EU membership may be a reality for eight of central Europe's former Communist sovereigns, but this does not mean the convergence game is over – as many foreign investors are discovering when they invest in local debt markets. Entering the single currency is their next target, with entry slated for between 2007 for early joiners such as the Baltic States and Slovenia, and 2010 for others like Hungary and Poland.
This means that there is still time for investors to take advantage of the relatively attractive yields on offer in Europe's new member countries. "Last year at January's EMTA [Emerging Markets Traders' Association] meeting in London only one of the panellists was invested in local currency bonds," says Dmitry Shishkin, a fixed income strategist at WestLB. "This year, they were all invested in local markets, including one who claimed last year he never would be."
Hungary and Poland, which have the largest local currency markets of the region, see the greatest foreign participation. Poland's domestic bond market, excluding
T-bills and private placements, stood at Zl234 billion (e55.9 billion) at the end of
January, Hungary's at Ft5,917 billion (e23.8 billion) and the Czech Republic's at Kc395 billion (e13.1 billion).
"There is a lot of foreign investor participation in central Europe's local currency
markets," says Shishkin. "Hungary has the highest foreign participation, at above 40%, and although there was a decrease in foreign ownership [in mid-April], that was little more than a blip."
The other new EU members from central Europe – the Baltic States, Czech Republic, Slovakia and Slovenia – do see some foreign participation in their domestic
markets, although their size makes them less attractive for foreign investors who
prize liquidity.
Yields are also very low on the Czech market – with five-year paper yielding around 2.66% compared to 5.56% in Poland or 7.34% in Hungary – making them less attractive than some of their neighbours, although this may change longer term. "We stick to our outlook of a mid- and long-term rise in interest rates and bond yields [in the Czech Republic]," says Helena Horska, an analyst with RZB in Prague.
Foreign investors in Poland compete with domestic pension funds, which wield the largest domestic liquidity of any of central Europe's domestic markets. Polish pension funds are restricted in the amount of foreign assets they can hold, and prefer longer-dated instruments, making this end of the curve more competitive.
Yes and no
But foreign investment is a mixed blessing. "As a result of foreign participation, local capital markets are becoming more liquid, although also more volatile," says Shishkin. "Hopefully the influx of investors will help to stabilize markets in the longer term."
Foreign investors break down into three main categories, analysts say. "There are the real money accounts – those who believed in the convergence story way back and have always believed in it, so are happy holding local currency paper," says Giancarlo Perasso, head of EM research at WestLB. "Then there are the new entrants, who are more opportunistic and who buy in dips. Finally there are the short-term focus and carry traders who play at the short end."
Hedge funds have become increasingly active, particularly in Hungary thanks to its high interest rates, and have been largely blamed for periods of forint weakness in recent years. "Some policy-makers would perhaps not like to have big inflows, as they generally do not want so-called speculators, but they cannot prevent them getting into the game as the new EU members had to liberalize all market access," explains Perasso. "For that reason Romania has been liberalizing its market very slowly."
Since EU accession on May 1 last year, a new class of investor that can only own EU government paper has entered the market. But analysts believe there are more new entrants to come, pointing to banks as one investor class that has taken longer than fund managers to realize the appeal of central European local debt.
Foreign investment is unlikely to stimulate the development of corporate bond markets though. "The biggest companies in these countries have either foreign ownership or a strong foreign presence, so it makes sense for them to borrow via their parents," says one credit strategist.
"Furthermore, the markets' development pattern is more along the Germanic
style, where companies have strong relationships with house banks that take care of their borrowing needs."