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Skip Navigation LinksHome :: Back Issues :: Reality check for rosy view of convergence

September 2002

Reality check for rosy view of convergence


The affair is not over but investors’ passion for a new EU convergence story has cooled. They are beginning to price in the impact of delays to entry for leading candidates, the long run-in for others, and the unlikelihood of rapid single-currency status for any new members.




Central and eastern European sovereign bonds have become the darlings of emerging-market investors in the past few years. Investors found the 13 official candidates for EU entry particularly appealing since they offered the tempting option of reasonable yields combined with the prospect of credit rating upgrades and capital gains as these countries moved closer and closer to EU accession.
Investors made huge gains on convergence trades in the run-up to the European single currency in the mid-1990s, buying high-yielding bonds of countries such as Italy on the basis that political momentum would push it into the single currency. Now investors want to enjoy a second version of the great convergence-trade party.
After all, nowhere else in the emerging world could you guarantee that every credit in the region would be on the same conservative economic and political path in order to meet EU accession criteria. Or that 10 of these countries would have to meet these criteria at exactly the same time in order to qualify for big-bang entry in 2004. These were not credits being priced according to investor emotions. On the contrary, they were driven by logic.
That was the theory anyway. "Certainly when we were buying into Hungary or Poland two or three years ago, one of the pulls was that future EU accession was going to keep policy on track," says Ingrid Iverson, portfolio manager at Rothschild Asset Management. "In the same way, the prospect of eventual membership of the EU for Bulgaria and Romania is a factor in people buying them and pulling spreads in, even though this is a long way off."
Even over the past year, the number of EU convergence funds set up and the number of existing funds diversifying into CEE sovereigns has been growing, all aiming to capitalize on this apparent gravy train. As a result sovereign paper from these countries traded tighter and tighter until some looked more like EU sovereign bonds than bonds from EU candidates.
This is particularly true of Hungary, at the head of the frontrunner group. In the 10-year sector, Hungary is trading at Libor plus 30 basis points - not too much wider than Greece. A year or two before Greece joined the EU it was trading at similar levels to Hungary now. In general, the market has behaved, somewhat naively, as if big-bang entry was a foregone conclusion.
But investors are beginning to wake up to the fact that it is not. Some of these bonds are therefore beginning to look expensive. "Last year, pretty much anything in central and eastern Europe was getting bought because of that EU accession trend," says Jonathan Brown, vice-president at JPMorgan. "This year there's been a bit of a re-evaluation of the underlying credits and the issues around each of them."
To be fair, market players have been moaning for some time that this is not a very accurately priced market. Supply is scarce - there have only been nine foreign-currency bonds from this region this year - and when these sovereigns do issue, their debt often gets snapped up by German investors that buy and hold until maturity. But now investors must realize that if the EU accession timetable is delayed the urgent need to work towards a conservative economic policy could lose impetus. They could end up carrying a large amount of risk for, in some cases, scant reward.
Dangers to the deadline
There are sizeable obstacles to EU accession going ahead on schedule for 10 countries as planned in 2004. To meet this deadline, even the countries at the front of the enlargement pack could have to overcome some pretty serious opposition.
       

View graph.
Problem one is the amount of disquiet about the plans from existing EU members. One impending hurdle is the Irish referendum on approval of the Nice Treaty due later this year. The treaty deals with such issues as the distribution of seats after enlargement in the European parliament and the number of votes per country in the parliament. The Irish, who are bound to hold a referendum on this subject, have already voted against it once. If they reject it again, this would be a "heavy, heavy blow", says EU Commission president Romano Prodi - whereas before he had suggested that enlargement could still move ahead regardless - and several parts of the treaty might have to be renegotiated.
Another worry springing from within the EU is the possibility of a victory in the German general elections for the Christian Social Union in their alliance with the Christian Democrats, since CSU leader Edmund Stoiber has questioned whether the Czech Republic should be allowed in to the EU. "Although this is probably unlikely, if there is a swing in the EU towards the right which we have seen in France and may see in Germany if the CDU gets back into power, these governments may consider the timing aspects of the accession process again," says Peter Malik, director in the emerging markets group at CSFB.
Problem two is the small issue of whether the EU candidates themselves will be able to muster enough support at home, particularly when referendums will be held in many countries before enlargement can finally go ahead. Popular support in candidate countries is generally high, but general elections could throw a spanner in the works. The elections in Slovakia later this month are a good example. If Vladimir Meciar of the Democratic Slovakia party (HZDS) becomes prime minister again, and reverses the country's existing reformist policy, the EU might not be happy to accept the country into the EU in 2004.
While this may be unlikely, it's a considerable worry to investors in Slovakia's outstanding debt. Although the country is not one of the favourites for EU entry in 2004, its bonds have become dramatically more expensive over the past few years. "Slovakia has accelerated in the last three years," says Aidan Freyne, managing director of fixed income syndicate at Schroder Salomon Smith Barney. "This is reflected very much in the fact that it now trades at spreads which aren't a huge premium to Poland, the Czech Republic and the Hungarys of this world."
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