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A period of above-potential growth lies behind most Central and East European countries, however the pace of growth in the region's banking sectors will slow slightly as a result of indirect effects from the sub-prime crisis, a new report from Erste Bank says.

Having analysed the region's banks, Erste Bank's "top picks" for CEE are Raiffeisen International, because of its ongoing growth story, and the value play OTP, which, it says, provide the strongest upside potential based on current share prices.

The CEE banking sector has lost much of its performance and valuation premiums in the last couple of months, due to the negative sentiment in the global banking sector, the report says. The share price of banks is still sentiment-driven, due to the US sub-prime crisis and its direct and indirect effects on the global economy and banking sector.

The good news, the report says, is that banks in the CEE region are not involved in sub-prime or sub-prime related investments and therefore had no need to write-off their assets. However, the focus since the first quarter of this year has shifted from direct effects such as asset write-offs and capital needs to the indirect effects of slowing economic growth and increasing funding costs, both of which are on the agenda for CEE banks.

Slow down

This means a moderate slowdown in the region's economies is now expected. First and foremost, growth needs to come down, Erste's report says, as the pace of recent years was unsustainable, which would lead in the medium term to overheating economies. The second factor is that important export markets (particularly the EU) are also set to slow, as the financial crisis and the slowdown in the US are felt, though a strong impact on the Euroland economy is not anticipated.

On the funding side, the crisis has squeezed liquidity. The 3M Euribor, for example, increased by 125bp to 4.97%, from 3.725% at the beginning of 2007. Funding ability and funding quality have therefore become an issue in the last couple of months, in order to secure asset growth at a reasonable price.

Deposit growth in general has been slower than loan growth in the region. "While the deposits are already at a relatively high level in countries like the Czech Republic and Croatia, in the emerging banking markets a lot of money is still stored in piggy banks," says one of the report's authors, Gernot Jany, a banking sector equity analyst at Erste Bank.

"We expect the commercial banks to continue to replace piggy banks as confidence in the banking market rises. The entrance of foreign players usually has a very positive effect on confidence in the banking market, which can already be seen in Ukraine, Bulgaria and Bosnia & Herzegovina," Jany says.

However, the slow growth of deposits has in some countries lifted loan/deposit ratios above the 100% barrier. Erste's research finds that the most stretched banking systems are in Russia, with a 161% loan/deposit ratio and Ukraine (150%), followed by Slovenia (141%), Hungary (132%) and Romania (122%).

In Russia in particular, the smaller and mid-sized banks are currently running into trouble funding their strong asset growth, Erste Bank's report says. Players with good regional branch networks could therefore become increasingly interesting for bigger players, which need to grow their retail networks in this heavily under-banked country.

Loan growth

The strongest loan growth in 2007 was seen in the new EU members, Bulgaria and Romania, and the CIS region, Ukraine and Russia, at more than 50% on year. The main driver in the CEE region was again retail loans, growing by more than 50% in Ukraine, Romania, Russia, Bulgaria and Serbia. Corporate loan growth was very strong in Bulgaria (+77% on year) and Ukraine (+62% on year).

"In many CEE countries, the low penetration of loans provides a basis for strong lending growth rates in the coming years," says Günter Hohberger, banking sector equity analyst at Erste Bank and co-author of the report. "The main drivers for the loan growth in most of the countries are mortgage and consumer loans - a consequence of decreasing unemployment rates, rising GDP per capita and subsequently growing demand for consumer goods and housing."

With the higher interest rate levels in most CEE countries compared to the Eurozone, demand for FX loans has risen heavily in recent years. In 2007, the strongest FX loan growth was seen in Bulgaria (+86% on year), Romania (+84% on year) and Ukraine (+75% on year), resulting in FX exposure of more than 50%. The strongly FX-exposed countries face higher default risk than markets relying on local currency loans in the case of a depreciating local currency, which increases credit instalments.

By contrast, Hohberger points out, "the Czech Republic (low interest rate level), Slovenia (euro implemented as of January 1, 2007), Croatia and Serbia can be seen as safe havens in terms of FX exposure."

This slowdown is not yet reflected in the CEE banking sector data available for the first quarter of this year. Key markets like Poland, Romania and Ukraine have not yet lost their strong pace set in 2007. In Romania and Ukraine, the loan growth from January to March 2008 even accelerated to 66% on year and 76% on year, respectively.

"The new EU members Bulgaria and Romania, as well as Ukraine and Russia, will offer the highest growth rates in the coming years, converging to mature market levels. Overall, we expect all CEE countries to use the catch-up potential they have, resulting in above-average growth rates for more than ten years," says Jany.

Erste has used its 'dividend discount model', a peer group valuation and regression analysis to identify the banks in CEE best placed to grow over the coming years.

In addition to Raiffeisen International and OTP, which Erste considers to have the strongest upside potential, the bank has also identified Romania's highly profitable BRD GSG, Romanian growth play Banca Transilvania, PKO BP - the "Polish big play with a strong bottom line growth," the Czech Republic's Komercni banka, which provides comfortable funding quality, and AIK Banka, the Serbian high growth and profitability play.

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