On the face of it, the economic turmoil that swept through
emerging Europe last year bears some similarities to
Asias 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 todays east Asia couldnt 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 regions 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 Morgans 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 Russias 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 Greeces bailout has hit asset prices
and currencies across the board. Emerging Europes
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 regions 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 45% this year. More
generally, investor concerns over sovereign debt burdens in the
region have moderated due to government spending cuts and
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 Latvias 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 countrys 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 countrys
redemption in the eyes of global capital markets after last
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.
In another sign of the countrys rehabilitation by
international investors, Ukraine, by the end of the first
quarter of this year, cemented its position as the worlds
top-performing equity market. The Ukrainian stock market is
trading only 23% below its pre-crisis high. By contrast, Russia
and Kazakhstans 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 RZBs 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 governments 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 years 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 markets 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 &
He says Russias $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 Portugals
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
In many respects, a rebound in emerging Europes
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
CEEs 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
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
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
Europes 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
Europes corporate growth potential is now purely a Russia
and the Commonwealth of Independent States (CIS) play, says
Its 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
Europes rally over the course of the year.
But provided western Europes 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 Europes descent in the
crisis, says Lubin at Citigroup.