Rozlucki still leads the exchange today, but his bold ambitions have been only partly fulfilled despite the progress that has been made since 1989. Takeovers of Polish companies by strategic foreign investors have reduced the number of listings on the Warsaw exchange by more than 10 percent over the past two years, few small companies are willing or able to go public, and the Social Democratic government of Prime Minister Leszek Miller essentially stopped privatization dead in its tracks three years ago. Pension reform has produced a fast-growing base of institutional funds, but many of them are itching for permission to put more of their money in more-liquid foreign markets.
"Economic transition has proven more difficult than we all expected, but I think our expectations were wrong," Rozlucki tells Institutional Investor . "Building a market economy is a formidable task."
Rozlucki's mixed emotions are shared by many across Central and Eastern Europe as eight countries in the region prepare to join the European Union in May, along with Cyprus and Malta. The so-called accession countries have made tremendous strides since throwing off the shackles of central planning and embarking on market-oriented reforms. Great swaths of industry have been denationalized, and the private sector now accounts for roughly 80 percent of economic activity, compared with less than 50 percent a decade ago. Gross domestic product stands significantly above 1989 levels in all EU accession countries except the Baltic states, whose economies were devastated by the collapse of trade with Russia in the early '90s. Growth is firmly established, with output forecast to increase by about 4 percent this year, more than twice the rate of the 15 existing EU members. EU membership promises to anchor those gains by locking in the eastern countries' access to Western European markets, bolstering the region's appeal for foreign investors and providing the new members with much larger dollops of EU development aid.
"Eastern Europe is a huge engine of growth," says Alessandro Profumo, chief executive of UniCredito Italiano, which has invested E 2.6 billion ($3.2 billion) over the past four years to build up a presence in eight Central and Eastern European countries. Those operations generate nearly 15 percent of the bank's profits today.
But for all the progress, much hard work remains to be done. Unemployment is still extremely high, up to 20 percent in Poland and Slovakia. Foreign investment has slowed over the past 18 months, and the region has found itself facing tougher global competition from low-cost producers like China. Reform has stalled in many countries because of the political difficulty in trying to restructure troubled sectors like steel, shipbuilding and mining, and budget deficits have surged out of control in several countries, threatening to undo the economic gains of recent years and casting doubt on the ability of most countries to adopt the euro before the end of the decade. In short, while accession to the EU is a remarkable achievement, it is no guarantee of success in the years ahead.
Recent events in Hungary underscore the risk. After attracting the largest share of foreign investment to the region for most of the 1990s, the country suddenly hit a crisis last year because of the Socialist government's lax budgetary policies and tensions between the Finance Ministry and the central bank. The flight of foreign capital forced the authorities to effectively devalue the forint and boost interest rates by 6 percentage points between June and November, to 12.5 percent. The crisis sent yields soaring on domestic Hungarian bonds and forced the Finance Ministry to cancel a bond issue in November. The turbulence also drove up bond yields in Poland, which has similar deficit problems, raising the specter of financial contagion across the region.
The market turbulence "suggests that the fallout of receding euro hopes could be quite damaging," says Riccardo Barbieri Hermitte, an emerging-markets economist at Morgan Stanley in London.
The abrupt reversal of fortune for Hungary, which slashed interest rates to fend off speculative pressure for an appreciation of the forint as recently as January 2003, came as a rude shock to policymakers. "Three or four years ago, nobody thought this kind of turbulence could happen," Csaba László, Hungary's Finance Minister, tells II . László spent months insisting that Hungary didn't need a course correction before bowing to market pressure in December and announcing cutbacks in a popular mortgage subsidy program in an effort to reduce the country's gaping budget and current-account deficits.
THE TURBULENCE IN HUNGARY HAS SPARKED A major debate about the stance that Eastern European countries should take toward the euro. Hungary continues to regard early entry to the euro zone as a paramount goal, believing it will guarantee economic stability and reassure foreign investors. To further that aim, the country plans to peg the forint to the euro in a revived Exchange Rate Mechanism, known as ERM II, after it joins the EU in May, just as Western European countries pegged the French franc, lira, peseta and other currencies to the deutsche mark in the '90s in preparation for launching the euro. "The euro itself is an integrating power for the whole economy, the whole society," says László. "This is clearly of interest to the business sector and ordinary people."
An early attempt to fix the exchange rate in ERM II could merely invite more speculative attacks against the forint, though. Many economists believe the accession countries should focus instead on fostering growth, reducing budget deficits and pursuing structural reforms, such as deregulating energy and telecommunications markets and getting around to those difficult privatizations. Accession countries, they say, should be firmly on the path of achieving real economic convergence in living standards -- the strategy that Poland and the Czech Republic have adopted -- before they attempt financial convergence with the euro zone.
"For me, the question is not when to join the euro zone," says Jean Lemierre, president of the European Bank for Reconstruction and Development, the multilateral agency that has played a key role in financing transition in Eastern Europe. "The question is, what must they do to attract investment, create wealth and reduce the deficit. Exchange rate targets can help to drive policy reform, but it would be a mistake to join too early."
Hungary's problems have reinforced Poland's determination to focus on growth while letting the zloty's exchange rate float. Finance Minister Andrzej Raczko says the government won't attempt to establish a timetable for euro entry before the end of 2004, or until it sees whether it can meet its targets for growth, foreign investment and deficit reduction. The Czech government has also refused to set a date for euro entry, preferring to concentrate on growth in the short term. Asked about Hungary's efforts to peg the forint to the euro, Finance Minister László tells II bluntly, "I think it was a wrong decision."
The EU has enlarged four times since the Treaty of Rome established a customs union among six founding countries in 1957. The entry in May of ten new members -- Poland, Hungary, the Czech and Slovak republics, Slovenia, Estonia, Latvia, Lithuania, Cyprus and Malta -- will be by far the most historic, and the most daunting, expansion yet. The accession will formally reunite Western and Eastern Europe 15 years after the fall of the Berlin Wall, anchor democracy and capitalism in former Warsaw Pact countries and extend the EU's stability up to -- and in the case of the Baltics, into -- the territory of the former Soviet Union. Enlargement will increase the EU's land mass by a third; boost its population by 20 percent, or 75 million people, to 454 million; and raise the bloc's total economic output by 5 percent to E 8.2 trillion, making it some 11 percent larger than the U.S. economy.
The sheer number of new members, their radically different postwar experiences and their much lower standards of living promise to make their integration into the EU much more difficult than previous accessions. The potential for political difficulties became apparent early last year when most of the new eastern members signed a letter backing U.S. policy toward Iraq. Their stance drew a sharp rebuke from President Jacques Chirac of France, who led EU opposition to the war and said that the new members had "missed an opportunity to shut up." But having only recently thrown off the yoke of Soviet domination, such countries are unwilling to blindly accept the dictates of their EU partners, however much they are keen to enjoy the advantages of membership in the union.
The EU's institutions and rules, which were designed for the six founding members and make consensus difficult among today's 15 members, may well be unworkable for a bloc with 25 members. Efforts to streamline decision-making procedures and adopt the first-ever EU constitution foundered in December, however, because of opposition by Poland. Prime Minister Miller objected to proposals to adopt a new double-majority voting system, which to pass legislation would require not just a majority of member states, but a majority representing at least 60 percent of the EU's population. The plan would give greater clout to big EU countries like Germany and France while reducing the influence of midsize countries like Poland, which enjoys nearly equal voting power with Germany under current rules despite having only half the population. The fact that Miller found an ally in Prime Minister José María Aznar of Spain, who had hitherto been wary that expansion would siphon EU aid away from his country, suggested that new members could shift the balance of power in the union.
"For the past 14 years, we have been doing everything to become a member of the union. We knew this was our major goal," Danuta Hübner, Poland's minister for EU Affairs, tells II . "But we can't understand why we must make a decision [about new voting rules] before we see whether the current system works or not."
France's President Chirac reacted to the collapse of the constitutional talks by calling for deeper integration among a core group of EU countries, led by France and Germany. But it was a sign of the lack of political cohesion in Europe today that the leaders of the Netherlands and Luxembourg, both founding EU members, rejected Chirac's proposal. The new EU "will be a different Europe -- there are more of us," says Hübner. "Everyone has national interests. The challenge is to make them compatible with the European interest."
Economically, the new members promise to give the union a helpful boost with their stronger growth rates. The ten accession countries together posted a year-on-year growth rate of 3.2 percent in the third quarter of 2003, compared with just 0.6 percent for the EU, and a mere 0.3 percent for the 12-nation euro zone. "They're doing very well in the circumstances," says Alexander Italianer, director of international affairs at the European Commission's Economic and Financial Affairs division. "They've kept growth at 3 percent, with their big neighbors hardly growing at all."
Still, the impact of the new members on the EU will be modest in the short term because of the small size of their economies and the low level of living standards in most countries. In the first two years, enlargement should increase GDP in the existing 15 EU members by about 0.4 percent and in the accession countries by a little over 2 percent, as a result of increased trade, capital flows and EU aid, estimates Erik Nielsen, an economist at Goldman Sachs International in London. Per capita GDP ranges from highs of 76 percent of the EU average in Cyprus and 69 percent in Slovenia to lows of 41 percent in Poland and 35 percent in Latvia. Greece entered the union 23 years ago with living standards at 68 percent of the EU average; it has only managed to climb to 71 percent today.
In the longer run, however, the new members should strengthen the forces within the EU that are pushing for greater liberalization, lower taxes and increased competitiveness. The new members have spent the past 14 years reducing the state's role in their economies. Most of them have significantly lower corporate tax rates than existing EU members. Hungary cut its rate to 16 percent this year from 18 percent, and Slovakia and Poland slashed their corporate tax rates to 19 percent from 25 percent and 27 percent, respectively. "We very much support the idea that a competitive tax regime is necessary to attract investors," says Hungary's László.
The new members are also pursuing export-oriented growth strategies and have introduced funded pension systems. When they enter the EU in May, countries like the Baltic republics, the Czech Republic and Slovakia will be likely allies with the free-market wing of the union, which includes Ireland, the Netherlands and the U.K. "There will be fewer obstacles to entrepreneurship and risk-taking. That's how the EU will benefit from enlargement," says Willem Buiter, chief economist at the EBRD.
CENTRAL AND EASTERN EUROPEAN COUNTRIES have made remarkable progress during the past 14 years of economic transition. Since 1989 foreign investors have poured a total of $114 billion into the region's eight accession countries through privatizations and green-field investments, according to EBRD figures. Goldman, Sachs & Co. estimates that another $30 billion in portfolio money has flowed into the region's stock and bond markets. Real GDP, which plummeted initially, has rebounded. It now stands 33 percent above 1989 levels in Poland, 20 percent higher in Slovenia and 8 to 15 percent higher in Hungary and the Czech and Slovak republics.
The banking industry has experienced the greatest transformation. Western European banks have effectively taken over the banking system in most eastern countries, with the likes of Erste Bank, HVB Group's Bank Austria Creditanstalt and UniCredito Italiano having built formidable regional networks. "This is a real asset for all of the countries," notes the EBRD's Lemierre.
UniCredito has slashed bloated staff levels and developed a common information technology platform for its eastern business. Now it's seeking to raise its average loan-to-deposit ratio of 60 percent by lending to the region's relatively undeveloped small to midsize businesses sector and marketing more retail products, such as mortgages and auto loans. The combination of stronger economic growth and the potential to increase banking intermediation in the economy gives UniCredito "a double factor of growth," says CEO Profumo.
Western European manufacturers have built component and assembly operations across the region, taking advantage of low wages and skilled labor to enhance their global competitiveness. Volkswagen's $2.6 billion purchase of (breve)Skoda Auto has sparked the development of an auto and parts industry in the Czech Republic. Robert Bosch GmbH employs 7,200 people making auto parts and providing service in the country, while Toyota Motor and PSA Peugeot Citroën are jointly building a E 1.5 billion plant to produce a new line of small cars. PSA is also investing E 700 million in a small-car plant across the border in Slovakia.
And some homegrown players are beginning to expand across Central and Eastern Europe. Magyar Olaj-és Gázipari (MOL), the Hungarian oil company, last year acquired control of Slovnaft and INA, the leading oil companies in the Slovak Republic and Croatia; began discussions that could lead to a merger with PKN Orlen of Poland; and signaled its intention to bid for control of Romanian oil company Petrom when the government auctions it off later this year. "There is room for one strong oil player in central Europe," says Michel-Marc Delcommune, MOL's Belgian chief financial officer. The company sees demand for fuel growing twice as fast in the accession countries of Central Europe as in the EU as car ownership rates converge toward Western levels. "We think we are in the best place to be," Delcommune says.
The challenge for Eastern European countries is to remain attractive to foreign direct investors in the face of increasing competition from lower-cost producers elsewhere. The situation of Koninklijke Philips Electronics highlights the challenge. The Dutch electronics company was quick to invest in the East, buying a Polish lightbulb maker in 1990. Today it employs 11,000 people in Eastern Europe, including 7,400 factory workers in Poland and Hungary making everything from lightbulbs and vacuum cleaners to television screens and compact disc players. The company's top priority today, however, is China, which Philips expects will become its largest single market within four years.
"We have now exploited to a major extent the advantages of Eastern Europe in manufacturing. The real opportunity lies behind us," says Wim Wielens, Philips's chief executive for Europe, the Middle East and Africa. To remain competitive, Eastern Europe needs to capitalize on its educated workforce and move toward higher-value activities. Philips is doing this by establishing a European accounting and purchasing department outside Warsaw. Wielens also urges Eastern governments to invest in infrastructure to maximize their geographical advantage. "Poland has to improve its roads," he says. "Just-in-time delivery is an enormous advantage compared with Asian countries."
CAN EASTERN EUROPE MEET THE CHALLENGE? Disturbingly, several governments display signs of reform fatigue. Prime Minister Miller's Democratic Left Alliance in Poland has shown little willingness to make structural reforms since coming to power in 2001, although the October sale of the country's largest steelmaker, Polskie Huty Stali, to U.K.-based holding company LNM Group for $2 billion has raised hopes of tougher policies. The Socialist government of Hungarian Prime Minister Péter Medgyessy raised public sector salaries by more than 30 percent after taking power in 2002, weakening the country's competitiveness and setting the stage for last year's currency crisis. And budget deficits have ballooned to 8 percent of GDP in the Czech Republic, while the red ink hovers around 5 percent in Hungary and Poland, with limited prospects for a significant reduction any time soon.
"There are huge structural deficits that need to be addressed, and they will have to be addressed through expenditure measures," says Moritz Kraemer, a senior sovereign ratings analyst at Standard & Poor's in London. "It's not a 100-yard dash. It's a long-distance run." He believes the earliest possible date for adopting the euro is 2009 for Hungary and 2010 for the Czech Republic and Poland.
Ironically, EU accession may in fact worsen the budgetary trend in the region. As the EBRD warns in its latest transition report in November, "There is a risk that the pressure for reform in these countries will diminish once they accede to the EU because the incentive for reform will no longer exist."
Beyond the political impact, EU membership also will have an adverse mechanical effect on budgets, at least in the short term. In Poland, for example, the government forecasts a rise in the budget deficit to 5.7 percent of GDP in 2004 from 4.2 percent last year. Bringing customs duties and other taxes into line with EU levels will reduce the Polish Treasury's revenues, while spending will increase because EU rules require members to provide co-financing for development aid. The net effect of EU entry will add 10.7 billion zloty /($2.9 billion) to the deficit -- nearly one quarter of the total.
The government has pledged to reduce the deficit to 3 percent of GDP by 2006 in order to be able to adopt the euro by 2008 or 2009. "Even if we have 5 percent growth over the next three years, we have to decrease the public deficit," says Finance Minister Raczko. "If we don't reduce the deficit, we will kill the future growth rate." The government has failed to deliver on deficit reduction promises for the past two and a half years, however, and few economists expect Raczko -- who is Miller's third finance minister -- to succeed ahead of the general election that is due in 2005. "How can you propose political suicide?" asks former Polish central bank governor Hanna Gronkiewicz-Waltz, who currently serves as a vice president of the EBRD. "We need a new government with very strong credibility for two years, like what happened in 1989. You can do a lot in two years."
Reform fatigue is present even in the Baltic states, which have embraced market-oriented reforms with more zeal than most. The European Commission, the EU's executive agency, expects Estonia, Latvia and Lithuania to enjoy the region's strongest growth rates, about 6 percent, because of structural reforms and the macroeconomic stability generated by the currency boards that Estonia and Lithuania use to peg their currencies to the euro. But fast growth has ignited a consumer spending boom in Estonia and in 2003 generated a whopping current-account deficit of 15 percent of GDP. The EC recommended fiscal restraint to curb that deficit, but the government, which is already running a modest budget surplus, has thus far refused. "We should have tightened fiscal policy, but it's pretty tricky to convince the public and politicians that we are living too well," says Aare Järvan, secretary-general at Estonia's Finance Ministry.
The other big challenge facing Eastern Europe's policymakers is what strategy to take toward the euro. This will be the EU's first expansion since the single currency was launched five years ago, and unlike the U.K. or Denmark, which have the option of staying out, the new members are obliged by their accession treaties to adopt the euro when they fulfill the economic criteria. The criteria include a requirement that countries join the ERM II for a minimum of two years, which means keeping their currencies pegged tightly to the euro while maintaining low inflation and interest rates close to EU averages.
The past year saw a distinct cooling in enthusiasm for early euro entry as accession countries realized the financial discipline that the single currency demands. Estonia plans to enter the ERM II almost immediately upon joining the EU in May and to adopt the euro in 2006, but for a small economy that has pegged its currency to the euro for years, such a policy poses few challenges. Hungary, Lithuania and Slovenia also aim to enter the ERM II later this year. Poland, however, has a vaguer ambition of entering around 2006 in order to adopt the euro by 2008 or 2009, while the Czech Republic is deferring any decision until it is sure it can make a swift transition to the euro.
The EC contends that the ERM II is a good training ground for countries to prove that they can remain competitive with a fixed exchange rate. But commission officials stress that Eastern Europeans might need to spend far longer than the minimum two years in the ERM II and be willing to change their central parity to the euro if pressure builds. "Our message is that if you go into the ERM II, be aware that this puts an external constraint on your policies, as we've seen with the Hungarians," says the EC's Italianer. "If you behave stupidly, the EU will not rescue you."
Is the ERM II really a good training ground? Hungary, after all, was effectively operating its own ERM IIlike arrangement by pegging the forint in a narrow trading range against the euro before the country's Finance Ministry and central bank fell out with each other last June. The Finance Ministry ordered a modest 2.6 percent devaluation in a bid to boost exports, only to have the central bank tell markets that it would continue to target the previous exchange rate to keep downward pressure on inflation. That policy inconsistency eventually triggered the flight of capital from the country. "The lesson is that you can't target two things at the same time," says Graham Stock, an emerging-markets economist at J.P. Morgan Chase & Co. in London.
Accession countries that peg their exchange rates to the euro without first reducing their budget deficits run the risk of giving speculators a target to shoot at, says Mahmood Pradhan, an emerging-markets analyst at BlueCrest Capital Management, a London-based hedge fund. "I think it's a mistake to be in ERM II for a five-year period. It's a recipe for inviting more pressure."
The European Central Bank recently cautioned accession countries not to attempt to fix their exchange rates too quickly. "Given the risks implied by premature rigidity of the exchange rate, it might be appropriate for some new member states to only consider applying for ERM II membership after a further degree of convergence has been achieved," the ECB said in a policy paper last month. In particular, the central bank said, accession countries must ensure that "major policy adjustments are undertaken prior to participation in the mechanism and that a credible fiscal consolidation path is being followed."
Many direct investors in the region are urging policymakers to focus on growth and medium-term budget reforms rather than the single currency. "I don't see any reason why there should be such a rush to enter the euro zone, because for many of those economies, it's simply premature," says Peter Goldscheider, founder and managing partner of Vienna-based European Privatization and Investment Corp., which manages about $2 billion in Central and Eastern Europe. "Currency is probably the most important variable. If you remove it, you hurt economies more than help them. This is clearly what we see in Hungary. It is much more important to look for growth and for a socially acceptable distribution of wealth."
That view is echoed by UniCredito Italiano's Profumo. "It would be dangerous to accelerate the process of joining the euro," he says. "You have to be able to compete within the single-currency structure." The Italian bank is making a long-term bet on the region's prosperity, and exchange rates are a secondary consideration. "Our main focus is on the growth of GDP in these countries."
That's a focus that Eastern Europe's policymakers should be glad to share.
Hungary's pitfalls on the road to union
Betting that the economies of Central and Eastern Europe would converge with those of their neighbors in the European Union has been a popular trade for fixed-income investors, but the recent setback in Hungary's bond market dramatically underscores the fact that convergence isn't a one-way bet.
Bond funds have loaded up on Central European paper in the past two to three years in the belief that interest rates would fall toward EU levels as those countries joined the union and proceeded to adopt the euro. Fund managers launched dozens of dedicated convergence funds; Goldman, Sachs & Co. estimates that more than $20 billion poured into accession-country bonds. The trend accelerated in late 2002 as investors piled into Hungary's domestic bond market, anticipating that the forint would appreciate in real terms because of the country's robust growth rate.
"They went on a bandwagon, and they got it wrong," says Jerome Booth, head of research at Ashmore Investment Management in London.
Hungarian authorities acted swiftly to rebuff the pressure on the forint, cutting interest rates by 2 percentage points last January, to 6.5 percent, and intervening to drive the forint down by 6 percent, to Ft251 to the euro.
Soon after, confidence in the forint began to ebb. The European Commission's announcement in April that it would apply strict exchange rate criteria to accession countries seeking to adopt the euro caused many investors to doubt the prospects for the quick entry of Hungary and others into the euro zone. At the same time, Hungary's economic fundamentals began to deteriorate following a spending spree by the Socialist government, which boosted public sector wages by more than 30 percent after winning the parliamentary elections in 2002. The budget and current-account deficits ballooned, consumer spending boomed, and inflation rose above 5 percent, forcing the government to abandon its inflation target of 3.5 percent for 2004.
The Finance Ministry lowered the forint's central parity against the euro by 2.26 percent in June, hoping to restore export competitiveness. But the Hungarian central bank undermined that move by announcing that it would continue to aim for an exchange rate of 250 to 260 forints to the euro to contain inflationary pressures. The open clash among policymakers sent a clear sell signal to investors. "Basically, there's an inconsistency between fiscal and monetary policy, and this is not unique to Hungary," says Ashmore's Booth.
Rate hikes by the central bank, including a three-point increase to 12.5 percent on November 28, failed to stop the rot. The biggest blunder came on December 1 when Finance Minister Csaba László told institutional money managers at Citigroup's London offices that the government could fend off speculative pressure without a change in policy. "Straight after people came out of the meeting, they were shorting the forint," says one emerging-markets fund manager. The currency dropped 4 percent over the next three days, to Ft273 to the euro, and the government was forced to cancel a Ft30 billion ($136 million) auction of 15-year bonds.
László relented two weeks later by announcing cuts in a popular mortgage subsidy program. The cuts will barely scratch the surface of the deficit -- saving Ft10 billion out of an estimated deficit of Ft760 billion this year -- but László is betting that the move will curb consumer spending and narrow the current-account deficit. Many investors have their doubts. "The measures are a step in the right direction, but they're not there yet," says Mahmood Pradhan, an emerging-markets analyst at BlueCrest Capital Management in London. "The government is not very popular. The mortgage subsidy cutbacks will really hurt a lot of consumers, and 2005 is a presidential election year. There's a concern that they can't really pursue fiscal adjustment."
For all of its problems, Hungary is hardly another Argentina. The imminence of EU entry provides enough political and economic stability to prevent a financial meltdown, most investors believe. Yields on the government's ten-year domestic bonds, which began 2003 at less than 5 percent, rose to a peak of more than 9 percent during the crisis before settling back to about 8.5 percent by late December. Spreads on Hungary's euro-denominated bonds fared better, widening to a little more than 100 basis points above German government bonds in December from just over 50 earlier in the year. The government will increase its euro-denominated funding this year by an extra E 1 billion ($1.24 billion), to E 3 billion, a tactic that Poland also will employ. EuroMTS, the London-based electronic fixed-income trading platform, launched a new service in December for trading both countries' euro-denominated bonds, confident that the two nations have a bright future in the EU despite the recent market turmoil.
"The path may not be straight, but the target is clear," says Gianluca Garbi, chief executive of EuroMTS. -- T.B.