First, the good news: emerging Europe has turned the corner. Optimism is gaining ground among even the most pessimistic forecasters and, for the first time in quite a while, the region is in a sweet spot. As the eurozone slowly drags itself out of the doldrums – with Germany’s economy growing by a healthy 0.7% in the second quarter and on track for 0.4% expansion in the third – things are looking up for emerging Europe, and particularly for central and eastern Europe. “I am relatively optimistic, as most of the CEE countries have in the past carried out quite significant structural reforms that allow them to be more competitive than many ‘older’ European Union members,” Miroslav Singer, Czech central bank governor, tells Emerging Markets. His view is shared by analysts, who see growth returning to the region.
“The macro story in CEE is more dependent on what we see in the eurozone,” says Simon Quijano-Evans, head of emerging markets research at Commerzbank. “And given we’re starting to see some green shoots in the eurozone, and given that the CEE economies are very open, those are the main factors that will be driving CEE in the next six to 12 months.
“I think we should start to see gradual improvements in the macro story everywhere,” he adds. “You’ve seen the media starting to get more positive, which should feed into consumer and corporate sentiment.”
When Federal Reserve chairman Ben Bernanke suggested in May that a tapering of quantitative easing (QE) was possible as early as September, emerging Europe – with the exception of Turkey – looked good when compared with other developing economies. There were relatively fewer outflows of foreign capital. “CEE, except for Turkey, has not relied on portfolio inflows. The capital inflow impact of the first round of QE that hit all the emerging markets, when currencies appreciated and there was talk of currency wars, largely bypassed emerging Europe. They rely more on foreign direct investment, which is much better in many respects,” Piroska Nagy, an economist with the European Bank for Reconstruction and Development, tells Emerging Markets.
Some analysts even believe that now is the time for the region to attract its share of portfolio capital, especially with the threat of Fed tapering postponed. “There has been very little equity money in central Europe for a long time, because it was associated negatively with the eurozone,” says Charles Robertson, Renaissance Capital’s global chief economist. “But now that things are picking up in the eurozone, the one region in the world that you want to be in is the region that no one wanted to be in six months ago. It is now the one most likely to benefit from the eurozone recovery.”
Raffaella Tenconi and Mai Doan, analysts with Bank of America Merrill Lynch, also believe that the CEE countries are likely to be “first in, first out” of the crisis, helped by the “significant reforms” they introduced to address the imbalances that exacerbated the effects of the 2007–08 global financial crisis.
BELOW THE SURFACE
And now, for the bad news: emerging Europe is still a place where uncertainty abounds, sudden changes in policy sometimes create new risks and reforms are easily forgotten or reversed. The EBRD’s Transition Report will be published in November and, Nagy warns, it will be reporting on “some backsliding in some areas, in the banking sector but also in utilities”.
She says there are some countries in the region where administered prices (which can be influenced by the government) are being cut for “short-term political purposes”, which will damage investment and investor and business confidence over the long term. “In general the reform process is not proceeding as well as we believe it should,” Nagy adds. “It’s very clear that we are stuck in transition as a result of this crisis.”
She did not disclose further details of the report, but experts say that one of the countries where reforms have gone into reverse is Hungary. On the face of it, things are going well. The country managed to pay off its debt to the International Monetary Fund and is therefore no longer tied by IMF conditions; it also managed to get out of the European Union’s Excessive Deficit Procedure, which uses corrective measures to return countries to a budget deficit of no more than 3% of gross domestic product.
In 2010, Hungary became the first eastern European country to roll back reforms it had implemented to the pension system more than a decade ago. Under those reforms, many states in eastern Europe introduced a so-called “second pillar” of pensions, into which both the employee and the company would have to make compulsory contributions. To give it a start, governments decided to finance the second pillar with a part of the compulsory contributions to the state pension system. This made their budget deficits look much worse, because the state had to surrender revenues to kick-start the second pillar. The reform was acclaimed at the time as the right thing to do as it ensured that workers had more than the meagre state pension to fund their retirement, and it contributed to the development of local capital markets.
However, the countries that implemented it subsequently incurred the EU’s wrath for exceeding their deficit ceilings. They wrote a joint letter demanding that the funds used for the pension reform be discounted from the overall budget deficit, but the EU rejected their request. This, some analysts say, is why it should come as no surprise that eastern European countries are now going back on the reform. “It’s more a necessity than anything else,” says Quijano-Evans. “When Poland, Hungary and the other countries sent a letter to the European Commission, they weren’t paid heed to, so the countries have gone down their own path. While central and eastern European countries were sorting out their pension system, in western Europe there wasn’t any indication that things were going in that direction as well.”
At the beginning of September, Poland also took a step back from pension reform, according to critics. The government announced it would transfer to the state the government bonds held by the private pension funds, a move criticised by many. Nomura fixed-income strategist Peter Attard Montalto said at the time: “The system has been decimated to serve several government purposes.”
POLITICS AT PLAY
As Poland was quickly approaching its 55% of GDP debt limit that would have brought automatic cuts in spending, the move provides short-term respite; analysts estimate that it would cut debt by around 8% of GDP, thus reducing the danger. But, warns Juraj Kotian, an analyst with Erste Bank, “long-term fiscal sustainability will not improve, as there is no such thing as a free lunch.”
Other countries in the region have also dipped into the pension funds to boost state revenues during the crisis. The EBRD’s Nagy says there has been “an onslaught on private pension funds” in emerging Europe. The measures taken by various countries were partly motivated by concerns about the fee structure or by competition issues in some cases, but governments should have dealt with those issues rather than simply “move towards nationalization”, she says.
“We feel that this is really detrimental, because it basically eliminates your main domestic investment source,” Nagy adds. “Over the long term, you want to rely on domestic investors. A more balanced financial system means the development of local markets. Relying on foreigners is not a bad thing, but you have to have a local buffer when, in times of shock, everybody retreats to their own quarters.”
Politics are behind the reversal of reforms, according to some observers. Analysts say the changes in the Polish pension system give Prime Minister Donald Tusk some spending power just as the parliamentary majority of his coalition is dwindling to dangerously low levels and after thousands of people protested on the streets of Warsaw, demanding his government’s resignation.
Protests and political tension have marred much of eastern Europe over the past year. Bulgaria’s centre-right government fell in February after street protests against high energy bills. Its socialist-led successor has faced repeated street demonstrations as well, with people protesting against corruption. In neighbouring Romania, the centre-left coalition saw thousands take to the streets for days in September against plans to give the go-ahead to an open-cast gold mine in a picturesque spot in the mountains. In the Czech Republic, the centre-right government, which was praised for facilitating corruption investigations and attempting to streamline public spending, collapsed in June, and elections are scheduled for later this month.
EYES ON HUNGARY
Despite the popularity of its current government and lack of street protests, a lot of worried eyes are on Hungary, where the government’s various legislative changes have been characterized as, at best, “unorthodox”. Prime Minister Viktor Orban was animated solely by his desire to get re-elected when he went back on pension reform, critics argue. The same, they say, was behind his government’s decision to force the banks to take the risk of foreign exchange lending when the currency plunged during the crisis and to impose a supplementary tax on banks. But, the critics warn, over the long term this will be bad for Hungary.
Herbert Stepic, the former CEO of Austrian bank Raiffeisen Bank International (RBI) and the man who pushed the bank’s expansion into eastern Europe, remarks that Hungary was the darling of foreign investors in the 1990s but now the Orban government’s unconventional measures have irked many, especially in the financial sector. However, the Hungarian leader has played his cards smartly, Stepic concedes, by first breaking free from the constraints of the IMF and by confining most of his reforms in the area of taxation, which the EU regards as a national issue and in which it is therefore unlikely to interfere.
“He is a populist and wants to win the next election; therefore he is taking measures that are reducing the financial burden for ordinary Hungarians,” Stepic says in an interview with Emerging Markets. Hungary was the country with the highest foreign-exchange denominated lending activities in eastern Europe, and by forcing the banks to take losses when the forint depreciated, Orban showed that he helped the people, he adds.
“He gets applause from the Hungarian voters, and he is not being hindered by any sort of EU authorities,” the former CEO of RBI says. “I can say that, because we didn’t receive any sort of assistance from EU authorities as what I would call the expropriation went on. We were more or less expropriated due to these measures.”
Orban forced the banks to accept loss-making exchange rates for the hard currency loans they had extended to their customers, slapped taxes on them and said that foreign banks were welcome to leave if they didn’t like his government’s measures, Stepic says. Easier said than done. Who would want to buy a bank in Hungary right now, he wonders.