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Foreign capital inflows make a comeback to CEE

Foreign direct investments have started rebounding in the Central and Eastern European region, an analysis published on Tuesday by Erste Group reveals.

The Czech Republic is the absolute champion in the region with FDI inflows more than double the levels recorded in 2010 (almost 4% of GDP). In nominal terms, FDI levels were even higher than in 2008.

Hungary was also a positive surprise: according to preliminary data, the negative trend has been reversed and FDIs reached about 2% of GDP in 2010. FDIs also picked up in Slovakia reaching 1% of GDP, on a strong rebound of reinvested earnings and stabilization of inter-company loans between parent companies and their local subsidiaries.

Given that the Hungarian economy posted a surplus on its current account (2% of GDP), this creates a very solid basis for the sustainability of Hungary’s balance of payments.

Ukraine kept its FDIs at high levels (close to 4% of GDP), which actually covers the whole current account deficit – this significantly reduces its external borrowing needs.

Poland and Czech saw portfolio investments invigorated

Since 4Q, 2009, there has been a rebound of portfolio investments, particularly into the Czech Republic and Poland. The vast majority of portfolio investment inflows went into debt instruments, mainly government bonds. Non-residents increased their exposure in Czech and Polish government securities by €5 billion and €25 billion, respectively (3.3% and 6.1% of the Czech and Polish GDP, respectively).

Both countries have been favored by foreign investors because of their relatively low level of public debt and their economies’ resilience during the global economic downturn. However, the lack of a fiscal consolidation effort in Poland and the uneven split of government financing between domestic and foreign investors make Polish assets more risky than those in the Czech Republic, in Erste Group analysts’ view.

CEE countries getting more attractive

Many CEE economies managed to stand on their own feet throughout the crisis (the Czech Republic, Slovakia, Poland and Croatia) and without severe tensions in external financing.

Some countries had to undergo an economic rebalance (Hungary, Romania, and Ukraine) and adopt corrective measures, including structural reforms, the analysis states. Coordinated IMF and EU assistance has lowered the pressure on their external financing and helped them implement measures to narrow imbalances.

On the other hand, euro area countries that faced a shortage of private capital inflow (Greece, Portugal) were able to buy time due to access to ECB refinancing, which served as a substitute for private capital inflows or external assistance. Thus, they were not pressured to correct their large external imbalances. Unfortunately, this “palliative” was short-lived and came without strict conditions, which meant the imbalances of southern euro area countries persisted or even grew in 2010, while CEE countries narrowed their current accounts substantially. Despite this marked contrast, it took rather long for markets to realize that many CEE countries are in a much better shape than some euro area members.

“The next question is: how long will it take for rating agencies to align ratings to fundamentals, or will ratings become partially ignored by markets as too rigid and outdated? We notice that the latter is already happening. The Slovak government (rated A+) pays a lower risk premium compared to the multi-notch better rated Spain (AA) or slightly better rated Italy (AA-). Croatia (BBB-) and Hungary (BBB-), which are both at the low end of the investment grade, and Romania (BB+), which was during the crisis downgraded to junk category, borrow more cheaply than Portugal, which is (even after recent multi-notch downgrades) still rated higher than them,” Juraj Kotian, co-head at Erste’s CEE Macro Research noted.

Less external financing is needed in Hungary and Romania

The first country hit by a reversal of flows was Hungary, where a significant reduction of portfolio investments paralyzed the Hungarian bond market and put pressure on the currency as well, Erste said. Thus, the government was not able to issue new debt at reasonable yields and asked the IMF for assistance.

Other CEE countries were not as sensitive to portfolio capital outflows (volume-wise), due to their significantly lower stock of portfolio investments. For instance, foreign investors held only about €3 billion (2% of GDP) of Romanian government securities at the time when the crisis emerged, while foreign investors held about €30 billion (29% of GDP) of Hungarian government securities.

On the other hand, the global financial crisis constrained the opportunities for financing of the Romanian current account deficit (at that time, about 13% of GDP) and the economy had to adjust quickly in order to narrow its current account deficit. The adjustment has been eased by coordinated IMF and EU assistance, which has lowered the pressure on external financing and helped to install measures leading to a narrowing of imbalances. Also, the so-called Vienna initiative has played an important role there, as foreign banks operating in the country promised to maintain their exposure. The recent decision to replace the expiring IMF stand-by program in Romania with just a Precautionary Stand-By Arrangement (drawing funds is not expected) and not extend the previous program demonstrates the progress Romania has achieved. “Both Hungary and Romania narrowed their current account deficits substantially and thus reduced their external financing needs to levels which can be smoothly financed on markets,” Kotian concluded.