The securities markets of eastern Europe had to be built from scratch after the fall of communism. While banks have slowly evolved into the main source of finance for businesses, the securities markets have grown at an even more modest pace. Yet there is increasing focus on the crucial role these markets can play in supporting economic development. It is more and more evident that they extend choice and competition in the provision of financial services, provide longer-term finance, help improve corporate governance, diversify risks and, ultimately, contribute to a sound financial system.
The history of securities markets in the region dates to the 19th century, when they existed in some form in many of what are today the transition economies. But these markets were closed under communist rule and only re-emerged thanks to the privatisation programmes of the early 1990s. The Ljubljana and Budapest stock exchanges re-opened in 1990, the Warsaw Stock Exchange in 1991, and the Prague and Bratislava exchanges in 1993. Currently, 23 out of the 27 countries where the European Bank for Reconstruction and Development (EBRD) operates have formal capital markets.
Significant improvements in the sector have been made in the last decade in many areas, including establishment of the formal exchanges, the development of legal frameworks and regulatory institutions, the establishment of internationally compatible accounting standards, and improvements in transparency and corporate governance. However, most markets are still in their infancy. Many of the small markets remain illiquid or exist only on paper. Even in the advanced countries, there remains considerable room for improving market depth and liquidity, as well as regulations and institutions.
Development of equity markets
The stock market capitalisation of the transition economies of central, eastern and southern Europe, as well as the former Soviet Union, increased from about USD1bn in 1992 to USD152bn in 2000. The average market capitalisation to GDP ratio increased from 2% to nearly 25% during the same period. Four markets in the region had a market capitalisation in excess of USD10bn at end-2000: Russia (USD43bn), Poland (USD31bn), Hungary (USD12bn) and the Czech Republic (USD11bn). Croatia, Estonia, Kazakhstan, Lithuania, Romania, and Slovenia are among the stock markets with a capitalisation of more than USD1bn, but the rest are negligible in size. The region, which accounts for almost 8% of the world population, accounts for 1% of the world market capitalisation.
In terms of market size relative to economic activity, the stock market capitalisation to GDP ratios reached 22% in the Czech Republic, 26% in Hungary and 20% in Poland. These figures are slightly less than the average of 30% in Latin America and almost half of the average of 52% in East Asia -- not to mention the European Union and the United States, where market capitalisation often exceeds the value of GDP.
The stock markets in the region have thus not yet reached a level that corresponds to the size of its population and economy. As a result, many large firms from the region are seeking foreign listings on larger and more liquid markets. These firms tend to list on pan-European and/or US stock exchanges. By the end of 2001, 61 of the region's large companies had issued international equity in the form of global depository receipts (GDRs) and American depository receipts (ADRs).
Market liquidity has generally been increasing in many of the transition economies but is still modest by comparison to other emerging markets. Market turnover, defined as the value of trading over market capitalisation, has increased significantly during the decade. As of 2000, it was highest in Hungary at 101%, 61% in the Czech Republic, 49% in Poland and 54% in Russia. However, most of the smaller markets are illiquid, in particular those in the CIS states. Furthermore, concentration of the markets is substantial since stock markets in the region are dominated by a small number of large firms -- typically those in the banking, electric power, natural resource and telecommunications sectors.
The price performance of the stock markets has been mixed. In general, equity markets in Central and Eastern Europe (CEE) are high yield, yet volatile, markets. Over the past five years (1996--2000), stocks in transition economies have on average yielded a positive total return (measured as capital gains plus dividend income using S&P Total Return indices), but these returns have varied widely over time and across countries. The countries that have achieved positive total returns over the period are Hungary, Russia, Poland, and Slovenia. Over the same period, the Eastern Europe indices averaged 14.4% of annualised return and 43.7% of standard deviation. At the same time, the correlation of returns with those in the developed markets has been low over the period, pointing to potential diversification gains by investing in the region.
Development of the fixed income markets
The fixed income markets tend to be more developed than the stock markets, with a number of governments successfully issuing domestic and international bonds over the decade. Domestic bond issues had increased from USD3bn in 1991 to USD64bn in 2000 with a peak of USD147bn in 1998. International issues have also increased from some USD1.5bn in 1991 to USD10bn in 2000, with a peak of USD21bn in 1998. But both domestic and international bond issues have declined significantly since the 1998 Russian crisis. The total domestic bonds outstanding of the four largest markets (Czech Republic, Hungary, Poland, and Russia) at September 2001 was just above USD86bn.
Most of the issuers are central governments, government-related enterprises, and local authorities. The number of corporate and bank issuers of debt securities is very limited -- with perhaps one exception. Only in the Czech Republic has the issuance of corporate, municipal and bank bonds developed significantly. Until recently, maturities of bond issues, including those by governments, have rarely extended beyond one year. The most active fixed income markets normally consist of treasury bills. However, with increasing economic stabilisation, the length of maturities has been increasing in recent years. There has been a sizeable increase of paper with maturities of 2 to 5 years. The Polish and Hungarian governments notably issued 10-year fixed-rate treasury bonds in 1999.
Legal and institutional development
There has also been considerable progress in the legal and institutional development in the financial sector during the last decade. Many of the central and eastern European countries have already harmonised their legal systems with those of the European Union and with internationally recognised standards. Independent regulatory institutions for the financial markets have been established.
The length of the law's reach, however, varies widely from country to country. For example, minority shareholders' rights and corporate governance standards in Russia have been weak over the decade and firms have tended to be controlled by insiders rather than shareholders. Senior managers often used their powers for personal gain. Even in the most advanced economies, the implementation and enforcement of established laws and regulations remains problematic as regulatory institutions lack sufficient empowerment, as judges often hesitate to apply newly introduced laws, and as the necessary information is not widely distributed. Thus, the legal protection of investors has been more effective on paper than in reality.
A clear priority is to promote sound corporate governance and business practices. In recent years, significant progress has been made in this area in a number of countries. A new commercial code came into effect in Poland in January 2001, which permits small investors to band together in order to influence a company's activities. In Hungary, a new comprehensive securities law has been enacted as of January 1, 2002. This strengthens the protection of minority shareholders and is a direct response to controversial transactions concerning a Hungarian chemicals company last year. In the Czech Republic, a comprehensive commercial code of 1992 was amended effective January 1, 2001, replacing approximately 80 assorted codes and regulations and establishing a sound legal framework for most business-to-business activities. The legislation should improve the protection of minority shareholders' rights, clarify the responsibilities of the board of directors, improve disclosure and make takeovers more transparent.
Importantly, Russian corporate governance standards are also expected to improve. A comprehensive set of amendments to Russia's 1995 joint stock company law came into force on January 1, 2002. This will strengthen shareholders' rights considerably. The Federal Commission for the Securities Market is also developing a comprehensive corporate governance code with the assistance of the EBRD. The proposed code is modelled on the OECD corporate governance principles and covers all aspects of corporate governance, in particular focusing on financial disclosure, transparency and the role of the board of directors to ensure that management run companies for the interests of their owners. Moreover, the Institute of Corporate Law and Governance, directed by the former chairman of the Federal Securities Commission, launched a rating agency that ranks Russian firms on the basis of their corporate governance standards. The institute reported that important progress was made last year in corporate governance of Russian companies. For example, a number of large enterprises have appointed independent directors representing the interests of minority shareholders.
The key challenges
Although capital markets in transition economies have significantly improved since the beginning of transition, the markets are still small and illiquid compared with those in countries with similar per capita income. There are still some important challenges ahead. As financial markets consolidate globally, transition economies must be sensitive to global developments in the securities markets, in particular for those preparing for accession to the European Union.
The strategy over the next decade must be to build on and evolve from that of the last 10 years. Looking back, the emphasis has been on opening exchanges, starting trading in post-privatisation shares, the establishment of legal frameworks and responsible institutions, and introduction of internationally recognised accounting systems and audit standards. Looking forward, the focus must be on the establishment of efficient trading systems, improving the effectiveness of the laws and regulations, enhancing the quality of disclosure and transparency and broadening the asset base of institutional investors.
I consider that the key challenges for the transition economies for the development of capital markets are as follows. Many of these are inter-related and complementary.
Strengthening the institutional capabilities of regulator
The establishment of a reliable and transparent regulatory framework is a key ingredient. Investors cannot have confidence unless the rights of shareholders are secure and reliable financial information is fully disclosed. Securities regulations and accounting standards should be brought in line with internationally recognised standards (such as IOSCO and EU directives). While there have been significant improvements in these areas in more advanced transition economies, this progress needs to extend to all countries of the region. At the same time, the key challenge for all of the countries lies in the implementation and enforcement of the established regulations and standards.
Establishment of good corporate governance
Corporate governance has become a key issue in all of the transition economies. Abuses of corporate power by managers, owners and controlling shareholders have seriously diminished investors' appetite. The lack of sound corporate practices has damaged the region's investment climate. Significant improvements have been made recently and many of the CEE countries have improved their commercial codes and established financial regulations that protect minority shareholders' rights. However, due to the short history of these improvements, much could still be done to enhance effective corporate governance in the future.
Introduction of foreign portfolio investment
The importance of foreign investors to the development of domestic markets cannot be overemphasised. The restrictions and barriers for foreign investors, which have already been reduced significantly in many of the CEE economies, should be completely phased out as the integrity and strength of the markets permits. In many CIS countries, it is particularly important to underpin the opening of local markets to foreign portfolio investments with sound and effective regulation and standards to avoid excessive volatility in capital flows.
Broadening the asset base of institutional investors
One of the most significant factors limiting the growth of the fixed income markets has been the lack of adequate and educated demand from institutional investors. The asset base of institutional investors has been small in transition economies, representing an average of 7% of GDP, while the total financial assets of industrial economies often exceed GDP levels. Significant progress has been made in recent years, including the introduction of a defined contribution pension scheme in a number of countries. The development of institutional investors may hold the key to giving stock markets more depth in the near future.
Demutualisation and merger/alliance of stock exchanges
In the face of global competition and the need to establish efficient trading systems, the demutualisation of exchanges is becoming a major trend in the world. Stock exchanges might need to raise large amounts of capital for investment in new technology, to establish efficient trading systems, and to create an efficient management structure. The example of Europe illustrates this trend well. All of the four largest exchange alliances (NOREX, Deutsche Börse, London Stock Exchange and Euronext) have chosen demutualisation and gone public. Mergers and alliances of stock exchanges are also a major concern in Europe. 'Euronext' was created in 2000 by the merger of the stock exchanges of Paris, Amsterdam, and Brussels. 'NOREX' was established as a strategic alliance of four Scandinavian stock exchanges. 'Deutsche Börse' was created by a German strategic alliance with the Irish and Vienna stock exchanges.
Although transition economies have generally not yet participated in the consolidation process, the exchanges in the region might have an incentive to join an international grouping or establish a regional alliance among the transition economies. A notable exception is strategic cooperation between the Finnish HEX group (owner of the Helsinki Stock Exchange) and the Tallinn Stock Exchange. HEX acquired 60% of the Tallinn Stock Exchange in spring 2001 and the trading of the securities listed on the Tallinn Exchange have been traded in the HEX´s trading system since February 2002.
Conclusion
Over the past year, the performance of stock markets in the region has been mixed. Five of the 13 countries covered by the S&P total return indices have increased their index value, while the rest have seen a decline. The financial crises in Argentina and Turkey and the September 11 attacks on the United States, as well as the economic slowdown in major industrial countries, have all contributed to the decline in stock prices. However, given the good economic fundamentals inside the region and limited economic ties with the regions in crisis, the impact on the CEE markets should be muted in the medium term. Prices have already picked up, and markets are in bull-market territory as of early 2002. If the countries in the region succeed in generating new issues and broadening the asset base of institutional investors in the region, the markets will be significantly deepened. The authorities must also step up their support for development of the capital markets by strengthening institutional capacity.
The EBRD has been active in the process of private-sector development in the 27 transition countries in which it operates. Through its projects, the Bank aims to transform state enterprises into commercially driven ones, introduce market-oriented principles, establish good corporate governance and increase transparency and disclosure. The Bank supports a number of the initiatives aimed at improving corporate governance in the region. For example, the Bank recently helped the Federal Securities Commission of Russia draw up a corporate governance code. The EBRD also promotes the development of non-bank financial institutions, including insurance companies and pension funds, to help expand the base of institutional investors. Its contributions in these areas have been significant and positive. But what is still needed for the securities markets to work well is the establishment of a sound business culture and the rigorous implementation of the reforms that have been pushed through on paper. Only that will offer investors the security they need.
