INVESTORS IN EU CANDIDATES MUST WEIGH GREATER RISKS*

Views on BG | February 4, 2002, Monday // 00:00

Financial Times
By Robert Anderson and Stefan Wagstyl


Betting that central and east European countries would soon join the European Union was an easy way to make money in domestic currency bond markets last year.

After a strong performance in these instruments in 2001, the likely profits this year could well be smaller in the front-rank applicant states of Poland, Hungary and the Czech Republic. But some analysts see investment opportunities in states that are further away from EU membership but making progress - notably Bulgaria, Romania and Croatia.

There are still risks in investing in the region, with economic conditions poor in Germany, the largest export market, and a general economic slowdown across the globe.

Nor is the enlargement process itself a guaranteed success: the biggest worry is that the EU itself will not be ready to accept the new wave of members. Events such as the re-run Irish referendum on enlargement could still create some bumps on the convergence road.

"The risk is mainly in Brussels and not in the applicant states," says Zsolt Papp, economist at ABN Amro in London.

The more adventurous investors concentrate on domestic bonds in central Europe because the yields on international denominated instruments issued in US dollars or euros by Poland and other front-rank applicant states have long been at low levels. For example, Poland's 10-year government eurobond trades at less than 50 basis points above similar German issues.

A sharp decline in local currency interest rates in central Europe brought big gains to investors in Polish zloty bonds last year. The spread between Polish zloty 10-year bonds and Eurozone equivalents has fallen from a peak of more than 750 basis points in August to about 400 today. As the chart shows, the gains were smaller in the Czech Republic and Hungary but still noticeable.

The main reason behind the decline in interest rates was a fall in inflation. This in turn reflected a drop in global inflation combined with the huge efforts central European countries are making to restructure their economies in preparation for EU accession.

The Czech Republic, Hungary and Poland - together with the smaller countries of Slovenia, Slovakia and the three Baltic states - are hoping to enter the EU on schedule in 2004 and eventually adopt the euro.

EU accession has its critics in every candidate country. They will make themselves heard this year in general elections due this year in the Czech Republic, Hungary and Slovakia, just as they did last year in Poland's polls. But fundamental changes of direction are not expected even in Slovakia, where Vladimir Meciar, the country's authoritarian-minded former premier, is now trying to convince the EU he will be a good European if he wins.

If political risks in these countries are now relatively small, economic dangers still lurk despite the overall improvement in economic performance. Poland offers probably the greatest cause for concern. With economic growth stagnant and unemployment rising above 17 per cent, the central bank is under great pressure to continue cutting interest rates.

The short-term danger for investors in zloty bonds is that the currency will fall as interest rates decline. The medium-term risk is that interest rate cuts will fail to stimulate the economy enough to reduce unemployment and the government could then be driven to raise public borrowing to boost the economy. If the government goes too far, inflation could return with a vengeance. But investors have so far been ready to trust Warsaw. "Poland is still a big convergence play. It is really the one that offers the most in terms of pick up," says Mr Papp.

For Hungary, spreads between local currency and German bonds have come down from about 350 basis points in November to less than 200, as shown in the chart. But analysts see scope for further interest rate declines, with inflation falling, and for currency appreciation.

The Czech Republic offers limited short-term potential in bond yields as spreads against bunds are already very low, having narrowed from 250 basis points in January 2001 to less than 40. However, a big flow of foreign direct investment is driving up the koruna to record levels.
The risk is that inflationary pressures could lead to interest rate rises at the end of the year.

The government has to issue debt to pay for bailing out the banking sector and may need to offer higher interest rates to ensure it is taken up.

Investors prepared to accept bigger risks in return for the prospect of larger profits are considering switching to "second wave" EU enlargement candidates such as Romania, Bulgaria and Croatia, says Charles Robertson, economist at ING in London.

These countries hope to enter the union in the second half of the decade. However, the economic risks are considerable, notably in Romania, which recorded an inflation rate last year of 34.8 per cent.

*Title, changed by the Editorial Staff of novinite.com/The News

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