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The financial crisis and recession across Europe has uncovered fundamental differences between CEE economies and markets. Krystyna Krzyzak untangles what we have learned

The 10 CEE EU member states have delivered a range of performance since the financial crisis hit in 2008. At one extreme, Poland was the only EU state to escape recession in 2009. At the other the Baltic states of Estonia, Latvia and Lithuania experienced double-digit contractions after several years of heady growth. All, except Latvia and Romania, experienced recoveries in 2010, with Slovakia, at an estimated year-on-year GDP growth of 4.1%, producing the EU’s second strongest growth after Sweden. Only Latvia and Romania have sub-investment grade credit ratings (from Moody’s and Fitch) - although as we went to press in mid-December Hungary was looking as if it could join them. On December 6 Moody’s pushed it down to Baa3, one notch above sub-investment grade, and warned of further action to come if things do not stabilise.

Differences in macroeconomic performance boils down to structure, currency regimes and government policies. Poland, as the largest of the CEE EU states, is far less dependent on exports than its smaller neighbours. A floating currency regime gave the central bank flexibility to adjust accordingly, maintaining competitiveness. The country’s credit expansion was modest by regional standards, partly due to relatively high unemployment. Infrastructure spending has continued, propelled partly by the impending Euro 2012 football championships that it will co-host with Ukraine. The current government, which took power in November 2007, enacted tax cuts that provided a fiscal stimulus immediately after the financial crisis, although more recently this is causing deficit headaches.

In contrast the smaller, open economies of Hungary, the Czech Republic and Slovakia went into recession (in 2009 GDPs contracted by 6.7%, 4.1% and 4.8% respectively) as their export partners suffered. These three have the region’s highest export-to-GDP ratios (close to 60% for the Czech republic; 65% for Hungary; 70% for Slovakia). They have also benefited significantly from recent industrial offshoring by Germany and other industrialised west European countries. Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management, argues that their future prospects are bound up with those of core Europe, particularly Germany and France.

Germany, whose GDP shrank by 4.7% in 2009, but rebounded by an estimated 3.7% the following year, is proving critical to the region’s recovery. In 2010 it accounted for around a fifth of exports from Slovakia and Romania, a quarter of those from Poland and Hungary, and almost a third of Czech exports. Germany’s €5bn car scrappage scheme in 2009 provided an additional boost automotive outsourcing in the CEE region, especially the Czech Republic and Slovakia. The latter reportedly has the world’s highest per capita car output. Meanwhile Russia’s economic upturn benefited the Baltic economies.

Credit build up also contributed to growth patterns. The countries with the highest pre-crisis credit growth rates suffered the deepest contractions. Between 2002 and 2008 the credit-to-GDP ratio rose by more than 50 percentage points. “This led to a huge boom in domestic demand,” says Alexander Perjessy, senior economist, EEMEA, at AllianceBernstein. “In the most vulnerable countries a lot of that went into non-productive sectors such as construction and real estate rather than manufacturing, and on imports, leading to negative external balances.”

“We expect growth in Poland and the Czech Republic to recover to pre-crisis levels in 2012, but not in the case of the Baltics and Balkans because of their excessive credit expansions,” notes Agata Urbanska, senior economist, emerging Europe, at ING Bank. She highlights the case of Estonia, where consumer and corporate debt now account for 100% of GDP.

“The Baltic countries lost 20-25% of their economic output over the crisis and it will take several years for them to regain that,” notes Marcus Svedberg, chief economist at East Capital. The Baltic states’ vulnerabilities, and those of Bulgaria, have been exacerbated by being in fixed-rate currency board arrangements, with no monetary means to curb credit growth or ability to depreciate to restore export competitiveness. Market commentators started speculating on a possible devaluation of the Latvian lats - with a domino effect on Estonia and Lithuania - as early as 2007, but the Latvian government stood firm, for good reasons. Philip Poole cites the high and persisting costs of the massive debt write-downs and wealth destruction of Argentina’s abandonment of its US dollar currency peg in 2002. “If Latvia devalued by a meaningful amount, some of the cross-border trade between the Baltic states would have collapsed,” adds Perjessy.

Instead the Baltic states pursued so-called internal devaluation - swingeing public sector cuts that damped down private sector wage growth, especially in Latvia, which enacted one of the most severe fiscal consolidations on record. Unemployment shot up from 6% in 2007 to 19% in 2010, while wages, in 2009, fell by 15% in real terms. Yet public discontent largely dissipated, with the government re-elected in October 2010.

Additionally, each country chose a different way out of the crisis. Latvia sought an IMF bailout (see banking box), Lithuania funded itself though the capital markets, while Estonia doggedly, and ultimately successfully, met the Maastricht criteria to join the euro-zone as of January 2011. All three are now back in growth, with Latvia finally recording an upswing in the third quarter of 2010. The equity markets also seem to have appreciated the Baltics’ fiscal medicine, recovery and most recently Estonia’s adoption of the euro. “These were among the best performing eastern European equity markets in 2010,” reports Svedberg. From the beginning of 2010 to mid-November Estonia’s stock market had risen by 60%, Lithuania’s 45% and Latvia’s 32%.

The countries with fixed-rate currencies also ran up massive current-account deficits. In 2007 the deficit’s share of GDP totalled 15% in Lithuania, 17% in Estonia, 22% in Latvia and 20% in Bulgaria. “We saw a big adjustment in capital flows, with current account deficits disappearing - and turning into surpluses in the case of the Baltics and Bulgaria, ” observes Urbanska. “Although it came at the expense of domestic demand, in the short term it supports the sustainability of their exchange rate regimes.”

Euro convergence, which largely lay behind the restrictive currency arrangements, is now looking distinctly tired. “The idea that policies are driven by the need for convergence to the euro-zone is yesterday’s story,” says Poole. “There are clear benefits to having an independent monetary policy and being able to make quick currency adjustments. For countries not in the euro-zone, given the way the crisis played out, especially in Poland, what matters is sound policy, not getting under someone’s umbrella.” David Thornton, fund manager at Matrix New Europe, agrees that the convergence concept is “bankrupt”: “If Poland was in the euro-zone, it would have run the same risks as the euro-zone peripheral countries,” he observes.

While many investors in the region may have cooled on the convergence idea, performance, market size and policies still matter. According to Thierry Baudon, managing partner and founder at Mid Europa Partners, the region’s biggest private equity firm, economic soundness is the principal criterion. “You can always survive by buying a so-so company in a good macroeconomic environment,” he observes. “You can never survive by buying a good company in a bad environment.” The firm targets national champions in defensive rather than cyclical or consumer industries, and has exposures across a wide geographical spread, including the Baltics and Balkan countries. The exceptions are Bulgaria and Romania. “Bad, and unlikely to get any better in the short run,” explains Baudon, citing high debt, twin account deficits, and poor corporate governance.

Foreign direct investment remains healthy in part. Poland received $8.4bn in 2009, an estimated $10bn in 2010 and may get up to $20bn in 2011. For the Czech Republic the respective flows are $1.4bn, $2.3bn and $4bn. Hungary suffered net outflows of $3.3bn in 2009 and $3.7bn in 2010, but is expected to draw in $2bn in 2011, according to Catherine Chen, investment specialist in emerging markets at BNP Paribas Investment Partners. “There is a huge gap between fundamentals and [equity] valuations,” she adds.

For investors in securities the region often sits in emerging markets, where it compares unfavourably with Asia, Latin America, Russia and Turkey for growth. Svedberg argues that countries such as the Czech Republic should eventually be reclassed to developed. “On that basis a 2-4% GDP growth compares favourably with the eurozone, which is expected to grow by only 1-2%,” he notes. The traditionally Eurosceptic Czechs, with one of the region’s strongest fiscal positions, are aiming to cut the budget deficit from an estimated 5.2% in 2010 to 4.6% in 2011, and ultimately eliminate it. However, Tom Wilson, the manager of Schroders’ ISF Emerging Europe fund, notes that the Czech market, which is heavily dominated by the utility CEZ (50% of the benchmark index), offers a consensus 12-month forward EPS growth rate of only 2%, compared with 20% in Poland and 25% in Hungary.

“From an equity standpoint, the only significant market outside of Russia and Turkey is Poland,” says Thornton. “It has a big and well developed savings culture, with institutional investors such as pension funds that provide natural flows of capital into the country, supporting IPOs and privatisation.”

Bruno Vanier, CIO at Edmond de Rothschild Asset Management, adds that with unemployment bottoming out, and credit recovering, the country is starting to become interesting: “We’re looking for the moment of acceleration.”

Wilson notes that foreign investors will be drawn to Poland’s healthy growth and a relatively cheap currency: “Fiscal is the main concern, with a revised target deficit of 8% in 2010 and 6.3% target in 2011, in large part due to fiscal laxity in advance of general elections. The need to fund this and avoid breaching constitutional limits on debt-to-GDP will lead to a continuation of the privatisation programme, set to generate PLN25bn (€6.2bn) in 2010 alone. This will continue to overhang the equity market.”

Government policies came under increasing scrutiny throughout 2010, especially where deficit and debt levels were concerned, leading to increased stock and bond price volatility, nowhere more so than Hungary. In the summer of 2010, during the height of the Greek crisis, the new centre-right Fidesz government led by prime minister Viktor Orban informed the media that Hungarian fundamentals were worse than those in Greece, precipitating a massive sell-off by investors. The government also failed to reach an agreement on IMF and EU assistance, arguing that it could bring its deficit to below the critical 3% level in 2011 on its own.

In July 2010 the government imposed a tax of 0.5% on banks with assets above HUF50bn (€182m), followed in October with a tax, retroactive to the start of the year, on (largely foreign-owned) energy, retail and telecoms companies. Initially limited to two years, these taxes are now set to continue until 2014. “This leads to greater uncertainty on the tax environment and is a negative drag on both the near and medium term investment outlook,” says AllianceBernstein’s Perjessy. “Companies are talking about scaling back. The government is focusing on near-term one-off measures instead of addressing the structural deficit,” warns Tom Wilson. “The government is sticking to the fiscal consolidation plan, but picking the low-hanging fruit.”

Chen disagrees, arguing that while the Hungarian market took a hit as a result of these proposals, the approach is sound in the long-term: “We believe that in 2011 Hungary will reduce its government deficit to 2.9-3% of GDP. Poland and the Czech Republic are following with proposed bank tax cuts and we assume they will roll out their tax scope to other sectors.”

In late November the government announced an effective nationalisation of second-pillar private pensions funds after surveys showed that only 30% of private pensions fund members intended to take up the government’s initial proposal of voluntary transfer back to the state system (see article in this report). Members can still remain in the private system, but at the cost of surrendering all their future pension state benefits - while still legally obliged to maintain their pay-as-you go contributions. At the end of the month the central bank raised the key base rate by 0.25% as inflation exceeded the target, again surprising the markets - not to mention the government, who wanted the inflation target raised instead. All these moves, ostensibly aimed at lowering the cost of Hungarian debt, have instead unnerved investors. At the end of November government bond yields hit a 14-month high, while the currency and stock prices have tumbled.
 

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