Cover Story : Living On The Edge

Prague’s stock exchange is one of many in the region that are attracting foreign investors.

Despite recent political maneuverings by Russian president Vladimir Putin, which have led some to speculate that a return to Cold War politics in Europe may be at hand, the prospect of EU enlargement has drastically altered the political and economic landscape in Central and Eastern Europe (CEE).

Even when former Soviet leader Mikhail Gorbachev announced his perestroika reforms back in June 1985, which introduced private ownership of formerly state-owned enterprises and permitted foreign investment, few could have anticipated the far-reaching impact it would have. Gorbachev’s structural reforms planted the seeds that ultimately lead to the dissolution of the Soviet Union in 1991.

No longer able to rely on financial support from the Soviet state machinery, a number of former Soviet republics embraced their newfound nationalism and freedoms to implement economic, political and social reforms that were more in line with capitalist and democratic principles. Renewed political and economic zeal lead to the election of leaders such as Lech Walesa to the Polish presidency in 1990, which inspired a new generation of reformists including the Czech Republic’s Vaclav Havel, Estonia’s Mart Laar and Slovakia’s Mikulas Dzurinda, who embraced the principles of a free market economy and flat taxes in an effort to boost their fledgling economies and attract investment.

Joining NATO in the early 1990s symbolized these countries’ pursuit of democratic and free market principles, and a decade later they entered the ultimate club, the European Union, which admitted the Czech Republic, Hungary, Poland, Slovakia, Slovenia and the Baltic countries (Latvia, Lithuania and Estonia) as members on May 1, 2004, in its largest-ever intake.

Although the accession countries contributed no more than 5% to total EU GDP, EU entry symbolized new opportunities for them in terms of increased foreign investment, more liquid capital markets and higher disposable incomes. “EU accession contributed significantly to balanced economic development, high growth and reduced inflation,” observes Rainer Singer, research analyst with Erste Bank. “It [EU membership] also triggered FDI inflows, which improved the macro picture of these countries and some of the legal frameworks that were implemented.” This was a much different scenario from that of the early 1990s, he says, where despite early economic reforms preceding the fall of the Iron Curtain, growth rates were unbalanced, inflation and foreign trade deficits were higher, and domestic production could not keep pace with demand.

Budapest’s stock exchange is seeing less action as Hungarys privatization program winds down.

Debora Revoltella, CEE chief economist at UniCredit Group, underscores the importance of EU convergence as a trigger for improving legal and judicial processes within CEE, which helped countries such as Poland and Slovakia establish themselves as low-cost production centers in the high-tech and automotive sectors. Large-scale privatizations such as the issuing of shares in Poland’s second-largest bank, PKO Bank Polski, and national telecom company Telekomunikacja Polska proved too alluring for foreign investors to ignore. Of the record amount of net FDI Poland attracted in 2000 ($9.3 billion), $4 billion was accounted for by income from sales of Telekomunikacja Polska. By the end of 2002, Poland led Central Europe, attracting more than $65 million in FDI.

Today, Central European countries continue to enjoy high levels of FDI. “There is quite a high level of FDI going into the Czech Republic and Slovakia, particularly greenfield investment in the expanding telecom and banking sectors,” says Gintaras Shilzhyus, a CEE analyst with RZB. Most of the indigenous banks now within Central Europe and the Baltic countries are foreign controlled. “International banks will continue to play a significant role in CEE, targeting the region as a market for growth,” says Federico Ghizzoni, UniCredit Group’s head of Poland’s market division.

Yet investors recognize that there are not as many privatization opportunities in the core CEE countries (Czech Republic, Poland, Hungary and Slovenia) as their used to be, says Shilzhyus, which means the focus is now shifting toward Slovakia and Eastern European countries. New investment flows are also increasingly going to countries such as Bulgaria and Romania, which joined the EU in January this year and introduced tax incentives to stimulate foreign investment.

Increased consumption and investment is spurring economic growth across CEE. “Standards of living are increasing, and these countries have access to credit markets,” notes Revoltella. Erste Bank predicts GDP will grow by 6.3% in real terms in Poland this year and by 5.6% in the Czech Republic. For new EU entrants such as Romania and Bulgaria, UniCredit predicts GDP will grow by 5.5% and 6.2% in real terms next year. “The growth outlook for these countries is still higher than EU major markets and will remain at that level for several years,” notes Singer of Erste Bank, adding that growth rates in the more established CEE markets have definitely come down. “But they are still at a relatively high level,” which Singer expects will continue, given that these countries enjoy high competitiveness cost advantages.

New Entrants Face Old Problems
But the transition from a communist to a market economy is not always a road paved with gold, as the early 1990s demonstrated when a number of countries had to battle high inflation and trade deficits. Some of these problems (rising inflation and high current-account deficits) are returning to the region, albeit at much lower levels than in the 1990s. Country-specific concerns have lead some media commentators to suggest CEE is “ill-prepared if the weather turns nasty.” They are specifically referring to the situation in countries such as Latvia, where the current-account deficit remains stubbornly high at 21% of GDP, reflecting the high levels of domestic consumption and debt financed by foreign-owned banks.

“There are questions about the sustainability of these higher deficits,” says Shilzhyus. “Economic growth in some of these countries has to cool down. It is the central bank’s job to put the brakes on.” Romania saw its current-account deficit widen by 104% year-on-year (yoy) in the first five months of this year. “The current account is contributed to by a rapidly growing investment economy and consumption,” Singer explains. “They need more flexible exchange rate and interest rate policies, which is not happening yet.”

Revoltella of UniCredit says high current-account deficits are not unusual in transition economies that attract high levels of foreign investment. “When consumption and investment remain high, current-account deficits widen,” she says, adding that the story is good insofar as these deficits are largely financed by FDI. “It could, however, generate problems if there is a reverse of positive attitudes toward these countries,” she notes.

Has Complacency Set In?
Booming economies and domestic consumption mean inflation is also on the rise in CEE. In Hungary June inflation increased to 8.6% yoy due to hikes in the price of consumer goods. UniCredit analysts highlighted a “more disturbing sign” in terms of higher yoy core inflation, which increased from 5.7% in May to 5.9% in June.

Warsaw’s stock exchange: Providing a focus for investors in Poland.

In Estonia inflation accelerated to 5.8% yoy in June, says UniCredit, based on increased food, housing and health service costs. “There are still no clear signs of the economy cooling down,“ UniCredit analysts wrote in their July 18 CEE Biweekly. Ratings agency Standard & Poor’s, also concerned by the “overheating,” changed the outlook on Estonia’s sovereign rating from stable to negative.

Inflationary pressures are also being felt in Latvia, where consumer price inflation (CPI) increased to 8.8% yoy in June, which UniCredit attributed to unexpected hikes in food prices. And although productivity gains have offset wage increases, inflation is also on an upward trajectory in Poland. “In Poland and the Czech Republic, interest rates need to increase to keep inflation in check,” says Singer of Erste Bank, adding that interest rates in the Czech Republic are still lower than they are at the EU level.

In the eyes of some market observers there is a sense that CEE governments have become more complacent about fiscal tightening and that the process of structural reform has ground to a halt. “Being complacent on the fiscal side is tempting for any government be it a mature or emerging economy,” says Singer, adding that structural reforms in CEE are not so much of an issue now, as economies are growing strongly. The OECD’s 2007 Economic Outlook points to the slow pace of reforms in the Czech Republic, where more progress could be made in terms of reducing the deficit as well as pensions and healthcare reforms. Since joining the EU earlier this year, Romania and Bulgaria have also failed to impress with their slow pace of judicial reforms and efforts in combating corruption. “Concerns remain about the level of corruption in the judicial system,“ says Shilzhyus. “In terms of implementation, this has suffered a setback.”

Poland faces yet another potential break-up of its ruling coalition after prime minister Jaroslaw Kaczynski dismissed his deputy, Andrzej Lepper, following corruption allegations. So far, foreign investor sentiment has not been swayed by the uncertain political climate in Poland, but even if early polls are called and elections result in a change of leadership, Revoltella says this would not have a negative impact on investors’ perceptions, as the current ruling coalition has been slow in implementing structural reforms needed to ensure Poland’s entry into the European Economic and Monetary Union, which is not anticipated before 2012. Revoltella says given the current generation of more “conservative” political leaders in CEE, there are less reforms in the region than there were a few years ago. “However, structural reforms have not completely stopped,” she adds. “There are still reforms going on; some of them have just been delayed.”