Investing in the European Union’s frontier

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Our recent trip to the sunny Balkans investigated a number of countries which, although neighbours to each other, have their own individual characteristics and in some cases are on opposing macroeconomic trajectories.

In this article we take Serbia, Croatia and Romania in turn, examining both the investment opportunities they offer and the associated risks.

In short, we currently see better opportunities for fixed-income investments in the western Balkans.

Looking first at Serbia, the macroeconomic situation has surpassed even the most optimistic expectations and overall remains on a positive course.

Successful structural reforms linked to the International Monetary Fund’s (IMF) programme, as well as a rebound in economic activity – a spill-over from core Europe – have resulted in Serbia’s headline fiscal deficit falling from 7% of GDP in 2014 to 1.4% in 2016.

The government is keen to maintain the positive momentum aided by a follow-up IMF deal.

Perhaps counterintuitively, Serbia’s structural adjustment has not prevented economic growth from recovering. Higher output is being accompanied by a stronger performance of the labour market, where the private sector is not only absorbing reductions in the public sector but also creating additional new jobs.

In 2017, an expected pick-up in imports will likely reduce the contribution of trade to GDP, but other sectors will be supportive.

In terms of meeting the country’s financing needs, Serbia has mainly funded itself by issuing local securities denominated in euros. Nonetheless, the country is also continuing to develop a local dinar-denominated yield curve and is seeking inclusion in the JP Morgan Government Bond Index-Emerging Markets (GBI-EM) as soon as next year.

Croatia is also a country whose macroeconomic picture has improved. Economic growth here has rebounded too, but is of a very different composition, being led by tourism.

Croatia has a current account surplus and has reduced its fiscal deficit. As a result, the focus, increasingly, is the question of whether Croatia will be able to join the eurozone and adopt the euro.

While it seems clear that both the central bank and the public would generally be in favour, it is far less obvious that the political community would be supportive.

For those in favour of accession, the main motivation is mainly the potential elimination of currency risk for both external and indexed domestic debt.

Although there is some uncertainty due to political infighting, there are more significant challenges that currently present themselves to the country’s economy.

Having finally pulled out of a six-year recession, a dark cloud has been cast over the positive momentum by Agrokor, the country’s largest retailer. Mismanagement of its debt means the company is facing a systemic crisis that will significantly impact a range of sectors in Croatia, including banking.

Although at this stage it remains unclear as to the extent to which specific institutions will be affected, the central bank estimates that the impact of the Agrokor crisis could amount to 0.4% of GDP.

Tourism has been boon to the Croatia, in part due to the misfortunes of other eastern Mediterranean tourist destinations, such as Turkey or Egypt. In addition, there has been a structural change in the type of tourism, with better quality hotels attracting wealthier visitors and foreign direct investment (FDI) strong in this sector. A caveat to this, however, is that the country needs to build its industrial base rather than growing into a Caribbean-style economy wholly reliant on tourism.

Romania, at first glance, appears similar to its western cousins. Its GDP growth is relatively strong and benefits from significant investment programmes following its accession to the EU (Romania joined the EU along with Bulgaria on 1 January 2007 – see Exhibit 1 below). Romania also boasts a competitive economy after years of adjustment since the Global Financial Crisis. However, the current policy mix is negative from a credit perspective and the country appears at the moment to be a good story going bad.

Exhibit 1: Romania joined the EU along with Bulgaria on 1 January 2007

EU Frontier

Source: Bloomberg, BNP Paris Asset Management, as of 10/07/17

In theory, the EU’s institutional framework should act as a backstop to limit the pace of fiscal damage and eventually correct the direction of policy change. However, this will prove toothless as an ex ante means of preventing poor policy until deficit numbers are posted and EU safeguards kick in, if at all, and also remains open to political considerations. In the meantime, Romania appears set to push ahead with pro-cyclical fiscal stimulus, which will also manifest itself in a deteriorating external balance.

Alongside this, poor absorption of EU structural funds stemming from an unstable political situation may put additional pressure on the credit. There’s also a risk that EU investments are curtailed on account of the higher-than-expected current expenditure.

Ultimately, we fear we know how this story ends. A crowding-out of the private sector pushes up interest rates, which further chokes off productive investment and scares away bond investors. The currency, which could underperform on account of rising inflation, may also suffer from a wave of portfolio outflows.

Romania’s saving grace is its low level of public debt. We can only hope this remains the case once its current fiscal extravagance is unwound.

Exhibit 2: Serbia, Croatia and Romania – at the frontier of the European Union

EU Frontier

Source: Bloomberg, BNP Paribas Asset Management, as of 10/07/2017


Written on 10/07/2017

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

Hardeep Dogra

Portfolio Manager, Emerging Markets Fixed Income

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