Why Invest in East European Sovereign Debt?
ANZ Bank

As a distinct class, in the past five years emerging market debt has outperformed almost all other asset classes globally, including emerging market equity. In the same period a sub-group of the emerging markets, emerging Europe debt, has provided impressive returns. Emerging Europe offers opportunities in sovereign and non-sovereign, and foreign and domestic currency assets. In addition to the diverse assets available, the region offers a wealth of differing credits, from the A3-rated Slovenia to the B3-rated Bulgaria.

Even though neither emerging Europe nor Latin America share the problems that triggered the crisis in south-east Asia, both regions have felt the impact of the collapse of confidence. However, unlike Asia, the sovereign foreign currency debt markets in emerging Europe have already started to recover, with returns on local currency products continuing to be attractive. Indeed, there have already been clear signs of asset reallocation into the region.

Comparative US$ sovereign returns

In 1998 the global environment should favour emerging market debt. Yields are likely to remain depressed in most developed markets, kept low by the south-east Asian/Japanese led economic downturn. Meanwhile, developed stock markets are likely to post only modest returns. Nevertheless, the reforms and austerity measures that are now underway in south-east Asia and the defensive measures implemented elsewhere, should start to restore faith in the emerging markets, reasserting the attractions of the asset class next year. Emerging Europe debt will share in this.

Comparative local currency sovereign returns

The model of reform in emerging Europe

Economic reform has brought an enormous improvement in underlying country fundamentals, with the countries that adopted transition policies first and fastest being the most successful. This has been reflected in economic performance.

The reforms which have made emerging Europe sovereign debt an attractive proposition have followed a common pattern, though each has possessed idiosyncrasies in the sequence, emphasis and pace of their programmes.

In the first instance, transition countries have experienced a marked slowdown in growth, as both trade and prices are liberalised and the economy is forced to adjust to the imposition of market forces. This has typically been followed by a bout of high inflation, as stabilisation is sacrificed to maintain popular support for the reforms, or to compensate for deterioration in tax revenues. Stabilisation and sustainable growth are achieved after the implementation of tight fiscal and monetary policies, which produce stable exchange rates and low inflation. Concerted structural adjustment then occurs.

As inflation falls the reform process starts to gain greater legitimacy. Despite the reinstatement of reconstructed communists in a number of emerging European countries, this has not been the end of reform. Instead, these administrations have been compelled to adopt the same macroeconomic policies and reforms as their predecessors, though more often than not, at a slower pace.

Fall in emerging Europe inflation

Once stabilisation has been entrenched and outstanding debt restructured, transition countries have been quick to tap the international markets. During this period governments have been able to issue short-dated local currency paper, and as the economy improves, the tenor of the paper lengthens and the interest rate offered declines.

Volume of selected emerging Europe public bond issues

Issues (by nationality of issuer and currency)
(April 1, 1996 to March 31, 1997) Source: Capital Data Bondware

US$ Deutschmarks Other currencies Total
$m Iss. $m Iss. $m Iss. $m Iss.
Croatia 300.00 1 0.00 0 54.17 1 354.17 2
Czech Republic 250.00 1 292.80 3 0.00 0 542.80 4
Estonia 0.00 0 40.53 1 0.00 0 40.53 1
Hungary 0.00 0 332.51 1 414.28 1 746.80 2
Kazakhstan 200.00 1 0.00 0 0.00 0 200.00 1
Lithuania 50.00 1 0.00 0 0.00 0 50.00 1
Romania 300.00 2 0.00 0 768.18 2 1,068.18 4
Poland 200.00 3 163.61 1 0.00 0 363.61 4
Russia 1,025.00 2 1,163.53 1 0.00 0 2,188.53 3
Slovakia 280.00 2 0.00 0 0.00 0 280.00 2
Slovenia 325.00 1 0.00 0 0.00 0 325.00 1
Total 2,930.00 14 1,992.99 7 1,236.64 4 6,159.62 25

Political background

Emerging Europe, particularly key strategic countries such as the Ukraine and Russia, can expect to receive continued political support from the west. Countries which have enjoyed the support of the west have come under enormous pressure to follow the west's view of how economic and political transition should proceed. Though the policies prescribed by the International Financial Institutions have not always met with universal domestic approval, public opinion has been galvanised to such an extent that there are few siren voices calling for a return to the political or economic systems of the past, even from within the opposition parties outside the mainstream.

With policy making now designed by technocrats, rather than politicians saddled with ideological baggage, the quality of macroeconomic management throughout the region has improved. Technical assistance and advice on implementation from the International Monetary Fund (IMF), World Bank, the EBRD and others has brought added credibility, since their financial assistance should ensure the sustainability of the transition process.

Though political uncertainties remain, particularly delayed implementation of reforms, greater nationalism and regional conflict, the west and the International Financial Institutions have both the ability and the incentive to minimise these.

Emerging Europe does not share the problems of east Asia

In 1998 emerging Europe should offer greater stability than east Asia. Countries in the region are already following the economic policies that east Asia is now being forced to implement. Significantly, they have not based their economic development on a policy of cheap labour export led growth. So, despite the impact of the problems in south-east Asia, their sovereign risk fundamentals remain on an improving trend.

There is also a wide gulf between the politics of the two regions. Emerging Europe has been through intense and radical political reform. Consequently, the economic reform process has enjoyed democratic legitimacy which has, in turn, enhanced its sustainability.

Significant factors

Two significant medium-term influences on emerging Europe should remain positive in 1998:

  • United States Treasuries can be expected to provide a constructive backdrop as the deflationary effect of the crisis keeps yields low;
  • funds are likely to be reallocated from east Asia into other emerging markets, as investors' search for high yields continues.

Debt performs better than equity

As an asset class, emerging Europe debt has performed better than equity over the last five years, and should continue to do so. Radical structural reform is good for sovreign debt, but can be bad for growth and equities in the short term. Another reason why debt is more attractive is because equities do not have the liquidity of bonds. For instance, the average daily traded volume on the Russian stock market is about US$40 million, compared to up to $1.8 billion for debt. As a result, active portfolio management of debt is far easier. Active management by experienced fund managers can be shown to outperform, consistently and significantly, passive management.

Individual emerging market debt instruments can be volatile, but risk may be diversified by investing across emerging Europe in a variety of assets. Since local currency assets are poorly correlated with other major asset classes, overall portfolio risk can also be reduced by investing in local as well as foreign currency paper.

For further information please contact:
John Cartwright or Tobias Webb
ANZ Emerging Markets Fund Management
Minerva House
PO Box 7
Montague Close
London, SE1 9DH
Tel: (44) 171 378 2864
Fax: (44) 171 378 2900