Bulgaria celebrated its Independence Day last Thursday, and as Bulgarians used the bank holiday to head off to the same ski resorts where a couple of years ago many Brits sought real estate investment opportunities, we looked at how this and other Eastern European countries are faring amid the global economic recovery.
The entire Central and Eastern European region (CEE) was badly hit during the economic downturn as export markets dried up and individual economies had to contend with the double-edged sword of being heavily indebted in foreign currency while also experiencing local currency devaluation. However, several of the larger regional players have experienced upward market momentum since mid-2009 and Poland, for example, is now a frontrunner in regional as well as European economic growth.
Speed of recovery, however, is far from uniform across the Emerging Europe region. The latest Transition Report of the European Bank of Reconstruction and Development (EBRD) talks of a multi-speed recovery in Eastern Europe, with countries in South Eastern Europe at the low end of the speedometer. With weak fundamentals, illiquid bourses and few IPOs planned, countries such as Bulgaria, Serbia and Croatia also rank low on asset allocators’ preferred list.
According to Alexander Nikolov of Sofia-based Karoll Capital Management, the Balkan markets are next in line after Eastern Europe to benefit from an uplift in Western European and other leading global markets. Nikolov believes that deep equity market losses have resulted in attractive valuations which could prompt some investors to look towards the states in South Eastern Europe when assets elsewhere begin to look relatively expensive.
Economy
Erik Berglöf, Chief Economist and Special Adviser to the President of the EBRD, writes that while the EBRD region, which includes 29 states in Eastern Europe and Central Asia, is emerging from the crisis, “it is doing so more hesitantly than other emerging market regions, predominantly because its pre-crisis imbalances were larger and are taking longer to unwind.” Commodity-exporting countries such as Azerbaijan, Kazakhstan, Mongolia and Russia, have each seen solid growth, albeit significantly below the 2005-08 average, the EBRD 2010 Transition Report points out. In contrast, the recovery in South Eastern Europe is progressing slowly. For example, Romania’s economy actually contracted over 2010, versus Poland’s 3.3% expansion and Azerbaijan’s energy-fuelled growth of 9%.
A number of factors contribute to these diverging regional trends, the EBRD concludes. Economic frontrunners are countries that have the capacity to take advantage of demand for exports and prudent fiscal policy, whereas a pre-crisis legacy of a high degree of private sector leverage and weakly-capitalised banking systems has weighed on economies such as the Baltics.
Schroders economist Azad Zangana groups the CEE region into four tiers of economic growth. Poland is clearly the frontrunner, he says, followed by the Baltics, the so-called Visegrad countries included in which are Hungary and the Czech Republic, and finally South Eastern Europe. Various factors have contributed to the speed of recovery in these countries. Estonia, Latvia and Lithuania had very high levels of debt in foreign currency in the wake of the credit crisis and as foreign investments withdrew and their currencies became less attractive, servicing these obligations became an increasingly heavy financial burden. Currently, with Latvia being propped up by an IMF loan and the associated stringent fiscal policy requirements, and Estonia being the newest member to the euro-zone, the region is looking more stable, commented Zangana.
Countries in South Eastern Europe, such as Bulgaria and Romania, suffer from deeper structural problems which restricted their economic performance during the global recession and the region has only just begun to recover. Bulgaria has been struggling to find an attractive mix of exportable products that produces a sustainable stream of foreign capital, while Romania needs to push through fiscal and labour market reforms in order to increase the attractiveness of its business environment. Both countries are underdeveloped in terms of infrastructure, the EBRD report points out.
Mutual Funds and Equity Markets
Between 2008 and 2010, markets in South Eastern Europe lost value at an exceptionally fast rate. The main index on Sofia’s stock exchange for example, collapsed from its peak of 1,950 points in March 2007 to a trough of 260 points in February 2009, a fall of 87%. The performance of the comparatively larger and more liquid market of Romania has seen an 80% drop in its main index from peak to trough. Though each of these indices has now begun the long climb back up, they are still a long way from pre-crisis levels..
Low liquidity is one of the main reasons small Eastern European markets lost their appeal in the crisis, explained Alexander Nikolov, who manages the Karoll Advance Eastern Europe fund. As of January 31, 2011 he had allocated 37% of its EUR 5.2 million assets to Russia, 17% to the Ukraine, 11% to Romania, 10% to Croatia, 7% to Serbia and 2% to Bulgaria. The majority of the remaining assets are held in cash deposits.
Nikolov believes that interest in the smaller Eastern European markets will be restored when the developed markets’ recovery moves from the early stages to the full recovery phase of the economic cycle. He explained that assets tend to flow to the small Eastern European markets once the larger regional players have experienced significant gains and investors begin to seek opportunities elsewhere. This trend was observed prior to the latest recession and Nikolov expects it to now resume.
To the extent that 2011 looks set to be the third year in which headline global markets have seen growth, says Nikolov, this could be the time when asset flows return to the region. In the current year, Nikolov has relocated some of his assets under management from the larger to smaller Eastern European markets. He has also observed the signs of growing confidence from foreign institutional investors in countries such as Bulgaria and Serbia. This is a trend equity markets have picked up on, he says, pointing to double digit gains on local indices.
In his view, investor interest in the region is relatively irresponsive to bad economic news at the moment. Equity market losses were much deeper than the economic slowdown in these regions, he pointed out. Thus, given how much markets have fallen already, Nikolov believes that mild disruptions to the global economic recovery are unlikely to have a significant impact on local markets. By the same logic, the low levels of regional liquidity mean that fluctuations in global economic growth have a limited impact on local markets, Nikolov said.
Exceptionally low valuations are key potential drivers of investor interest in the region, Nikolov says. He points out that the Balkan markets are still significantly below their peak as well as being behind in terms of regaining market momentum compared to other regional players. The Balkan markets need to gain over 100% to catch up with neighbouring markets such as Romania, Poland or the Ukraine, which have enjoyed stronger equity markets since mid-2009.
Real Estate Investment in the Region
Prior to the financial crisis, many perceived Eastern Europe, Bulgaria in particular, as offering interesting investment opportunities, primarily in the form of real estate. But when the sub-prime contagion started in mid-2007, property prices collapsed and those who had invested indirectly in property there, such as via real estate investment trusts (REITs), got their fingers severely burned.
The closed-end funds sector, including REITs, provides a particularly clear picture of the lack of demand and liquidity in what was once considered one of their region’s most attractive asset classes. Morningstar Director of CEF Research Jackie Beard explains that when Bulgarian property tumbled, prices and net asset values of the related closed-end funds headed directly south, as over-valued properties were marked down. Discounts have yet to recover, however, and even at such wide discounts Beard doesn’t think there’s much to attract investors into Bulgarian property funds right now. Looking further afield, at closed-end fund performance in the broader Emerging Europe region, the majority of the sector is still trading at substantial discounts to NAVs and this is particularly true of country-specific property-focussed CEFs in Eastern Europe ex-Russia.
On a Final Note
Words such as risk and reward, or crisis and opportunity, are often used in conjunction with Emerging Europe to explain the combination of potential gains and need for reform that is typical throughout region. For many Eastern EU member states the global recession illustrated the need for prudent politics and structural changes. So far this year, professional investors in the region believe a more favourable balance between risk and reward is slowly being restored and, in some cases, could be starting to look particularly attractive. The smaller Eastern European states, however, are still in the early stages of economic recovery and the limited liquidity on these markets can restrict the opportunities on offer.
