Eastern and central Europe’s capital markets aren’t what they used to be. For investors, they are more complex. For borrowers, they are more flexible. For bankers, they are less lucrative. The tables have turned as local businesses that have traditionally struggled to get noticed are able to ditch their begging bowls and raise their expectations.
The internationalization of finance, the accelerating development of the region and the flood of liquidity following years of rock-bottom interest rates in the major economies have all shaped the markets.
Traditional niche markets are rapidly becoming big business. For example, in Russia the MICEX Group said in March that foreign exchange transactions over its platforms jumped 70% last year to R16.8 trillion ($620 billion). Corporate bond trading climbed by 50%, the value of government securities bought and sold doubled, and derivatives transactions leapt 14-fold, the company said.
drop in supply
One of the biggest changes, though, has been a sharp drop in supply in debt sales. Sovereign issuance has all but dried up, with even traditionally reliable springs like Turkey shrinking to a trickle after taking advantage of tight spreads to front-load sales in the first months of the year. Companies have been faced with an enormous array of fund-raising options, with many finding that syndicated loans can supply needs most cheaply. Others have taken advantage of surging profit growth, driven by unprecedented economic performances in the region, to reinvest and render external funding unnecessary.
Foreign banks have piled into the new European Union countries over the past decade, whether through takeovers of established banks in Poland or the Czech Republic, or simply by taking advantage of laws freeing up cross-border financial services. The competition has crushed margins for vanilla products, spurring banks to come up with more innovative and bespoke options that can command premia.
Raising equity is getting more attractive as foreign investors become more confident dealing in local markets and household wealth surges, inflating stock valuations. Russia, in particular, is facing a spate of initial public offerings with the easy money luring some big, traditionally market adverse, family businesses to the stock exchange.
listing abroad
A mark of the development of corporate governance and the internationalization of markets is the increasing tendency of companies to list abroad. Such a move can avoid inconsistently enforced and arbitrary regulations on local markets. It is also popular with overseas investors wary of dabbling in a divided and complex Russian stock market: share trading is split between ADRs, the RTS electronic dollar market and the MICEX rouble exchange.
London markets have been particular beneficiaries, with seven Russian listings raising $5 billion in 2005, a figure almost certain to be exceeded this year. Rosbank, Vneshtorgbank and insurer Ingosstrakh are among names which may arrive on the London Stock Exchange this year.
Angara Mining plc, owner of a Russian gold mine, also plans an IPO this year. Typically of the new breed of Russian businesses, it is capitalizing on a range of finance options and recently sold $50 million of bonds convertible into stock. Company director John Fairly says the process of raising capital has transformed during his time of working in Russia. “Six or seven years ago it was hard work. Now it is a lot better,” he tells Emerging Markets.
Other Russian IPOs will include supermarket chain Magnit, tapping into investor demand for consumer businesses which are less susceptible to government interference than more sensitive commodities companies. The Russian government is also seeking to shift stock of Aeroflot amid the equity euphoria to help fund consolidation of an inefficient industry.
So far there hasn’t been a spectacular flop, though some sales including supermarket Pyaterochka have struggled in the aftermarket owing to stretched valuations. The sale of Rosneft, packed with assets acquired from Yukos, could be a litmus test for whether investors are adopting a more sceptical approach to the high prices, according to Ian Hague, managing partner at Firebird Management. He says Firebird is becoming more cautious as valuations continue to soar.
“We have been increasingly careful about the positions we open and we have been taking some profit,” says Hague.
With IPO valuations so high, Hague says, the benefits of greater liquidity don’t outweigh the lower cost solution of buying unlisted stock. Another option Firebird is using is to explore less well-known markets such as Georgia, Armenia and Kazakhstan.
Kazakh companies have been able to tap international demand while innovatively circumventing the pitfalls of the local market by using reverse takeovers of cash shells in the US and especially Canada. Injecting oil assets into the acquisitions can then lead to a flotation in liquid and stable markets.
bankers’ problems
Bankers claim the fees available for deals are sometimes crippling, turning certain products into loss leaders. More prominent firms are turning away that kind of business, leaving them with a dilemma of how to beat the record turnovers achieved during 2005. One answer is to head further afield (see box). Georgia, Armenia and Kyrgyzstan are candidates for them too.
“We have moved further east” from traditional markets in Poland, Hungary, Romania and Bulgaria, says Petri Kivinen, head of corporate finance and origination for EEMEA at Dresdner Kleinwort Wasserstein.
Market sophistication has run up against the ceiling of regulatory suspicion in many of eastern Europe’s markets. Even in Poland securitizations are difficult and derivatives markets undeveloped. In Russia investors find it almost impossible to short stocks and difficult to hedge. Regulators often struggle to apply the necessary expertise in their supervision.
Even in some of the region’s most developed markets that makes things difficult for banks that are faced with western European-level competition but no possibility to hedge their exposure as effectively as rivals in other countries.
“Poland still lacks a little bit of legal environment to have a really open banking market because a lot of things are hindering banks from coming up with new products. There is an impressive area of governance law regulations to be dealt with,” says Ronnie Richardson, CEO of Kredyt Bank, the Polish unit of Belgium’s KBC.
Growth in corporate banking in Poland is almost non-existent, Richardson says. With such poor margins available on loans to companies, Kredyt bank is focusing on offering more complex products (trade finance, derivatives and mezzanine credit) and diverting more resources to servicing the booming consumer market. Households themselves are also taking advantage of more sophisticated borrowing options, as the explosion of mortgage borrowing in Swiss francs demonstrates.
Although foreign investor interest in eastern and central Europe has never been higher, companies are sometimes finding that blossoming domestic wealth means they don’t need to look beyond their borders for funding.
RZB, owner of banks in more than 15 eastern European countries, has responded to the narrowing of prospects by moving down the food chain to service retail and SME customers who a few years ago would have had little possibility of raising capital at affordable rates. The bank has also shifted focus to newer markets like Ukraine, Serbia and Albania. The time has also come, however, to take a serious look at cutting costs through synergies to keep up profit growth, managing board member Patrick Butler tells Emerging Markets.
“What do we do next? There are still efficiencies we can build on in terms of looking at markets not simply country by country, but looking at whole regions and adjusting our infrastructure accordingly,” says Butler.
Comparisons with last year’s performance will be difficult for many operators in central and eastern Europe, but nevertheless, the regional economy is likely to grow at double the pace of even a revitalised eurozone this year, according to RZB. There is also clearly plenty of space left in the market. Loans to private enterprises as a percentage of GDP are well below 15%, compared with over 50% in the eurozone.
promise of accession
The biggest catalyst to the development of markets in the region has been the promise, fulfilled or not, of EU accession. Not only are candidate governments falling over themselves to impress Brussels with the speed of their reforms, but the prospect of membership also attracts flows of funds from private and government sources. The European Investment Bank (EIB), having helped prepare Hungary, Poland, the Czech Republic and others for integration, is now gunning for the next in line, Romania and Bulgaria.
The bank has played a key role in extending yield curves, most notably with the first 15-year bond in Czech koruna in 2000 and a pioneering 25-year Slovak koruna issue in 2003.
The EIB sold its first debt in Bulgarian lev in 2004 and plans a debut in Romanian leu possibly as soon as next year, simultaneously raising cash for lending and setting local market benchmarks. Still, even for an issuer like the EIB, inconsistent and inappropriate regulations pose a headache. On the regulatory front, “well-intentioned advisers” who encourage governments to set up regulatory structures suitable for retail equity offerings, but not relevant for wholesale bond issuers like the EIB, are “the single biggest problem we have”, says David Clark, head of non-euro funding for Europe and Africa at the EIB. Ensuring that the bank gets equal treatment alongside other issuers and that regulations are properly applied also consumes considerable time in less developed markets, according to Clark.
Whatever the shortfalls of east Europe’s markets, the success the countries have had in creating favourable conditions for investors and borrowers can be seen in the blossoming state of their economies. Inflows have surged, spreads have tumbled and, as Kredyt Bank’s Richardson points out, “for those companies that are trying to dip into the market it’s a buyer’s market.”