Expansion of the European Union: The Incomplete Convergence of Financial Markets
In recent years, the markets of Eastern Europe have been the stars of the investment world, when it comes to profitability. Slovenia, Slovakia, Estonia, Lithuania, Latvia, Malta, Cyprus, Poland, Hungary and the Czech Republic have all experienced strong gains thanks to the European Union’s convergence process, which culminates on May 1. This as been especially true for Poland, Hungary and the Czech Republic – which have been the main targets of international investors because of their greater liquidity and transparency.
According to an analysis in Expansión, the Spanish daily, the Polish stock index, WIG; the Hungarian index, BUX; and the Czech index, PX 50, have all shot up in value since 1999 – by 45%, 131%, and 81%, respectively, when adjusted to the euro. Over the same period, the FTSE Eurotop 300, a pan-European indicator, has dropped 19%, and the Euro Stoxx 50 index, which covers the euro zone, has dropped by 15%.
Much the same way, investment funds that were bullish on stock markets in these countries have come away with the strongest results of any region worldwide. Despite the crisis in global variable income and the collapse of the Internet bubble, these funds have enjoyed a cumulative rise of about 75% since March 2001, according to data from Standard & Poor’s and Expansión. Those returns are extraordinary if compared with a drop of about 26% in funds that invested in Western European stock markets over the same period.
When it comes to debt markets, the numbers also speak volumes. Emerging European countries’ medium- and long-term bonds grew in value by 18.6% over the last three years. That exceeds the 15.25% increase recorded by [West] European bonds. These results are much better than the returns that European investors derived from American or Asian debt, despite the strength that the euro demonstrated in foreign exchange markets, relative to other currencies.
In analyzing fund profitability, one has to take into account that many funds are also investing in Russian variable income markets because of that country’s geographical proximity. The Russian market has behaved very well in recent years, thanks to the rising price of crude oil, which its economy depends on to a considerable extent. The numbers [from Eastern European markets] should continue to show exceptional gains for investors who bet, years ago, that Eastern European markets would converge with markets of the European Union.
This sort of market behavior seems logical, not only because of improvements that follow from joining the EU but also because of the gradual disappearance of the perception that Eastern Europe is an emerging market, with the usual risks. The new Europe of 25 will be able to respond to any member-state that has a problem. Already, the view of the region as a very risky area has been disappearing, now that it has become clear that the ten nations would achieve EU integration.
However, to what degree has convergence really taken place in markets and in the financial system? According to experts, convergence may not be as real as equity and debt markets seem to have assumed.
Still Very Far Away
According to a recent study by Alicia García Herrero and Pedro del Río López, both researchers at the Bank of Spain, “the financial systems continue to be very small, and relatively inefficient when it comes to being able to contribute to growth.”
Their report, published last summer, notes that “the countries joining [the EU] are characterized by a level of development in which financial systems are particularly undeveloped; not only in terms of size but also efficiency. If you compare them with the countries of Southeast Asia, which have a similar per-capita income, the total financial assets of the countries that are joining [the EU] is about one-third, on average. A comparison with the [15 earlier] member states of Europe turns out to be even more unfavorable.”
According to Juan Antonio Maroto, professor of finance at the Complutense University of Madrid, “It’s enormously important that there is hardly any collective investment because the pension systems are public. Practically the entire financial system is based on public-sector banking and banks with foreign capital. Specifically, that means Austrian and Belgian banks, which are very active in those countries and have business based in large part on providing long-term loans to companies.”
“The development model of the new EU members has been based on the system of banking, not on capital,” Herrero and López write in their study. Moreover, the importance of these countries’ banking assets is smaller when seen through a European Union perspective. The banking assets of these countries represent, on average, only a fifth of their total [national] assets. That is a small amount, considering that these countries comprise one-third of the total population of the expanded EU.
This is the fifth time new members have joined the EU – and it is a unique process, despite the fact that new members usually have a lower level of economic development. “Even if you compare the assets that [new member] countries had in previous integration processes, such as Spain in 1986 (when Portugal also joined the EU), this year’s new members don’t have even half the assets that Spain had at that time,” say Herrero and López.
A weakness of the new members’ capital markets is their small scale, despite the recent strong performance of their stock markets. In half of the ten new members, the total market capitalization in 2001 was equivalent to less than 30% of the national GDP, compared with an average of 70% in the European Union.
An Imbalance of Supply and Demand
According to Maroto, “a basic problem is that variable income markets are very poorly developed, and debt markets are underdeveloped. In fact, they are practically non-existent.” Although this argument appears paradoxical at first, it can also help to explain the very high profitability of Eastern European markets in recent years.
The major global investment funds have discovered that “there is not much to buy [in the region] because the debt markets barely exist and the remaining assets are also limited,” Maroto adds. As a result, the forces of supply and demand converged to set off a very rapid rise in prices. Why is there such a scarcity of supply? According to Herrero and López, “for a long time, most of these countries functioned as planned economies (with low levels of public debt and very prudent fiscal policy). Moreover, there was no institutional framework that clearly protected the rights of creditors; financial management standards were generally low.”
Experts believe that financial market conditions will have to develop as these countries make significant progress integrating their economies with the rest of Europe. Along the way, opportunities will emerge for major companies.
“The major Spanish banks are rubbing their hands with glee,” notes Maroto. In his opinion, just as in Latin America, Spanish banks “realize they can take advantage of an entire business sector. They can supply personalized services to small and midsize companies and to individuals. Moreover, they have this advantage: They are arriving as brand-new players in the market, so they do not have to assume any arrears that are in the system. They can develop their own systems for measuring risk, in order to adapt better to the conditions of each customer.”
The big banks “have interest rates in their favor,” Maroto adds. “Although they will have to analyze each situation, case by case, interest rates in the [new member countries] are generally higher than in major economies of the euro zone; this is something that also happened in Latin America.” Higher rates allow financial institutions to achieve higher margins for their traditional activities – charging interest on loans and paying interest on deposits.
Elsewhere in Europe, banks may wind up with an additional source of revenue -- financing ventures by Western European companies in the new EU member-states. Maroto explains, for example, that if a Spanish company decides to manufacture in a Polish city, it will need financing to carry out the move. That will mean new business for Spanish banks.
However, in Maroto’s view, there is a potential snag in developing this market. “Banks could wind up using the profits they make to improve their earnings figures, not to contribute to the improvement of the actual financial system. This situation could continue until someone says, ‘enough already.’ That’s what happened in Latin America, with American banks and with governments.”
Given that prospect, it might look like financial systems are facing a dead end. However, the situation is not that dramatic, according to Maroto. “Fortunately, the big advantage these countries have is that there are few borders in financial markets. When capital moves into these countries, it winds up developing their markets and strengthening them.”
The continued confidence of global investment managers provides proof of that assertion. The major funds have created a favorable atmosphere for extraordinary growth in the profitability of the assets that these markets offer. Experts believe that this trend will continue so long as there is continued growth in the supply of financial assets and continued progress in regulating and supervising financial markets.