Central and Eastern European (CEE) markets continued to outperform developed markets and other emerging market last year. This development was mainly supported by efforts to speed up the EU enlargement negotiations. EU accession, which structures the reform process in these transition countries and leads to closer approximation of western standards, continued to provide the region with stability and high growth prospects. The restructuring of CEE industries and foreign direct investment into the region will enable the GDP of CEE countries to grow above the EU average.
According to the latest of the European Commission’s regular reports on the candidate countries, EU accession by up to 10 countries should be possible in 2004. Although it is not formally a condition for accession, the candidate countries have defined the Maastricht criteria as a target, so as to be able to introduce the euro two years after they join the EU. Investors are likely to profit from above-average economic growth in the CEE region and the convergence of inflation and interest rates. Together with decreasing risk premiums this offers outstanding performance opportunities for both equity and fixed income investments.
The growth differential between core CEE countries (the Czech Republic, Hungary and Slovakia) and Euroland has increased in 2001 and will continue to do so in 2002. The only exception will be Poland, which is suffering from high real interest rates and slower than expected reforms. As CEE countries successfully re-oriented their external trade links to the European Union, their macroeconomic development is now closely linked to the EU business cycle. The deterioration in business sentiment in those economies is of course adversely affecting the open economies of Central and Eastern Europe, but even today there is no meaningful evidence that the CEE countries are tumbling into recession. Quite the reverse – it seems more likely that the majority of CEE countries will prove resistant to the sharp decline in business activity being observed in the German economy (which has the most influence on the region). In particular, the CEE region’s respectable GDP growth figures are being driven by domestic demand. Consumer demand is expected to remain robust in most CEE countries. Investment should continue to grow strongly in the Czech Republic and Slovakia, supported by high inflows of foreign direct investment.
Slack demand from the EU is likely to put pressure on external balances in the CEE region. However, this is likely to be eased by falling energy prices, which will help CEE countries that are net importers of energy products to keep imports in check. Although current accounts in some countries are still expected to widen, this is unlikely to pose a threat to macroeconomic stability or to the development of their currencies. The economic effects of a deteriorating external environment will prevent further declines in CEE budget deficits. In addition, parliamentary elections in a number of countries are likely to lead to temporary loosening by incumbent governments. Given the clear objective of achieving the fiscal targets for EMU, renewed fiscal restraint can be expected after the elections.
As the countries also proceeded with liberalisation of foreign exchange regulations, previous rigid currency regimes have been abolished and CEE currencies are now more or less freely floating. The main reference currency in most cases is the euro. With CEE inflation rates having already converged considerably, the need to offset price increases via exchange rate depreciation has diminished. Quite the opposite is the case. The ongoing restructuring of CEE industries and greenfield investments from western companies enable substantially higher growth in productivity compared to their western peers. As this process is going to prevail for several years, we expect CEE currencies to follow a long-term appreciation trend.
In addition to that, we think that there are a number of reasons to expect the CEE currencies to remain strong versus the euro this year as well, despite lower interest rate differentials to Euroland. The most important is the steady flow of funds into the CEE region being fuelled by privatisation and FDI. Secondly, the yield and interest rate gaps versus euro and US dollar markets and the potential for spread decreases make fixed income instruments denominated in CEE currencies attractive for portfolio investments.
While monetary easing has probably ended in the US and in Euroland, this is not the case in the CEE region. Because of the unrelentingly poor economic environment and the likelihood of further falls in rates of inflation to record lows (in Hungary and Poland), we believe that the cycle of interest rate cuts in the CEE region will continue. As a result, the rate differential versus the established markets should continue to narrow during 2002.
Lower interest rates will propel bond market yields further down the road to extremely low levels by historical standards. Improving credit ratings are underscoring the trend towards lower yield spreads versus government benchmarks within the Euroland. That would almost be enough to make investing in the CEE fixed income markets an attractive proposition.
Liquid local currency markets exist in Hungary, Poland and the Czech Republic, although the Slovak market remains relatively illiquid. The total size of outstanding domestic local currency debt amounted to $63bn (e73bn) with Poland making up roughly 50% of the total market. Most important instruments are government bonds. Due to the early financial market liberalisation in the Czech Republic, this is the only country that has a sizeable liquid corporate market. A liquid swap market exists in Poland, the Czech Republic and in Slovakia. Last year’s changes in foreign exchange regulations and the currency regime set the starting point for the development of a swap market in Hungary.
The ongoing liberalisation steps that are in line with the proceeding negotiations for EU accession and the more stable macroeconomic development have enabled further deepening and broadening of CEE financial markets.
Early this year, Hungary started to issue a 15-year fixed coupon government bond, another indication of efforts to lengthen maturity of outstanding government debt.
Another important segment of the CEE debt market is eurobonds denominated in CEE currencies, mostly in Polish zloty and Czech koruna. With the possibility to deal Hungarian forint swaps, forint eurobonds started to develop quickly.
Apart from higher performance due to decreasing interest rates and yields, investors in CEE markets are profiting from higher coupons in CEE fixed income instruments, which provide a cushion when international interest rates are increasing. Therefore the attractiveness of investments for portfolio investors stems from a favourable risk return profile. In addition, despite increasing integration of CEE markets into international financial markets, the low correlation of CEE yields with euro yields offers interesting potential for portfolio diversification.
Although the fourth quarter 2001 was extremely difficult for hard currency debt of emerging market issuers, many segments of this market ended up with attractive returns. Indeed, the CEE segment has effectively decoupled from Argentina’s woes, whereas the implications of the attack on the US were rather contained.
Furthermore, CEE will remain the primary beneficiary of the decoupling process, thanks above all to the EU enlargement process. In fact, several highly rated EU aspirants are no longer considered emerging markets but convergence credits. Even those CEE issuers that have been the victims of global volatility are doing well. An expected upsurge of primary market activity in the first quarter of 2002 should stimulate the CEE segment as well.
Indeed, both dedicated and non-dedicated fund investors will retain an appetite for CEE issues following a favourable risk profile also associated with the EU enlargement story. Furthermore, due to investor demand for speculative grade, CEE will also remain strong on the back of an improved risk profile of these particular issuers.
Roland Schneider is a fund manager, global fixed income with RZB in Vienna