Over the past decade significant improvements have been made in the securities markets in eastern Europe. Formal capital markets now exist in 24 out of the 27 countries where the European Bank for Reconstruction and Development operates. In particular, considerable progress has been achieved in the legal and institutional development of these markets. Strengthening the institutional capabilities of regulators and establishing good corporate governance are vital steps for the further deepening of capital markets.
In the past year, capital markets in the transition economies of eastern Europe outperformed the US and European markets and other emerging markets. This was the result of strong economic growth in the region, progress in reform and the imminent prospect of EU accession for eight transition countries. Economic growth in the region as a whole reached 3.7% on a weighted average basis in 2002, only slightly less than the 4.3% growth recorded in 2001. This is a respectable performance in view of muted global recovery and difficulties in a number of other emerging markets, particularly in Latin America. A notable example of the region's progress in structural and institutional reforms was the improvement in corporate governance standards in Russia. Listed companies in Russia are now required to have auditors' statements in their annual reports on their compliance with the Corporate Governance Code adopted in March 2002.
Of particular significance last year was the finalisation of EU accession negotiations for eight countries in eastern Europe. The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, the Slovak Republic and Slovenia are set to become EU members in May 2004 while Bulgaria and Romania are likely to join in 2007. EU accession does not lead to an immediate membership of economic and monetary union (EMU) but markets are already preparing for 'convergence'.
Recent developments in the markets
Eastern Europe was the only region in the world where stock markets made gains in 2002, ending the year around 15% higher than they started. This is even more remarkable when major markets in the United States, Europe and Japan continued to post significant negative returns. The Czech, Hungarian and Russian markets ended the year substantially higher, with annual returns of 41%, 29% and 14% respectively. In contrast, the Polish market performed relatively poorly among the transition economies, closing the year with a negative return of 0.5%. This partly reflects a subdued economic performance in Poland during the year. The volatility of returns in the region - that is, the variance of returns during the year - decreased, declining to 25% in 2002 from 32% in 2001. This occurred at a time of increased market volatility in both established market economies and other emerging markets.
The robustness of the east European markets shows that there has been very limited 'contagion' from other markets and a strong focus by investors on the characteristics of individual markets. As returns differed markedly from those in the developed markets, the region remains attractive to investors from the perspective of portfolio diversification. In terms of the 'depth' of the market, the trend varied across countries.
Market capitalisation in the Czech Republic and Russia increased substantially as a percentage of GDP from 15 and 26% in 2001 to 21 and 37% respectively. In Poland there was a marginal increase, from 14% to 14.6%, despite the decline in the index value. On the other hand, the ratio declined in Hungary from 19% to 18% although the value of the index increased.
A number of companies - primarily in Russia - were able to take advantage of the buoyant domestic markets and issued new shares in the international market. In 2002 seven companies (including banks) raised some USD1.6bn through the issuance of American Depository Receipts (ADRs), a significant increase from USD20m international equity issues in 2001. Most of the companies were in the telecommunications and energy sectors. The success of Russian companies is partly due to improved corporate governance practices. Both domestic and international agencies now provide corporate governance ratings of Russian companies.
The largest transition economies performed relatively well in the fixed income markets. Yield spreads on the JP Morgan emerging market bond (EMBI) sub-indices of Bulgarian, Polish and Russian bonds narrowed by 160, 18 and 200 basis points to 288, 178 and 472 basis points respectively. In Bulgaria the narrowing of the spread reflected a sharp fall in the public and external debt ratios following sustained economic growth, tight fiscal policy and an active debt management policy.
Similarly in Russia, credit ratings were upgraded by both Standard & Poor's and Moody's, reflecting solid GDP growth and an improved fiscal position partly fuelled by high oil prices. In Poland the announcement of the EU accession timetable at the Copenhagen Summit in December 2002 has improved investor confidence despite subdued growth. The performance of bonds from transition economies was in sharp contrast with bonds from Latin America, where political and economic concerns in Argentina and Brazil have driven the yield to widen sharply.
It is clear that international investors are now increasingly differentiating among borrowers. In 2002 international debt securities issued by transition economies increased by more than 50% from the previous year, reaching a total of US$12.8bn compared with USD8.2bn in 2001. This increase was largely due to the increased presence of Russia and other CIS countries in the market as well as the maturity extension of existing debt by Bulgaria and Romania.
The total gross value of international debt securities issued by central eastern Europe and the Baltic states (CEB) declined as Hungary abstained from tapping the international bond markets. The domestic bond markets are still largely confined to CEB as these markets have been opened to significant portfolio flows. While the gross issues of domestic debt securities declined from USD64.2bn in 2001 to USD53.9bn in 2002, the authorities are attempting to extend the maturity of sovereign debt and expand domestic yield curves. In 2002, Poland issued a 20-year domestic bond for the first time and Hungary reopened a 15-year bond.
Implications of EU accession
The EU accession candidates of eastern Europe have already made remarkable progress with structural reforms, benefiting from the impetus generated by the prospect of EU accession. The Copenhagen criteria for EU accession have contributed to enhanced political and economic stability in these candidate countries. All ten countries have institutions guaranteeing democracy, the rule of law, human rights and the protection of minorities. The candidate countries also have functioning market economies with the capacity to withstand competitive pressures and market forces. The only country currently not meeting this criterion is Romania but it is making good progress in this respect. Another benefit of the EU accession process is the overhaul of the candidate countries' legal and administrative systems to bring them in line with EU standards. In the area of securities markets, the accession countries have introduced a legislative framework broadly in line with EU directives although the enforcement of rules would require further strengthening.
Economic growth in the candidate countries reflects the positive institutional and economic environment achieved as a result of the EU accession process. The growth in almost all of the eight first-wave accession candidates since 1995 has far exceeded the levels seen in the EU and other emerging markets over this period. On (a weighted basis) average, the eight first-wave countries grew by 3.5% per annum compared with 2.4% for the existing EU members.
Looking forward, accession is likely to lead to an increase in growth for both the new and existing members as there will be a better allocation of resources between sectors, higher productivity growth, and increased investment in infrastructure. Formal accession will lead to the full liberalisation of conditions for foreign capital and for trade and market integration. This will create significant opportunities for foreign investors.
Based on the experience of previous enlargements and the implementation of the Single Market, additional growth resulting from accession is estimated to lie within the range of 0.5 to 1.5 percentage points per year. As a result, the accession countries will be in a position to record growth rates ranging from 4 to 5% per year over the next decade. The growth of existing members could also increase by 0.7 percentage points per annum.
The speed of 'convergence' with existing EU members is a particular concern. The current income gap between the eight first-wave candidates and the EU is wide. It will take 20 to 30 years, on average, for the candidate countries to reach 75% of the average income level of EU members. This is based on the accession countries growing by four% per annum and the EU by two% per annum.
Even with a more optimistic growth forecast, it would take more than a decade for the gap to narrow. When Portugal and Spain became members of the European Union in 1986, per capita GDP was around 60-70% of the EU average in purchasing power parity terms. Convergence has occurred gradually since this time and per capita income levels in these countries are now at around 70-80% of the EU average. For Greece, however, the gap between Greek and EU per capita GDP actually widened following EU membership before starting to converge only relatively recently.
EU grants to the less wealthy members have helped to stimulate growth in these countries and to narrow the income gap but in the first three years of accession new member states will receive much less support than existing member states per head of population. According to the Budget Commissioner of the European Commission, Poland will receive EUR67 per capita, Hungary EUR49, Slovenia EUR41 and the Czech Republic EUR29. In contrast, in 2000, Greece received EUR437 per capita, while Ireland obtained EUR418, Spain EUR216 and Portugal EUR211.
EMU membership is mandatory for all candidate countries and none of them will be granted derogation on this point. In other words, the new EU members will join the eurozone at some point in the future. However, to become an EMU member, the new EU states will have to meet several macroeconomic criteria on exchange rate stability, fiscal deficit, public debt, inflation and nominal interest rates. Currently, no candidate country meets these criteria and their fulfilment will be no easy task.
Monetary policy will be made more difficult for some countries by the requirement of full capital mobility, which is part of the acquis communautaire (the entire body of EU laws). Although all the candidate countries have established current account convertibility of their currencies and most of them have completely liberalised foreign direct investment, some restrictions remain with respect to short- and medium-term capital transactions. While full capital account liberalisation will benefit portfolio investors, it may also complicate the management of exchange rate especially if the countries were to move to a more inflexible foreign exchange regime. Fiscal policy will also be a challenge. The achievement of EU standards requires substantial investment in many sectors. The environmental and transport infrastructure requirements for EU accession, for example, could add between four and six% of GDP per annum to the public sector investment programmes of the accession countries in the medium term.
For transition countries, there may be a problem with the Maastricht Treaty's conflicting goals, such as nominal inflation and stable nominal exchange rates. The candidate countries are most likely to experience consistent pressure for real exchange rate appreciation as part of the process of improving productivity and living standards.
It seems likely that the differential between productivity growth in the traded goods sector and in the non-traded goods sector will be larger in the candidate accession country than in the eurozone because productivity improvements are likely to be faster in the traded goods sector than in the non-traded sector. Assuming equal wages between the traded goods and non-traded goods sectors, this means that the relative price of non-traded goods to traded goods will rise faster in the accession candidate than in the eurozone (Balassa-Samuelson effect). This in turn implies that, at a given exchange rate, the overall inflation rate will be higher in the accession candidates than in the eurozone. Various studies estimate the Balassa-Samuelson effect in the candidate countries to be in the range of 1-2.5% per annum.
In view of these challenges, the candidate countries have been cautious in fixing a date for adoption of the euro. This is sensible as the candidate countries should focus on firstly implementing the structural reforms under the acquis communautaire.
Compared with the 'depth' of stock markets in the euro area (over 70% of GDP on average in 2001), capital markets in the EU candidate countries have a lot of ground to catch up. However, this process may not be straightforward. Eurozone capital markets have undergone profound changes since the introduction of the euro. There has been further integration of the stock exchanges through mergers and alliances.
In 2000 'Euronext' was created through the merger of the stock exchanges of Paris, Amsterdam and Brussels. 'NOREX' was established as a strategic alliance of four Scandinavian stock exchanges. The 'Deutsche Börse' was created by a German strategic alliance with the Irish and Austrian stock exchanges. Although there has been no further integration of stock exchanges in recent years due to the adverse market environment, further integration cannot be ruled out in the future.
Stock exchanges in the accession countries may become part of the pan-European consolidation process. Tallinn Stock Exchange and the HEX group (the owner of the Helsinki Stock Exchange) have established a strategic alliance. Further alliances are likely involving the stock exchanges of accession countries. Another issue to consider is the competition from the banking sector where integration is more advanced. In most of the accession countries, foreign investors control more than two-thirds of the banking sectors. These banks may 'crowd out' the corporate debt market through the provision of corporate loans.
It is difficult, therefore, to predict accurately how stock markets will develop in the new EU members. Drawing on the examples of the less wealthy members of the EU, such as Greece, Portugal and Spain, where stock market capitalisation as a percentage of GDP has more than doubled in the past five years, it is possible that stock markets in the accession countries will develop in the medium term. To facilitate this, further efforts are needed to improve regulatory framework and to establish good corporate governance.
One area where there is likely to be a boost in the medium term is the development of sovereign debt markets. As mentioned above, EU accession will require further capital expenditure on infrastructure in the medium term. EU grants would finance part of this but the remainder will require financing through the issuance of sovereign debt. As local institutional investors are relatively undeveloped, foreign investors are likely to play a key role.
As stated earlier, some countries are already focusing on debt management by extending the yield curve. The markets appear to be already taking account of 'convergence' as interest rates have been falling quickly to EU levels. Local interest rates (both short-term and long-term) in the Czech Republic are already below rates in the eurozone. The reduction in EU accession risk as the date of accession nears and increased competition will force the margins for both sovereign and private sector transactions to decrease, potentially close to the levels of the less advanced current EU member states. However, many structural deficiencies are yet to be addressed, and public sector deficits are large. Macroeconomic performance and the pace of structural reforms should determine the prospects for new EU countries.
Conclusion
The markets in transition economies have performed strongly in the past year. This reflects a gradual improvement in the institutional framework that supports the development of capital markets. The 'depth' of the markets is also improving. In south-eastern Europe the opening of new stock exchanges in Bosnia and Herzegovina in 2002 heralds the achievement of reforms in the post-war period and may complement the privatisation efforts in the country. In the Commonwealth of Independent States we have seen a significant deepening of markets in Russia partly due to the continued favourable macroeconomic environment but also due to much improved corporate governance standards. Next year (2004), eight east European countries will become EU members. The benefits of an enlarged EU will not only be evident to the new members but also to the existing members. Over the coming years we can expect further integration of financial markets, including capital markets, within the EU. In the fixed income markets, investors appear to be already taking account of 'convergence'. But challenges remain in the implementation of structural reforms and the maintenance of macroeconomic stability. It could be a bumpy ride.
