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Created on Tuesday, 14 February 2012 15:40

The prosperity of Emerging Europe is interwined with the volatile eurozone.  But one economy in the region is providing some welcome respite from the doom and gloom, writes Simon Brett.

Emerging Europe covers a vast geographical area, from the Baltic Sea in the North to the Black Sea in the South.  It encompasses a range of cultures, populations, economies and investment prospects. Some countries within this group are faring better than others, from those with expanding economies to those with some serious structural problems that need urgent resolution.  Within emerging Europe, some nations – such as Hungary and Poland – are within the EU while others are not. Of those within the EU, the likes of Estonia have adopted the euro whilst others have not. While emerging Europe is not without its risks, the region’s diversity offers investors select opportunities.  

Perhaps the greatest immediate threat to a number of central European countries is their exposure to Western Europe whether it is via their banks or trade flows. Prior to the financial crisis of 2008 a number of banks from Western Europe - especially Austria and Italy - lent freely in the region. Helping to fuel their economic growth in these regions, often they became the dominant players in the local banking market. Owing to fears that these banks may withdraw from the markets and provoke a credit crisis, the European Bank for Reconstruction and Development (EBRD) devised in 2009 the Vienna Initiative. An agreement for lenders not to divest from the region, the initiative aimed to curb the onset of a local banking crisis.

However, following the expiration of the initiative in April 2011 and banks now faced with having to increase their capital, banks are likely to have to scale back in the region. The term ‘de-leveraging’ is being used to describe the process of reducing lending and selling assets which will conserve and raise capital. Unilaterally Austrian bank regulators have instructed their banks to limit lending to Eastern Europe. One of the reasons cited by Standard and Poor’s for the recent downgrade of Austria sovereign debt was exposure to Eastern Europe.

As the euro crisis rolls on there are growing fears that the Eurozone may dip into another recession. This is also bad news for Emerging Europe as the region represents its most important export destination. Those countries that are most integrated into the Eurozone will be the most vulnerable. For example, the euro area accounts for 80% of the Czech Republic’s exports.

In addition to some of the above macro risks, there are also specific country risks. The recent crisis in Hungary is a good example. Despite being a member of the EU and wanting to join the euro, recent changes to its constitution have spread alarm amongst investors. Given the Hungarian debt has also been reduced to “junk” status; the country is finding it hard to raise new monies at reasonable interest rates. With an IMF loan due to be repaid in the first quarter of 2012, Hungary has the potential to be a“non-euro crisis” within the EU.

As with any investment that has the word “emerging” attached, investors should expect greater volatility and emerging Europe is no exception. The immediate outlook looks challenging given many of the countries have close ties with their Western neighbours. However, it is not all doom and gloom, Russia look set to have a better year than most and an investor does have a choice to invest in a dedicated Russian or BRIC fund. For those interested in the wider region, a satisfactory resolution of Europe’s ills is probably required before there is more clarity on their growth prospects for the next few years.

By far the largest economy in Emerging Europe is Russia, a market that has come to prominence as part of the BRIC grouping of emerging markets (Brazil, Russia, India and China).  The country is to a large extent insulated from the travails of the rest of Eastern Europe whose fortunes are more closely tied to their Western neighbours. With its vast oil reserves and given the continuing high oil price Russia is in an enviable financial position compared to the indebted west.

Whilst it is easy to think of Russia as an oil economy, and it will certainly benefit from price rises from any Gulf tension, other parts of the economy look strong. Consumers do not have the debt burdens of their Western counterparts and want to spend money. Meanwhile, infrastructure spending on the Winter Olympics in 2014 and the World Cup in 2018 will also provide a boost. Russia joined also the World Trade Organisation (WTO) in December last year. Becoming a member of the WTO should boost its economy by adopting rules/regulations, attracting foreign investment and integrating its economy more into the global economy. Furthermore, although there were recent popular protests questioning the recent election results and the possible return of Putin as president, it is unlikely that the protests will turn into a “Russian spring”.

As with any region or asset class, emerging Europe is not without its risks. However, made up of a diverse range of countries, there are opportunities to be found. Slightly separated from its European counterparts and with key sporting events set to boost infrastructure spend, Russia has the potential to provide some respite from all of the doom and gloom in Europe.