Central and eastern European markets have soared over the past few years. Investors have sought to cash in on the region’s rapid growth as it catches up with the west. Poland, for instance, grew by an annual 6.1% in the first quarter, compared to the EU’s 2.2%, while Latvian and Estonia have hit growth rates of over 10% in recent years. And there is still plenty of upside in the “convergence” story over the longer term. GDP per head in the Czech Republic, the region’s richest state by this measure, was about $14,000 in 2006, less than half the eurozone figure of $34,000. The region’s nascent banking sector is booming as consumers have begun to open accounts and take out loans. The overall balance sheet of the banks operating in the area expanded by 28% in 2006 alone and could more than double by 2011, according to Raiffeisen International.
For now, however, the region’s markets are struggling. The NTX index of 30 companies in the region has slid by around 20% this year to a three-year low; key indices in the Czech Republic, Romania and Latvia have respectively lost 22%, 38% and 13% this year. Growth in western Europe, the region’s main export market, is slowing, and after years of strong growth labour markets are tight. This lack of spare capacity in the economy hampers potential growth, as Henning Esskuchen of Erste Bank points out. But the main problem is that investors are seeing inflation “rear its ugly head” in the region, says Neil Shearing of Capital Economics, and “a sustained period of higher interest rates” is on the cards.
Inflation has reached 15% in Russia and Bulgaria, 18% in Latvia, and 30% in Ukraine, as Shearing points out. Away from the overheating periphery, inflation is less eye-popping: Czech and Hungarian consumer price inflation is around 7%, while in Poland the figure is 4%. But take out the usual suspects of food and energy, and core inflation is also looking uncomfortably high. In the Czech Republic, for instance, it’s over 4%, compared to the central bank’s 3% target. The same applies to wage growth – over 10% year-on-year in Poland and the Czech Republic. This has raised the spectre of a wage-price spiral in the region.
Monetary policy is mixed across the region, says The Economist; Poland and Hungary have positive real interest rates, but in Ukraine policy is too loose, with credit growth still expanding at an 80% annual clip. One potential danger for investors is that governments may “crack down too hard” on inflation, causing a recession and collapsing earnings, while another is that they fail to control it, which implies a sliding currency and a possible currency crisis as investors lose confidence. A falling currency portends a rise in bad debts as many companies and consumers have taken out foreign currencies over the past few years. In Estonia and Latvia 80% of household credit is foreign-denominated; in Hungary and Lithuania the figure is around 55%.
Meanwhile, ongoing credit problems are denting confidence in equities globally. So, while the long-term story remains compelling and the NTX’s p/e is at a three-year low of around 10.5, there are, as Shearing notes, likely to be better buying opportunities ahead.