Central Europe is converging with the western markets, but caution is still needed when it comes to investing in this economically fragile area, says Jean-Pierre Grimaud of CCF Capital Management
The return of central and eastern Europe to the world economic system and to western organisations creates a new financial reality for investors. The term ‘convergence’ may help to clarify some particular features of this process. The challenges facing these countries lie in undertaking economic and political restructuring during a time of transition. At the start of the reforms, many eastern European economies had a strong industrial base, relatively diversified consumption and a highly educated labour force. As a result, they succeeded in transforming their planned economies into market-orientated systems. The commitment of these countries to the EU and to NATO supposes the execution of Maastricht criteria, liberalisation of the institutional environment and adherence to democratic principles.
Some central European countries represent converging markets rather than emerging markets. The average rating of central Europe is approximately BBB on the Standard & Poor’s scale. Greece occupies the intermediate position because of its EU membership. Despite the adherence to the principles of western economic development, many of these regions remain relatively fragile. The devaluation of the Czech coruna in 1997; the sizeable budget deficit in Hungary during the last eight years; and the unenviable state of Bulgaria and Romania are just a few testimonies to this fragility. Thus the evaluation of sovereign risk is an important criteria to consider when making investment decisions and we have developed instruments to measure this risk.
Risk Management:
How does the system work?
The system involves a scoring process designed to measure the ability and willingness of states to repay their borrowings. The system is based on two foundations:
q an analysis of quantitative factors, which basically consists of processing economic and financial data for each country; we obtain this information chiefly from Datastream and central banks;
q an analysis of qualitative factors, by which we seek to identify a country’s structural strengths and weaknesses. The process of assessing these factors involves discussions in a special committee composed of credit analysts, fund managers and economists from CCF-CM with economists from the economic research department, as well as CCF country risk specialists. Specialist external consultants are frequently invited to join these discussions. In addition, regular visits to central Europe enable us to conduct a more thorough analysis of the situation of those countries in situ.
We have identified some 30 risk factors. The analysis of one or several variables, depending on the case, enables us to allocate a risk rating – from zero to four, in ascending order of risk – to each of these factors.
Each factor is then given a weighting. These weightings are laid down for each geographical region (Latin America, south-east Asia, central Europe and so on) to achieve the most precise analysis possible. In every case, considerable stress is placed on qualitative factors, which on average account for 45% of the final rating.
However, for the sake of clarity and a better understanding of the level of risk involved, this rating is converted to a scale running from 000 to 222, in order to provide an easy cross-reference to the ratings issued by the rating agencies and to compare the results obtained (see table 1).
The introduction of the euro has sharply reduced the number of ‘traditional’ sources of international bond portfolio performance. Euroland has a single yield curve and only one currency (instead of 11 as previously). With the interest rates at low levels, quite probably on a long-term basis, it has become necessary to explore new horizons in an effort to maintain some level of risk diversification and to find other sources of extra returns.
This explains CCF-CM’s interest in emerging countries, which is evidenced in the two aspects of our asset management approach:
q as part of a widening of the European investment universe to include those central European countries that are candidates for EU entry, with the instruments being managed on a local-currency basis. This is the concern of our Primerus Pan European Bonds fund;
q in the form of pure credit-risk management (sovereign debt denominated in strong currencies). This is the purpose of our Primerus Emerging Sovereign Debt fund.
In order to invest in new countries involving higher levels of risk, we developed special analytical methods and decision-support tools described earlier.
In general, the sovereign risk can be expressed like a particular case of credit risk. It is clear that the prices of different kinds of assets depend on the fundamental and market conditions. In order to provide the necessary quality and efficiency of emerging markets operations, CCF Capital Management elaborated its own process of sovereign risk management.
Our approach permits us to analyse closely the investment opportunities in that region.
The regional-debt market characteristics and markets typology
Poland, Greece, the Czech Republic and Hungary are countries that have the favour of the international investor. The improved credit quality and the increased liquidity in these markets has helped increase investor confidence.
Nevertheless, Poland and the Czech Republic have important weaknesses. During last four years, the business activity in Poland has grown more rapidly than its neighbours which has provoked some
economic imbalances. High consumption levels, increased imports and the deceleration of economic growth during the first
half of 1999 jeopardised exports. As a
result, this year, the current account and budget deficits could reach seven and 3.5% GDP, respectively. The Czech Republic suffers from a long-term recession as a consequence of insufficient structural reforms.
While these countries remain our main investment orientation in eastern and central Europe we do not exclude other countries of the region. We see Slovenia and Slovakia as good diversification opportunities.
Generally, the region’s risk is stable because of recent upgrades. These rating increases closed the gap between the old rating and the fundamental economic and structural changes that have occurred during the last couple years. We do not expect further rating changes for the medium term although increasing world growth will certainly benefit these countries’ economic status. In these kinds of situations, the value of market research is more important than fundamental economic research.
Market typology
The bonds market configuration depends primarily on macroeconomic obstacles. Determining the degree of government bonds and other state-credit instrument use is a priority determined by the size of the budget deficit. Central European countries that have had considerable budget deficits spanning several years, have financed them through capital markets that have generated public debt augmentation. Typical examples are Greece and Hungary which have been obliged to diversify their baskets of instruments in order to refinance their government debt and spread out its time structure (see table 2). Currency volatility and significant hard currency needs have let these states undertake substantial borrowing in the international markets.
By contrast, Slovenia and the Czech Republic have always attempted to implement healthy fiscal policy and to contain the amount of public debt. As a result, corporate issues dominate the Czech bond market. Foreign capital needs were covered by local instruments as exchange-rate stability was insured by the governments. The poor level of financial-market infrastructure can explain the important share of government bonds in Slovenia (see table 2).
Poland and Slovakia could be regarded as an intermediate case. They have a fairly typical level of public indebtedness and they maintain a reasonable budget deficit. Their current account deficits are two of most sizeable in central Europe. The FDI cannot satisfy all external financing needs due to these deficits and they resort to the help of international bond markets.
Evolution of fixed income markets
During last eight years, the repartition between government and private bonds in Greece and Hungary has remained generally stable. Last year was an exception in Hungary where national companies financed themselves with large bond issues. Between 1996 and 1998, both countries tightened their monetary and fiscal purse strings so as to reduce inflation and meet the Maastrich convergence criteria. Hungary has restructured its public debt by increasing its average maturity and introducing benchmark bonds. In the past couple of years, Greece’s borrowing requirement has been reduced by almost GR$1,000bn. This reduction principally involved the decrease in treasury bill issuance. In Hungary, bonds account for 70% of the turnover of government paper (see graph 1).
The recent yield history can be divided into two parts. At the end of 1998 and at the beginning of 1999 bond interest rates came down very sharply following decreasing inflation and lower official interest rates. In March 1999, yields stopped falling and have stagnated ever since (see graph 2).
The relationship between Greek and Hungarian international bonds rates and euro rates have increased and generally follow the same trend.
Poland has the biggest potential among all central European bond markets. During the last five years, Poland’s economic growth has averaged 6% and polish businesses have expanded rapidly. Polish public debt accounts for 50% of GDP ($150bn), leaving a considerable public finance liberty. Before July 1999, yields of government bonds had the same trend as Greek and Hungarian bonds. However, predictions of rising inflation provoked some market correction. It is necessary to add that these prediction were vindicated when the CPI year-on-year was 7.2% in August, up from 6.3% in July. After a release of a very unfavourable money-
supply growth figure on 22 September 1999 (broad money supply increased 2.5% in the first 10 days of September as compared to a 1.3% month-on-month rise in August) the central Bank hiked its key 28-day repo rate to 14% from 13% (see graph 3).
During the first three quarters of 1999, despite credit-rating improvements, Polish international bonds mainly outperformed or were highly volatile.
During 1999, the Slovakian market was exposed to weak economic activity and decreasing budget deficit compared with 1998. The situation was aggravated by rising CPI year-on-year (13.6% in August, compared to an average annual level of 7%). As a result, the Treasury bill rate increased sharply and demand on the government papers declined. In comparison with June, the government bonds fell by 28% in July. So far, Slovakian international bonds have not reacted strongly to these events.
The Czech bond infrastructure is the most sophisticated in central Europe. Its modern state helps us understand the kind of evolution we could expect from other central European bond markets in the near future.
Bond market capitalisation amounts to $6.4 bn: the main market circulates 63% of total bonds; the free market circulates 35.5% of total bonds and the rest are circulated on the secondary market. Most tradable bonds are banks, such as the Kommercni Banka and the CSOB bank, telecommunication group SPT Telcom, and treasury bills. This year, the bond market has performed particularly well, benefiting from a record low level of inflation and a strong exchange rate.
State budget development is being carefully adhered to. Though the economic recession negatively influenced the state of public finances, the government will probably succeed in keeping the budget deficit within the limits of 2.5 to 3% of GDP. Another important factor which influenced the markets was the adoption of new legislation on bonds taxation. This provoked some yield gap between ‘new’ and ‘old’ issues. The spread between ‘old’ and ‘new’ can reach 150bp.
Last time, the market’s perceptions concerning this kind of risk were diminishing and the spreads were narrowing. For example, in August the gap between the yield of savings bank Ceska Sporitelna’s issue and MoF 10.55 was cut from 60 to 30bp.
Issuing activity is also very intense. After recently issuing two mortgage bonds, Kommercni Banka decided to issue a five-year CZK5bn plain bond with a fixed coupon of 8% p.a. The oil company UniPetrol has announced it is planning another bond issue, a five-year CZK 4bn. The bond is to be lead managed by a consortium of ABN AMRO, Ceska Sporitelna and CSOB.
The revival of economic growth in 2000 could increase inflation perspectives. The current inflation outlook for 2000 is 3.5% to 5%, which could result in market volatility.
In Slovenia, treasury bills represent the bond markets. Sustained development of this market began in 1997 but its capitalisation remains relatively low ($1bn) and thus does not offer the liquidity required by foreign players. We expect that Slovenia will continue its prudent fiscal policy which, in turn, should stimulate corporate issuing activity to satisfy investors’ growing appetite. Issues of privatisation, housing funds and commercial banks form the essential share of private bonds capitalisation.
Our analysis shows that although these countries are on the path to convergence, we must examine the risks of investing in such markets in a way that allows us the insight of sovereign-risks appreciation. This can only be done through a fundamental approach and permanent market monitoring.
We believe that central European bond markets will develop in two directions. Firstly, the projection of decreasing inflation coupled with healthy fiscal policy will increase the share of long issues. Secondly, the consolidation of the banking system will result in more sophisticated investment services and the rapid growth of the private sector, which will increase corporate issuance and diversification of financial instruments. These tendencies will result in a form of merger between first and third market types, but with conservation of government bonds diversity in the Hungarian case and conservation of significant corporate bonds presence in the Czech case.
Jean-Pierre Grimaud is head of fixed income investments at CCF Capital Management in Paris