Crisis Throws Up Eastern European Opportunity

The region still lags in attracting foreign investors

ANTON KHMELNITSKI, MANAGING DIRECTOR, ELBRUS CAPITAL

The Orange Revolution spurred investment in Ukraine, but the nation still needs to change its ways. While painful for many, the current economic crisis provides an opportunity to assess Eastern European economies more than two decades after the fall of the Berlin Wall. It is also a chance to look at challenges and opportunities ahead. The 2008 global economic crisis has without any doubt been the biggest economic shock since the Soviet Union’s disintegration. In general, Eastern Europe has done relatively well as a group.

Currency devaluations were relatively mild, with the exception of Ukraine, whose currency devalued by nearly 50%. There was no widespread run on deposits, although many Ukrainian banks froze withdrawals – and some depositors are still waiting for their savings. Overall, output losses were no worse than the Asian crisis in 1997 and foreign corporations did not leave the region en masse.

Banking bailouts were also lower than during the emerging markets crisis of a decade ago, contrary to the developed world. Many countries needed financial help. But sovereign solvency remains relatively good, compared to developed markets, helped by lower debt-to-gross domestic product ratios.

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The reasons behind both crises – the 1997 Asian and the 2008 global – were similar: cheap money and a credit-fueled asset bubble. But policy responses vastly differ today. Countries have managed to combine loose monetary policies with a large fiscal stimulus, contrary to what the International Monetary Fund has been preaching for decades.

On the investment side, over a 20-year period, Eastern Europe received $700 billion in net investment. Poland took a large share of this inflow, close to $110 billion, while the biggest country, Russia, attracted only $43 billion and Ukraine received $41 billion. Out of 30 countries, 15 entered the European Union, which played a large role in bringing foreign direct investment to them, sometimes regardless of reforms achieved. But outside the EU, there is still an Eastern European market of over 300 million people.

Resilient Poland
EU member Poland was among the most resilient economies, with growth in gross domestic product of 0.8% in 2009. By contrast, its neighbor, Ukraine, recorded a 15% GDP drop, among the steepest declines. Ultimately, foreign direct investment is a fundamental pillar in the resilience of an economy and its ability to sustain wealth creation. The ability to attract foreign investment also remains the best indicator of sound governance, economic openness and a barometer of long-term confidence. The realisation that one dollar of direct investment is worth more than a dollar of GDP is largely misunderstood by governments, often for political reasons.

Poland barely felt the 1998 Russian crisis. It had already managed by then to diversify its exports away from Russia. Poland’s success was rooted in swift privatisation and pension fund development, which allowed the stock market to become a real source of complementary wealth for Poles. At the other end, Ukraine, Georgia, Moldova, Russia, Serbia and Tajikistan underperformed. Russia, contrary to perception, attracted only $43 billion over 20 years, only $2 billion more than Ukraine.

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Russian wild card
Russia is in a strong but vulnerable financial position due to its dependency on exports of oil and natural gas. Nevertheless, it doesn’t explain why other economies like Kazakhstan and other Central Asian countries did relatively well in both performance and foreign direct investment inflows. Interestingly Ukraine, as well as Georgia, attracted 85% of their foreign investment in the last five to seven years.

Ownership of Russian enterprises is concentrated in the hands of a narrow group of actors dominated by the state and so-called oligarchs. Russia has thus far been unable to diversify its economy and attract sizable foreign investments in key sectors. A lack of competition in many Russian business sectors, poor infrastructure, high reliance on imports of finished goods and an unreformed banking system remain so many brakes on economic development. A sizeable budget expenditure to GDP ratio (above 30% since 2005) and a sharp fall in revenue in 2009 triggered a budget reversal equivalent to 14% of GDP. Russia’s status outside the World Trade Organization is symptomatic. If any of these elements were to change positively, this economy would be able to attract substantial capital inflows. Russia, as the biggest country in the region, remains a wild card for foreign investors.

Orange Revolution spurred investment
Ukraine is the largest domestic market after Russia, with almost 46 million people. It benefits from a cheap currency, a large resource base and a strategic geographical location. However, a weak institutional framework and a lack of political consolidation are still holding the nation back. Nevertheless, it is often forgotten that Ukraine had been nowhere on the investment map until the 2004 Orange Revolution marked the end of the authoritarian regime of President Leonid Kuchma.

Since then, the country has spent five years at the mercy of global markets and was able to attract large investments in its banks. Like Poland, its banking is now largely integrated with European financial institutions, which own more than 50% of bank assets. Without the support of European banks, the financial system of Ukraine would have collapsed with dramatic social consequences during the crisis. Nearly 90% of Ukraine’s foreign direct investment since independence came since the 2004 democratic Orange Revolution – and most of it in the banking sector.

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The sector that has barely received attention is agriculture. Ukraine could potentially feed an estimated one billion people and is among the global leaders in production already today. Agriculture accounts for 8% of Ukraine’s GDP – the second highest in the world – and 20% of the country’s exports. But it lags far behind in productivity levels. Overall, Ukraine’s agricultural-related foreign direct investment has skyrocketed to 10% of all money received in the last three years. Total market capitalisation of agriculture companies has reached $4 billion. Land reform – allowing the buying and selling of soil – is likely to be a major catalyst for further investment growth.

Bulgaria, Romania and Kazakhstan
Bulgaria and Romania attracted investment due to their rapid European Union integration. Kazakhstan has managed to attract capital consistently and in large amounts. In 2009, the amount reached $22 billion, thanks to Chinese investment, primarily in oil. We believe the country is now in strong shape for the next leg of growth following the crisis that forced bank sector restructuring. Though Kazakhstan is a market of only 15 million people and somewhat distant geographically, its strategic resources are well-managed and benefit from open policies and relatively stable legislation. A large portion of these assets are privately-owned through public companies today.

The opportunity
Large inflows of foreign direct investment tend to accelerate currency appreciation through rising productivity gains and capital inflows. For equity investors, many more factors are at play in deciding performance: excess domestic capital, corporate governance and disclosure and level of governmental interference. Generally the optimal way to capture investment is via the financial sector. Unlike in developed markets, where many banks may end up with heavy regulation, emerging markets and Eastern European banks will ultimately continue to lend money and benefit from the broad exposure to these economies.

As the long-term impact of the crisis has yet to be felt, policy responses to attract investment are going to take on even more importance in light of the overall deterioration in regional fiscal positions. Deflation risk may well continue to dominate the global financial environment in the near future. Attempts to sell bonds and more initial public offerings are expected. But the lack of risk appetite may well give foreign direct investment an even greater role in the next few years. Unlike Asia, Eastern Europe suffers from a chronic lack of savings. Thus the dependence on external capital inflows looks set to increase rather than abate.

In resource-rich economies, there is a tendency for governments to use commodities both as a source of financial stability and as a means to create wealth. Unfortunately, these are not sufficient drivers of economic development as diversification requires profound structural changes in the way that capital is allocated and know-how is acquired. Besides, in a post-Soviet economy, rent-seeking advantages (attempts to make money through manipulation or exploitation of the economic environment rather than by adding value) tend to disappear over time as capital needs rise faster than what can be extracted from commodities. As savings are too low, specifically in Eastern Europe, serious long-term financing gaps can appear.

We also see no reasons to justify the European Union integration model. It has demonstrated both positive and negative examples. A growing number of EU members are under increasing financial strain. As critical solvency levels are reached in Greece, Hungary and elsewhere, several years of financial house cleaning are likely to be triggered, stalling further expansion.

Non-EU countries have an incentive today to reform their economies. European corporations will continue to seek new markets, but only when these economies move out from the rent- seeking model will their full potential to attract investment be unlocked. Eastern European nations are likely to be main beneficiaries of new foreign investment as this market of 300 million people still remains under-penetrated. Financial gains for investors will be a function of how these economies adjust to their long-term needs, rather than theoretical hopes of EU integration. This may be the new reality for Eastern Europe.