Despite Central Europe's remarkable political and economic progress since 1990, investors cannot help feeling slighted as they have watched these markets decline on bad news from Russia and Asia, and the recent volatility in developed markets.
By most economic measures, Poland, Hungary and the Czech Republic have done well in recent years. But while they are managing to decouple from Russia economically, financially and in the hearts and minds of foreign investors, Russia still looms large.
"Russia has an impact only because people think it should," said one local fund manager in Poland in June, following a 15% drop in the Polish market that was caused by turbulence in Russia.
But many market participants, such as Christian Elsmark, product manager for the $572 million FFF-Fleming Eastern European Fund, see the countries of Central Europe taking their place alongside Portugal or Greece in the European Union. "The story in Central Europe is one of convergence," said Mr. Elsmark.
Membership in the EU is expected to bring currency stability through pegged exchange rates to the euro, and improved international fund flows as institutional investors rebalance their European portfolios to include the candidate countries. Indeed, local currency funds have been the best performers in the region's markets this year.
But for now the abysmal state of investor sentiment in emerging markets appears to be holding sway in Central Europe. Fear of another Asian currency crisis forced regional markets down, leaving Poland the only market in Central Europe in positive territory on the year. "This has nothing to do with Central Europe," said one London-based trader at an international investment firm. "This is about investors making sure that they locked in some profits this year."
Still, the launch of new funds dedicated to investing in Central Europe -- there now are more than 140 equity and debt funds with a majority of their assets in the region -- is a sign of tremendous potential for future growth.
Poland: We're NO. 1
By mid-August, Poland's equity market had risen 9% in dollar terms, the only country in Eastern Europe to have gained ground in 1997, while its debt market was attracting considerable foreign interest and offering attractive yields.
Poland is drawing investors with the region's best macroeconomic story, including gross domestic product growth of 6.7% in the first half of 1998 year-on-year, a 12% annual inflation rate, industrial production that rose 6% in the second quarter, a better-than-expected current account and continuing inflow of foreign direct investment.
"Nothing is wrong with the Polish economy and foreign investors are recognizing it, but they are a bit more cautious because of Russia," said Mateusz Szczurek, an economics analyst with ING Barings in Warsaw.
Investors also are reaping profits from the appreciating zloty. The zloty has been rising against the basket of currencies to which it is pegged. And with yields on treasury bills and bonds in mid-August around 15%, demand for Polish debt has been running high this year, largely responsible for the soaring zloty.
Investors are less sanguine about the ability of Polish managers to adapt to an evolving free market. The style of many corporate managers, according to equity analysts who know them well, is still mired in old-school thought where management is held accountable to nobody -- least of all shareholders. Consequently, earnings growth this year has suffered in most sectors, except banking and construction.
But because Poland is primed for European $45 million Central Europe Stock Fund, managed by Erste KAG in Vienna, "the public relations of listed companies throughout the region has improved dramatically, but especially in Hungary."
Foreign investors now own sizable stakes in many of Hungary's largest companies and comprise about 51% of the entire Hungarian equity market. The downside to such a large proportion of foreign ownership, though, is vulnerability to the mercurial sentiment of emerging markets portfolio investors. In August, foreign investors responded to renewed volatility in emerging markets by taking profits on some of the larger and more liquid companies on the Budapest Stock Exchange.
"The optimism is back," said Norbert Toth, an analyst with ING Barings in Budapest. "But the market is more concerned with global and regional developments and corporate fundamentals than before."
Czech: The fallen star
Once considered the jewel of Central Europe, the Czech Republic has emerged as the least friendly of the "big three" countries.
Political instability and what one U.K. fund manager calls "deep-seated corporate governance problems" have kept foreign investors out of the Prague Stock Exchange for most of the year. The country's PX-50 index had slipped more than 4% in dollar terms by mid-August.
Market experts in particular point to the questionable practice among Czech companies of "circle ownership," in which a company holds its shares through its own investment vehicle. In addition, sundry scandals and violations of minority shareholder rights have kept foreign money at bay. And a new regulatory commission might be too little, too late.
The PSE this year fell steadily before the country's June election, reflecting the frustration of investors with prolonged political uncertainty. But investor confidence in the Czech Republic recovered somewhat after the election, which brought a Social Democrat (CSSD) government to power. The CSSD was forced to a partnership, albeit a weak one, with the Civic Democratic Party.
"The election results have at least brought some action back into Czech politics," said Tibor Schindler, a senior fund manager with Raiffeisen Kapitalanlage in Vienna, which manages Central European debt and equity funds.
There has been a great deal of action on the currency market, fueled by foreign investors seeking to profit from the interest rate differential in the local currency debt market. Buyers have been snapping up the local currency, the koruna, pushing the exchange rate to near an all-time high against the deutsche mark. But since the koruna is on a managed free float, compared with Hungary and Poland's crawling peg, it is subject to volatile movements. And like Poland, good yields and an appreciating currency make an attractive investment and a booming debt market.
Investors will continue to look closely at what many analysts consider an undervalued equity market for signs of structural improvement. But few investors are holding their breath.
