Divided fortunes

IFR Emerging Europe and Turkey Special Report 2014
10 min read

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For all the talk in recent years of “core” and “periphery” European nations, it’s easy to overlook the fact that the Continent has two sets of both. The first group roughly hews the eurozone in half, separating the “good” or fiscally upright nations of the north from the “bad” sweep of largely southern states.

But look east and you see the same phenomenon at work, writ small. Central and Eastern Europe, much like the eurozone, remains a region split between countries that “work”, largely by cleaving to investor ideals such as fiscal probity, strong manufacturing bases, and low debt and labour costs, and those that for reasons both within (a lack of reformist zeal) and beyond their control (geography, conflict, irascible neighbours) don’t.

This divide has created not just a two-speed region, but, said Gautam Kalani, Central European economist at Deutsche Bank, also “a two-speed recovery that divides countries with strong fundamentals from countries that are either struggling, or which rely more on external conditions being supportive”.

Kalani points to successful core CEE nations such as Poland and the Czech Republic, whose manufacturing and export-led economies are bound tightly to the resurgent German growth engine; and nations whose stock with global investors has either risen (Romania) or remained stable (Hungary). GDP in 2014 is set to expand by 3.2% in Poland, and by 1.6% in the Czech Republic, according to the Economist Intelligence Unit, with industrial output having risen by 5.3% and 6.8% respectively year on year in February.

Compare that with Ukraine, whose indebted, conflict-wracked economy is set to shrink by 2.3% this year, according to the EIU, or Slovenia, another contracting economy that utterly failed, in the post-Soviet era, to impose a reformist agenda. (See Slovenia.)

Vienna-based Erste Group, a key player in the region’s banking sector, tips the economies of regional laggards such as Serbia to grow by just 1% in 2014, with Croatia only just breaking par.

Geography matters

Geography either aids or hinders a sovereign’s prospects. It can hardly be happen-stance that Poland and the Czech Republic, countries whose supply chains, said William Jackson, an emerging market economist at Capital Economics, are “inextricably intertwined with Germany’s”, are recovering fastest from Europe’s half-decade of malaise. It is no surprise that the likes of Croatia and Bulgaria “are struggling because their economies are more closely tied to Italy’s economy”, which grew by just 0.3% year on year in the final three months of 2013.

But reform matters too. Take Bulgaria and Romania. Both, squeezed between the Balkans, Ukraine, and the Black Sea, suffer from topography and geography, but the two nations’ fortunes have diverged wildly in recent years.

Romania, whose economy expanded by 3.5% in 2013, has visited the sovereign debt market four times in 15 months, raising US$5.5bn from a blend of seven, 10 and 20-year notes. A raft of regional peers, including Hungary and Slovakia, followed suit, printing well-received bonds. Meanwhile, Bulgaria, which saw its economy grow by just 0.9% last year, remains conspicuous by its absence, despite the clear hunger among global investors for higher-yielding CEE sovereign debt.

The underlying reason – why global investors like Romania but shy away from Bulgaria – comes down to the former’s ongoing desire to reform, which trumps (though often only just) the yearning to remain within its comfort zone. Investors are keenly awaiting a trio of initial public offerings expected in the second and third quarters, from state-run power producers Hidroelectrica and Oltenia, and power distributor Electrica, set to net the state up to US$1.5bn.

David Smart, global head, sovereign funds and supranationals at Franklin Templeton Investments, which manages national investment fund Fondul Proprietatea, said that if the country continued to break up its old, unwieldy state sector, bringing in competition and private capital, there was “no reason” why it could not replicate Poland’s success story over the coming decade.

There’s no guarantee that Romania’s economic future will be strewn with glory. The country has a marvellous ability to shoot itself in the foot, and the next chance to do so is likely to come during presidential elections slated for November. Elections usually incite unrest in Bucharest, unsettling investors and shaving slices off GDP.

Alberto Gallo, head of European macro credit research at RBS, flags up the “large number of elections taking place across CEE” in 2014, with presidential or parliamentary polls also scheduled for Hungary, Latvia, Moldova, Romania, Slovakia, Serbia, Macedonia, Lithuania, and Turkey.

Perhaps the most important date of the lot is May 25, when Ukraine’s population heads to the polls to elect a new president. The conflict in Crimea, following the ousting in February of former Ukraine leader Viktor Yanukovych, has been an economic disaster not just for Kiev but also for Moscow, which suffered record capital flight in the first quarter.

Christian Schulz, senior economist at Berenberg Bank in London, flags up Ukraine as the “number one risk” across the region, with Russia in third place.

Turkey could provide another flashpoint. Schulz places the country second in his list of risky regional sovereigns – the past 12 months have hit the nation hard. The Federal Reserve’s decision to begin tapering its QE programme in May 2013 weakened the Turkish lira and send bond yields soaring. (See page 10.)

Prime Minister Recep Tayyip Erdogan then suffered a long winter of discontent punctuated by political bickering, street protests, and corruption claims, only regaining his footing after a strong showing in the March 2014 local elections. Further troubles could emerge mid-year, with presidential elections slated for August.

“We expect some political uncertainty surrounding that period,” said Gulcan Ustay, director of business development at Fitch in Istanbul.

Yet some believe the past year’s vicissitudes have perversely aided Turkey, a curious economy that boasts both weaknesses (notably a current account deficit that reached US$65bn in 2013) and strengths (a debt-to-GDP ratio of 34% and falling, a level most eurozone countries would die for).

Prior to the Fed’s decision last May, Turkish 10-year bonds were yielding just 4.6%, a serious premium in a country still suffering from persistently high inflation. Yields then soared to 11.6% in early 2014 before easing to 9.8% in early April, a level that, said Emre Akcakmak, a Turkish portfolio manager at East Capital, was “just about right. Investors were being unrealistically optimistic about Turkish risks before the Fed stepped in. We are now back in the realms of reality.”

SG’s head of EM research, Benoit Anne said despite the challenges of the past year he remained a “big bull on Turkey. Valuations are amazing, notably in terms of fixed-income assets and the Turkish lira, both of which are very cheap in my view.”

Fed’s force

Indeed, all eyes across the region remain firmly fixed on the Fed, widely tipped to hike interest rates from mid-2015. Capital is already flowing out of emerging markets and into the US, where yields on 10-year bonds hit 2.7% in early April, a rate that continues to crank higher.

Analysts are divided over the impact on CEE nations. RBS’ Gallo said regional sovereigns were “less exposed than Latin America or Asia” to waning investor sentiment for emerging market debt. But Fitch’s Ustay said a higher US interest rate environment was “the big risk, not just for the region but for all emerging markets”.

Yet Central and Eastern Europe has always been a broad church of nations, and making predictions has long been a fool’s errand. For proof of this, look no further than Hungary. Regularly written off as an investment story since the rise to power in 2010 of Prime Minister Viktor Orban, the country has repeatedly defied its many doubters. (See page 20.) Hungary’s economy grew 2.1% in 2013, with industrial output surging respectively 7.2% year on year in February, according to the EIU, on the back of strong automobile and chemical exports to Germany.

“It’s the one country that has surprised me positively, in economic terms,” said Berenberg’s Schulz. “Economic confidence is strong, growth figures look good, and voters seem more than happy with Orban.”

Hungary’s fortune has been to enjoy a low current account deficit (2.3% of GDP in 2013, according to the World Bank) at a time when the balance of payments is uppermost in investors’ minds.

Hungary’s fortunes may change if its economic prospects turn sour – always a possibility in a country ruled by a dominant populist who tends to put investors’ needs way down his list of priorities. But for now at least, for Hungary, and for several “core” members of Central and Eastern Europe, things are looking up.