The turmoil in late February/early March originated in the United States and Asia but affected almost all financial markets and Eastern Europe was no exception, although some of the smaller and less liquid markets were almost unaffected. The same thing happened again in late July/early August. Fears over the US subprime market quickly spread across the globe and all but four markets in Eastern Europe fell in August. Both times it was the largest and most liquid markets, such as Russia and Turkey, together with the most noticeable out-performers that were the most affected. However, the markets that have dropped the most have rebounded relatively quickly and strongly. This is nothing new as we have seen a similar pattern in emerging markets previously.
What has surprised analysts is that Eastern European markets have been less affected during the past few weeks than during earlier periods of volatility. Emerging markets have, in other words, been unusually resilient.
The first and most general explanation to the improved resilience is that many emerging markets have been maturing financially to such an extent that they can withstand the most adverse effects of global volatility. Economists talk about financial deepening, which is a way to describe how institutions like banks, stock exchanges and insurance companies have grown relative to the gross domestic product. The privatisation process in Eastern Europe has been an instrumental factor in developing the equity markets in the region in a relatively short period of time.
The capitalisation of the Russian market, which is the largest and most important in the region, is already larger than its GDP. And banking assets are similarly above 100% of GDP in Kazakhstan. A lot has happened during the past few years and these sectors continue to develop.
The European Bank for Reconstruction and Development (EBRD) evaluates the economic and market reforms in Eastern Europe on a yearly basis and in its most recent evaluation, 11 out of the 25 reforms dealt with the financial markets. There are plenty of examples. Bulgaria got an upgrade for the ôstrong growth in leasing and insurance market matched by improved regulatory supervisionö whereas ôfurther improvements in the institutional and regulatory framework for capital markets; introduction of new products and innovation; volume increases in stock, bond and insurance marketsö entitled an upgrade in Russia. Kazakhstan got credit for the ôincreased capitalisation of stock and bond markets; emergence of pension funds and private operatorsö and Montenegro for ôgrowth in credit to the private sector, financial deepening and presence of an independent supervisor as well as the introduction of deposit insuranceö
Second, although the recent subprime scare arguably is a unique case, the economies in Eastern Europe is in a relatively good position to tackle the turmoil as the domestic macro economic situation is stronger than ever in most Eastern European countries. The two largest economies in the region, Russia and Poland are probably in their best economic shape since the transition to market economy started in the early 1990s. Russia has been enjoying growth levels around 6%-7% since the late 1990s and the outlook looks very strong.
The Russian economy is still too dependent on energy exports but with an oil price above $80, leading to large budget and current account surpluses, the incentives to diversify the economy are not so strong. Russia has moved from the verge of bankruptcy in 1998 to having the third largest reserves in the world.
Kazakhstan, the dominating economy in Central Asia, has also benefited from the increasing demand for natural resources. Poland, which is the leading economy among the new EU members in Central Europe, has turned its economy around and is enjoying strong growth, low inflation and interest rates combined with rapidly falling unemployment levels.
It is true that Turkey and some of the new EU members, such as Latvia, have worrying macro economic imbalances. But not even TurkeyÆs notoriously high interest rate and LatviaÆs record-high current account deficit are enough to scare the long term investors. Turkey has been reforming its economy very ambitiously and is now seriously targeting inflation. The recent rate cut in September was as surprising as it was important and also signals that the Turkish economy is moving in the right direction.
The current account deficits in some of the new EU member states that are not being financed by foreign direct investments are covered by intra-bank lending. Latvia is a case in point since foreign (primarily Swedish) banks have been lending very generously to their Latvian subsidiaries. There is, in other words, no immediate concern even if global liquidity may be drying up somewhat.
There is third reason to believe that Eastern European markets may be able to withstand global turmoil stemming from concerns about the US economy in particular. Eastern Europe has very little direct trade exposure to the American market. Emerging EuropeÆs exports to the US as a share of total exports is less than 4%. The corresponding figure for Asia is more than 20% and for Latin America as much as 45%. Citigroup and Oxford Economic Forecasting has calculated that the Eastern European economies are among the emerging markets that would be the least affected by a drop in US housing investment. Indeed, six out of the seven least affected emerging markets (out of a total of 22) were Eastern European: Russia, Turkey, Hungary, the Czech Republic, Romania and Poland.
Eastern European markets are relatively resistant to global financial turmoil, in particular when originating in the US. But the primary risk in most of these markets is nevertheless external as the domestic economies are stronger than ever. Sectors with a high degree of exports together with commodities where the price is set by the global market will continue to be the most vulnerable. It thus seems likely that investments into domestic growth sectors in Eastern Europe will continue to be a very attractive prospect.
Peter Elam Hskansson is Chairman at East Capital.