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Country reportsMarch 1 2013

Bonds come in from the cold in eastern Europe

Although foreign banks may be reining in finance for their subsidiaries in central and eastern Europe, any transition to local currency bond financing looks likely to be gradual.
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Bonds come in from the cold in eastern Europe

The onset of subprime and later eurozone debt crises from 2008 onward sparked concerns that the supply of lending to central and eastern Europe (CEE) might dry up. The majority of banking sectors in major regional economies such as Poland, the Czech Republic, Hungary and Romania are in the hands of foreign – mostly eurozone – banks.

This prompted the European Bank for Reconstruction and Development (EBRD) to launch a local currency and capital markets development initiative (LCI) at its annual meeting in 2010, as a way of reducing dependence on hard currency and parent funding in its countries of operation.

“In the past two years or so there has been deleveraging, with net new lending negative or very modestly growing at best, and in many markets that lending is still dominated by foreign exchange and short tenors,” says Andre Kuusvek, the EBRD’s country representative in Ukraine who will head up a newly created interdepartmental coordination unit for the LCI from March 2013.

Laying foundations

Government support is essential to build a local bond market, including a transparent programme of government bond issuance creating a domestic yield curve, plus reforms to pension systems and financial market regulation to foster the local investor base and secondary trading.

“The vast majority of governments in our area of operations understand the benefits of developing a local bond market, including the alternative source of funding for non-banks, and enabling banks to diversify their funding base and assets. But they will inevitably need to think about the details of changes to laws and regulations, and any political impact that these may have,” says Mr Kuusvek.

Where it can, the EBRD itself stimulates development by lending in local currencies, and by issuing local market bonds to fund its activities. The Russian rouble market remains much larger than those of most CEE EU member and candidate countries, and accounts for most of the multilateral’s local currency bond issuance.

“The zloty and forint markets are well developed, as Poland and Hungary follow EU prospectus rules and their bonds are Euroclear eligible, while demand is also consistent. Kazakh tenge issues are also relatively straightforward, there is a good domestic investor base of pension funds in Kazakhstan that lack local currency issuance,” says Isabelle Laurent, deputy treasurer and head of funding at the EBRD.

Mind the gap

There is still a fairly large gap between this group and other CEE markets. Countries with heavy sovereign borrowing needs, such as Ukraine, may fear any issuance that risks crowding out the official sector. Even in Hungary, the corporate market, which amounts to Ft600bn (€2.1bn), is dwarfed by Ft20,000bn in outstanding government bonds. In other markets such as Serbia, Ms Laurent says the authorities are keen to see local currency issuance by the EBRD, but the multilateral will first need to establish consistent uptake in local currency lending programmes to justify a medium-term bond issue.

In Romania, there has been a multi-pillar pension system in place since 2007 which has already accrued invested assets equivalent to about €2.4bn and growing. The government meets about 50% of its funding needs from the domestic market, but there is still room for improvement, says James Stewart, head of treasury and capital markets at Raiffeisen Bank International (RBI) in Romania.

“The Romanian treasury will cancel or expand auctions depending on the price offered in the market. It would be more manageable for primary dealers if the treasury kept to a pre-announced auction size, as is the case in more developed markets. The forced scarcity of a fixed borrowing amount could well lower interest rates for the government,” he says.

There has been no corporate bond issuance in Romania aside from the local subsidiaries of foreign firms such as Gas de France in 2012, which was the first corporate issue since RBI’s own subsidiary in 2005. While the new government elected in December 2012 appears keen to foster corporate bond market development, bankers say the previous government’s decision to put power firm Hidroelectrica into insolvency in June 2012 sent a negative signal to the market. Hidroelectrica is 80% government owned, and had generated a small profit of €9.35m in 2011. It had no outstanding bond issues, but the fate of bank creditors is still unclear.

The Czech Republic has a much more developed government curve and an active corporate market, with banks even beginning to issue securitisations backed by commercial real estate loans. Jan Pudil, executive director of treasury, investment banking and financial institutions at RBI in the Czech Republic, says a recent amendment to local legislation has also simplified procedures for private placements so that they will not need the same lead time as an exchange-listed issue.

In 2012 there was an active market in international names such as BNP Paribas, General Electric and Crédit Agricole using Czech koruna public and private placements, to take advantage of the opportunity for smaller issue sizes and good currency swap pricing. Mr Pudil believes rising local activity will begin to displace foreign issuers in 2013.

Seeking investors

Local currency issuance does not necessarily rely on local investors. Low interest rates in major economies and uncertainty over the fate of the euro prompted significant inflows to CEE local markets in 2012. Foreign holdings of Romanian government bonds peaked at 18%, while foreign investors held more than 40% of the stock of Polish and Hungarian government bonds at one stage. Foreign investor expertise may be particularly helpful for developing a local high-yield market. Polish fertiliser manufacturer Ciech, rated ‘B’, broke new ground with a debut 320m zloty (€76.67m) five-year issue in November 2012.

“For sovereign and investment-grade corporate bonds, we see the usual list of local pension funds and bank treasurers, plus global bond funds looking to diversify their exposure and earn a premium. But high-yield issues tend to attract specialist foreign investment funds that are more familiar with the product than local investors,” says Jakub Papierski, deputy chief executive and head of investment banking at PKO Bank Polski.

However, to build a stable long-term local corporate bond market requires what Dominique LeMaire, head of non-investment grade debt capital markets (DCM) at UniCredit, calls “local-local” issues – local currency placed with local investors.

“The experience in Mexico, Brazil and Russia has indicated that foreign investor flows into local currency bonds tend to be more volatile than their investments in hard currency debt and are usually deemed hot money. Local market investors in local debt are more stable; they look for local currency assets because they are based in that market, they are not just in it for a yield play,” says Mr LeMaire.

Pension reliance

Pension funds are the core investor for corporate bonds. To build that segment needs not just pension reform, but also the right mandates for newly established private schemes. Poland requires 95% of pension fund assets to be invested domestically, whereas a significant proportion of Romanian pension portfolios are invested abroad. Both of these regimes are more supportive than in Hungary, where the government effectively re-nationalised pension funds in 2011 to help plug its budget deficit.

“There are perhaps 50 companies large enough to issue forint bonds, but the pension fund move drained about 3000bn forints from the system. Investment funds, insurance companies and the remainder of the pension funds are very cautious, so the Hungarian corporate bond market is in a quiet period, with the largest corporates looking at Eurobond and US markets,” says Gabor Nagy, head of corporate finance at RBI Hungary.

While institutional investors are clearly important, the retail market should not be ignored. The Czech government has a highly successful programme that includes both fixed and inflation-linked instruments reserved purely for retail buyers. Institutional investors are hoping that the government will provide them with inflation-indexed issuance in the future. In the corporate bond market, Erste Bank used its retail network in Croatia to distribute an own-name senior unsecured bond for Hrk300m (€39.55m) in November 2012.

“Our senior unsecured and Tier 2 subordinated debt issues in Croatia have been well absorbed by the retail network," says Manfred Burdis, head of DCM origination at Erste Group. "There is also a pension fund buyer base with at least €1bn equivalent to invest, but it tends to focus on government bonds. And Croatia is quite distinctive because the economy is highly euroised, so there is euro liquidity available domestically.”  

Banks still dominate

Perhaps the greatest structural impediment to the bond market is not necessarily a negative one: the liquidity of bank balance sheets in the CEE region. Many countries still have system loan-to-deposit ratios of well below 100%, especially in the Czech Republic and Poland. This enables banks to meet corporate credit needs comfortably without the banks or their clients tapping bond markets.

“For short-term zloty liquidity management, we have a regular three-month bill programme, but long-term funding in zloty comes from our network of 1200 branches and a similar number of agents. This is the source of 90% of our funding, although we will examine bond issuance in the future,” says Mr Papierski of PKO.

There is general consensus, however, that Basel and local liquidity regulations will drive bond market growth from both an asset and a liability perspective. Cross-border banking groups will seek to fund CEE subsidiaries locally, and banks will prefer easily tradable bond assets to give them greater flexibility in managing balance sheet size.

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