The economies and stock markets of the eastern and central European countries that became European Union members in 2004 are flourishing. But political malaise and instability, combined with structural weaknesses and inefficiencies, are undermining their convergence with the rest of the EU.

Barring Cyprus and Malta, the eight other new members — the Czech Republic, Estonia, Hungary, Lithuania, Latvia, Poland, Slovakia and Slovenia — were part of the former Communist Bloc, which endured significant reforms in moving to democratic free-market economies following the collapse of communism in central and eastern Europe in the late 1980s. The addition of these 10 new countries, known as the EU-10, brought the regional body’s membership to 25.

Growth in the region is being fuelled by individual companies that are performing well, providing investors with good growth opportunities, says Chuck Bastyr, portfolio manager and chief investment officer of Toronto-based Meadowbank Asset Management Inc. “If you’re a growth investor, eastern and central Europe is a good region to look at,” he says.

But, even though the region has excellent companies, good valuations, relatively cheap labour compared with developed European countries and potentially higher returns, the risk premium is greater, says Don Reed, president and CEO of Franklin Templeton Investments Corp. in Toronto and portfolio manager of Templeton International Stock Fund. He also warns that companies tend to be smaller and the opportunities limited.

In addition, the stock markets in these countries “are relatively small, liquidity is limited and there are few quality companies of size,” says Bastyr. “Market growth is largely fuelled by smaller companies, which typically grow faster.”

On the other hand, growth has been supported by “relatively strong foreign direct investment inflows, which have been driving up capital investment,” adds Bastyr. Although FDI inflows into the EU declined by 61% between 2001 and 2004 — from 146 billion euros to 57 billion euros — they climbed to 70 billion euros in 2005, benefiting emerging Europe substantially.

Another growth stimulant is the shift in production from high-cost developed Europe to much lower-cost eastern and central Europe, says Mark Grammer, vice president of investment at Mackenzie Financial Corp. in Toronto. Production in developed Europe is generally more capital- and skills-intensive compared with more labour-intensive in the new member countries, he says. Productivity is generally lower in the new member countries, but that is more than offset by labour cost savings.

As well, EU-10 members offer trade and investment opportunities, choice of locations, improved economies of scale, reduced costs, lower taxes and increased competitiveness — all combining to make them attractive, Bastyr contends.

These countries have also made infrastructure adjustments to accommodate EU requirements, accelerating their transformation in the process. This has earned them the greater credibility and respect typically associated with EU membership than if they had pursued individual paths to change. Consequently, “their risk premium has declined,” says Grammer.

The EU-10 have benefited from abolishment of import duties for manufactured goods, relaxation of capital restrictions, access to a larger export market and increased investment by the private sector.

As a result, the annual change in GDP growth for each of the new EU member countries was higher than the approximately 2% average growth of the remaining 15 EU members last year. For example, Poland, with a growth rate of 3.5%, and Hungary, at 4.1%, were among the EU-10 countries with the lowest GDP growth, while Estonia, at 10.5%, and Latvia, at 10.2%, experienced the highest growth.

The returns of the three largest stock markets of the EU-10 members, part of the MSCI emerging markets eastern European index, are also buoyant compared with their developed counterparts — although the performance of the developed European markets has picked up significantly over the past year. As of Oct. 31, the one- and three-year MSCI returns (in U.S. dollars) were, respectively, 27.9% and 49.3% for the Czech Republic, 5.7% and 35.5% for Hungary, and was 33.7% and 35.3% for Poland. Comparatively, the MSCI Europe index, which represents developed European markets, was up 28.2% and 20%, respectively, for the same period.

But despite their buoyant economies and markets, the EU-10 is still struggling with convergence. The major problem of the new EU member countries is with their governments, says Grammer: “The hangover from communism weighs heavily on their ability to adopt EU standards.” Supporters of ruling parties in some countries, such as Hungary, expect their governments to take care of them and maintain subsidies on certain goods and services, such as gas prices and health care, he adds: “These things were taken for granted under the Communist regime and, all of a sudden, a premium must now be paid for them.”

@page_break@Grammer argues that not only can these countries “no longer afford to meet the expectations of populists,” but “this would be a big problem going forward as they integrate into the EU.”

According to an Economist intelligence unit October report entitled The Long, Long Road to EU Convergence for Eastern Europe,the current political malaise afflicting much of eastern and central Europe following EU entry raises questions of how deeply rooted democracy is in these countries: “Populism, lies, xenophobia and instability have afflicted Poland, Hungary, Slovakia and the Czech Republic.”

Arguably, EU expansion has raised thorny issues, among them migration, controls over labour markets and when new members should begin using the euro as their common currency. More important, EU-10 members are concerned about maintaining their autonomy within the EU. There are also legal barriers with lack of recognized qualifications, nationality and/or residency; and social barriers because of linguistic, diversity and cultural differences.

As these countries converge, they have to conform to broad political, economic and legal criteria characteristic of the established EU framework: adopt and implement EU laws; make commitments to support stable institutions and market economies able to withstand competition; and guarantee democracy, rule of law, human rights and respect for minorities.

They have to adhere to membership criteria under the EU Stability Growth Pact regarding budget deficits, debt inflation, trade, and exchange and interest rates, but have been allowed a transition period.

Size differences, per-capita GDP and other variables are other challenges to integration, says Bastyr. On average, new entrants have a per-capita GDP significantly lower than the overall EU-25. Using a base of 100 for the EU-25, Slovakia, Poland, Lithuania and Latvia are each less than 60% of the base, while Slovenia and the Czech Republic, the two richest entrants, are 83.6% and 77.9%, respectively.

Reed believes the retail, banking/financial services, automotive and telecommunications sectors offer opportunities. Bastyr likes financial, consumer and property stocks.

For convergence to succeed, the gap between the EU-10 and the EU-15 must be quickly closed. But, according to the Economist report, the EU-10 will need favourable demography and fast-growing labour productivity. “They don’t enjoy the former, while the outlook for productivity growth is patchy,” it says.

“Government reform and better fiscal management are also required,” Grammer adds.
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