Eastern Promise: Why China’s only half the story

Kristen Paech talks to Michael Hanson-Lawson, CEO of East Capital Asia, about the new kid on the emerging markets block – Eastern Europe – and why pension funds should consider an allocation to the region, which has tripled nominal GDP over the past five years.

China and India have dominated the emerging markets story for some time now, and not without
reason.

India is the world’s second most populous country and the largest democracy. Its population is expected to surpass China’s within the next 25 years and it will move to third position after the US and China in terms of total GDP.

China, on the other hand, is a rapidly developing market economy and has been the fastest-growing major nation for the past quarter of a century, with an average annual GDP growth rate above 10 per cent.

However the new kid on the block, emerging Europe, is becoming harder for pension funds to ignore, despite the region experiencing a tough time during the last 18 months.

Nominal GDP has tripled over the last five years in Eastern Europe, with Russia, Turkey and Poland representing 37.3 per cent, 16.2 per cent and 11.7 per cent of GDP respectively in 2008, according to data from the International Monetary Fund (IMF).

Eastern European markets rallied while the macro picture deteriorated in the second quarter of this year, with
Turkey up 80 per cent since the beginning of 2009 and Russia up 65 per cent.

But despite the gains, Michael Hanson-Lawson, Hong Kong-based chief executive officer of East Capital Asia,
says markets are still some 40 to 80 per cent off their peaks.

While macro numbers in general remain poor, he believes the overall situation in the region has stabilised and points to signs of economic recovery, including higher commodity prices and stronger currencies, record high correlation between the Russian stock market and the oil price, and an improved political climate.

Founded in 1997 and headquartered in Stockholm, East Capital specialises in Eastern European financial markets, with around‚¬2.4 billion (S3.4 billion) in assets under management, both in public and private equity. The company has regional offices in Paris, Tallinn, Oslo, Moscow, Hong Kong and Vienna.

Hanson-Lawson admits Eastern European markets were torrid during the last quarter of 2008, with drops of 50 to 70 per cent due to the region’s exposure to a number of imbalances, including big current account deficits in Hungary and the Baltics.

Both currencies and markets were falling, and Hanson-Lawson says people feared a repeat of the devaluation and default of 1998, when the “bust in Russia sent the area into a tail spin”.

This time, however, the Russian market proved more resilient. The market rallied between late January and early June as the oil price recovered and the rouble started to appreciate after the managed devaluation in the winter.

Euro bond markets have reopened in the last six months, Gazprom, Russia’s largest company is borrowing once again, and sovereigns are re-entering the region.

“The situation has stabilised,” Hanson-Lawson says. “There was wild speculation that the Eastern European debt would bring down the developing nations, but that did not happen.”

Few Anglo-Saxon pension funds have dared to stray into Eastern Europe, and Hanson-Lawson points to the infancy of the markets as the major barrier.

Scandinavian funds are the most advanced, with the Premium Pension system (PPM), part of the Sweden’s national pension, East Capital’s largest client. Finnish fund Ilmarinen has been investing in Eastern European equity since as early as 2001, according to its annual report.

“These markets only came on the radar screen of institutional investors this decade,” Hanson-Lawson says.

“Consultants are observing the region; there’s only been a modicum of interest from institutional investors since 2000
to 2001.”

The biggest risk for institutions investing in the region is “that of company specific risk”, Hanson-Lawson says, adding
that investors should not “overlook one third of the GDP of the region” by investing only in countries that make up the MSCI Emerging Markets Index.

When compared to its neighbours, Hanson-Lawson says Poland is the “laggard”, up only 23 per cent this year – a stellar performance relative to Western markets but more than half that of Russia and Turkey.

Poland was one of the few economies throughout Europe with positive growth in the second quarter, indicating the strong macro economic situation and relatively prudent banking sector is finally starting to pay off on the stock market.

Hanson-Lawson believes Poland is the only country that will continue to see an increase in GDP this year, and as a result, East Capital has upped its weighting in the Eastern European Fund from 7.7 per cent in July to 11.5 per cent in August.

Turkey’s weighting, on the other hand, has been reduced from 7.2 per cent to 3.9 per cent on the back of what Hanson-Lawson describes as “extraordinary performance”.

“We have decreased our exposure to the banking sector in Turkey,” he says. “We think the huge surge will run out of steam, so we’ve switched into Poland, which has lagged.”