Over the next decade, the EU expects to welcome at least 10 former Communist countries as new member states. So far, the transition of the EU applicants to market economies has been far from uniform. Laurence Knight reviews governments' progress in developing domestic bond markets, their efforts to diversify the investor base, and how banks are importing capital market expertise
For international investors, the story in central and eastern Europe is one of yield convergence as government fundamentals improve, and expectations of inflation fall. "Convergence play will be in place until [former Communist] countries join the EU and Emu," says Ronald Schneider, an economist at RZB in Vienna. "EU accession will reduce the risk premium included in yield levels."
But he warns that taking on exposure in the domestic bond market is not a one way bet. "On the currency side, Poland and Hungary in 2001 are showing that there can still be big swings in the exchange rate until they join Emu."
The convergence play available in the three most liquid and accessible markets - Hungary, Poland and the Czech Republic - differs greatly. While the Czech market offers yields of only 6%-7%, Polish inflation and a determined central bank have produced yields of nearer 15%, or real yields of 10%, in 2001, and Hungary lies in between the two.
"The responses to the Argentina crisis in July shows how different the countries of central Europe are from each other," says Ota Otepka, a fixed income trader at Commerzbank Capital Markets Eastern Europe (CCME) in Prague.
"Most traders have money in Poland, and Polish yields and the zloty took the biggest hit in the region," he says. "But the Czech Republic has decoupled from the emerging markets. Its yields are too low to attract much international interest, and it was untouched by Argentina."
"There is a chance that the premiums available in a country become so low that they are no longer attractive to foreign investors," agrees Schneider at RZB. "In the Czech Republic, interest rates and yields were too low given the slowdown in growth in 1999-2000. I would not see this as a risk in Hungary, though. Even though inflation and yields should fall there, the long term growth prospects are much more positive."
The region's domestic bond markets have attracted two kinds of international player - speculators, often characterised as London bank proprietary desks, and investment funds, the bulk of them German speaking.
"As a general rule, foreign real money accounts in this region prefer to get duration in the government bond markets," says CCME's Otepka. "The trading accounts prefer the forex and forwards markets, though they do also enter the bond markets and use the swaps to hedge their positions."
The London banks are not the only investors to blame for volatility over the summer of 2001. "The foreign pension funds in Poland behaved like sheep," says one banker. "They all want to meet the average performance, so when the biggest fund bought zloty bonds, so did the others, and when it sold, everyone did. This makes the market really volatile."
Despite the volatility inherent in a floating exchange rate regime, Hungary decided in effect to depeg the forint in May, and to remove most remaining restrictions on cross-border capital flows.
"EU accession necessitates the liberalisation of capital flows," says Schneider. "This is a big topic in Hungary, where the central bank decided that it cannot afford a rigid exchange rate with liberalisation. Of the big markets, only Poland still has some restrictions, and it will probably dispense with these during the accession negotiations."
CCME's Otepka says the three main central European markets are quite similar now in terms of access for foreign investors. "In the Czech Republic and Poland, it is possible to get any kind of exposure you want without any size or other restrictions," agrees Schneider, but he adds: "Hungary is still lagging a bit behind."
The change in exchange rate policy allows the Hungarian National Bank, like its colleagues in most other countries in the region, to focus on inflation targeting, to achieve the Maastricht criteria on inflation, interest rates, and ultimately the exchange rate. Maastricht also stipulates targets for fiscal policy. But while most countries in the region are within the 60% debt/GDP ceiling, they have found achieving the maximum 3% deficit for Emu a harder task.
"The Maastricht criteria for Emu entry do not require the countries to reduce their budget deficits to zero," says Schneider of RZB. "And given the high adjustment costs the countries will have to bear, it is unlikely that they will do so voluntarily. The Czech Republic and Poland are running large deficits because of restructuring costs, as well as weak growth and delays in the reform process before the elections."
However, approaches to debt management have differed markedly across the region. One banker accuses the Slovak finance ministry of showing a lack of experience for abandoning its benchmark tapping policy in the face of rising primary auction prices. In contrast, Hungary's AKK, an independent agency for the comprehensive management of public debt, has earned widespread praise.
"Specialised debt management agencies like the AKK in Hungary have many benefits," says Tomas Cerny, head of debt management at CCME. "They reduce the influence of the ministry of finance with its own policy agenda, enable closer co-operation with the market, and improve professionalism and techniques of bond issuance. They also help to co-ordinate better the issuance policy between various authorities than when debt management and treasury bond issuance is split between the finance ministry and central bank."
Most governments in the region now concentrate on building yield curves of liquid benchmark issues at regular auctions. An important prerequisite was the creation of a core investor base - the banks. However, a common problem for governments has been balancing the need to develop the domestic market with the need to minimise the cost of their borrowings. In most countries, at some point in the 1990s debt accumulated by the largely state owned banking sector resulted in a crisis, which was almost universally solved by recapitalising the banks with new government paper, recovering the costs by selling the banks off to foreign strategic investors.
Building regional presence
The opening of the domestic financial markets to international banks has met with two responses. Some have focused on organic growth, to connect their existing investors with credits in the region. Others, often small retail banks, have sought to expand by acquisition, and to build a new investor base.
But Bank Austria, for example, took an organic approach to growth in the region. "Some of the banks in the first waves of privatisations in the 1990s were a touch on the expensive side," says Harald Kreuzmair, head of origination at Bank Austria in Vienna.
Erste Bank provides a classic example of growth by acquisition, having bought the main savings banks in the Czech and Slovak republics, Ceska Sporitelna and Slovenska Sporitelna, as well as a more modest agricultural bank, Mezobank, in Hungary.
"Erste Bank, KBC and some others that did well through acquisitions will not be primary competitors for us in the international capital markets. But they will have a strong position for deals with domestic buyers" says Kreuzmair, citing the Slovak National Property Fund's euro and Eurokoruna bond via Credit Suisse First Boston and Slovenska Sporitelna in April 2001.
"Our strategy in all of our purchases is to become a major regional retail bank," says Gerald Fleischmann, head of central and eastern European treasury at Erste in Vienna. "Emu is driving a consolidation of banking across Europe into regions."
He explains that the strategy has two legs. "We have a strong presence in the retail sector, and want to build up a force as a retail intermediary in the capital markets," he says.
In addition to the banks, the insurance, pension and other funds are an important and new source of investor demand in the region.
"We foresee a great demand for treasury products in this region," says Fleischmann. "We have seen it in the EU, and it will happen here too - retail customers no longer want retail accounts, but instead will want investment funds." Some of the countries in the region have been more proactive in pension fund reform than certain EU countries, setting up second pillar (obligatory) and third pillar (voluntary) funded pensions.
"The non-bank investor base is very important for providing liquidity and opening these markets to corporate borrowers," says CCME's Cerny. "In Hungary, Poland and especially Slovakia, the banks dominate. But in Hungary and Poland, the pension and insurance funds are picking up, and promise to deliver real liquidity in the future."
Corporate sector next
Falling interest rates, a growing domestic investor base, and in some cases a stabilisation of government supply, have created the right conditions for corporate and other non-government issuance to take off, though in most markets this is still at an early stage.
"When you talk about corporate bonds, you are only really talking about the Czech Republic," says Cerny. "Until 2001, corporate issuance has been the main driving force of the Czech bond markets. In Poland and Hungary the government is the main issuer, and does not leave much spare demand for anyone else."
In some countries, notably the Czech and Slovak republics, a credit crunch has followed the privatisation of the banking sector, as banks were cautious not to expose themselves too quickly to risky credits again.
"We allow our subsidiaries as much independence as possible," says Fleischmann. "But we have to be very cautious with Ceska and Slovenska because of credit problems they experienced in the late 1990s. We do assign limits - to trading volumes, products and risk assessed by independent credit officers in each bank."
"Corporate credits switch into the bond markets for two main reasons," says Cerny at CCME. "Either they want to borrow more cheaply on a longer maturity than they can achieve on the syndicated loans market, or they find their credit lines at the banks are full." But many corporates choose the Eurobond market over a domestic issue, adds Cerny, because their funding and tenor needs cannot be met domestically.
Just as important, says Cerny, are the spreads available for good domestic credits - such as municipals - in the Euromarkets that are usually as cheap as those at home. "The Czech Republic has been unique for a long time, in that the corporates get far and away better terms in the domestic market, though this is becoming less true now,". *