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The FT recently concluded that emerging Europe “shares some characteristics with other emerging markets in Latin America and Asia, such as a cheaper workforce, but also some of the more negative aspects of developed Europe, including high levels of social spending and relatively low savings rates.” So does something have to give, or can the best of these economies have it both ways? As it stands presently, the piece noted, central Europe came out of the [credit] crisis divided into three parts–a central core consisting of members of the Visegrad regional grouping of Poland, the Czech Republic and Slovakia, “with fairly strong public finances, strong banking sectors and decent growth prospects,” the Baltics to the north which face prolonged pain and the Balkans to the south including Hungary, where two-thirds of household debt is mainly in Swiss francs (oy vey!) and draconian regulatory headwinds on domestic banks will likely stifle output and consumption for some time, per Political Capital, a Budapest-based think tank.
Poland and Slovakia are both attractive ways to play emerging Europe, though admittedly their performance is strongly correlated with Germany as the two have become somewhat integral members to that country’s export-focused supply chain. Poland’s deficit (7.9% of GDP) and rising public debt (55%) are troubling high and in addition to already pushing back the country’s initial 2012 euro adoption target, may ultimately require spending cuts, analysts warn. That said, part of the decifit hike has been a function of a pension system overhaul over the past decade whereby the country has shifted employee pension contributions to private funds from the state-run system in order to curb the rise of obligations as the country’s demographic pyramid deteriorates and also to meet the EU’s deficit and debt criteria. To this end, by 2020 Hungary is projected to have the highest old-age dependency ratio among emerging market economies of 30.1%, up from 24.0% in 2010, while other countries with an old-age dependency ratio over 20.0% in 2020 will include Poland, Romania, Russia and Ukraine. Yet against the backdrop of continued largesse (€67bn from Brussels between 2007-2013 have turned Poland into “the EU’s largest construction site”), increased geopolitical clout and a politically and economically pragmatic approach to Russia in regards to energy and trade, Poland may be in the perfect position to adroitly navigate away from the negative and towards the positive aspects of emerging Europe.
Against the backdrop of soaring CDS spreads for the likes of Greece, Portugal and Spain, certain central European countries–namely Poland and the Czech Republic–continue to garner increased attention from investors looking to flee risk but still earn appreciable yield. As Dominik Radziwill, Poland’s deputy finance minister, who helped place a €3bn 15-year bond issue last month, told the FT on Friday, “we are a safe haven. We have become an alternative for investors who are looking at the periphery of Europe. We can see an increase in interest on the part of foreign investors in Polish debt.”
Some observers tout the virtues of Polish debt both in the short and long term. According to Baron Chan, an emerging-market strategist with Credit Suisse Group AG in London, in regards to the government’s vow to limit spending growth and speed up asset sales in order to bring the budget deficit in line with euro-adoption standards, “the idea of acceleration in fiscal consolidation will be good for the risk profile of Poland and should support the zloty.” Credit Suisse, for one, anticipates the euro/zloty, now at 4.11, to trade around 3.75 by year end. Meanwhile, Investec Asset Management touts the long end of Poland’s yield curve, noting thje country’s “good fundamentals and flows supporting bonds.” In particular, some analysts forecast the 10-year Polish bond yield to fall around 30 basis points in the first half of 2010 from 6.1%.
As for the PIGS label, it seems Ireland has replaced Italy, for those keeping tabs on the acronym.
Traders patiently watching the zloty’s climb against the dollar in 2009 have fairly good evidence of an imminent reverse trend. A glance at the five-year chart shows that USD/PLN has now twice bounced off some fairly important support levels. Furthermore, intuitively the breakdown makes sense. Per a Bloomberg report today, Ulrich Leuchtmann, head of foreign- exchange research at Commerzbank in Frankfurt, opined that currencies in eastern Europe were starting to come under pressure. “It’s a natural correction from the very upbeat sentiment that we saw recently. From a fundamental point of view such a quick recovery didn’t make much sense,” he said. Thanks to JB3 over at Xtrends, by the way, for pointing out this setup.
According to the Financial Times on Thursday, “Poland will remain among the EU’ s top performers because of actions “undertaken by successive governments and the clear commitment to financial discipline”. That said, rising unemployment and declining credit will hamper consumer demand, whose resilience hitherto has help to allow Poland’s GDP growth to easily outshine the EU average in 2009. The bigger question is whether Poland can make it to Euro entry–falling tax revenues are accelerated by plummeting credit growth, a spiral which may require public debt to ultimately expand beyond that which Brussels deems kosher.
In the meantime, Standard Chartered, a bank, recommends buying the zloty and selling the euro. Poland’s currency has fallen 28% since last July’s highs–the world’s worst performing emerging market currency–despite being the only country in the region to report expansion in that time. Complicating such a trade, however, would be possible contagion from Latvia’s impending devaluation of the lat.
Interesting piece in this week’s Economist regarding the lack of correlation among central and Eastern European economies during the credit crunch:
Tarring all with the mistakes of overheated Latvia, chaotic Ukraine or debt-sodden Hungary makes no sense. Nor does lumping together rich and poor countries, or those in the European Union and those outside. Exchange-rate regimes vary: two countries are in the euro; five countries have pegged their currencies to it; others float.
So far at least, speculators who counted on contagion toppling countries like dominoes have little to show for it, while those who bet the other way have juicy gains. Poland’s stockmarket is up by nearly 40% since its low in February, Hungary’s has risen by half and Russia’s by nearly 90%.
Poland received a $21b credit line from the IMF this month and is widely considered the region’s most resilient, partially due perhaps to the fact that domestic demand makes a relatively larger contribution to the economy. Polish firms make up a sizable chunk of certain frontier ETFs.
That said, one looming in the Polish economy (and most likely other central and eastern Europe nations) is the lack of commercial credit being extended by banks, which are 80% foreign-owned and have a 67% market share. Consequently, industrial and commercial companies find themselves delaying their payments to supplies (causing a cash-flow conundrum), while drawing down their deposits in order to fund operations, meaning banks are under continuous pressure to strengthen their capital bases while their owners are less than anxious to pour more money in.
One commentator today noted that “in many ways, what’s happening now across Eastern Europe – including Russia – is reminiscent of the Asian economic depression that began in Thailand in July 1997.” Foreign currency loans taken out during the boom years through 2007, when economic growth averaged more than 5% (“mainly from Austria and other EU members that included leveraged mortgage loans tied to low interest rate currencies like the Swiss franc”), coupled with precipitously falling local currencies and low currency reserves, has spelled disaster for even Eastern and Central Europe’s largest economies, which serve as core manufacturing hubs for Western Europe, as well as for Balkan states and the Baltic Republics. The IMF, which has already bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, warned last month that bank losses may widen as “shocks are transmitted between mature and emerging market banking systems.”
One reason to bet against a complete and utter collapse of the East, however, is the fact that the de facto foundation for the EU–Germany and, to a lesser extent, France–have quite a vested interest in its survival and long-term health. Over 25% of Germany’s exports head to Eastern Europe, and particularly in regards to those countries that are already part of the single currency euro-zone–continued solvency is a must for the Euro’s continued viability and also for its members relatively low financing costs.
Moreover, some commentators say the fear of collapse is overstated. Concerns that east European borrowers will default on foreign-currency loans, triggering bankruptcies among western lenders that have caused a sell-off of emerging- market assets are “overdone,” said a UBS report published on Tuesday. Per the report:
More than half the outstanding short-term external debt is owed by larger countries such as Russia, Poland and Turkey, which are less impaired due to a lower rate of leverage in the economy and better growth prospects. [However], smaller economies such as Lebanon, Latvia, Estonia and Bulgaria face the highest repayments in the coming 12 months, each at more than 40% of their GDP.
Standard & Poor’s, while admitting that the effects will differ country-by-country, warned of especially dire consequences for the Baltic’s Latvia, Estonia and Lithuania, as well as Bulgaria, Hungary and Romania. S&P contrasted their positions with that of the Czech Republic, Poland and Slovakia, for instance, which it argued are better placed to emerge “stronger and more competitive” from the crisis.
With this in mind, punters interested in the Polish or Czech debt market, or even its default swaps, may be rewarded. The cost of protecting payment on Poland’s debt has risen more than six times in the past six months, credit-default swaps show, which is roughly the same as on contracts linked to Serbia, which is rated three levels below investment grade at BB- by S&P. And both Polish and Czech government debt, among the highest rated in emerging markets, has already been downgraded by bondholders.
Bloomberg reports that “some euro-region members now pay more to borrow than emerging markets such as Poland and the Czech Republic. The spread between a Czech 10-year sovereign note and the German bund was 78 basis points, less than Italy, Spain, Greece, Portugal, Belgium and Ireland.” The Czech Republic is rated A at S&P, and Poland A-.
Prices now reflect odds of between 10 percent and 20 percent that the euro-region will disintegrate following a series of credit downgrades from Standard & Poor’s this month, according to BlackRock. The difference in yields, or spreads, between [Greece, Spain and Italy’s] 10-year bonds and those of benchmark German securities was close to the widest today since the euro’s debut in 1999.
JGW
Frontier Markets 