Passing the point of no return

A SUPPLEMENT TO EUROMONEY – APRIL 1997

It was the perfect symbol of the new Russia. Last month president Boris Yeltsin appeared at the Helsinki summit looking fitter and more confident than he had done for months ­ an image reinforced by the contrast to Bill Clinton, who had been confined to a wheel-chair after a knee operation.

For most of the 1990s Russia has been the sick man of eastern Europe, weakened first by the loss of its satellite states in eastern Europe and then by the disintegration of the USSR. Things seemed to worsen last year. The conflict in Chechnya spiralled out of control while Yeltsin at first seemed incapable of winning the June presidential election ­ and once in office he appeared unlikely to live more than a few months.

But every month that Yeltsin stays in office ­ and remains healthy ­ reinforces the reform process not just in Russia but across the whole region and makes a regression to communism less likely.

The World Bank, for instance, argues in its World Development Report ­ from Plan to Marketthat the chances of a return to state planning are remote. But the report, which was published at the end of 1996, warned that “long-term stagnation and rising poverty ­ likely outcomes of inconsistent and unstable policies ­ cannot be ruled out for some countries. In the last analysis… reforms will not bear fruit unless they are underpinned by a broad political and social consensus.”

Many bankers believe that the 27 former communist states in eastern Europe and the CIS have already passed the point of no return. They are increasingly certain that most of the former communist world has survived the trauma of transition and is poised for sustainable economic recovery based on the disciplines of the free market. Conversely, advocates of a return to the past lose credibility as economies strengthen, inflation falls, credit agencies upgrade ratings and central banks understand the need for sound monetary policies and strict banking controls.

“The dismantling of the old command economy has taken place irrevocably. Most of the countries are now market economies,” says Guy de Selliers, deputy vice-president of the European Bank for Reconstruction and Development (EBRD). “Belarus is not and Ukraine may not yet be ­ but Russia is a market economy. In Russia, you will see that decisions to invest are made by the market and that the authorities’ room for manoeuvre is ­ for example on the value of the rouble ­ determined by the market. The ability to run a large deficit is determined by the impact on inflation. This forces them to take very tough decisions.”

De Selliers regards the recent surge in Euromarket borrowing by east European countries as another signal of the pace of economic reform, adding that these issues provide an objective measure of performance. Since 1995 borrowers from the region raised nearly $12 billion in more than 80 bond issues.

Many billions more will have to be raised for the reconstruction of the old interdependent command economies, to re-equip factories that used to produce military hardware and modernize obsolete industrial production techniques that turned much of eastern Europe into an environmental disaster area.

There has been an equally sharp increase in the volume of international loans to the region. Japanese banks are leading the way, committing large sums at extremely tight margins ­ a reaction to credit reports that some west European bankers regard as wildly over-optimistic.

One Austrian banker says: “Spreads have over-reacted to a surplus of liquidity with margins squeezed to the benefits of borrowers so much so that they no longer compensate for the underlying risk. Japanese banks, in particular, have driven margins down to a point where we wonder whether lending makes sense.

“Two years ago, for example, Hungary was borrowing at maturities of over one year at a spread of 200 basis points. They now pay 30 basis points for five years. The country has made progress over that period ­ but not that much. Slovenia, a tiny country, can now borrow at breathtakingly thin rates. Russia was able to place a Dm2 billion bond at a spread of 340 basis points ­ I hope everyone realizes it is a junk bond. We need something negative to happen to bring people to their senses.”

Another banker rejects suggestions that east European risk is fundamentally mispriced, but cites isolated idiosyncrasies. “There is too much casual name lending,” he says. “Japanese banks will lend to a borrower like, for example, the city of Prague at outrageous prices. There is a lot of competition to lend to borrowers that are regarded as the best. But there are only a handful of them.”

The range of borrowers is broadening to include credits whose presence in the international bond market would have been almost inconceivable 12 months ago. Kazakstan, for instance, raised $200 million with its first Eurobond at the end of last year. The deal was extremely successful even though bankers in Almaty were worried just a few months before launch that the government would be unwilling to divulge the information that the ratings agencies needed. Likewise, fears that investors would fail to be convinced by the economic prospects of this land-locked country proved to be unfounded.

Kazakstan did not have a pressing need for funds and launched the issue to establish a benchmark for future borrowings. It may return to the market this year to do deals in yen or Deutschmarks.

Although sovereign issuers dominated eastern Europe’s first wave of international borrowing, the focus is expected to shift this year to corporate credits. Companies have been frustrated by the limitations of their domestic bank lending markets, where maturities are usually limited to one year, and have been forced to obtain most of their funds from reinvested profits.

Russia is expected to lead the surge of non-sovereign borrowings. Until now the stock market had been the only way for companies to raise money. But prices are still undervalued and most companies have comparatively low levels of gearing, so international debt issues make a lot of sense.

This year alone between $1 billion and $2 billion could be raised in Russian Eurobond issues as up to 10 companies and regional governments raise money in the wake of the success of the Russian Federation’s inaugural $1 billion issue last year. Deals are expected from Rostelecom, the telephone company, Uneximbank, Russia’s fourth largest financial institution, and Mosenergo, Moscow’s electricity company.

The growth in international issuance by east European borrowers is matched by developments in the region’s domestic debt markets. This is especially true in Poland and Hungary, where central banks understand the importance of being flexible. At the end of last year, for instance, ING Barings raised Ft24.97 billion for Hungary’s Pannon GSM Telecommunications. The issue, which was 20% oversubscribed, was the longest maturity bond ever for a Hungarian corporate ­ and the first to exceed Ft1 billion.

The increasing availability of cheap funding in the bond market has fuelled criticism of the EBRD, including accusations that its funds are overpriced. De Selliers regards these comments as evidence that reform is taking place and confirmation that the bank is pursuing the correct strategy. “It shows we are conservative and price our assets reasonably. It also shows we are truly additional and not competing with the private banks. I would be worried if we were too cheap,” he says.

From the outset, eastern Europe has had a roller-coaster ride in its transition to free market. The initial euphoria at the end of communism gave way to the realization that transition would involve short-term costs: millions of jobs would be lost and there was to be a dramatic decline in living standards for everyone except initially for a handful of businessmen.

It was not until the mid-1990s that the first tangible benefits of recovery began feeding through. There was also an improvement in environmental conditions. A recent report on the Baltic Sea, once the most polluted in northern Europe, noted that tough anti-pollution measures in former east Germany, Poland and the Baltic states had helped restore the ecological balance.

As a result of all this, bankers last year started to talk of eastern Europe’s capacity to grow as fast as the Asian tiger economies. The improving sentiment was fuelled by the rating agencies’ decision to upgrade several of the best performing economies. Standard & Poor’s gave investment grade ratings to seven countries: the Czech Republic and Slovenia were rated A; Latvia was rated BBB; Hungary, Slovakia, Croatia and Poland were assigned BBB- ratings.

These seven ­ along with unrated Estonia and Lithuania ­ were defined by the EBRD as being in “advanced stages of transition”. S&P has also assigned Russia, Kazakstan and Romania BB- ratings, a much higher level than they could have expected until recently albeit below investment grade. But the overall improvement in the region’s credit standing may not continue. “After the upgrades of last year, we don’t expect to see comparable developments this year,” says S&P’s Konrad Reuss.

Likewise, growth forecasts have been scaled back from some of the more optimistic levels touted last year with most countries now expected to grow by only 3.5% to 5.5% in 1997.

“Growth in a number of countries will decelerate in the near term after the strong performance of 1995,” said a recent report by the EBRD. “Most countries will have been affected by the slowdown in demand in western Europe ­ in particular in Germany, one of the region’s main export markets.”

The availability of long-term western investment will be one of the key factors determining the region’s development. In 1995, the last full year for which World Bank figures are available, foreign direct investment (FDI) and portfolio placements in eastern Europe, the Baltics and the CIS reached $45 billion, compared with $31 billion to $33 billion a year between 1991 and 1994. The 1996 figures are also expected to show an increase.

According to the most recent EBRD Transition Report, the increase in medium and long-term flows in the early 1990s came almost entirely from official sources such as the IMF, World Bank, the EBRD and other multilateral organizations. But that trend halted in 1995, according to the EBRD. “The increase in aggregate inflows was caused entirely by flows from private sources which rose from about $21 billion in 1994 to about $31 billion in 1995. The 48% increase in such flows was much greater for eastern Europe, the Baltics and the CIS than the 5% rise for developing countries as a whole. The flow of FDI into the region almost doubled to $12.2 billion, accounting for 13% of all flows into developing countries compared with 8% in 1994.”

However, before committing their institutions to providing more funds, western bankers need to be convinced that these market economies are working in an orderly and fair way. Recent events in Albania, where the collapse of pyramid investment schemes impoverished the many while making a few extremely wealthy, provided the clearest evidence that there are not adequate controls in some countries.

There is also the example of Bulgaria, whose performance has shown that refusing to reform offers no solution. The economy collapsed last year after months of dithering by the then socialist government. Inflation spiralled, banks failed and international lenders pulled out. The caretaker government that took over is committed to reform and reaching a new deal with the IMF and World Bank; elections on April 19 will show whether there is popular support for this.

The EBRD’s De Selliers believes that governments are starting to understand the need to set an example in promoting proper standards of behaviour if the reform process is to retain popular acceptance. “Governments are starting to realize that it is essential to foster a culture which meets a standard of best practice that is recognized world-wide. It is nothing to do with cultural or moral values or imposing western values on Russia. It has just to do with the fact that successful businesses behave in certain ways. Governments are starting to realize that this is the only way to foster growth in the long-term.

“This is the approach we are adopting in our relationship with customers. We insist on international standards of best conduct ­ we are blunt and clear about this. Borrowers and companies who want our money have to accept this. We don’t try to be too sophisticated in this.”

Bankers are worried that the impact of this message is being diluted as some companies succeed even though they ignore proper business practice. And others are helped to break the rules by western companies. De Selliers has a clear message for firms that are prepared to break the rules. “You can do business without breaking the rules: it is easier to insist on normal standards than you think. I also believe you are playing a dangerous game if you don’t because, the moment you start, you are tainted; racketeers only approach those who are likely to give in. Because we are not under that sort of pressure at the EBRD, we can give a lead in that respect and become a bulwark for companies that want to break the vicious circle.”

This type of behaviour is most likely to occur in the financial sector, which remains a problem throughout the transition economies both in terms of the quality of assets and the relationships between the banks, their loans and their shareholders.

Standard & Poor’s points out that “large bank failures are occurring in the single-A rated Czech Republic as well as in BB- rated Russia and BBB rated Latvia. In most of these countries, macro-economic shocks, lack of experience in credit appraisal, mushrooming of smaller new banks and inadequate banking supervision have resulted in large stocks of non-performing loans. Bankruptcies in the banking sector can seriously undermine public confidence. How countries handle the banking sector has a direct impact on the amount of their public debt and thus on their sovereign credit quality”.

One senior western banker counters that the domestic banks are becoming stronger despite these problems. “Local markets will become important and the need for foreign capital will slow down,” he says. “Some of these countries have high savings ratios and they can develop an active local market. The domestic banks will become hard to beat because they know their local markets best.”

In addition to the credibility of financial institutions, another important factor in assessing risk in eastern Europe is the development of political institutions. The EBRD asserts: “The state must provide conditions for market-oriented growth by advancing structural reforms. It must provide conditions which will ensure a good standard of education and health in the population so that individuals may participate in the market process by earning their own living. Third, there should be protection for those who are unable to participate by earning their own living.”

Investors are taking these issues into account as they become more discriminating across the region. Hungary, Poland and the Czech Republic are regarded as the most advanced and they have attracted the bulk of foreign investment. Even the election of governments dominated by former communists has not deflected the broad direction of economic reform in Hungary and Poland. Other countries, such as Croatia, are affected by worries about stability and the CIS states were regarded by some as too risky until the election of Yeltsin and his recovery from heart trouble.

Russia owes its attraction more to its size than any confidence in its legal framework, political stability or internal security. In the last year these countries have been joined by smaller countries, including Latvia and Slovenia.

“The Czech Republic and Slovenia are better credits than the others,” says an S&P analyst. “They are the most developed and prosperous countries in the region ­ as reflected in per capita income ­ and most qualitative and quantitative indicators also support the view that their industries and exports are more developed and diversified than those of any other countries in the region. In both, the political scene has been more stable and conducive to reforms than in other countries ­ notwithstanding recent inconclusive elections in Slovenia.”

The analyst adds: “Macro-economic management has been exemplary and policy consensus on structural reform has remained consistently strong. The governments’ financial positions are very strong and both countries are net external creditors. These factors reinforce each other, ensuring that the potential to address potential financial or economic stresses is much stronger than elsewhere in the region.”

Among other countries, Hungary has led the way in establishing the private sector. It was the first to introduce competitive markets and as a result has attracted a higher share of FDI. But only last year did the situation improve when it launched much needed restructuring of its generous welfare programme; the delay in bringing these forward, combined with the need to bail out badly performing banks, undermined some of the country’s economic progress in earlier years.

The performance of CIS states has in general lagged behind those of eastern Europe, partly because they have taken longer to carry out stabilization policies and been slower at introducing market reforms. In the short term, it reflected the uncertainty in Moscow over Yeltsin’s re-election and health; had he failed to survive there was a real risk of a return to communism and a return to a nationalist leadership that aspired to recreate the USSR.

There were exceptions. Armenia and Georgia are expected to show growth levels this year which, albeit from a low base, are higher than eastern European countries achieved at their peak in 1995. Moldova and Kyrgyzstan are also expected to record positive growth, contributing to overall growth of 4% in the CIS this year.

The eastern European states, headed by the Czech Republic, Poland, Hungary and Slovakia, are pressing for early admission to the EU; Yeltsin even announced recently that Russia was considering a membership application ­ a clear sign of where Russia sees its future and that the reform process will continue.

A year ago eastern European states were booming while the CIS was in a state of deep political uncertainty before the critical Russian presidential election. Today the edge has gone off the boom, not least because of western Europe’s continued failure to make more than the most belated recovery from recession.

However there is now greater political certainty about eastern Europe’s future and that the billions of dollars of foreign investment needed to complete the reconstruction of the former communist states can be mobilized. If everything goes right, this could still be the year of the east European borrower.

Progress in transition in eastern Europe, the Baltics and the CIS

If you haven’t noticed ­ I’m back

Russian president Boris Yeltsin, apparently in rejuvenated form, fired almost all of his cabinet in early March. Prime minister Viktor Chernomyrdin remains in his post, but everyone else has been dismissed, though not in every case replaced. Yeltsin’s convalescence seems to have strengthened his resolve to push on with reforms. This is evident from his state-of-the-nation address in early March and the new ministerial appointments.

Anatoly Chubais has been promoted from chief of staff to deputy prime minister with control of the finance ministry. Backing Chubais, who played a critical role in the privatization programme, is a calculated risk. He is a reformer, but he is also unpopular.

Foreign investors should be encouraged by the changes, according to Peter Derby, president and chief executive of DialogBank. A reinvigorated government with Chubais in a key position could have the will to address what he refers to as the remaining “structural problems” in the economy.

“Chubais is able to make tough decisions,” says Derby. In this, the new deputy prime minister is unlike his immediate boss. Chernomyrdin, though he has a clear grasp of what needs to be done, has earned the nickname “Gorbachev junior” for his inability to take the plunge. Whether Chubais will be able to provide the necessary shove has yet to be seen, however.

Specific issues which the financial community hopes to see resolved include the introduction of a new tax code. Under the present tax system, the assessment of company liabilities is based more on turnover than actual profits. The heavy tax burden this places on enterprises has made it almost impossible for them to invest funds in order to improve performance, and in some cases it has rendered them insolvent.

There is also hope that Chubais will step up efforts to institutionalize the country’s capital markets and encourage the development of mutual funds, which companies can use to raise finance.

“Privatization has consisted largely of redistributing voting rights, with companies getting nothing in return,” says Derby. “Giving companies the opportunity to raise capital domestically will be critical in improving their performance.”

Investment bankers also hope the government will urge big ticket companies to seek funds internationally. There have been pitifully few international equity offerings from Russian enterprises so far, partly due to a lack of political will. If this changes, a stake in Svyazinvest, the telecoms holding company, may be one of the first to be offered to foreign investors (see Russian equity article).

However, the duma, Russia’s lower house of parliament, is likely to oppose such a move. In February its members approved the first reading of amendments to the foreign investment law which would ban or limit foreign activity in telecommunications, as well as in the power, financial services and oil sectors.

“Given the Duma’s current mood, a proactive, pro-reformist government is absolutely essential if anything at all is going to get done,” says Alasdair Breach, an expert at the Russian European Centre of Economic Policy.

It may be a mistake, though, to place too much confidence in Chubais’s credentials as a reformer.

The controversial loans-for-shares scheme was carried out under his auspices (though to be fair without his enthusiastic support). Under the scheme, critics say, companies were sold to Russian banks at a fraction of the value they could have raised abroad.

Prime minister Chernomyrdin has sought to allay fears of corruption by saying that he will appoint more “professionals” in the government; people who will put service to Russia before lining their own pockets. It is hoped that this reflects a desire on the part of Yeltsin for increased probity.

Western bankers welcome the indications of change, even if they are not convinced that corruption will disappear. “At least greed might be lower down the priority list,” says one.

Russian bankers, habitually bearish in nature, are not sure that even this modest shift can be achieved. “Problems will remain as before, and nothing the new government can do will change them,” says one.

Sophie Roël