On the face of it, the economic turmoil that swept through emerging Europe last year bears some similarities to Asia’s 1997 crisis.
From the Balkans to the Baltics, governments are grappling with high debt, IMF programmes, deleveraging and internal deflation. In key economies such as the Czech Republic, Hungary and Romania, the global crisis is estimated to have slashed trend growth estimates by as much as a half. Meanwhile, 10% unemployment in the former Communist bloc this year threatens to create a lost generation in the labour force.
The contrast with today’s east Asia couldn’t be more stark. The region – thanks to structural reforms implemented after the 1997 crisis – is today providing a buffer from the global storm: low public and private debt, liquid banking systems and current account surpluses. And markets have embraced the region’s low debt, high-growth story. The Institute for International Finance (IIF) estimates net private flows to Asia amounted to $191 billion in 2009, and will surge further to $273 billion in 2010.
Emerging Europe – by comparison – fell out of favour with global portfolio investors in 2009 as the region grabbed a paltry $43.5 billion.
But since the fourth quarter of last year, a spirited resurgence in risk appetite has come roaring back. In fact – before the Greek debt crisis set off in February – central and eastern European markets were the strongest performers in the world, over the preceding six months, as investors grabbed regional currencies, stocks and bonds.
Year-to-date, EMEA (Europe, Middle East and Africa) corporate bonds in JP Morgan’s CEMBI index have provided returns of 40%, compared with 28% for Latin America and 26% for Asia. The IIF estimates capital flows will hit $179 billion this year, thanks to excess cash on the sidelines, cheap global liquidity, and Russia’s economic rebound due to the uptick in oil prices.
In recent weeks, however, global risk aversion – triggered by fears over sovereign debt burdens in the West in the wake of Greece’s bailout – has hit asset prices and currencies across the board. Emerging Europe’s recovery could be blown off course if growth slows in the eurozone as exports and capital inflows take a hit.
But market players still reckon cheap liquidity and attractive valuations could help emerging Europe navigate its way through the wild swings in global market sentiment – barring an economic catastrophe in the heart of Europe which triggers another global financial crisis.
“Emerging Europe was always going to rally since asset prices in the region tumbled the most,” says Julian Jacobson, an emerging markets fixed income portfolio manager at Fabien Pictet & Partners. But in a world of low interest rates and pricey valuations for stocks and bonds for emerging market favourites in Asia and Latin America, investors are still seduced by the region’s still-high returns even as the rally compresses yields, he says.
In Russia and Ukraine, a sustained market rally “has its roots in stronger economic fundamentals,” says David Lubin, chief EMEA economist at Citigroup.
Gains in commodity prices and cleaner public finances are set to boost growth to around 4–5% this year. More generally, investor concerns over sovereign debt burdens in the region have moderated due to government spending cuts and multilateral lending.
In addition, historically high sovereign debt in the eurozone has underscored the relative health of public-sector balance sheets in emerging Europe. For example, the projected government debt to GDP levels for central and eastern Europe this year is 40% compared with 80% in the eurozone.
And for economies in the region that face prolonged distress, a risk relief rally has taken centre stage as fears of an economic Armageddon have receded.
Latvia is a case in point: this time last year, the country was in the global spotlight as a looming currency devaluation threatened to push the Baltic region further into economic freefall. But over the past year the government has boosted market confidence through tax increases and wage cuts to reduce the public deficit.
As a result, the yield on Latvia’s March 2018 government bond is around 5.46% compared with its all-time high of 12% in March 2009. In addition, the cost of insuring Latvian government debt, through five-year credit default swaps, is only 320 basis points compared with 1,200bp last March.
Buoyed by the colossal recovery in the country’s debt dynamics, Latvia has even signalled its intention to issue a Eurobond later in the year. The feat – if successful – would be an audacious sign of the country’s redemption in the eyes of global capital markets after last year’s tumult.
Ukraine is another star performer in the region. Its five-year credit default swaps have tightened from 1,280bp, at the end of last year, to just 640bp. And the recovery in global credit markets combined with renewed enthusiasm for emerging market risk spurred Ukreximbank to become the first Ukrainian issuer since July 2008 when it raised a $500 million in the Eurobond market in April.
SCREAMING BUYS
In another sign of the country’s rehabilitation by international investors, Ukraine, by the end of the first quarter of this year, cemented its position as the world’s top-performing equity market. The Ukrainian stock market is trading only 23% below its pre-crisis high. By contrast, Russia and Kazakhstan’s equity markets are off their respective pre-crisis highs by an average 35%.
In the near term – and barring further fallout from Greece – the rally still has legs as emerging European equities are still a screaming buy, says Peter Brezinschek, head of RZB’s division of economics and financial markets research. For example, the two largest regional equity markets, Russia and Turkey, still trade on discounts of close to 40% and 20%, respectively, compared to the emerging market average.
Across the region, “low interest rates, resilient risk appetite and the projected year-on-year 30% jump in corporate earnings” will buttress the stock market rally this year, Brezinschek says. However, the Polish bourse is likely to underperform, as markets may struggle to digest new share supply on the back of the government’s large-scale privatization drive this year, he says.
Russian stocks – the sell-side EMEA favourite – have rallied hard this year, as oil prices have doubled from their 2009 lows, and the rouble has strengthened 25% against the dollar from last year’s low. Year-to-date, Russia funds have attracted some $1.7 billion, the most among its peers in the so-called Bric (Brazil, Russia, India and China) group of countries. By comparison, China-focused funds have absorbed $1 billion of inflows and India $490 million.
More generally, investors are awakening to a new reality of modest returns this year following the market’s stellar performance in 2009. For example, in the fourth quarter, the Russian equity market notched up 7% compared with 43%, 28% and 15% over the previous three quarters.
But higher interest rates and lower risk appetite due to eurozone debt troubles could whittle away recent gains in regional stocks and bonds, says Jacobson at Fabien Pictet & Partners.
He says Russia’s $5.5 billion sovereign bond on April 22 is a turning point. The $2 billion, five-year tranche widened from 125bp over US Treasuries at launch to 175bp just three trading days later. Investors balked at aggressive pricing of the bonds, while Greece and Portugal’s sovereign debt downgrades on April 27 have heaped on the risk of a sovereign default in the eurozone.
Jacobson says: “The Russia transaction shows that the rally in emerging market debt has gone way too far in the context of the regional and global headwinds – we will see emerging market credit spreads widening in the coming months.”
LONGER TERM
In many respects, a rebound in emerging Europe’s financial market fortunes was the easy part as asset prices, ranging from equities to bonds, overshot fair value in the wave of forced selling following the crisis. But after the biggest global crash since the 1930s’ depression, and the CEE’s deepest recession since the fall of Communism, investors should take stock and ask: where does the region stand in the global portfolio investment landscape?
Jorg Kramer, chief economist at Commerzbank, paints a grim picture. In the coming years, eastern Europe will grab a lower relative share of foreign capital inflows compared with the bull run years as a “structural consequence of the crisis”, he says. “Foreign capital and economic growth mutually reinforce each other, but over time, capital tends to return to the most productive destinations. And, at this time, Asia is a more productive destination.”
Central and eastern European economies grabbed hefty capital portfolio inflows in the bull run – which in tandem with foreign currency bank lending – outpaced the contribution of labour, productivity and exports in driving regional growth, he says. “The mutual reinforcement between trend growth and capital inflows could now run in reverse,” says Kramer.
Manfred Schepers, vice-president at the EBRD, says: “The region faces the challenge of a prolonged period of constrained capital growth.”
The IMF predicts central and eastern Europe will grow 2.8% in 2010, 3.4% in 2011 and 4% in 2015. This compares poorly with developing Asia, which is projected to expand 8.7% in 2010, 8.7% in 2011 and 8.5% in 2015. Growth laggards in the region include Hungary, Romania, Bulgaria and the three Baltic states, Latvia, Estonia and Lithuania.
Economies are still reeling from a correction in the real estate market and a public and corporate debt overhang that will restrict consumption and investment in the years to come.
Meanwhile, Europe is set for anaemic growth relative to the US in the coming years due to lower productivity and an older labour force. The IMF predicts the eurozone will expand by 1.5% this year compared with the 2.6% in the US.
Subdued European import demand will temper emerging Europe’s growth in the coming years. Resurgent capital inflows and speculation in foreign exchange markets have led to real effective exchange rates in many CEE countries to return to pre-crisis levels, says Kramer.
But he says the pace of currency appreciation in the region is likely to be modest in the coming years. Stronger growth and higher interest rates in Asia and commodity price recovery in Latin America will cause emerging European currencies to underperform emerging market competitors, he says.
But the crisis has not torn apart the investment proposition for the region, says Martin Blum, co-head of asset management at Ithuba Capital in Vienna. “It is important to remember that emerging Europe is still an attractive destination for capital due to its proximity to developed Europe.”
He says access to EU markets, a well educated skill force relative to wage levels, mature institutions and legal frameworks in the region will boost corporate growth for years to come. This growth outlook will boost capital inflows into stocks in the biggest and most liquid markets: Russia, Turkey and Poland. But for fixed income portfolio investors, emerging Europe’s corporate growth potential is now purely a Russia and the Commonwealth of Independent States (CIS) play, says Jacobson.
“It’s extremely difficult for global macro portfolio managers to be overweight emerging European debt as this is a one-way, concentrated bet on oil prices.”
After sucking in record capital inflows in the bull run, emerging Europe is set for modest inflows in the coming years as regional growth undershoots emerging market competitors. Moreover debt crises in the West will weigh heavy on emerging Europe’s rally over the course of the year.
But provided western Europe’s woes remain contained, there may be a silver lining for its eastern neighbours. “Modest capital inflows will help reduce the risk of current account deficits and destabilizing capital inflows that contributed to emerging Europe’s descent in the crisis,” says Lubin at Citigroup.