Emerging Europe - knowingly oversold

By bne IntelliNews March 10, 2009

Nicholas Watson in Prague -

It might be thought of as the start of the fight back by emerging Europe, but the complaint from several eastern EU states on March 4 that investors are misreading data and tarring all countries with the same brush is one that's been voiced by a growing number of analysts. Basically, investors have been guilty of indiscriminate selling.

The joint statement from the central banks of Bulgaria, the Czech Republic, Romania and Slovakia, as well as the financial supervisory authorities of Hungary and Poland claimed that information about risks in Central and Eastern Europe "is often simplified and misleading and could have negative implications for banks operating in these countries."

The information these authorities are specifically referring to include the brouhaha over data out of the Bank of International Settlements (BIS) in February. A headline figure - highlighted by many analysts and media organisations, bne included - showed that emerging Europe had accumulated total external liabilities to BIS banks of $1.7 trillion as of September, of which $1.5 trillion is owed to European banks. This is equivalent to about 40% of emerging Europe's GDP in 2008.

However, the relevance of this figure and the way it was used has been disputed by many economists, including Erik Berglof, chief economist of the European Bank for Reconstruction and Development (EBRD), who described in a letter to the Financial Times that the figure of $1.5 trillion is "badly misleading." This is because it represents the total balance sheet exposure and doesn't take into account the liabilities side, for example where local lending is largely funded via local currency deposits. A much better measure of refinancing needs, Berglof argues, is short-term external debt owed by the region's banking sectors to foreign creditors. Excluding Russia and Kazakhstan, which can draw on big reserves generated from all the oil and gas they've sold, the number shrinks to about $130bn. Of this, more than half is debt owed by subsidiaries to parent banks. In this light, the package of bank support put together by the World Bank and other multilateral lenders at the end of February of about $24.5bn looks more substantial than when compared with the figure of $1.5 trillion.

The Czechs were already active in trying to highlight these discrepancies over information. On February 24, the Czech National bank issued a statement disputing data in an FT article that purportedly showed foreign bank loans to the Czech Republic totalling $192bn when the country's debt vis-à-vis foreign banks was actually only $38bn. "Most of the data circulating should be correct, but is misinterpreted or taken out of context. The fact that the Czech National Bank had to publish a statement officially clarifying and correcting interpretations on numbers published in press articles speaks volumes," Erste Bank wrote in a report.

Perhaps unsurprising given the current mood in the region, some CEE authorities have even been heard muttering darkly about a conspiracy by some British journalists to damage the region using false data and thus undermine the despised Eurozone, vindicating the UK's decision to stay out of the single currency.

Whatever the truth in the allegations that the data is being used and reporting is biased, many economists still insist the region saved too little, borrowed too much externally, and the subsequent capital inflows have been used to maintain over-appreciated exchange rates and to run excessively wide current account deficits. "This process is now going into reverse, an adjustment not helped by the parallel collapse in trade, via the de-globalisation process," says Timothy Ash, head of emerging market research at Royal Bank of Scotland. "It is difficult to describe the region as fundamentally sound when it is experiencing double-digit declines in industrial output and exports."

As such, few doubt the CEE region will face a significant slowdown of capital inflow in the coming years, which will in turn put considerable pressure on countries with high and debt-fueled current account deficits, high levels of short-term external debt and pegged currencies like those in the Baltics and Bulgaria.

Lumped together

Where the CEE authorities are on safer ground is when they complain about investors seeing the region as one whole instead of different countries with differing characteristics. "Each of the CEE member states has its own specific economic and financial situation, and these countries do not constitute a homogenous region," the statement from the six countries said. "It is thus important first to distinguish between the EU member states and the non-EU countries, and also to clarify issues specific to particular countries or particular banking groups."

It's easy to see what has happened here. The CEE states share a common history: communism. However, the 19 years since the collapse of the Soviet Union have been very different for the region's various countries, making terms like "emerging Europe" and "Central and Eastern Europe" as much a hindrance as a help when talking about the region.

"The main reason is that many research products refer to the region as 'emerging Europe' or 'CEE' - but the macro picture of the countries differs so much that this is really something that has allowed the pessimistic sentiment of the market to be too far exaggerated," says Rainer Singer, co-head of macro/fixed income research at Erste Bank. "In the region, countries range from Czech Republic to Ukraine, which are completely different stories."

Indeed they are (see table below). Few would argue seriously that Ukraine with its political paralysis and plunging economic growth resembles Poland, which has relatively sound public finances and is still growing, albeit at a much slower rate than last year (Polish GDP growth slowed to 2.9% on year in the fourth quarter, after growing 4.8% on year in the third). "The Czech economy has almost nothing in common with the Baltic economies or Bulgaria (except for being an EU member), nor the Slovak economy with Turkey, Albania or Moldova, nor Croatia with Russia. Geographically and trade-wise, Berlin is closer to Prague than Kyiv or Moscow," says Singer.

Yet this clearly hasn't sunk in with investors, which analysts say opens up opportunities for those brave enough to trust their instincts.

In the first week of March, five-year credit default swap prices (CDS) bought to insure against the default or restructuring of Czech euro-denominated debt had jumped to around 300 basis points (bps) from 170 bps at the start of 2009, meaning it would cost $300,000 a year to cover $10m of Czech five-year debt against default.

Likewise, Austria, with its large banking exposure to the region through the international operations of Raiffeisen Group and Erste Bank, now finds itself with a higher default risk than Italy, Portugal and Spain when its CDS rose to 253 bps on March 3, compared with 17.5 bps a year ago.

Then there's Hungary. This is undoubtedly the most seriously affected country in Central Europe, but with an agreement with the International Monetary Fund (IMF) already in the bag and most of its short-term external debt covered for the next 12 months, many analysts wonder why its CDS are trading at 590 bps.

"If I take the numbers and apply halfway rational behaviour, I don't see these risks being properly priced. You have to take on a country-by-country basis - this is not what the market is doing and it's overpricing the risk by far," says Singer.

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