Foreign capital flows back to CEE
Foreign direct investments have rebounded in central and eastern Europe, picking up by about 9% year on year, according to a report from Erste Bank.
The Czech Republic’s FDI inflows have reached more than double the levels recorded in 2010 (almost 4% of GDP). In Hungary the negative trend has been reversed and FDI reached about 2% of GDP in 2010. Flows also picked up in Slovakia, reaching 1% of GDP. In the Ukraine FDI remained at a high level (close to 4% of GDP), covering the whole current account deficit and significantly reducing its external borrowing needs.
Juraj Kotian, co-head CEE Macro Research at Erste Group, said that after a slump of 45% year on year in 2009, FDI was picking up again. He called Czech republic the regional “champion”, while Hungary was a “positive surprise”.
“We also notice the markets are one step ahead rating agencies, having already acknowledged the strong fundamentals in CEE. CDS spreads are tighter than those of southern European countries.”
Although Euro Area countries (Greece, Portugal) were able to buy time with ECB financing to substitute capital inflows and external assistance, they were not pressured to correct their large external imbalances. This has resulted in imbalances in the southern Euro Area.
On the other hand, in CEE, the Czech Republic, Slovakia, Poland and Croatia managed to stand on their own feet throughout the crisis without severe tensions in external financing.
Some countries had to undergo an economic rebalancing (Hungary, Romania, and Ukraine) and adopt corrective measures, including structural reforms.
Coordinated IMF & EU assistance has lowered the pressure on their external financing and helped them implement measures to narrow imbalances. Despite this marked contrast, it took time for the markets to realize that many CEE countries are in a much better shape than some Euro Area members.
“The next question is: how long will it take for rating agencies to align ratings to fundamentals, or will ratings become partially ignored by markets as too rigid and outdated?” asked Kotian.
“We notice that the latter is already happening. The Slovak government (rated A+) pays a lower risk premium compared to the multi-notch better rated Spain (AA) or slightly better rated Italy (AA-). Croatia (BBB-) and Hungary (BBB-), which are both at the low end of the investment grade, and Romania (BB+), which was during the crisis downgraded to junk category, borrow more cheaply than Portugal, which is (even after recent multi-notch downgrades) still rated higher then them.”
The report noted that since Q4 2009, there has been a rebound of portfolio investments, particularly into the Czech Republic and Poland. The vast majority went into debt instruments, mainly government bonds. Non-residents increased their exposure in Czech and Polish government securities by €5bn and €25bn, respectively (3.3% and 6.1% of the Czech and Polish GDP).
Both countries have been favored by foreign investors because of their relatively low level of public debt and their economies’ resilience during the global economic downturn. “However, in our view, the lack of a fiscal consolidation effort in Poland and the uneven split of government financing between domestic and foreign investors make Polish assets more risky than those in the Czech Republic,” said Kotian.
The first country hit by a reversal of flows was Hungary, where a significant reduction of portfolio investments paralyzed the Hungarian bond market and put pressure on the currency. The government was not able to issue new debt at reasonable yields and asked the IMF for assistance.
Other CEE countries were not as sensitive to portfolio capital outflows (volume-wise), due to their significantly lower stock of portfolio investments. Foreign investors held only about €3bn (2% of GDP) of Romanian government securities at the time when the crisis emerged, while foreign investors held about €30bn (29% of GDP) of Hungarian government securities.
On the other hand, the global financial crisis constrained the opportunities for financing of the Romanian current account deficit (at that time, about 13% of GDP) and the economy had to adjust quickly in order to narrow its current account deficit.
The adjustment has been eased by coordinated IMF & EU assistance, which has lowered the pressure on external financing and helped to install measures leading to a narrowing of imbalances. Also, the so-called “Vienna initiative” has played an important role, as foreign banks operating in the country promised to maintain their exposure.
Kotian concluded: “Both Hungary and Romania narrowed their current account deficits substantially and thus reduced their external financing needs to levels which can be smoothly financed on markets.”