Emerging Europe: Steering Through a Hard Landing

As the sub-prime mortgage tsunami wreaked havoc in the advanced economies, the emerging markets seemed immune to the crisis with strong growth rates continuing into 2008. Led by the BRICs (Brazil, Russia, India and China) and emerging Europe, these economies were thought to be less exposed to a US recession and market analysts endorsed the ‘de-coupling’ theory because on the one hand they believed that commodity prices, which are of primary importance to these economies, would either continue to rise or at least stay high and, on the other hand, that these economies would continue to have access to international capital markets.

But by the second half of last year, the de-coupling theory was discredited as the emerging markets’ credit quality began to deteriorate – and emerging Europe was identified as one of the regions most at risk. In January this year, leading international banks operating in central and eastern Europe clubbed together to lobby the European Union (EU) and the European Central Bank (ECB) to extend their anti-crisis policies to ease the credit crunch in the region. The group of nine, which includes Raiffeisen, Unicredit, Intesa Sanpaolo, Erste Bank, Société Générale, KBC, Bayern Landesbank, Swedbank, and EFG Eurobank, urged Brussels and the ECB to extend support beyond the EU’s new member states, such as Poland, to prospective members, such as Serbia, and to Ukraine, which has few prospects of joining the bloc soon.

The region was hit by three severe shocks: the banking and capital market shock, the global recession and the fall in commodity prices. Edward Parker, head of emerging Europe at Fitch Ratings, said: “Other emerging markets have been hit by the same shocks but the difference in emerging Europe is that this played out on underlying vulnerabilities, particularly large current account deficits and external debt that need to be refinanced, the unwinding of a particularly frothy bank credit boom, the extent of foreign currency debt and mismatches on sectoral balance sheets, the openness of some of the countries and, in the case of the Commonwealth of Independent States (CIS), their exposure to commodity prices.”

In light of the deterioration in credit-worthiness across emerging Europe, Fitch downgraded the ratings of nine countries by a total of 12 notches: Bulgaria, Georgia, Hungary, Kazakhstan, Estonia, Latvia, Lithuania, Romania and Ukraine. There were only two upgrades in 2008 – and Slovakia’s upgrade was due to its adoption of the euro. Moreover, Fitch has nine countries on negative outlooks and none on positive, which illustrates that rating dynamics in emerging Europe remains strongly negative (Figure 1).

Figure 1: Emerging Europe Upgrades and Downgrades

Source: IMF, country sources and Fitch

Parker believes that the financial shock is the most damaging out of the three for most countries. “On average, net external borrowing in 2007 was around 10% of gross domestic product (GDP); on top of that there was net foreign direct investment (FDI) of around 2.5% of GDP. Those huge capital inflows were both fuelling and financing large current account deficits and also leading to a build up in foreign exchange reserves,” he explained. “But after Lehman’s collapse, we have seen foreign parent banks, which were big suppliers of that capital, facing acute capital and funding pressures and also the international syndicated loan and bond market shrivel up, so those capital flows are now shrinking if not reversing.

It will be difficult for countries to get in net external borrowing or even to roll over what is coming due,” (Figure 2). Robert Ruhl, senior economist at the economics department of ING Wholesale Banking, adds to Parker’s analysis. “It was quite clear that the banks in the emerging markets also suffered the liquidity squeeze that hit the interbank markets. The Bank for International Settlements (BIS) data confirms the reduced lending activity of BIS banks in central and eastern Europe (CEE) as of the third quarter of 2008.

Figure 2: Bank Credit and Capital Inflows: Feast to Famine

Source: IMF, country sources and Fitch

However, the withdrawal of deposits by BIS banks from the region had started already in the first quarter of 2008. On balance, as of the first quarter of 2008, BIS banks contributed to a worsening of the liquidity position of countries in CEE. Now some emerging markets countries have serious funding problems, especially those highly dependent on external bank loans. The International Institute of Finance has projected that there will be a severe outflow of capital from the emerging markets countries, including CEE, in 2009 – particularly since this year will see the re-financing of a substantial amount of euro bonds,” he said.

It is the high level of integration – the antithesis of ‘de-coupling’ – of these economies into the world market that amplified their exposure to the global recession. For example, the most exposed central European countries are the ones that are well integrated into the EU economy; therefore, the recession in the EU, which is forecasted by the European Commission to be a 1.8% decline in EU economic output in 2009, is “very bad news” for them, according to Parker. The bad news was underlined by recently released industry figures, such as Czech industrial production that was down 17% in November year-on year. “This is a country that does classify as an innocent victim: it had been growing at 6% plus in recent years without any significant banking or macroeconomic imbalances, but it did not escape the slowdown in the auto industry,” said Parker.

At a company level, Alro, one of the largest aluminium smelters in central and eastern Europe, has been directly affected by the global downturn as the company operates in the base metal markets. Leonid Prujanski, director of treasury at Alro, explained: “The market price came under pressure in the second half of last year, as demand rapidly deteriorated due a collapse in key user sectors, such as construction and auto industries. At the same time, the industry is expecting a record surplus due to the failure of production cuts to keep pace with the decrease in demand.”

Prujanski also highlighted the impact of the credit crisis on treasury, which has resulted in an increase in the cost of non-committed borrowings and reduced availability of credit.

Liquidity, Credit and Cash Management Challenges

Prujanski’s concerns about the cost and availability of credit are resonating in corporate treasuries across the region. The environment for treasury in emerging Europe is highly volatile because of the lack of liquidity in the market. “Treasuries are now facing higher funding costs in the region and much volatility, particularly in the currency rates. Banks are faced with limited liquidity and funding from abroad is scarce to non-existent for the treasury,” said ING’s Ruhl. “They have to stick to the local situation, so the focus will be on improving the cash management in the local area and finding the funding structures which will help to reduce external funding. We see a lot of treasurers doing that.” Treasurers see cash management as top priority.

Operating in Romania, Prujanski believes that the primary goals of a good corporate cash management system should be to maintain adequate cash to meet the daily cash requirements of the company in each currency, while maximising the amount available for investment and reducing the borrowings under overdraft type facilities; and obtain maximum earnings on invested free cash while ensuring the return of the principal. In order to reach these primary goals, a treasurer faces the following challenges:

1. Development and maintenance of strong, internal control of collections and payment – at Alro, it was done by implementing an enterprise resource planning (ERP) system to gain an overview of cash flow on a regular basis.
2. Establishment of clear lines of communication between the treasury and originators of payments and collections to avoid any unexpected payment or unexplained delays of collections that have impact to daily cash balance.
3. Development of solid professional relationships with domestic and foreign banks.
4. Establishment of highly effective procedures of electronic data interfaces (payments, collections, account statements) with relationship banks through web-interface, multi-cash, etc.
5. Ensuring real-time access to financial information through access to an integrated information and transaction service (e.g. Reuters 3000 Xtra).

The first and second points are critical areas for all treasurers because in order to reduce the need for external funding, treasury has to be in control and have visibility of its cash inflows. Miklós Hanti, group treasurer at Grafton Recruitment, an international Irish-based company with its treasury headquartered in Hungary, believes that the main issue today is credit control, regardless of where the treasury is based.

“Treasurers are trying to maintain their cash conversion cycle, their days sales outstanding (DSO), and keep up their collections. We are seeing that there are certain spots, not just in the UK but also other regions of the world, that have difficulty meeting payments or the payments cycle has certainly stretched out.

“For example, certain business partners that would have paid us regularly in a 30-45 day term basis have stretched it out to 60-90 days. I don’t think there is insolvency but, with the credit crunch, their partners are not paying them so they have to stretch their cycle out which then has an impact on us. We are still trying to maintain our payments cycle but it is only possible if our partners pay us,” said Hanti.

What Corporates Need from Banking Relationships

Prujanski’s last three points address what corporates need in terms of their banking relationships. One treasury analyst, based in Romania at the trading arm of a large multinational firm, outlined her top priorities when choosing a bank:

1. The bank has to be very flexible in solving all issues and should not block or postpone any requests.
2. The bank’s policies and procedures should be less strict than ours and amendable according to our requirements.
3. To have a person dedicated to our business and available all the time.
4. The bank should be able to provide the all range all services required.
5. The services should be of the highest quality with comparative prices.

The trend appears to be a move away from multiple local banks to one or more large international financial providers that works cross-borders. The Romanian analyst said that in her treasury they only work with first class multinational banks. Prujanski said that although Alro has a strong presence across eastern and central Europe, it does not have presence with local banks. “Our collections are concentrated in relationship banks in Romania. We have studied the possibility to open current accounts in some other countries in the region to be closer to our customers and reduce the collection float, but as of yet we have not ‘crossed the borders’,” he said.

Hanti is also consolidating Grafton’s banking relationships; he is about to start a global cash pooling operations for the entire group worldwide. Presently Grafton Recruitment deals with about 20-25 different banks; in the next three or four weeks, it will move over to one big international multinational bank, ABN Amro that can do the cash pooling, provide services and cash movements, as well as payables. “It is about rationalising processes and gaining transparency and visibility across the group,” said Hanti. “I think one of our biggest problems, which other corporates also find particularly in today’s environment, is knowing what cash we have on an intraday level and getting the best use out of it.”

In this economic climate, an important aspect of treasury is to get faster and better visibility of funds, so that a corporate can position itself in the country and in the currency; but, in order to do that, the corporate has to implement a standardised process for accessing this information, says Christian Kothe, head of central and eastern Europe at SWIFT. “Corporates today want to use working capital efficiently. The major driver for a corporate to sign up to SWIFT is so they can implement a single process on a global basis to get access to their banking information – they want fast information on their liquidity position in different countries in a consolidated way. This allows for effective management of funds.”

Because of the crisis and resulting financial constraints, banks and corporates will have to take a close look at how many alternative communication channels they are prepared to support. “The majority of the banks are using SWIFT, therefore the consolidation of channels into SWIFT is considered an option versus setting up new channels, which require other technology and support set. For corporates, the driver for implementing SWIFT isn’t primarily technology cost reduction – the drivers are more in the area of reducing risk via standardised and audited processes, reducing working capital requirements, and having faster access and management of their liquidity positions across countries,” he says.

The trigger for emerging Europe’s corporates looking at SWIFT often comes from international corporates doing business in those countries. Domestic take up is still limited, which has to do with the size of those corporates and their predominantly domestic business focus. As these corporates move cross-border, international banking relationships appear on the radar screen. Kothe believes that take up will increase over the next two years and that SWIFT’s newly launched Alliance Lite, aimed at smaller banks and corporates, will provide potential SWIFT customers with yet another option for connectivity.

“Lite can provide effective and less costly access to SWIFT, but corporates and banks still need to understand and leverage the benefits of using SWIFT in their corporate to bank communication,” says Kothe.