisis on individual economies that have dominated discussions in the developed world have been brushed over in favour of sweeping, and predominantly negative, statements.

On March 2 Joaquin Almunia, the European commissioner for economic and monetary policy, gave a speech highlighting the problems facing central and eastern Europe. In his speech he notes that while many member states of the European Union (EU) are experiencing difficulties “the problem appears particularly acute for some of the union’s newest members”.

His comments came at an unfortunate time as eastern European stocks fell to their lowest for five years on the same day following the EU’s decision to reject a region-wide bail-out package.

Jose Barroso, the president of the European Commission, said eastern Europe did not need special treatment as it already had access to €15.4 billion (£14.1 billion) as part of the balance-of-payments assistance fund. He said EU member states must be treated equally to ensure that the organisation remains “one union, not two unions or three unions”.

The reaction of the markets, however, suggest investors believe many of these countries will need considerably larger capital injections if they are going to survive the crisis.

The proposed bail-out fund, put forward by Hungary, requested as much as €180 billion giving a strong indication that €15.4 billion will fall significantly short of the required number. Hungary alone has already received $25.1 billion (£18.1 billion) in emergency aid from the International Monetary Fund (IMF), the EU and the World Bank.

The IMF has also been tapped for financing by Ukraine and Serbia with standby arrangements negotiated with Latvia and Belarus. In all the fund has allocated more than $35 billion to the region, and could increase its contribution significantly if talks with ­Romania over securing a possible loan are successfully completed.

With these kinds of numbers being thrown around and the current account positions of many eastern European countries rapidly worsening it is unsurprising that sentiment has weakened on the region.

Elena Shaftan, the manager of the Jupiter Emerging Europe Opportunities fund, says despite the panic the countries most at risk from the rising cost of external financing are some of the smallest contributors to regional GDP.

“It is important to note that the countries genuinely in a difficult debt situation – the Baltic countries, Balkan countries, Hungary and Ukraine – are the smallest economies,” she says. “Their combined GDP in 2007 was about $570 billion (about 20 times smaller than the eurozone economy) and the sum of all their short-term external debt is less than $200 billion.”

To put this into perspective Britain’s external debt at the end of June 2007 was estimated to be about $10 trillion. The problem, however, is not simply the size of the debt relative to GDP but the credibility of central banks in the region that governs the price at which countries will be willing to extend credit to the governments of these struggling ­countries.

Unfortunately despite the relatively limited needs of eastern European countries when compared with developed markets, the availability of credit remains tight especially for markets perceived to be high risk. It is this particular problem that makes distinguishing between countries in the region so vital from an investment perspective, says Zoltan Coch, fund manager in the emerging markets equities team at Raiffeisen Capital Management.

Coch agrees with Shaftan and says the Baltic countries, the Balkans, Ukraine and Hungary are looking especially vulnerable.

“Things are not looking good for these countries,” he says. “The debt situation is high, you have rising unemployment and falling GDP. In the case of the Ukraine they don’t have a very co-operative government. I understand the IMF and the EU want to help but aren’t being allowed to due to internal ­divisions.”

Despite the difficulties faced by the Ukrainian economy because of the financial crisis political divisions between Viktor Yushchenko, the country’s president, and Yulia Tymoshenko, the prime minister. The high profile spat has threatened to derail finely balanced negotiations with international bodies such as the IMF to secure funding for the ailing economy.

Political strife is merely exacerbating an already precarious situation for the country, which has been severely hit by a combination of collapsing steel prices, over-leveraged local banks and the ongoing dispute over gas supplies with Russia.

Hungary is similarly suffering from the contagion effects of the crisis. The country has a net external debt equivalent to 46.3% of its GDP as well as a rising current account deficit compounded by a contraction in both internal demand and export demand. Exports make up over 60% of the country’s GDP making it particularly vulnerable to a softening of global demand.

Likewise Serbia’s current account deficit has more than doubled since 2005 reaching 18% of GDP in 2008. While this was easily serviced by capital inflows in recent years this is showing signs of drying up posing significant stability risks with the country’s large external deficit and high levels of private sector indebtedness weighing on sentiment.

“From an equity investor’s perspective the countries facing the largest difficulties are of peripheral importance,” says Shaftan. “They have relatively small equity markets, with combined market capitalisation of around $50 billion (or about 3% of the size of the UK equity market).”

Their relative unimportance is reflected in her fund’s portfolio which has almost no direct exposure to these countries.

Furthermore, investors who have stuck with eastern Europe have been given other reasons not to panic.

“I have to say the Czech Republic would be the safest in terms of the credit crisis, although we expect a decline of 1.2% in GDP,” says Coch. “Poland is also a stronger one where investments, especially in infrastructure, can support growth which may even be positive this year.”

Notably while stockmarkets have fallen the financial sectors of these countries have remained resilient since the onset of the crisis and have even seen growth over the past 12 months, in contrast to their western counterparts.

While some of the world’s largest banks suffered record losses last year the majority of banks in both countries reported profits over 2008. Komercni Banka, the Czech subsidiary of Societe Generale, reported a rise of 18% in net income over the year while Bank Pekao, part of Italy’s UniCredit Group and Poland’s largest bank by market cap, saw fourth quarter profits rise 28%.

“Bank stocks are starting to look expensive in Poland on a global basis,” Coch says. “AIB now has a subsidiary in Poland that is actually worth more than the parent company.”

Unlike some of the smaller economies in the region both the Czech Republic and Poland have been able to aid their economies with fiscal stimulus packages, mimicking action taken by so-called developed economies. Last month the Czech government doubled the size of its stimulus package to $3.3 billion, or 1.9% of GDP, and Coch says both countries have the financial flexibility to increase stimulus measures if necessary.

Moreover both the Czech Republic and Poland were vocal in their opposition to Hungary’s proposed bail-out fund stressing that their economies were sound and such extraordinary measures were unjustified.

Some commentators saw the rejection of the proposal as a sign that the EU were not appreciating the scale of the problems facing the worst hit ­countries in the region. More confusion, however, surrounds the refusal to support the measures by countries like Poland and the Czech Republic, who have suffered from the flight of foreign capital as nervous investors indiscriminately sold their holdings in the region.

“It’s quite difficult to understand why they’ve been so keen to differentiate themselves from the rest of the region,” says Neil Shearing, an emerging Europe economist at Capital Economics. “If there was a pan-regional bail-out fund that they didn’t use that would make the point more strongly.”

Shearing argues that a pan-regional IMF or EU-led bail-out fund offers the best way out of the bout of indiscriminate selling in recent months. He says accelerated membership of eastern European countries to the single currency or the creation of a ‘bad bank’ will both ultimately prove more expensive to western Europe.

Although there is a compelling economic case for the plan, political resistance from certain countries on both sides of Europe have at least temporarily scuppered the idea. Shearing says in the longer term even a plan worth $200 billion “could be a small price to pay for ensuring broader political, social and economic stability in Eastern Europe”.

The financial crisis has already provided numerous worrying signs that countries are reverting to protectionist policies to prop up their economies. Whether in the “Buy American” clause in the American fiscal stimulus plan or the French government’s aid packages to the automobile industry, protecting what are seen as key sectors threatens to undermine claims of a unified and truly global response to the crisis.

Coch says he has also picked up concerning signs of an unwillingness of western European governments to come to the aid of their eastern counterparts.

“I think the eastern European bail-out fund would have been helpful but I fully understand why the EU has rejected this package,” he says. “There’s definitely a danger that protectionist sentiment could separate western Europe from the region. If it really is coming then it could hurt the financing [of countries in the region] and their current accounts.”

Another possible consequence of isolating central and eastern Europe could be driving many former soviet states, who have made efforts to distance themselves from Moscow in recent years, back under the influence of the Kremlin. With the dispute between Gazprom and Naftogas Russia has taken the opportunity to flex its muscles in the region and its large pot of foreign currency reserves may prove tempting a prize for countries on its borders desperate to refinance.

The overtures of closer ties with the east with the expansion of Nato and EU membership could quickly be reversed if countries were forced to go cap-in-hand to Russia.

Karine Hirn, a co-founder of East Capital, says western investors should not be more concerned over greater Russian involvement in eastern Europe than they would if it were a western country.

“We’ve always felt that the region has been dealt with unfairly,” says Hirn. “We have seen already that Russia is talking about helping out Ukraine. One thing that is for sure is that [even if you doubt its motives] Russia cannot have two wars; an economic one and a political one.”

The real problem, Hirn says, is the sentiment of people in eastern Europe who are suffering from the consequences of the financial crisis by losing their jobs and seeing their economies falter.

“Eastern Europe is struggling from a crisis that did not start in the region,” she says. “Everyone looks for a scapegoat in these situations.”

Already protests over the way the crisis has been handled by local governments have broken out across the region. Mass gatherings have been held in Bulgaria, Czech Republic, Latvia, Lithuania and Hungary many of which turned violent as people vented their frustration at government policies which have left their countries disproportionately hit by what is perceived as a western crisis.

Lending to eastern Europe from the eurozone amounts to a total of $1.25 trillion with Austrian involvement in the region amounting to an exposure of about 63% of its GDP. It is estimated that western banks control between 70% and 90% of shares in eastern European banks, a fact that has allowed high levels of lending in recent years but has also facilitated the contagion effects of the crisis.

Although anger among local populations does pose a significant risk to political stability, western economic exposure to the region may prove to be essential to its salvation.

“While these economies could theoretically ‘melt down’ due to difficulties rolling over their substantial external short debt (in the range of 30-60% of GDP),” says Shaftan, “we think it is more probable that EU countries with significant exposure and international organisations will provide them with short-term funding to avert such an outcome.”

Shaftan’s confidence is so far well placed as Raiffeisen Bank Aval, the second-largest bank in Ukraine, announced on March 2 that it was to get $160m subordinated loan facility from Raiffeisen Zentralbank, part of its Austrian-based parent company. It joins several western European banks which have moved to support developing market subsidiaries in the face of unprecedented problems in credit markets.

As dramatic as this may seem the prospect of a complete region-wide economic collapse remains distinctly remote. Looked at from a bottom-up perspective the region’s banks are in better shape than many of their developed market competitors.

“The world crisis really began with leverage,” says Hirn. “This is still a region that is less indebted than many countries in the world. We still think they will recover faster than other places coming out of the crisis.”

With the macroeconomic forecasts suggesting global demand is set to remain weak at least for the rest of the year those countries that have benefited from export growth are likely to see sharp declines in GDP. This should mean a difficult period ahead for countries such as Hungary and the Czech Republic, which both derive most of their GDP from exports.

The key differentiator between struggling countries will be the state of government finances coming into the crisis and consequently the scope to use both fiscal and monetary policy to ease at least some of the impact of the crisis on the population.

In contrast strong domestic economies like Poland should fare relatively better as they rely less on flagging western consumption.

Negative sentiment on the region as a whole is being seized on by some investors who are seeing markets in the region trading significantly lower than what they would consider fair value. East Capital is increasing its Polish allocation while Shaftan is keen to promote her holdings in the country.

“We believe that the situation for these countries is manageable, and see elements of excess in the recent panic surrounding eastern Europe,” says Shaftan. “While markets are likely to remain volatile in the short term, we think that the current situation could provide opportunities for long-term investors who can take advantage of the market turmoil to acquire shares in high-quality businesses at extremely attractive prices.”

Imbalances in government finances in the Balkans and Baltic countries, as well as political strife in Ukraine and Hungary’s reliance on exports may justify some of the negativity surrounding eastern Europe.

However, as many managers will point out, the mantra that panic among investors and indiscriminate selling usually indicates a solid buying opportunity could well hold true for some of the region’s stronger economies.

Protest and unrest in affected countries in the region

Eastern European countries have seen some of the largest protests in recent months over perceived government mishandling of the economic crisis in the region.

In January thousands of people attended a protest in Vilnius, the Lithuanian capital, over the government’s decision to raise taxes and cut spending to try to limit the damage to the country’s budget revenues in the wake of the crisis.

Police used tear gas, dogs and rubber bullets in an attempt to disperse the crowd as protestors threw bottles and stones at the parliament building.

Simultaneous protests took place in five other cities in the country, with about 20,000 estimated to have taken part. Also in January thousands of workers at Dacia, a Renault subsidiary in the southern Romanian city of Pitesti, demonstrated in defence of their jobs. News had earlier emerged that the company’s management planned to
cut up to a quarter of the workforce in the face of collapsing demand.

Political unrest continued last month as hundreds of rioters attacked vehicles, smashed windows and looted shops in Riga, Latvia’s capital, after a peaceful protest calling for early elections descended into violence.

Smaller protests have also taken place in both Hungary and the Czech Republic as anger over the region’s economic policies of recent years spilled out into the streets.

Such is the concern in the region that Vladimir Putin, the Russian prime minister, warned opposition parties not to instigate protests “outside the law” insisting the state would defend itself against such actions. He did, however, insist that the government would not prevent “lawful forms of protest”.

In many cases the gatherings have been some of the largest since the collapse of the Soviet Union and commentators have suggested that protests could not only continue but spread further throughout the region.

Concern is growing over the prospect of widespread public demonstrations in Ukraine. The country is already facing deep political divisions as Yulio Tymoshenko, the prime minister, and Viktor Yushchenko, Ukraine’s president, engage in an increasing hostile spat.

Already small gatherings have been seen in Sevastopol, the Ukrainian Black Sea port town, following comments made last month by Leonid Kravchuk, a former president of the country, encouraging Yushchenko to resign.

A survey conducted by IFAK Market Research Institute in Ukraine from February 5-15 suggested as many as 64% of respondents were ready to take part in peaceful protests against the government, including rallies, pickets and strikes.

Signs of serious political unrest will do little to quell investor anxieties over the ability of governments in the region to deal effectively with the financial crisis. The governments of Romania and Hungary have already announced that they will implement further measures to shore up their budgets, suggesting the public will have to bear the brunt of the downturn.

Such moves are likely to further incite already bitter populations who feel they are being hit by a combination of poor regulatory oversight in the west and equally dire economic management by their own governments.

IMF loan arrangements


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