Bonds to the fore

By bne IntelliNews March 25, 2009

Ben Aris in Berlin -

There is something wrong with the bond market. The yields on Eastern Europe's debt - both corporate and sovereign - seem to bear little relation to reality. Take, for example, the fact that on the day Iceland defaulted on its debt last year, spreads on the Russia 30 sovereign Eurobonds were higher than those of Iceland - and this was despite Russia being the least-leveraged economy in the world.

The value of Russian assets has always been subject to sentiment, but the current crisis has driven these emotions to extremes. Local analysts are salivating at the opportunities on most bonds, which they say have equity-like upsides at the moment. But they are also clearly frustrated as investors remain blinded by fear.

Markets are supposed to be efficient and would be if robots operated them. However, this crisis has highlighted the very human nature of trading and the huge gap between realities on the ground and reports about what is going on.

A slew of articles in the last month have been warning of an imminent collapse in Central and Eastern Europe (CEE), but these pieces made some very basic mistakes. Most focused on the alarming news that CEE had borrowed over $1.7 trillion from foreign banks and must roll over about $400bn this year alone. In recent weeks, the more informed banks working in the region have rushed out notes pointing out that reporters and analysts citing this trillion-dollar number have badly blundered.

"The figure of $1.7 trillion taken from the consolidated datasets does not refer to borrowed money from abroad, because it also includes loans provided (and funded) by local subsidiaries of foreign banks on local markets. Given the high share of foreign ownership of banks in CEE, this represents a significant proportion of the above-mentioned figure," Erste Bank said in a report in March.

Counting domestic loans in with foreign borrowing just because the bank making the loans is foreign-owned makes a huge difference. For example, the Czech Republic borrowed a total of $191bn as of the end of the third quarter last year, according to the Bank of International Settlements (BIS) data - well over double the country's total external debt of $88bn. This nonsensical result comes from the fact the bulk of Czech banks are owned by foreigners and the consolidated number of $191bn includes all loans made by their local subsidiaries. If you strip out these loans, the actual amount borrowed abroad was closer to $55bn. And if you add the $26.3bn these banks lent to foreign banks in the same period, then the net debt falls even further to $29bn - one seventh of the original sum.

The market has got hold of the wrong end of the stick and this is reflected in the spreads. Far from being on the edge of a disaster, when you look a little more closely, many of the countries in the region actually look in better shape than their western peers.

Russia is probably in the strongest position. The state's external debt is on the order of 6% of GDP while total external debt is about 40% of GDP, of which a third matures this year. Compare this to Germany or the UK where external debt is well over 200% of GDP - far in excess of the Maastricht recommended levels of 60% of GDP.

Likewise, consumer debt in Russia is a mere 9% of GDP, rising to about 25% in the recent EU accession countries in Central Europe. However, in the EU15 countries consumer debt stands at around 50% of GDP, exposing the highly leveraged populations to the impact of the credit crunch. "The low level of indebtedness is key, as it increases the likelihood of the debt to be serviced. With loans having a low portion of GDP, monthly fixed payments also have a relatively low proportion of household budgets. This makes CEE households more flexible in adjusting to the economic slowdown than countries where fixed costs make up a high portion of household budgets," says Erste.

Fresh money

This is not to say that CEE has remained unhurt by the global meltdown. Much of the fast growth was fuelled by the cheap credit of recent years. Russia took advantage of the low interest rates to siphon off all its oil windfall into a stabalisation fund, leaving banks and companies to borrow what they needed to grow on the international capital markets. Elsewhere, in the Baltics the governments could happily run double-digit current account deficits without any problems by borrowing abroad.

In 2007, CEE borrowed a total of $210bn abroad, according to the BIS. The first shocks to hit the region in the form of the sub-prime debacle in the US followed by a global spike in inflation, caused many governments to start pulling in their horns and foreign borrowing halved in the first three quarters of 2008. But many countries were still at the cheap credit trough when things went really haywire in September, which is why countries like Hungary and Latvia are in so much trouble now. The heavy borrowers will have to go cold turkey on their borrowing habit, while more prudent borrowers like Russia and the Czech Republic will just have to make painfully rapid changes to the way they fund their growth.

"In the Baltic countries and Bulgaria, net external borrowing from BIS banks increased by 10-20% of GDP in 2007, allowing these economies to run debt-fuelled, double-digit current account deficits. Given the slowdown of capital inflows, we should see a significant improvement of current account deficits over this year and the next. That is what is happening right now," says Erste.

How much is needed

So how much money does CEE actually need to raise if a financial meltdown is to be avoided? Although the debt is less than was first reported, clearly there is a lot less money about to service what debt there is.

All the countries are facing a series of challenges. First and foremost, they have to slash borrowing, which means making budget cuts. Secondly, they have to tap reserves to pay down as much debt as they can. Finally, what is left has to be refinanced or rolled over.

Ironically, western countries are going to find this process even harder than their CEE peers, largely because they are proposing to massively increase their borrowing to finance bailout packages, or simply resort to "quantitative easing" - a euphemism for turning on the printing presses, which smacks of desperation; no one in CEE is talking about printing more money to pay off debt. "So far, CEE governments have been keeping tight fiscal discipline. In the current circumstances, financing will remain tight. But again, the overall low level of indebtedness reduces the risks. So under normal circumstances, governments would have sufficient latitude on their debt side," says Oliver Weeks from Morgan Stanley.

Once you dig into the issues, things on the ground don't look as bad as they first appear in most CEE countries and this fact is filtering through to lenders. The total foreign debt of Bulgaria, Romania, the Baltics and Ukraine (excluding Russia and Turkey, which will be able to meet their debt with internal and IMF money) is on the order of €605bn, says Morgan Stanley. Of this amount, around €208bn is bank sector borrowing, of which around €182bn is due in a year.

However, Morgan Stanley reports that since the crisis hit, about half of the maturing debt has been rolled over and the bank believes this rate will rise. "Current account deficits have already contracted sharply so estimates of total balance of payments funding gaps that rely on historical current account data also look too high to us. Assuming rollover rates from 60% in Latvia and Ukraine to 80% in Estonia and Lithuania, we project a total funding gap of around €90bn. At a pessimistic rollover rate of 50% across the region (unlikely as some private sector debt will also be rescheduled), the gap rises to €140bn," says Morgan Stanley's Weeks.

€140bn is still a lot of money to find. The only money that has been put on the table to meet these debts so far is the World Bank, EBRD and EIB Group promises of about $24.5bn, which wouldn't even cover a quarter of Morgan Stanley's optimistic scenario.

Calls for the EU to ante up and come to CEE's rescue have been gaining in volume - even from within the EU itself - but so far have fallen on deaf ears, as most countries have enough to contend with at home. Crucially, Germany is Europe's financial backer, but as Chancellor Angela Merkel is facing a general election this autumn, she is clearly nervous about using German taxpayer money to pay off other people's debts.

Still, some EU money is in the offing. At the EU summit on March 1, the collective leadership rejected a Hungarian proposal for a €180bn package - which bankers say is on the high side of what is needed - to recapitalize the CEE banking system, and decided on an ad hoc approach instead. Countries like Poland, the Baltics and Georgia already have de facto stimulus packages in the form of EU infrastructure grants or war reconstruction loans.

The better-off EU countries like the Czech Republic and Poland also objected to pan-regional aid, as it would implicitly lump them together with riskier countries in the EU. There is another G20 meeting in London in April where more progress may be made on a rescue package for the weaker CEE countries.

While a grand plan is now unlikely, analysts say that a fire-fighting approach of help when and where it is needed is looking much more likely. This would be easier to sell politically and could be more effective, as it encourages investors to look at each country on its own merits.

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