Stock exchanges in central and eastern Europe are new to the international finance world. Geraldine Lambe looks at the tightrope they are walking between governments, issuers and foreign rivals.In a world of consolidating exchanges, the case for the small national markets of central Europe, and elsewhere, is becoming harder to justify economically. The exchanges’ problem of preventing the few large corporates – their main source of revenue – from de-listing is compounded by the fight to build an equity culture in a savings-dominated financial landscape.

Equally difficult are the tasks of persuading small companies of the value of listing in the first place and governments that they should introduce capital markets-friendly tax and regulatory frameworks. But without the stock exchanges, will the region’s many small companies have access to the long-term funding that is necessary to build the blue chips of tomorrow?

Cynics say there are lies, damned lies and statistics; but statistics can nonetheless tell a story. Compare the London Stock Exchange’s (LSE) 2777 companies and their combined market capitalisation of Ł2772bn at the end of March 2003 with Slovenia’s 156 companies and market cap of $3387m. And size matters. The pursuit of market share and deeper liquidity has been the driving force of many merger deals, and failed attempts, for the bigger western European exchanges, so those challenges are thrown into even starker relief for the new and small players of central Europe.

Hard choices

A report published last month by the Corporation of London, The future of stock exchanges in European Union accession countries, says the exchanges of central Europe must make some hard choices if they are to survive, let alone prosper. They face a host of challenges, including relatively few listed companies and low liquidity in any other than the top 5-10 stocks.

Perhaps as threatening, says the report, is the competition posed by the more liquid markets sited on their doorsteps, which provide access to far greater capital flows. “In some countries, it may be difficult to support an independent exchange,” it states.

According to Lynton Jones, a partner in Bourse Consult and ex-CEO of the International Petroleum Exchange and the now defunct OM/Morgan Stanley retail exchange, Jiway: “The fear is that these countries’ largest firms will dual list on a larger foreign exchange – usually the LSE or the New York Stock Exchange – and leach liquidity to that exchange, or will eventually de-list entirely from the home exchange. As the trading in the top few companies provides up to 90% of the trading activity and the greater part of their revenue for most of these exchanges, the fear is that without them, they cannot function properly or even survive.”

While the effect of a stock exchange’s disappearance may not necessarily be damaging for those companies that are large and mature enough to seek listing abroad, the lack of access to a domestic market for small to medium-sized companies could be disastrous. The negative effect that could have on the development of local economies and capital markets is equally clear.

“If the local stock exchange is absorbed into a larger European market, how many of Poland’s companies will be able to list – maybe the top 20 at most?” asks Dr Wieslaw Rozlucki, president and CEO of the Warsaw Stock Exchange (WSE). The WSE is the largest exchange in the region with 230 companies listed with a market cap of $25.9bn.

Inadequate activity

Many central European countries are faced with a chicken and egg conundrum: without a more developed capital market culture, the stock exchanges cannot survive, but without the local stock exchange, new or smaller companies will not have real opportunities to access the capital markets and to grow the domestic supply of equity. In varying degrees, Poland, Hungary and Slovenia – and many of their central and eastern European neighbours – suffer from a paucity of either investors or issuers, or both.

In Poland, Dr Rozlucki says the problem is one of supply, not demand. “Although not large by western European standards, we have an active institutional and a growing retail investor community in Poland, but they complain that there is not enough for them to invest in. There is a real lack of initial public offering (IPO) or debt capital market activity here.”

Lack of investment culture

The lament is similar in Hungary and Slovenia but is compounded by the lack of an investment culture. “We have to attract new issuers to the market as well as increase the local investor base and therefore local liquidity,” says Gyorgy Jaksity, chairman of the Budapest Stock Exchange (BSE) and managing director of Concorde Securities. The BSE has 56 companies listed with a market cap of $10.2bn. “In 1998/99, around 10% of savings was in equities or other investments. By 2002 that emerging investment trend had almost evaporated and the figure had reduced to about 2%,” says Mr Jaksity.

Attracting new issuers will be equally problematical at the current valuations, says Mr Jaksity, who argues that when shares are trading at around 10 times earnings, companies ask why they should sell equity. “This is a huge problem for us,” he says.

Dr Drasko Veselinovic, president and CEO of the Ljubljana Stock Exchange in Slovenia, agrees that investors do not want to invest in equities and that companies do not see listing as advantageous or attractive. “For example, aside from corporates finding the sort of disclosure demanded by stock exchange listing unappealing, their financing strategies are influenced by the low cost of bank loans – which is in turn fuelled by the Slovenian savings culture,” he says. “Our market capitalisation is approximately half the size of all Slovenian bank deposits, and investment in mutual funds represents around 1% of all bank deposits. Banks are looking for projects to put money into – funded by savings from the retail sector.”

One element of this capital market conundrum is not helped by government strategies. The stock exchanges argue that their development efforts have often been undermined, or at least not helped, by tax regimes or unwieldy regulations.

In Slovenia, for example, the interest on savings is not taxed while capital gains are. “We don’t get much support from the government,” says Dr Veselinovic. “There is a fear of speculators. The government still holds the belief that banks are safer and that deposits are better for the macroeconomic picture.”

The previous Hungarian government’s track record was no better. Mr Jaksity says that until recently much of the country’s legislation and economic and tax policies were “devastating” to investment and capital markets development. For example, in 2001, in the middle of the recession, the government introduced capital gains tax. “This was a cynical move because it had to be paid on capital losses because it couldn’t be accounted for until the end of the tax year when returns were completed,” says Mr Jaksity.

Luckily, a more sympathetic approach is becoming increasingly common. Dr Veselinovic says the Slovenian government promises that capital gains tax will be abolished within the next year. The recently-elected Hungarian government is more capital markets-friendly and has already introduced a more favourable tax structure – with a discount of 50% for capital gains on instruments that are listed on the BSE.

Although Poland has no capital gains tax, but a 20% tax on interest, Dr Rozlucki remains disappointed with the government’s policy response. He acknowledges the government’s increasingly sympathetic ear but bemoans its lack of action.

Champion needed

“The stock exchange and the capital markets need a champion,” says Dr Rozlucki. “Various strategies could be implemented, such as a low tax environment like that in Dublin. We are currently working on a proposal to present to government, to try to encourage it to bring in an overall structure that encourages capital market activity.”

According to Blazej Borzym, president of CDM Pekao Securities (a subsidiary of Bank Pekao, a Polish bank owned by Italy-based Unicredito), some harbour fears that the Polish government will change the current tax structure, but for one that is less favourable to the capital markets, not more. “The grace period [of no capital gains tax] ends at the end of this year and we don’t know what it will be replaced with.”

It is not just the government that needs to make changes, however. At Raiffeisen Bank Polska, a subsidiary of Austrian-based Raiffeisen Zentralbank Österreich, director of investment banking Konrad Sitnik says the WSE, the Polish government, the Polish Securities Commission and the Central Securities Depository are failing to balance the interests of investor and issuer.

“The listing costs are among the highest in Europe and the process takes too long; the disclosure regulations (based on the US model) are tougher than those in the European Union (EU) and the settlement process is messy, complicated and unclear,” he says.

Most of the stock exchanges are taking steps to develop awareness of the importance of capital markets and to demonstrate the benefits of listing on the exchange to corporates. Marketing and educational campaigns are increasingly common. But in the current conditions, the exchanges admit they are facing an uphill battle.

The involvement of the retail community is crucial but most banks in central Europe have historically focused on traditional lending and deposit-taking products. In many countries, an investment culture has yet to gain solid ground – typically, 75% of savings is held in cash or bank deposits, and only 25% in investments.

Mr Jaksity says this is the case in Hungary and complains of a lack of capital markets intermediation. “Front-office sales are dominated by banks that still think in terms of deposits rather than equities or other investments,” he says.

But things are beginning to change. Ceska sporitelna, a subsidiary of Erste Bank, is one of the largest retail banks in the Czech Republic. In the past two years, it has introduced a raft of new products and services aimed at retail clients. As important for nurturing companies that may ultimately list on the Prague Stock Exchange, it has also launched a bank-funded venture capital fund. The fund invests directly in small and medium enterprises, which was a condition of Erste Bank’s agreement with the Czech government during Ceska Sporitelna’s privatisation, says Heinz Knotzer, head of division for the bank’s Commercial Banking Centre.

In December 2002, the bank closed its first investment agreement with a fund management company (Czech TOP Venture Fund) for e10m ($11.4m) and at the beginning of February this year it committed another e10m with a second venture capital fund (Genesis Private Equity Fund ‘B’). In the second fund, Ceska is co-investor with the European Bank of Reconstruction and Development, which has also put in e10m. The bank is now deciding to which fund it will allocate the final tranche.

Help from EU accession

Most market participants believe that accession to the EU will accelerate the growth of a capital markets culture for both corporates and retail investors, as their behaviour slowly gets drawn into line with those of other EU countries.

Miklos Kormos, managing director and head of investment banking for central and eastern Europe at JP Morgan, says that formal membership of the EU should help to grow per capita income and help to feed domestic demand. “It should build retail purchasing power and help with the diversification from cash deposits to more sophisticated instruments,” he says.

However, even as the appetite for capital markets products increases and, hopefully, the supply alongside it, some are concerned that foreign banks (which are a growing presence in the region) show a preference for foreign investors during an IPO or bond allocation process.

Dr Rozlucki says Poland’s last big IPO had both a local and an international tranche. The local one was oversubscribed but a bigger allocation was given to the international tranche.

“The IPO was led by the government, which was advised by international investment banks, whose clients are mostly abroad,” says Dr Rozlucki. “It was easier for them to fulfil international client orders than to develop a local distribution network. It was not prejudice against Polish investors; they simply acted according to their own impeccable logic. Nonetheless, this sort of process inhibits local capital market development.”

Domestic efforts to improve capital market supply and demand notwithstanding, as much pressure is being exerted on the stock exchanges from outside. For example, the 12 most liquid Polish stocks and the top four Hungarian stocks dual-list on the LSE, and, according to an LSE spokesperson, volume on the exchange’s international order book is growing rapidly.

In 2001 there was $2.75bn of trading in Hungarian and Polish stocks; this had increased by 65% to $4.52bn in 2002.

Mr Jaksity says that 40%-60% of the Hungarian companies’ liquidity is pooled in London. But he says that some liquidity has been clawed back in the past couple of years.

Liquidity is key

Without mentioning figures, Dr Rozlucki says that liquidity tends to split between the WSE and the LSE when the companies dual-list and then the two pools move in tandem. So far, he says, no Polish companies have moved their primary listing to the LSE. Clearly, a key aim for all the small central European stock exchanges is to prevent liquidity moving away from the domestic market and to prevent companies from de-listing entirely and eliminating their major source of transaction revenue.

The likelihood of either danger is increased if a local company has been acquired by a larger international player and becomes part of a broader corporate strategy. Mr Kormos says that defensive strategies have been adopted by governments and shareholders alike. First, there are Golden Shares. These were issued when state-owned businesses were first privatised and were held by the government. Their purpose was to prevent companies from changing their strategy or company names, for example, without the assent of the holder of the Golden Share. Another mechanism is the so-called “poison pill” in company statutes that imposes a variety of limitations on shareholders.

“Clearly, local companies can become attractive targets for foreign players, and these measures have been introduced to prevent foreign investors from being the sole beneficiaries of the inevitable upside as these companies grow and improve,” says Mr Kormos.

Mr Jaksity, however, says that laudable as these efforts are, they are of limited value to the stock exchanges. “They don’t relate to the crucial stock exchange-related elements: they cannot prevent a company from dual- or de-listing. And, when we join the EU, they will have to be abandoned anyway because they are contrary to EU regulations.”

So, what are the options for these small stock exchanges? Steffen Schubert, a partner at Bourse Consult, who was CEO of Easdaq prior to its becoming Nasdaq Europe and was previously managing director of the Munich Stock Exchange, says that, continued independence aside, there are largely three strategies: the creation of a regional hub that combines multiple, smaller players; a merger with a larger exchange along the lines of the Euronext model; or an outsourcing arrangement such as that between Dublin Stock Exchange and Deutsche Borse, whereby all transactions processing is carried out in Frankfurt.

“The Euronext option allows a fair degree of autonomy even if the ownership changes, but is more expensive and time consuming to implement, while the Deutsche Borse option more quickly provides economies of scale.

The regional hub idea seems to find little favour in Warsaw, Budapest or Ljubljana, even though all three stock exchanges admit that they have discussed the idea with each other and with other central European players.

Dr Rozlucki is sceptical of the success rate of regional plays: he sees few benefits and significant up-front consolidation costs; and, while there are certain economies of scale, such as in clearing and settlement and maybe in trading, it does not work in areas such as market surveillance or investor education, both of which are needed at the domestic level.

Dr Veselinovic agrees that central European co-operation is unlikely. “If we join with Hungary, for example, what Slovenian investor wants to invest there? Yes, they want access to foreign markets, but to the blue chip stocks from the large exchanges, not another small market with similar companies.”

Enthusiasm for joint effort

Other market participants, however, see this as folly and are keen for central European exchanges to join together. Andreas Treichi, CEO of Erste Bank, has stated publicly that he believes the exchanges of central Europe should create a single stock exchange.

“Their turnover is too low for them to survive on their own,” says an Erste Bank spokesperson. “They will either have to merge to create an efficient and liquid central European platform or they will be absorbed by a bigger western European exchange.

“You don’t need a stock exchange in every capital city – for most investors it makes little difference where a company is listed. But for local capital markets, it is better to have a regional hub than to have to list in London or New York.”

Lack of sympathy for a regional exchange does not mean that the exchanges are closed to alternative alliances. The WSE signed a cross-membership agreement with Euronext (whose NSC platform it has already implemented) in February 2002, although it is not yet up and running. It will enable WSE members and brokerages to trade in the 2000 companies listed on Euronext and vice-versa.

In Hungary, a similar but a more limited deal has been undertaken with Deutsche Borse, which allows investors from the BSE to trade on the German exchange.

Deeper relationships with larger European players, such as a merger, are definitely second choice for these relatively new exchanges – whether because of their short history or out of purely practical considerations for the local markets.

Key aims are to help the local companies to grow and to develop indigenous capital markets. “I cannot imagine one of the bigger exchanges admitting small Polish companies or educating our investors,” says Dr Rozlucki. “For this you need local knowledge and an active domestic presence.”

Mr Jaksity is pragmatic about the future, saying independence in itself has little value for the country’s investors, companies, stock exchange members or shareholders.

Central Europe’s challenge to build stock markets from scratch, with no capital markets culture, has been an uphill struggle that has been severely hampered by a stock bubble and bear market. Many hopes are pinned on EU accession and the adrenalin shot that it may provide. There is nothing to say that strategies are mutually exclusive; multiple alliances, for example, whether technological or cross-membership, could create a credible alternative to acquisition by a larger competitor.

Dr Veselinovic appears a little weary of the fight, despite the fact that the Ljubljana stock exchange had its best year so far in 2002. “I’ve been battling to build the exchange since I founded it in 1989 – and not much has changed,” he says. “If Euronext asked us to become Euronext Ljubljana, we would think about it seriously.”

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