Could CEE convergence fund inflows reverse?

As an environment of global deflation persists, money looking for yield continues to flow into emerging-market bond funds. Funds that have never invested in central and eastern European debt are now queuing up to do so. One banker in Poland says even Australian investors now hold Polish debt.

This is great news for the debt agencies in convergence countries. As Edward Basinski, head of foreign debt at the Polish ministry of finance, likes to say: "We have now effectively converged." Spreads on Polish, Hungarian and other convergence debt are very low. At 47 basis points over swaps for Poland, and 27bp over swaps for Hungary, they are in line with spread levels for debt issued by Italy or Greece immediately before they converged.

Partly as a result of these very low spread levels, and partly as a result of falling foreign direct investment levels, some CEE economies are relying more and more on these portfolio inflows to finance government. The best example is Hungary.

The current account deficit in Hungary, which throughout the late 1990s stayed small, suddenly worsened in the second half of 2002, from e2 billion in 2001 to e2.8 billion in 2002. FDI slowed to 1% of GDP in 2002, so the Hungarian government relied more and more on portfolio inflows to support the deficit. Luckily, thanks to the strength of the convergence story, inflows had risen fast since the capital market was liberalized in 2001. Now, foreign investors hold 50% of both forint- and euro-denominated Hungarian debt. As Andrew Roberts, CEE economic analyst at Citigroup, says: "The level's been going up every month."

Roberts believes the current account situation will worsen in 2003, meaning Hungary needs portfolio inflows to remain at their present levels or even surpass them. That dependency on bond inflows could be dangerous, because investors herding into CEE debt could suddenly take fright and leave.

What might reverse the convergence flow? Mohammad El-Erian, emerging-market fund manager at Pimco, says: "The market has assumed it will be a smooth convergence process. It has fallen in love with the destination rather than the voyage." As a result, spread levels on CEE debt are now where Italian or Greek debt was immediately prior to convergence. But CEE economies such as Hungary, Poland or the Czech Republic are still a long way from convergence. If there are any serious bumps on the road, spreads could widen, leading to an abrupt exit by short-term investors.

Convergence diverges from reality

Christopher Rybinski, chief economist at BPH PBK in Poland, says: "If you look at the pace of convergence in spreads, it does appear very fast, compared to how close the economies are to actual EMU convergence. The market is expensive."

The fiscal situation in Hungary, Poland and the Czech Republic is "a huge mess", in Rybinski's words. In Poland, finance minister Grzegorz Kolodko is struggling to gain political support for his plans to cut public spending and reduce the government debt, which now stands at 43% of GDP.

He has been criticized for his plans by ministers from his own government and the central bank governor. With the collapse of the Polish coalition government in March, real public sector reform now seems unlikely before 2004. That may be too late, if the government is serious about joining the EMU in 2007.

Economists are now talking about EMU convergence in 2008, 2009 or even 2010. As Rybinski says: "The big risk that might frighten bond investors is a delay in EMU convergence."

Hungary's fundamentals could also be a lot better. Its budget deficit is 8.7% and its debt is 53% of GDP. Inflation is also quite high, at 4.5%. That could delay EMU entry from 2008, which the previous Hungarian government said it was aiming for, which could put off foreign investors. Alternatively, if the current account situation gets a lot worse, and goes from 4.8% of GDP to levels of 5.5% or higher, foreign investors may no longer be able to shut their eyes to the poor fundamentals in Hungary, and might have to sell its debt. That would in turn widen the current account deficit, which leans on foreign portfolio investment, leading to a vicious circle.

None of these outcomes would be disastrous for the economies involved. If Poland missed EMU entry in 2007, it would join in the next few years. No-one doubts it will eventually join, and if you are a retail investor holding its 10-year bond, you can happily sit out any volatility between now and convergence. Likewise, Hungary is expected to join the EMU by 2008 or 2009, so that shouldn't worry long-term investors. Those who might get caught out are the many relatively new or short-term investors expecting a further tightening of spreads. As Rybinski says: "The story is over. Don't expect any more big gains in Hungarian, Polish or Czech bonds. There may even be some downsides, as the market corrects itself."

The smart money has already decided this. Pimco's sophisticated emerging-market fund has now moved out of CEE convergence bonds. El-Erian at Pimco says: "The internal policy dynamics of some of these countries suggest a considerably more challenging convergence process than appears priced in current spreads."

El-Erian points out that the convergence story is now weaker partly because of the weakness of the EU economy, and in particular Germany. He says: "Converging with a weak economy is like a carriage trying to join up with a train moving backwards."