The lights are still on

Central and Eastern Europe* – a collection of countries that are as economically diverse as they are geographically close. As such, the region offers a fascinating laboratory for an analysis of the global downturn. Regardless of currency, size of economy or the level of reform so far undertaken, CEE countries have been hit hard by the disappearance of liquidity from the financial system and plummeting prices across asset classes. Membership of the euro is perhaps the most obvious characteristic that divides the region. Austria, Montenegro, Slovakia and Slovenia benefit from membership of the club, providing some stability to anchor their economies, while those with still independent currencies have seen their values come under extreme pressure. Among the outsiders, Hungary, Poland, Latvia, Lithuania and Estonia are seen as the closest to membership. But while there has been much debate about the prospect of speeding up their entry, this is seen as unlikely amid such a turbulent backdrop. The “old economies” of Europe are nervous enough about their own situation and are reluctant to offer a helping hand to the east, for fear that they will themselves be pulled into another quagmire. In terms of sovereign issuance, Austria remains on a different plane to its CEE neighbours. Other countries in the region have shared the nervousness about rising levels of debt that has plagued the most advanced economies around the world. Those outside the euro look worse off than those inside, and for the smaller economies, issuance looks a remote prospect. Evidence of the adaptability and durability of the market is perhaps most evident in the birth of the government-guaranteed senior debt market. Issuance here has to some extent offset the decline of the subordinated market. In the loan markets the downturn has been evident but less spectacular, dropping off from what were relatively low levels compared to the frenzied lending previously seen in other parts of the world. Here again regional diversity frustrates neat generalisations: Hungary faces a problem servicing its significant external debt, while Poland is among those expected to have less difficulty in getting support. Equity markets have been decimated and issuers are loath to come to market for an IPO or to raise capital unless it is absolutely vital. The Warsaw Stock Exchange has done enough to convince many that it remains a force for the future, and although activity has dried up, it is expected to pick up again next year. Nevertheless, London remains the key obstacle to its ambitions to become the regional hub. For all their diversity, CEE countries share notable challenges. While global demand has been hit hard, what little dynamism there is left appears to centre on Asia, particularly China, which seems a long way away from the factories of Warsaw and Budapest. And with protectionist forces gathering momentum, the region must hope that the global recession does not undermine all the advances it has made in recent years. * defined as: Albania; Austria; Bosnia and Herzegovina; Bulgaria; Croatia; Czech Republic; Estonia; Hungary; Latvia; Lithuania; Former Yugoslav Republic of Macedonia; Montenegro; Poland; Romania; Slovakia; Slovenia; and Serbia.

Among all the central and eastern European economies, Triple A-rated Austria is by far the best regarded. However, it has been severely impacted via its exposure to its eastern neighbours, more so than other EU states due to the relatively small size of its domestic economy and the resultant exposure of its banking system. The sovereign has seen its 10-year bond spread widen from plus 40bp to a peak at plus 128bp over Bunds between last autumn and February 2009. While this hasn't particularly hampered the ability of Austria to fund itself internationally, it has clearly had a negative impact on the cost of funding. Typically, Austria makes relatively infrequent recourse to the capital markets and often appears early on the calendar with the first of its syndicated deals. 2009 was no different with a €3bn long five-year issue sold at 15bp over mid-swaps in January, with a further deal yet to be announced later in the year. In addition to its syndicated issues, Austria relies on monthly auctions of its outstanding debt, adding almost €1.8bn to its 3.9% July 2020 bond in February. The suggestion in February by German finance minister Peer Steinbrueck, that Europe as a whole would eventually bail out the weaker member states was enough to create a short-covering rally which led to a spread tightening of all Eurozone member states. This benefitted Austria and the other euro-based economies such as Slovenia (Aa2/AA/AA) which has also been able to access the capital market this year with a €1bn three-year benchmark deal at mid-swaps plus 165bp. Slovenia, which has been a star performer among the new EU members, anticipates a domestic demand-led recovery in 2010, which should bring average growth back up to 2%. Despite this serious slowdown, it expects to remain one of the EMU's top achievers in terms of GDP growth. A country of around 2m people, Slovenia has modest 2009 borrowing requirements of just €2.8bn, of which €800m will be financed in the short-term market with €2bn of longer-dated financing. Like all sovereigns, Slovenia has seen its differential to German debt widen, although as a shorter dated issuer (typically three or five-years), the fall in absolute interest rate levels since last year has in part offset this additional cost. The situation of the Czech Republic and Poland is somewhat different: these economies are not yet using the single currency and have had additional funding requirements imposed by the devaluation of their own units. Both were able to issue 10-year euro-denominated debt last year with the Czech Republic (A1/A/A+) issuing at mid-swaps plus 25bp and Poland (A2/A–/A–) at plus 60bp. Poland has already made its return to the Eurobond market in 2009 with a €1bn five-year deal that was priced at mid-swaps plus 300bp while the Czech Republic has mandated Barclays, Deutsche Bank and Ceska Sporitelna for a benchmark issue to be sold this year. The performances of other recent EU entrants have been notably worse. Hungary, Romania and the three Baltic Republics in particular have struggled badly in macroeconomic, currency and bond spread terms. EU membership is no longer treated as a one way ticket out of the EM space. But the anchor provided by membership of the world's largest trading bloc, especially if combined with a desire to join the euro, caught the attention of convergence players, prompting spreads to tumble among the new entrants. These convergence plays helped JP Morgan's benchmark EMBIGD spread over Treasuries, which was as high as 1,631bp in September 1998, retreat to just 151bp on June 1 2007, before bouncing back above 650bp. Although a few investment banks continued to deal with new EU members from their EM desks, most banks removed them once they joined the world's largest trading bloc, reasoning that syndication teams execute the deals that best reflect the investor base they are aiming for. JP Morgan kept responsibilities for 2006 newcomers Romania and Bulgaria within its EM team, but the 1

The birth of the government-guaranteed senior debt market in October 2008 was intended to rejuvenate investor confidence and keep the supply engine humming in financials. Its rise to prominence has been steep. In the euro market, Austria became the tenth jurisdiction to utilise the government-guaranteed senior funding route, an asset class which was inaugurated by the UK’s Barclays Bank. Erste Bank opened the guaranteed senior market in Austria in mid-January, raising €1.5bn in two-year maturity. The Triple A rated, fixed-rate transaction was priced at mid-swaps plus 53bp, 2bp tighter than the initial guidance. The second deal came a week later. Kommunalkredit Austria managed to price a similar trade (in terms of size and maturity) 3bp tighter at mid-swaps plus 50bp. Subsequent issuance from Raiffeisen Zentralbank - €1.5bn in five-year maturity - the first such maturity trade in the government-guaranteed bank senior transaction (besides SFEF, which uses an intermediary approach) - priced at mid-swaps plus 68bp, 2bp tighter than its initial guidance. On the back of good secondary market performance of these bonds, Oesterreichische Volksbanken came with €1bn in three-year maturity, priced at mid-swaps plus 50bp in February, before Erste Bank came back for a second time, raising €1.5bn in five-year maturity. However, it was not all one-way traffic. Since rating agency Moody's raised concerns on February 17 about Western European banks' commitment to their Eastern European subsidiaries, citing deteriorating local conditions, questions have been asked about governments’ ability to foot the bills of their banks. Moody's noted that, from a creditor's point of view, the Austrian banking system was the most exposed among its CEE peers, with Eastern Europe accounting for nearly half of its global bank claims. The sovereign's five-year CDS subsequently gapped out, from 170bp on February 13 through to 215bp on February 17, to as high as 260bp on February 24th. In the cash market, the outstanding €1bn OeVAG February 2012s were bid in the mid-50s (from their mid-swaps plus 50bp pricing level), while the five-year €1bn Erste Bank senior was bid at least 15bp wider in the low 80s, on February 27th. The Kommunalkredit Austria issue priced on February 27 for a three-year maturity, cleared at mid-swaps plus 85bp, in line with guidance, reflecting the new wider spreads. Some respite came by eventually, when investor jitters about the sovereign were calmed by Fitch Ratings on March 4 when it affirmed the Republic's long-term foreign currency IDR at Triple A with a stable outlook. Austria's credit fundamentals were sufficiently strong to cover substantial losses on its banks' exposure to CEE without imperiling its Triple A status, said the rating agency. Taking advantage of the stability triggered by the news, RZB chose that week to issue its second Austrian government-guaranteed offering, with a three year maturity. The €1.25bn deal at mid-swaps plus 85bp, offered a 60bp–65bp pick-up over the interpolated (January 2011s to July 2012s) government curve. In quick succession, OeVAG too lined up its four-year maturity offering. It was the first such tenor issuance in the government-guaranteed senior debt market, in part chosen to suit the issuer's ALM considerations, but also signaling investor fatigue in three-year maturity. The borrower issued €1bn at mid-swaps plus 95bp in line with guidance. With the two most recent guaranteed deals from the jurisdiction, €1bn from Kommunalkredit Austria and €1.25bn from RZB (both in the three-year maturity), having cleared at mid-swaps plus 85bp, the issuer deemed it appropriate to offer a 10bp pick-up to compensate for the new issue's one-year longer duration. Compared to the Spanish and Irish GG market, Austrian deals have largely held value in the secondary market. But unlike its German counterpart, the Austrian borrowers face higher cost of funding despite their Triple A ratings. "The government guaranteed de

Currencies in Central and Eastern Europe are coming under increasing pressures as economies weaken in the face of continuing market deterioration. Recent discussions at European Union and country level have focused on the potential softening of euro membership criteria to accelerate the entry of Hungary, Poland and the Baltic states of Latvia, Lithuania and Estonia into the euro. This has been brought about by the need to protect countries from continued currency depreciation and financial instability. European Central Bank president, Jean-Claude Trichet nonetheless ruled out changes to euro membership rules to fast track eastern EU member countries. “Sticking to the rules is very important for the stability of the European Union,” he said on March 5. Early entry into Exchange Rate Mechanism 2, the fixed exchange rate system prior to joining the euro, would still require countries to wait two years before European Monetary Union. Early adoption of the euro would also require a change in the EU treaty, which EMU member states have clearly stated will not happen. “The conclusion is that relaxing the Maastricht criteria in this environment would be a bad idea and would weaken the euro as an institution,” said ShahinVallee, emerging markets strategist at BNP Paribas. Nonetheless, there are clear benefits of early euro membership. Currently, the main appeal for most of these economies is the instant elimination of the risk of a systemic banking crisis in the region, said Arend Kapteyn, chief economist for Europe, Middle East and Africa at Deutsche Bank. “There are massive potential foreign exchange mismatches on corporate and household balance sheets because many banks in the region have been lending in foreign exchange-denominated or indexed loans, and most of this is unhedged,” he said. “Falls in exchange rates have brought large problems for balance sheets in CEE, given the propensity for foreign currency lending,” added Chris Scicluna, senior emerging markets economist at Daiwa Securities SMBC. The Baltic nations and Bulgaria, whose currencies are pegged to the euro, would have been better off if they had adopted the euro, he said. Being pegged at current uncompetitive rates, without actually having the benefits of euro membership, means these currencies risk a beating. “Were the Baltics to devalue their currencies now, there would be a horrendous shock to balance sheets and I do not see the appetite for that at the moment,” he said. Pegged countries cannot devalue their currencies to give any cushion on the way down, said RBC Capital Markets’ senior emerging markets strategist Nigel Rendell. “Fixed exchange rates are a double-edged sword as they are good for generating stability but this kind of halfway house of ERM2 is not ideal for long periods of time, as seen with the Baltics,” he said. In addition to the Baltic states and Bulgaria, Rendell views Hungary and Romania as vulnerable due to their relatively high interest rates and large euro and Swiss franc borrowing. The Czech Republic enjoys better fundamentals, he said, as there was no comparable borrowing binge “largely because Czech interest rates were lower than in the euro zone and there was no point in borrowing in foreign currencies.” One source of pressure, particularly for Poland, is the exposure of the local corporate sector to FX options and structures. Firms are betting on the continuing appreciation of the zloty. Now, with depreciation, losses could affect a number of local companies, though it is uncertain which companies could suffer and whether any will go bankrupt as a result. “This could perhaps happen across the region as we see very large depreciation in CEE currencies which people were not expecting, and that could have an effect on banks and corporates as well,” said Jon Harrison, emerging markets strategist at Dresdner Kleinwort. The Polish national regulator disclosed PZL18bn worth of unrealised losses in the corporate sector due to FX options. If the

It is amazing to recall now that the IPO by Czech coal mining group NWR was more than seven times covered and priced at the top of the range at the beginning of May last year. That encouraged the Polish government to prepare five privatisation IPOs and selldowns, including energy group Enea, banking group BGZ and chemicals maker Zaklady Azotowe Tarnow. But, even before the banking crisis got into full swing in September last year there were signs that investor sentiment towards Central and Eastern Europe was beginning to wane. The Z294m (US$117.6m) IPO of ZAT in June was only completed because two strategic investors came to the rescue at the last moment, after institutional investors showed little interest. That led the Polish government to delay the US$1bn IPO of energy group Enea until September. The move surprised the market, given its qualities as a large, defensive stock. It was almost fatal because the deal then had to pause after two weeks of premarketing while the markets waited for the US administration to put together a rescue package for the US banking sector. When it resumed in late October it was aimed almost entirely at strategic investors. A month later came the unsurprising news that the Z600m IPO of coal mining group Bogdanka and, more symbolically, the IPO of the Gielda Papierów Wartosciowych w Warszawie (Warsaw Stock Exchange) had both been cancelled. The Polish government has since opted for an auction in the case of the Warsaw exchange, but has barred the Wiener Boerse (Vienna Stock Exchange) from participating because of its desire to see one of the major European exchanges, such as Nasdaq OMX and Euronext, take control. While some large new issues on the Warsaw exchange have been delayed over the past year, it continues to challenge the London Stock Exchange as the venue for emerging market stocks. Some issuers have recently expressed concern that index tracking funds in the UK introduce volatility into stock performance. The issue is not so common elsewhere because there are fewer funds and trackers focus on just the main indices and therefore cover fewer stocks. However, bankers believe that while there may be opportunities for other venues to pick up listings, the LSE still retains powerful advantages over some of its peers as a solid, international market with experienced regulators and operators. The speed of the deterioration of the region’s economic conditions is illustrated by the Czech government’s economic growth forecast, which at the start of the year stood at 2.9% for 2009. By the end of March the governor of the country's central bank was talking openly about the possibility that the economic activity might actually decline by 2% during the year. Towards the end of 2008 the market's attention turned to the high level of exposure of Nordic banks to the troubled Baltic states, and the possibility of large scale defaults on corporate loans. That led several major Swedish banks, including Swedbank and SEB Enskilda, to bolster their capital positions via large rights issues. Political instability has also risen in the region, exemplified by the recent resignation of the Hungarian prime minister and the collapse of the Czech government after it lost a confidence vote in parliament. While the Polish government appears to have avoided similar political fallout, some investors are worried about the level of foreign currency loans that some Polish companies have taken on. Concerns about their ability to repay them have contributed to the 20% fall, in dollar terms, in the Polish market in recent months. "The large domestic investment funds in Poland, which were net buyers for a long time driven by the growth of the Polish pension industry, have been net sellers of equities since Q4 of 2007, said Tom Attenborough, a managing director in ECM at Citigroup. Differences appear The economic downturn has forced investors to recognise the big differences between the markets in the region. Those within the EU

The overall volume for futures and options in 2008 showed a dramatic change from previous years. Volume growth globally had been close to 20% in 2006 and over 30% in 2007, with exchanges in developed and emerging markets both driving growth. Last year’s volatility disrupted this momentum and growth fell back to around 14% globally. Europe accounted for a 23.65% slice of this – up significantly year-on-year as Latin American volume collapsed. During 2008 counterparty risk soared to the top of investors’ list of concerns. Indeed while the Counterparty Risk Index – which tracks dealer CDS – has eased from its peaks, and fears that another dealer might disappear have fallen back, the experience of Lehman Brothers has ensured that investors continue to worry about counterparty risk. They are therefore willing to give up bespoke OTC contracts for the safety of central clearing that comes with standardised exchange-based trading. Volatility was also a huge factor in 2008. Although levels were stable in the first half of the year they began to soar as the year progressed. The combination of the rescue of AIG and then collapse of Lehman Brothers rocked markets. Equity volatility surged to never before seen levels and stayed there. Volatility rises as markets fall and drops as they rise. Markets tend to trend upwards with large downward corrections that are comparably short. As a result volatility patterns tend to be a series of spikes interspersed with benign periods. In the latter half of 2008 volatility rose to all-time highs and the oscillating pattern of the equity market sustained this high level for months. It is therefore not too surprising that interest switched from futures to options, as investors decided not to commit to future purchases and sales, preferring the flexibility of an option. This change in attitude proved a blow for some emerging exchanges where options markets have not developed – such as Budapest. Budapest is the 36th largest derivatives exchange globally. It had volume in 2008 of 13.4m contracts, yet this was a significant 29% drop on the previous year of 18.8m – though this reflected a drop in activity across all parts of the exchange. The split between cash and derivative markets actually remained stable, with derivatives accounting for 41% of activity. This contrasts with other exchanges which saw a change in their business mix, to cash or derivatives, but reflects the development stage of an exchange where activity is largely domestic and a high proportion is linked to equity. This ensures the same investors are present in both cash and derivative markets. Activity on these markets is also dominated by a few contracts or stocks which skew patterns. On Budapest 96% of equity trading is accounted for by the four main stocks, so changes in behaviour on just one of these names can determine overall volume changes – OTP is 57.8% of the equity market volume alone. Still falling The downward trend has continued into 2009 with index and single-stock futures dramatically down – though currency futures activity has remained firmer. Turnover in single stock futures was 125,913 for January and February on Budapest – a total that falls just short of turnover in December 2008 alone. Index futures volume has fallen less, though turnover was just 172,548 in February against an average of over 0.2m through 2008. While the turnover numbers have fallen further still this reflects a fall in trade size as transaction numbers have remained stable in recent months. Wiener Boerse, the smallest of the three notable derivatives exchanges in CEEMEA, has also seen derivatives interest slide, making the Warsaw Stock Exchange the only CEEMEA member to make progress. The Polish exchange now ranks just behind Budapest, thanks to growth of 34.5% in 2008 to 12.6m contracts. This is again largely due to a focus on a few contracts, such as index options, and dominated by domestics. The emerging market exchanges, which can see domestic inve

Nowhere has been immune to the general decline in financing. But in Central and Eastern Europe growth oriented investors continue to target opportunities in what remain economies with long term growth prospects. CEE deal flow grew from 27 buyouts in 2005 to 39 a year later and 46 in 2007, when the market peaked, before falling back to 35 deals last year. The relative resilience is in part down to the fact that activity rose from a very low base in recent years. "There is no point pretending that its 2006 again, but there are sponsors active in the region, people like Advent, Enterprise Investors and Warburg Pincus, for whom growth can be as big a driver as leverage," said one banker. "Most private equity is once again looking at smaller, growth oriented investments with modest if any leverage," said one investor. Enterprise Investors' acquisition of a 60% stake in Polish retailer Wema for €46m last August exemplifies the kind of deals currently finding favour, explicitly targeting growth alongside its existing private investors. Deal makers targeting larger acquisitions have suffered from the withdrawal of the institutional investors. As well as increasing the amount of debt available, institutional investors acted as a cross border levelling agent, driving the cost of debt down to western European levels. This is now in reverse. "The trend whereby price and leverage difference between CEE and western Europe was eroded has stopped,” said one banker. “The tightening up in all jurisdictions means that leverage is down dramatically. Today a sponsor might be able to achieve 2 1/2 x through senior and 3x in total, but not much more". Full syndication is no longer possible but bankers insist that club deals can be done, especially where there is domestic bank support for a credit. One damper on leverage since 2007 is the need to match the financing currency supporting transactions to the revenue currency. In 2006 and 2007 there was a trend of LBOs financed in euros but supporting companies with local currency revenues. Currency volatility over the past 18 months put an end to that trend. Financing currency now has to be matched to the revenue currency, limiting the number and type of institutions which can back individual deals. According to a debt arranger: "For a bank to be properly engaged in the region it now needs an on the ground presence of revenues". Club deals and bank heavy syndicates are a return to tradition for the leveraged market, rather than a paradigm shift. But it means borrowers need to be much more engaged with their lenders. "Leveraged lending is now a relationship business,” said one lender. “Banks are not interested in coming into a deal for its own sake - they want to know how it meets their relationship strategy and what ancillary business they can win on the back of the debt deal." The big concern is defaults International investors who committed to the region at the height of the boom are now active as portfolio managers rather than asset gatherers. So far deals have tended to be kept out of formal insolvency procedures, but how largely inexperienced investors grapple with largely untested regimes could be the big story of the coming years. Debt managers are already being tested. The €1.15bn financing backing Permira's buyout of Hungarian chemicals company Borsodchem in 2007 is already impaired. The sponsor's listed investor SVG Capital has written its equity in the deal down to zero, and the company has asked lenders to approve a covenant waiver. Bite Finance International, a mobile phone operator in Lithuania and Latvia, is another case in point. The company recently completed a buyback of a €110m tranche of subordinated FRNs at just 32% of face value, highlighting both the vakue destruction the downturn has wrought, and the attraction for some investors of finding an exit at almost any price

The equity-linked market in Europe began to slow in the summer of 2008, following a glut of issues in May. Issuance became increasingly patchy and exotic. A €573.4m LT2 convertible bond issue from Bank of Cyprus in July was the last fully-marketed bond of the year as conditions became increasingly challenging for issuance. Equity market volatility surged as the year went on, yet for a product that sees volatility as an asset, levels were too high. At the same time equity values were falling and most companies felt, at that point, their stock could still bounce back and so were unwilling to consider issuing bonds off a low base. Bulgarian conglomerate Chimimport took a different view, and produced the first convertible deal from CEEMEA in several years with a club deal in August. The company's willingness to invest time and profile in Bulgaria (it accounts for 1.7% of GDP) made it suitable to issue convertibles, and it found a handful of investors willing to buy. Chimimport is essentially a private equity company, yet unusually the firm had never issued straight debt. To make life even more interesting for the lead managers, no Bulgarian firm had ever issued a convertible. The convertibles issuance was therefore viewed by the firm as essentially equity at a premium. Through the convertible the company was able to, potentially, sell equity up 30%. It was so convinced the premium would be exceeded in the seven-year life of the bonds it was keen to include a premium redemption structure and back-end the cost of borrowing. Investors were not so keen, but the firm still managed to keep the coupon at 7% with the yield to maturity a punchier 9%. The major difference with other European convertibles was the marketing: a convertible is normally launched with the release of a termsheet early in the morning that heralds the start of bookbuilding. Hours later the book closes, bonds are priced and allocations completed. ArcelorMittal followed this timetable at the end of March 2009, even though the public market had been closed for eight months. This was clearly not an option for an issuer investors had not heard of. Therefore the structure and pricing of the bond was put together over a period of weeks. Investors were introduced to the company in a process that required the commitment of resources from the company, investors and the bookrunner. Getting interest also required the lead manager UniCredit to provide an asset swap, so investors could hedge the credit and access to some stock borrow. It is partly due to the commitment involved that corporate convertible bond issuance is expected to remain slight in CEEMEA. The deal sizes, such as €65m for Chimimport, will not give a sufficient reward for bulge bracket banks. The firm must also be able to deliver the stock underlying the bonds. Approval could be given to issue the shares, but they would not actually be issued until conversion, which opens up the possibility of approval being rescinded. In the case of Chimimport the major shareholder was willing to provide the stock, but without a major shareholder this would not be possible. Chimimport can also settle in cash. While the €65m Chimimport deal showed appetite for emerging market exposure if packaged appropriately (and providing something on the credit side was crucial here), secondary market performance has been a deterrent. "With a portfolio of BBB+ you can get a yield of 8.4%. With some spread tightening the total return could be pushed into double digit territory," said Alan van der Kamp, portfolio marketing manager for global convertible bonds at F&C in Amsterdam. "In the secondary market you are also effectively getting the equity option for free right now, so new investors are well positioned." Such high yields at low risk is helping to attract new investors to the convertible market, but not to the more speculative end of the market. As such a banker said the only way to attract interest (and even then it would be limited) in