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No room for complacency on CEE debt

Central and eastern European governments have exploited the flattering contrast between their headline debt numbers and those of western Europe to achieve ever lower funding costs. But there is still much work to be done to ensure the sustainability of debt levels.

When it comes to government debt, most countries in central and eastern Europe look to be sitting pretty, particularly when compared with their troubled neighbours to the west. The weighted average debt-to-GDP ratio for the CEE region has climbed 15 percentage points in the past four years but at 47% it pales into insignificance beside the 83% registered by western Europe – thanks in large part to the receptiveness of CEE politicians and voters to stringent austerity measures.

"These economies have been in many ways exemplary in that they did very front-loaded, expenditure-based fiscal consolidation during and after the global financial crisis, and as a result their debt levels at the moment are sustainable," says Erik Berglof, chief economist at the European Bank for Reconstruction and Development.

This prudent approach has extended to debt management offices, which have worked hard to ensure consistent and cost-effective access to international bond markets since the credit crunch. The region’s biggest borrower, Poland, has been the trailblazer, reopening the US dollar market for CEE sovereigns in 2009 when euro-denominated funding from public-sector-focused banks such as Depfa and Eurohypo dried up.

So successful, indeed, has Poland’s debt management office been in nurturing its international investors that the sovereign was able to print a $2 billion 10-year note in October, when bond markets were all but shut, and has become a regular visitor to the samurai and Swiss franc markets, including this year. And where Poland led, others were quick to follow.

Hungary has tapped dollar investors for $6.25 billion since January 2010, while smaller market players have included Lithuania, Belarus and even Romania, which found strong demand for its $1.5 billion inaugural dollar issue in February this year.

Dollars have retained their appeal because of the depth of the market, the favourable euro-dollar basis swap and the longer maturities on offer. However, borrowers have also seen a renewed enthusiasm for their paper among euro investors – as witnessed by the healthy oversubscription attracted by the Czech Republic’s €2 billion blow-out in February, which priced with a new-issue premium of just five basis points.

Funding officials have also proved adept at negotiating the difficult market conditions of the past two years, taking advantage of stable periods – such as the first quarter of this year – to achieve attractive pricing and in many cases to pre-fund. "These countries have adjusted to the new reality of windows of opportunity and cycles of constructive and nonconstructive markets, and can better react to these more volatile markets, as we saw with the activity from late January and onwards," says Zoltan Kurali, head of capital markets and treasury solutions for central Europe and Israel at Deutsche Bank.

A reflection of economic fundamentals?
CEE five-year CDS spreads
Source: Markit

This consistent approach to funding, combined with the relative scarcity of the credits and high levels of liquidity in both dollar and euro markets, has translated into impressively low spreads – the Czech Republic paid just 160bp over mid-swaps for its February issue and Romania’s dollar debut priced at 495bp over mid-swaps – which in turn has helped to keep a lid on public debt. As Magda Polan, chief economist, CEE, at Goldman Sachs, puts it: "There are very low risks to debt sustainability in the Czech Republic, for example because of its low cost of financing, so the government doesn’t have to generate extra revenue just to cover its interest costs – it can focus on repaying current debt."

Ease of market access and low debt-to-GDP figures, however, do not tell the whole story. Tight spreads, for example, are as much a product of the liquidity that has poured into the markets in the past two years from the ECB and unprecedented inflows into US dollar emerging-market bond funds, which were barely dented by the upheavals of last autumn.

"We did see some EM fund outflows in the second half of last year but those were balanced by steady inflows since the start of 2010 and again from January this year," says Marzena Niziol, head of CEE DCM, at Citi. "Investors still have quite a bit of money to put to work in the CEE region. Unless we were to see huge outflows from EM funds, demand will outweigh supply over the rest of the year."

Whether or not the current enthusiasm for emerging market bonds would survive a strong recovery in the developed world and in particular rising treasury yields, however, must be a moot point. The fact remains that many CEE countries are dependent on international investors to finance their high levels of external debt. Both Poland and Romania, the region’s two largest economies, have net external debt-to-GDP ratios in excess of 30% of GDP, while Hungary’s figure had reached 75.2% by the end of 2011, according to Fitch.

Indeed, Hungary’s travails serve as a timely reminder of the necessity for politicians to keep foreign investors sweet. Having lost its investment-grade rating at the end of last year thanks to the determined pursuit of populist policies by the Fidesz government, the country is now effectively shut out of international bond markets pending the conclusion of IMF negotiations – by hugely inflated spreads, if nothing else – and still had €4.6 billion of refinancing to do in mid-April when most of its CEE peers were fully funded for the year.

"Markets have lost faith in the direction of economic policymaking in Hungary; once that happens, it adds to the country’s risk premium," says Bob Burgess, CEEMEA economist at Deutsche Bank. "That rising risk premium is then reflected in the currency, and that can rapidly become a downward spiral because of their high levels of FX debt."

In other words, the combination of a gross external debt of 140% of GDP with the wild swings in value of the Hungarian forint – which depreciated against the euro from 257 in March 2008 to a low of around 320 in January and in mid-April had settled in the region of 295 – make achieving a steady decrease in overall debt levels nigh-on impossible.

It is not only for foreign-currency refinancing that Hungary is dependent on international investors; as with other emerging economies in CEE and beyond, it has seen substantial inflows of external cash in recent years into its domestic bond market. Nonresident investors hold around 40% of Hungarian domestic government debt, while in Poland the proportion has increased to closer to 30%.

Manfred Schepers, CFO of the EBRD
Manfred Schepers, CFO of the EBRD

Such levels are not necessarily in themselves a cause for concern, as Manfred Schepers, CFO of the EBRD, points out. "A high percentage of nonresident holdings of domestic government debt could simply be due to market forces, in which case – particularly if you have a strong domestic investor base that can absorb any selling – that need not be a problem," he says. "However, if you are dependent on the international community to buy your domestic government debt that can be very risky." The key to a strong domestic investor base and a stable domestic government bond market, he adds, is "a well-funded pension system that is very heavily invested in that market". Unfortunately that is precisely what Hungary no longer has since its nationalization of the second-pillar private pension system last year, which removed one of the key players in local debt markets – around 70% of the $13 billion in pension assets appropriated by the government had previously been invested in domestic bonds.

oland has also been unable to resist meddling with private pension funds to improve its deficit numbers, although it has limited itself to redirecting part of the inflows into the system – reducing workers’ monthly contribution to the funds from 7.3% of pay to 2.3% – rather than making a wholesale grab of the assets.

In both cases, the problem arises from the fact that moving to a second-pillar system involves an immediate drain on public finances – of 1.3% to 1.5% of GDP in Hungary’s case – while the benefits are much more in the long term.

"Redirecting part of the payments from the private pension system back to the government is an easy way to reduce your budget deficit because this counts as revenue, and politically it’s not that costly because people are more concerned about current tax rates than future pension provision," says Gyula Toth, head of EEMEA FI/FX strategy at UniCredit. "But the population is ageing in all of these countries, so you need to have a second pillar to make the pension system sustainable, otherwise in a few years’ time a country like Hungary will probably need to increase the retirement age quite significantly to avoid expanding deficits."

For Berglof at the EBRD, a big part of the cost for Hungary and Poland of tampering with the pension system will come in the form of a loss of credibility in future policymaking. "What both these countries have done is very short term; as a solution to their fiscal problems, it is a very poor policy," he says.

Paolo Mauro, assistant director in the IMF’s fiscal affairs department
Paolo Mauro, assistant director in the IMF’s fiscal affairs department

Even those economists who have doubts about the efficacy of second-pillar systems – and some dismiss them as a once-fashionable idea that has had its day – question the wisdom of abolishing them to achieve short-term political goals. "The general principle is that any changes in the pension system really should be motivated by considerations related to the sustainability of the pension system rather than by attempts to change the level of deficit from a purely accounting point of view," says Paolo Mauro, assistant director in the IMF’s fiscal affairs department. Not all countries have been scaling back their private pension schemes – the Czech government indeed has gone the other way, voting last year to introduce an opt-in second-pillar pension system – yet the temptation to do so will likely remain for as long as transition costs are an annual drain on the budget. And all countries in the region – barring eurozone members Slovenia and Slovakia – could see their domestic funding capacity severely impaired if, as is being mooted, regulators in the home markets of the western European banks that dominate markets across the region remove the zero-risk weighting for local-currency government securities.

That policymakers across the region appreciate the importance of cultivating a deep and liquid domestic bond market is demonstrated by widespread initiatives to strengthen local asset management industries, improve clearing and settlement systems, and expand the investor base – very successfully in the case of the Czech Republic’s retail bond issuance programme last year. Bankers warn, however, that CEE governments are unlikely to be able to dispense with the contribution of foreign investors in the near future.

"It’s in everyone’s interest that domestic markets continue to develop and deepen, but it’s fairly clear that to get the best execution these sovereigns are going to have to seek funding from international markets," says Chris Tuffey, co-head of credit capital markets EMEA at Credit Suisse.

And to keep that international funding flowing, CEE countries will soon need to offer more than just the low headline debt-to-GDP numbers that have provided such an appealing contrast to those of the eurozone over the past two years. "A sovereign debt investor clearly favours conservative fiscal policies that improve a country’s debt metrics, but what they don’t want is for the economy to contract substantially as a result since the serviceability of your debt is likely to deteriorate," says Tuffey.

That means returning to strong growth, something most of emerging Europe – with the notable exception of Poland – is still struggling to achieve owing to the heavy dependence of its predominantly export-driven economies on cash-strapped buyers in the west of the continent. What is more, policymakers in CEE have less room to manoeuvre than their counterparts in other emerging market regions thanks to their post-communist legacy of high and inflexible social spending.

"If you compare the CEE economies with countries at similar income levels elsewhere, what stands out is that the public sector plays a bigger role – social security contributions are higher, taxation of goods and services is higher, and the level of social protection is larger," says Mauro at the IMF. "That means that big-ticket spending items including pensions, healthcare and the wage bill in the public sector are areas to consider for reforms aimed at restoring the sustainability of the public finances in a durable manner."

Nevertheless, considering the shocks that have roiled European and international markets over the past two years, the record of the key CEE economies – with, again, the exception of Hungary – in terms of the commitment to achieving debt sustainability and balanced budgets has been impressive. Indeed Toth at UniCredit insists that current tight spread levels across the region, far from being a function of excess liquidity in the markets, are an accurate reflection of these countries’ economic fundamentals.

"If you look at the backdrop of these countries, their spreads should never have widened as much as they did last year," he says. "These economies are extremely strong, which is why we are seeing significant outperformance now that the fear of eurozone contagion is receding."

If that performance is to be maintained, however, policymakers will need to keep working on both sides of the debt-to-GDP ratio and maintain market trust. As the example of Hungary shows, CEE is still a vulnerable region and there is no room for complacency.

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