Eurozone contagion fears hit eastern Europe as investors seek safe havens

Poland: Pole position

After showing a strong recovery from the financial crisis, eastern Europe is beginning to suffer as the economic situation in the Eurozone worsens, causing bond investors to look for safe havens amid the turmoil.

While countries in the Balkan region, such as Bulgaria and Serbia, have been affected by their exposure to Greece through trade links and the the involvement of Greek banks in their respective financial sectors, the larger economies of central Europe have remained relatively insulated from the turmoil.

Both Poland and the Czech Republic boast healthy fundamentals and relatively little exposure to southern Europe. Public debt to GDP stands at 51% in Poland and a mere 35.4% in the Czech Republic, both significantly lower than the Eurozone average of 85%.

“The Czech Republic has very few problems. It has low debt and low inflation [0.4%], and while growth may be impacted by the crisis in western Europe, that won’t be too much of a worry for bond investors,” says Magda Branet, a strategist at Axa Investment Managers in Paris.

Tim Haaf, emerging market fund manager at Pimco in Munich, says Poland, too, is in a strong economic position. He sees good value in Polish government bonds. “If you want opportunities, I would look at Poland, where the currency [the zloty] has been unduly punished by the crisis,” he says. “The central bank in Poland is unlikely to hike interest rates this year, which is another factor.”

A seven-year Polish Eurobond issued in March at a coupon of 3.25% was yielding 4.1% on May 19, compared with a yield of 5.8% on a similar-maturity government bond from neighbour Hungary. But Hungary’s debt is much higher, standing at 73% of GDP, and Haaf argues Poland’s stronger fundamentals make its bonds attractive on a relative value basis.

“Yields on Polish bonds might be lower than in the likes of Hungary, but on a risk/reward basis Poland looks attractive due to stronger fundamentals and less exposure to southern European problems,” Haaf says.

Ondrej Matuska, a fund manager at Conseq Investment Management in Prague, is also bullish on Polish bonds.

“We’re investing with an intention to profit from the strength of the zloty going forward, and we’re also constructive on long-term bonds. We see disinflation trends continuing in the Polish economy, and a stable monetary policy for the remainder of 2010,” he says.

Independent monetary policy is one reason why the Polish and the Czech economies look strong; giving them the flexibility Eurozone countries lack. Another is that both have relatively developed domestic bond markets, making them less reliant on international capital flows than other countries in eastern Europe.

“The Czech bond market, which has a low portion of foreign investors in the composition of bondholders, has remained stable during the recent volatility,” says Matuska. “Poland is in an even better position: it has the highest liquidity and is very strong in terms of having domestic pension funds and mutual funds. The Polish bond market is the best in the region.”

Marcus Svedberg, chief economist at East Capital, an asset manager specialising in eastern Europe, argues Poland’s strong domestic market, fostered by shrewd economic policies, was a factor in its resilience during the financial crisis. Poland was one of only a handful of European countries to register positive GDP growth (1.6%) in 2009.

Countries more reliant on external funds were much more vulnerable when gross capital inflows to the region fell 54% in 2009. Lithuania’s economy, for example, contracted 17.5% that year. Svedberg says other eastern European economies must follow Poland’s example if they are to mitigate the effects of such crises in the future.

“This is a very important issue. Over the next couple of years, I hope governments in eastern Europe do more to develop domestic markets. Poland built up its domestic pension sector over the last couple of years, and that’s a key message to many other countries. I hope Poland becomes a role model to the others in showing what can be done.”

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