Central & Eastern Europe Investment: Eastward flows
Emerging Europe is looking ever more attractive to foreign investment flows, writes Daniel Ben-Ami. But should investors look east or south, to manufacturing or to retail?
It is easy to forget that Central and Eastern Europe (CEE) did not really exist a quarter of a century ago.
Until the late 1980s, the continent was sharply divided between a capitalist west and a socialist east. Although there were limited economic links between them, it made no sense to talk of ‘central Europe’ when the Iron Curtain was still intact.
The dismantling of this divide opened the way for the creation of a highly diverse region of about 30 countries (depending on exactly where the borders are drawn). Former eastern bloc states range from some with economies almost on a par with western Europe to others at African prosperity levels. Investment prospects across the region are similarly varied.
As a general rule, the countries closest to Western Europe are the most developed. Income per head in both Slovenia and the Czech Republic is only a little behind that of Spain and Italy, according to figures from the International Monetary Fund (IMF). Slovakia, Estonia, Lithuania and Poland are marginally further back. Estonia, Slovakia, Slovenia and Latvia are members of the euro-zone while Bulgaria, Croatia, the Czech Republic, Hungary, Lithuania, Poland and Romania are also EU members.
These countries tend to have close trade and investment links with Western Europe. Germany is the predominant influence in most cases, although the Baltic states – Estonia, Latvia and Lithuania – have close ties to the Nordics and residual links with Russia.
The Czech Republic has perhaps the closest ties of all with Germany. The links in the substantial automotive industry, which produced almost 1.2m units in 2012, are particularly important. Škoda Auto, a subsidiary of Volkswagen, is the largest manufacturer with a host of suppliers, many with German connections, also involved in the industry. In addition, Germany accounts for approximately 30% of the country’s external trade.
At the other end of the CEE income scale are some of the former Soviet states. Moldova, a small landlocked state with agriculture still playing a substantial economic role, is the poorest of all, with income at about the same level as Ghana. Ukraine, although more than twice as rich as Moldova, is still roughly on a par with Algeria.
Russia, by far the largest economy in the region, is still the predominant player in Eastern Europe while the countries of central Europe have moved into the western orbit. Indeed, recent domestic unrest in Ukraine, with conflict over a proposed co-operation agreement with the EU, at least partly reflects rivalry between Western Europe and Russia. The Russian economy itself is heavily skewed towards the production of energy and metals, although it has stated its intention to diversify and develop a high-technology sector.
Turkey is generally seen as an important part of the region, although it defies easy classification. Technically, it is itself divided between Europe and Asia, with the border between the two continents running through Istanbul, and it is often described as part of the Middle East. Yet it has significant links with the CEE region and arguably has the potential to play an even more significant role.
With this sketch as a background, this article will examine the prospects for the region with a particular emphasis on the larger countries, starting with the economic backdrop and moving on to look at local investment prospects. In conclusion, it will consider the potential for CEE firms to take advantage of direct investment by firms from outside the region.
From an investment perspective, the region’s economy presents a paradox. Its prospects are widely seen as positive precisely because the economy has the potential to rebound after several miserable years. Emerging Asia, in contrast, seems to be on a downward trend after many years of stellar GDP growth.
The CEE region enjoyed a strong economic expansion in the years running up to the global financial crisis. Peter Brezinschek, the head of research at Raiffeisen Bank International, says three key factors drove growth in central Europe in particular at the time: strong foreign direct investment (FDI), strong financing from the banking sector and strong domestic demand. He says the latter is still in place, although the first two have subsided.
Since 2008, the CEE region has suffered a double whammy from the global financial crisis followed by the euro-zone’s subsequent turmoil. In 2009, output contracted in absolute terms, 2010 and 2011 saw a recovery, but growth was muted once again in 2012 and 2013. The European Bank for Reconstruction and Development (EBRD) recently forecast 0.9% growth for central Europe and the Baltics in 2013 followed by 1.9% growth in 2014. It forecasts that other parts of the region, including south-east Europe, Russia and Turkey, will do better.
As the euro-zone, with Germany at its heart, has started to show signs of growth, the prospects for central Europe have also improved. Sebastian Kahlfeld, an emerging markets portfolio manager at Deutsche Asset & Wealth Management (DeAWM), says: “They are the clear beneficiaries of the Western European recovery this year”.
However, although it is undoubtedly true that international factors play a key role, it is important not to ignore domestic ones. “There is another part of the slowdown that is more structural in nature and that is a cause for concern,” warns Marcus Svedberg, chief economist at East Capital. Across the region there are numerous examples of insufficient structural reform and stalled productivity growth – the theme of the EBRD’s recent annual Transition Report entitled Stuck in Transition?.
Svedberg sees the lack of structural reform as particularly acute in Russia. He estimates that, given its rich resource endowment, it should be able to grow at about 4-5% a year. However, insufficient levels of investment by both corporations and government mean that this potential is not being fulfilled.
Sam Vecht, an emerging markets portfolio manager at BlackRock, emphasises that the key metrics for measuring the investment prospects of the region are “valuation, valuation and valuation”. In his view, the equity markets have not yet priced in the fact that the CEE region “has a bit of [economic] growth and is extremely cheap relative to other areas and to its own history”.
He points to several metrics to substantiate his point. In 2005-06, the CEE region was trading at the same valuation as other emerging markets but now it is at a 40% discount. He also says that on a 10-year view it has better earnings per share than other emerging markets and a higher return on equity.
That is not to claim that the region is without its problems but, in his view, the potential returns compensate for these. “Ultimately when you are buying a region that is trading at five to six times earnings, many of the risks are in the price,” he says.
In contrast, Ghadir Abu Leil Cooper, the manager of the Baring Eastern Europe Fund, emphasises the long-term drivers of growth in the CEE region. In her view, the potential exists for living standards in the CEE region to converge with those of Western Europe. Consumers on both sides of the continent are likely to end up wanting similar things. “There’s a lot more pent up demand in Eastern Europe than there is in Western Europe,” she says.
One particular factor that could work in the CEE region’s favour is FDI. This is a matter both of the region’s intrinsic attractions and its competitiveness relative to other areas. There are many reasons why foreign investors like the region, including its educated labour force and its physical closeness to the markets of Western Europe. Some also argue that rising labour costs in places such as China could lead to more future FDI going to the CEE countries. There is even the possibility of “reshoring” European investment from Asia to the region, and CEE governments are keen to promote FDI.
“One of the core elements of the recovery packages in Poland and Czech is to provide SMEs [small and medium enterprises] with incentives to try and hook up with firms abroad,” says Katya Kocourek, a central Europe analyst at the Economist Intelligence Unit (EIU). Such moves are designed to attract FDI from the US as well as Western Europe.
There is also significant scope for FDI into the financial service industry. Pension reforms in some countries could open the way for more private sector activity and foreign involvement, although governments are retreating from reforms enacted in the 1990s and 2000s.
However, Raiffeisen’s Brezinschek is sceptical about the prospects for FDI in Hungary. In his view, the government, which rejected EU and IMF loan conditions in 2012, is a “political disaster”. He says it is a great pity that “politics is preventing a positive long-term development”.
As for the region benefiting from rising labour costs in China, the EIU’s Kocourek, like many other specialists, is positive. “This is one of the big selling points in the CEE and one of the reasons why we think it’s going to experience major growth in the next couple of years,” she says.
However, East Capital’s Svedberg is more sceptical. He points out that the region’s labour costs are still, on average, higher than China’s. It is also possible that low-cost production will shift to other Asian producers, such as Vietnam, rather than the CEE region.
In any case, there is broad agreement that labour costs are far from the only criterion in determining where FDI should be located. Other key factors include productivity levels and the regulatory framework in each country.
However, DeAWM’s Kahlfeld takes a different view of the region’s FDI prospects on a 10 to 15-year time horizon. He argues that, from that perspective, Turkey is likely to be a more attractive target for FDI in manufacturing than the countries of central Europe. “It is more interesting from that point of view than, for instance, Poland or the Czech Republic,” he says.
Turkey has many advantages, in his view, including a large home market, an abundant supply of cheap labour and a regulatory framework that is modelled on that of the EU. It is also strategically located to supply other markets – with Europe to the north-west, Russia to the north, the Middle East close by and North Africa across the Mediterranean. The main downside is that there is, arguably, a bigger cultural gap between Western Europe and Turkey than there is between the western Europe and the CEE region.
Nevertheless, Turkey’s advantages when it comes to labour costs are likely to compensate for its drawbacks. For instance, there is little difference in labour costs between the Czech car industry and that of Germany.
That is not to say there are no attractive FDI propositions in central Europe but for Kahlfeld they are apparent in other sectors, such as retail, rather than manufacturing. “From today’s perspective it’s more interesting than setting up a facility to produce something,” he says.
Kahlfeld sees the emergence of a more pan-European retail market. He points out that some Western retailers already have extensive networks in the CEE region, while some CEE companies have the potential to move westwards.
As with any region of such size and diversity, the overall prospects for investment are mixed. But the consensus is that economic recovery, valuations and FDI trends should work in favour of those who invest selectively.