If you were to take an an over view of Central and Eastern Europe , Russia and Eurasia and it seems to a very tempting region for investment. Much of central Europe’s economy is forecast to expand by 3 per cent or more this year, Romania is expected to grow by 4 per cent. More so , Russia and even Ukraine have pulled out of recessions that followed the 2014 Ukraine crisis. Other important parts of the investment case remain intact, including well-educated workforces with wage levels still below those in western Europe — but growing fast enough to drive strong consumer spending. Investors, though, also have to take account of a negative element, at least in parts of the region: a resurgence of geopolitical and more local political risk.
For years, especially in the 11 former communist countries that have joined the EU since 2004, much of the region seemed to be embracing market democracy, building up institutions and the rule of law. More recently, countries such as Poland and Hungary have brought to power populist governments that are accused of neutering some of those institutions and pursuing policies much less friendly to foreign business. The phenomenon may spread: the Czech Republic is expected this weekend to elect a populist government headed by a billionaire businessman Andrej Babis. In Romania, the social democratic-led government that was elected last December provoked the biggest demonstrations since 1989 when it tried to decriminalise some corruption offences. Now, some investors are sounding the alarm over draft legislation they say would loosen Romanian corporate governance standards.
Russia’s annexation of Crimea and its fomenting of a separatist war in eastern Ukraine, following Kiev’s pro-western revolution in 2014, triggered western sanctions against Moscow and brought east-west relations to a post-cold war low. Investor hopes for a “reset” with the US under President Donald Trump have been dashed. The re-emergence of such risks is forcing investors to make more carefully calibrated investment decisions — and leading to changes in investment patterns. Kirill Dmitriev, chief executive of the Russian Direct Investment Fund, a $10bn sovereign wealth fund created by Moscow to co-invest in the economy, says interest — particularly from the US — declined sharply three years ago. Sanctions imposed over Ukraine combined with falling energy prices to send the economy into a tailspin.
There has been some recovery now, he says, while European investors have remained more engaged throughout. “US investors continue to invest but they’re more focused on public markets” than direct investment, says Mr Dmitriev. “But we saw a significant increase in investment from Asia, specifically from China and the Middle East. Asian and Middle East investors are in some ways replacing European and American ones.” He points to a deal assembled by RDIF in April to acquire a 25 per cent stake in St Petersburg’s Pulkovo Airport with a consortium that included several Middle Eastern and Chinese investors. This month’s business deals with Saudi Arabia that accompanied a visit by King Salman bin Abdulaziz was another sign of Russia forging new political and business alliances. So, too, was last month’s $9.1bn purchase of a stake in Russia’s Rosneft by CEFC China Energy. Mikhail Stiskin, chief financial officer of Polyus, the Russian gold miner that returned to the London Stock Exchange after a two-year absence in July, says his company’s successful initial public offering shows that western investors can still be enticed. Given the shallow market, he sees the IPO as a “feat”.
“What we can clearly state is that the Russia discount has widened and people are demanding more aggressive discounts compared to other emerging market countries that, frankly, tend to have the same corporate risks but don’t have the same political risks,” says Mr Stiskin. “In the commodities space, Russia can boast some of the best corporates in terms of their cost position and reserves life. However, there is always a perceptible discount versus peers.” Russia’s economy has adjusted to sanctions and low energy prices better than expected by some, helped by the central bank’s well-handled move to a fully floating rouble in 2014.
The currency’s devaluation — together with Mr Putin’s “counter-sanctions” of banning many western food imports — has even led to an agricultural boom. Some Russian sectors are now more competitive on wage costs than China. Macro Advisory, a Moscow consultancy, warns, however, that new legislation passed by the US Congress this year creates a “Sword of Damocles” over Russia’s recovery. As well as tightening existing sanctions, the legislation requires the US Treasury to present a report by January assessing the effectiveness of existing measures and listing potential new targets. This, warns Macro Advisory, is “likely to lead to a large number of investors and businesses taking a prudent view and standing back from Russia”, until it is clear how the new law will be interpreted. Risks are different in Poland and Hungary. Nationalist governments in both countries have become more hostile to foreign investment in some sectors, trying to boost domestic control.
Since 2010, the Fidesz government of prime minister Viktor Orban in Hungary has imposed “crisis” taxes on the retail, telecoms and energy sectors, where foreign businesses were dominant. It also slapped Europe’s highest banking levy on mostly foreign-owned banks. Poland’s Law and Justice government has, since 2015, also imposed a bank tax — albeit smaller than Hungary’s — and a tax on large retailers. The latter was shelved pending an EU probe and the European Commission ruled in June that it breached state aid rules. Anti-corruption groups in Hungary are also focusing on a new potential risk for investors — the emergence of a group of wealthy businesspeople close to the Fidesz party who seem to be favoured in awards of large state contracts. Jozsef Peter Martin, executive director of Transparency International in Budapest, says research it conducted found investors remained unmoved.
“To a certain, surprising extent, it came out that businesses think they can make money from this market,” he says, though investors suggested nurturing good relations with the government and avoiding other political activities. Neighbouring Romania, with the strongest growth in central and eastern Europe in the past three years, is attracting significant investor interest. But Fondul Proprietatea, a fund created by the Romanian state in 2005 to compensate citizens whose assets were confiscated under communism and which holds minority stakes in several state-owned enterprises, is sounding alarms. Greg Konieczny, Fondul’s portfolio manager, says the social democratic government has shown little respect for corporate legislation rules in making appointments to state companies.
Political loyalty is often being favoured over competence and experience, adds Mr Konieczny, who is also director of eastern European strategy at Franklin Templeton. Healthy growth still makes central and eastern Europe attractive, he argues, but investors have to be selective. “Stay invested in companies or sectors that are the least exposed to regulatory changes, as well as where the presence of state-owned companies is relatively limited,” says Mr Konieczny. The biggest risks are in sectors deemed “strategic” such as energy and mining. Less prone to risk is “anything to do with the consumer sectors . . . healthcare and information technology”.