Doing Business in the New Europe?

Keiron Root, Editorial Consultant for TMI magazine, looks at the potential benefits and disadvantages for companies trading with the expanded EU.

E urope is expanding. May 2004 saw the number of member states of the European Union grow by two-thirds, from 15 to 25, with a further group of eastern European countries queuing up behind them. The expansion of the European Union was bound to bring with it a major change to the way in which EU business has been conducted, but what effects will it have on the activities of European corporates? After all, the development of a single European market is one of the cornerstones of the whole European project, and the arrival of ten new members, at different levels of economic sophistication but all significantly below the major western economies in terms of size and regulation, was bound to impact upon financial, commercial and economic activity.

To start with the newest members of the European family, ten states became members of the European Union for the first time on 1 May 2004 – Poland, the Czech Republic, Hungary, Slovakia, Slovenia, Estonia, Latvia, Lithuania, Malta and Cyprus. Romania and Bulgaria are also well advanced along the road to EU membership, with a target date of 2007, while other states, notably elements of the former Yugoslavia and, more controversially, Turkey, are still at the very beginning of the process.

Although at the time of their accession, these ten new EU members accounted for around 2 per cent of total EU GDP, on the basis of population alone, their political and economic significance is growing. For example, within the councils of the EU Poland will be twice as important as The Netherlands; the Czech Republic and Hungary will each be as important as Belgium and Lithuania is of similar significance to Denmark. Over time, each state’s economic significance should grow to match its political position.

One of the key attractions of EU membership for what have collectively become known as the ‘Accession States’, is the anticipated stimulus that being part of the European Single Market will give to their largely underdeveloped economies, both in terms of opening up a much broader market to their domestic companies and in the form of direct financial assistance in the form of EU funding. At the time of the most recent accession, the total EU budget was EUR 90 billion, of which only EUR 3 billion is earmarked for spending in the accession countries. However, this proportion will grow significantly over time. By 2014, it is projected that roughly half the EU’s total budget – i.e. EUR 45 billion at current levels – will be spent in these countries, with an obvious impact on their economic activity.

This also creates potential problems for the economies of some of the longer standing EU member states. Walter Demel, of the research department at RZB Group, points out that “One of the major issues surrounding enlargement is the new EU budget covering the period from 2007 – 2013, which has to be finalised next year. The big question for countries like Spain and Ireland, which have received a lot of EU money in the past, is to what extent they will continue to receive these funds and how much will go to the new member states. That will continue to be a hot topic. The current agreement is that these new countries will receive between 0.6 and 0.8 per cent of their GDP in new Euro money.”

Indeed, the economies of the accession states have been exciting the interest of fund managers and bankers from Western Europe and the US for some time, because of the considerable growth potential they offer. Jan Zonneveld, programme manager for Central Europe at ING, notes that “There will certainly be accelerated growth in the accession economies, even if only because of the amount of European money that will be going there. Judging from the previous experience of economies like Portugal, Ireland and Greece, there will be a lot of infrastructure development which will stimulate growth. We reckon that 10 per cent of growth will come from this stimulus alone.”

He adds “It will be a similar story with the Czech Republic, Hungary and Slovakia although we would say that Poland is slightly different because it is so big. It has so many people. This will not be an overnight thing but you can expect growth in these economies to be faster than the rest of Europe and these processes will make it very attractive for multinationals to invest in these new countries. Wage levels are relatively low, labour regulations are flexible and inflation is also relatively low.”

Competitive advantage

There is certainly a perception that the accession economies have a distinct competitive advantage over their more established neighbours in western Europe. Maurice Cleaves of JPMorgan Treasury Services, says that “Although we haven’t seen it directly within the payments business, logic would tell you that the accession countries would have a lower cost of production and that they would now provide that opportunity within the European space. This is what happened in the US, where production moved to the lower cost areas. Of course, there is no single European market yet but it is developing and you would expect the accession countries to have a cost advantage.”

There is little doubt that the accession states have so far used those advantages well. Patrick Butler, RZB Group Board Member responsible for Treasury and Investment Banking, notes that “In terms of the direct impact of the accession states, you can see it on a number of levels. Clearly these have been, in the recent past, relatively cheap areas to produce. Companies like Volkswagen obviously doing tremendous things in the Czech Republic and Slovakia being a real success story in terms of third-party contracting and the like.”

However, he adds that “The main thing, though, is that with their success and with the fact that the costs of production are increasing fairly rapidly, what you are seeing now is that the outsourcing is tending to push further eastwards into the next row of potential accession countries. A key point to be made is that the cost advantages do not last for ever.”

Butler points out, however, that, to a certain extent, the investors in the accession economies are simply reaping the benefits of their success. “The kind of money that there was to be made out non-equity financial assets has again much reduced. And again much of the music is playing in the countries further to the east. Having said all this, these are the success stories. These are the countries that have managed to achieve a level of political, social and financial stability that some of the sceptics didn’t believe would be possible back in 1990, when this whole process began. Those banks, for example, that have invested in the region, as we have, in a very serious way, have been extremely pleased, therefore, with their investment, which has paid off very handsomely and continues to create a whole lot of opportunities.”

So far, the concentration of outside investors has been on the larger central European economies of Poland, the Czech Republic, Hungary, Slovakia and Slovenia, alongside two economies that remain resolutely outside the EU enlargement process, Russia and the Ukraine. Local institutions have, by and large, lacked the sophistication to provide the range of financial services demanded by major foreign investors, although there are signs that they have already been reacting to the new opportunities presented to them by enlargement.

Walter Demel points out that “The banking sector in Central and Eastern Europe (CEE) has displayed a remarkable development during the last 15 years of transition. Nevertheless, even in some of the most advance countries, bank restructuring and the subsequent privatisation process was completed only recently or is still ongoing. The vast majority of banks operating in the eight new EU member countries of central and Eastern Europe, and the three countries that are scheduled to join the EU in the next accession wave are now in private hands, and mostly foreign-owned.

“Western European banks have dominated the consolidation process to date, and control local markets to a large extent. Austrian and Italian banks, in particular, have used the opportunity to ‘Go East’ and offer the highest CEE exposure in terms of total group assets. Some international players, such as HSBC and Deutsche Bank, are still under-represented in the region, whilst countries such as Russia, Ukraine and Belarus are, to a large extent, untapped by international banks.”

A re-run of reunification?

One thing that has worried fund managers concentrating on Europe is that the expansion of the EU to include much of central and eastern Europe will be a re-run of German reunification, which was perceived to have held back the German economy and severely restricted pan-European growth. However, attitudes towards this process have been improving as the German economy itself has improved.

For example, Steven Andrew, chief economist at F&C Asset Management, observes that “Arguably a disproportionate amount of the pain of the long transition has been borne by the German economy. Reunification has been, and continues to be, a huge burden for the German economy. Huge over-capacity in the construction industry, high wage costs, high and rising unemployment have taken a hefty toll on the country’s finances. It is only in the past few years that we have seen some significant improvement in German companies’ profitability and cost control, providing hope that, with the costs of reunification now behind it, the German economy has begun to regain lost ground.”

He adds “In the wake of the 15th anniversary of the beginning of the fall of the Berlin Wall, I would argue that the benefits to the rest of Europe have far outweighed the economic burden of reunification for Germany. It was a potent symbol of the opening up of Europe, in terms of trade, travel and competition which has benefited the entire region.”

Norbert Beiner, portfolio manager for European Equities at Credit Suisse, argues that “We believe that the fundamentals are in place for solid performance from European equities, although we are currently encountering some fairly strong headwinds. Valuation is attractive, with the European market currently trading on 13.5 times this year’s pre-goodwill earnings, and 12.1 times next year’s earnings. Using price/earnings ratios as a measure of value, the market has effectively gotten cheaper this year, remaining range bound even though companies have delivered earnings growth of 33 per cent.

“Corporate restructuring, for the most part, has been completed, and many companies are now enjoying relatively robust volume growth. Companies have also reduced debt from the high levels of the late nineties, with corporate balance sheets now looking increasingly ‘overly’ healthy. Therefore, European companies are returning large amounts of cash to shareholders, either in the form of dividends or share buybacks, or both. We believe that European markets are well poised. Companies have cut costs and de-leveraged, so that much of corporate Europe is looking ‘lean and mean’. Investors in European stocks can look forward to cash returns from companies, through increased dividends, and share buybacks. The prospect for capital gains is also good, as the valuation of the market is not demanding.”

Robust corporate health

What this means is that the investment community regards European corporate health as currently robust and that it is, therefore, embarking on this dramatic period of expansion from a position of strength – which is just as well since the impact of the accession countries on the wider European economy has already been significant. Wolfram Roddewig, of Merrill Lynch Investment Management’s European Equity Team, says that “We believe that EU accession is having a positive impact on corporate restructuring within core Europe. First, cheaper labour is becoming increasingly available in old Europe, as people arrive from the accession countries demanding less in terms of wages, with the effect of depressing firms’ labour costs.

“Wage costs are being lowered further through a shift in employer-employee relations within core Europe, notably Germany. Employees within core Europe are demanding less from their employers as they fear potential job losses through the relocation of jobs to Eastern European countries, where labour and operational costs are much cheaper. As a result, European companies have been able to cut costs more radically than those in the UK or US, stimulating competition within the region.”

He adds “Another factor adding to the competitive environment is the average rate of corporate taxation in the 10 accession countries, which is 21.5 per cent, markedly lower than the 31.4 per cent average in the 15 pre-existing member states. This potentially could put downward pressure on corporate tax rate regimes in core Europe, as governments attempt to maintain competitiveness and their ability to attract foreign direct investment. Labour market reforms have been led at the corporate level by multinationals such as Siemens and Philips, where workers are accepting longer hours for the same pay, while other European corporations have introduced more flexible work arrangements. These, alongside improving corporate governance in Europe, should improve the investment environment for shareholders.”

Roddewig argues that “While substantial complications remain with accession in the short term, the arrival of these nations is encouraging corporate reform. We believe substantial investment opportunities exist in the Continental European equity market. “Financial services companies stand to gain the most, as they have the potential to gain market share in Eastern European markets where the sector is relatively underdeveloped. Banks can now capitalise from pent-up demand in credit card and mortgage loan markets, which are presenting substantial opportunity for growth in the accession region. For example, our European equity funds are taking advantage of this, with holdings in companies that have exposure to this growing region, such as Allied Irish Banks, who have operations in Poland, as well as Italy’s Unicredito, which operates throughout Eastern Europe. These are key examples of companies whose expansion eastwards we hope to benefit from.”

That fund managers are looking to play the accession economies through established western commercial, and particularly financial, names is an indication of how rapidly integration is taking place. Patrick Butler also acknowledges that, while the accession countries were relatively cheap places for western firms to do business in the early days, costs are now levelling out across the enlarged EU. He says “Another key point is in terms of the whole cost of capital for these countries, that has come down very considerably. Foreigners were under a tremendous advantage because they could raise capital relatively cheaply in other countries, whereas if you went to the Czech Republic a decade ago, you were talking about a situation in which the Cesko-Narody Bank, the national bank for the state was raising money at 200 basis points over, now you would be very lucky if you could buy a Czech bond for a relatively short period for 20 basis points over. So that advantage for the foreigner operating in those countries has disappeared.”

Another perceived advantage is that, because the financial systems of the accession states are less developed than those of their counterparts in Western Europe, they can react more quickly to modern developments, as they are not encumbered by expensive legacy systems that can be even more expensive to upgrade or replace. JPMorgan’s Maurice Cleaves argues that “For the acceding countries, it means that they have the opportunity to ‘leapfrog’ some of the more established western European banks. These countries have no entrenched banking systems, for example, and are not working to existing entrenched models. Retail banking is less advanced in these countries, which means that there are more opportunities in that space for them to introduce the new Euro payment protocols.”

He notes “There is no single currency yet across all 25 countries in Europe, but the process is moving towards that with implementation in 2007 expected to begin for some of the accession countries. Not all countries will be in a position to do that, but this convergence will allow those accession countries to work towards that time frame. Already some are reacting to IBAN and the automation of payments across borders, by making IBAN necessary for payments within these countries. This means that they are ready to adopt European-wide standards when they are enforced.”

Patrick Butler adds that “In the banking industry, for instance, there will be a lot more focus on cost than there was in the past in those areas, simply because the opportunities to increase the income side dramatically and rapidly are no longer there, or at least not on the same scale. Having said that, I think in the medium term, when one looks at the demographics, you are now seeing savings growing in those countries, private savings and corporate balance sheets relatively strong, the opportunities are actually still very considerable, although you are not going to see the same kinds of returns because these were countries that people had perceived to be ‘Iron Curtain’ and still unproven in the hard world of Western social capitalism.”

Regulatory influence

A lot of this is being driven by the regulatory impetus from Brussels. Maurice Cleaves says that “On the regulatory front, the EU is pushing ahead quite quickly. For example, it is pushing the EPC as the governing body for those banks. On payments, the EU would like to make SEPA a reality on an accelerated time-frame, in advance of the original 2010 target. There is quite a lot of change to come. Nothing much over the next year, but there should be something significant each year after that.”

Jan Zonneveld argues that “It is important to be aware of and, where relevant, to participate in, developments that result from the regulation process. For example, the European regulation on cross-border payments has also caused banks to develop the European Banking Association (EBA) with a central EBA clearing system. However, you will always have currency risks until you get to full eurofication, which will be at least up to 2010.”

Patrick Butler adds that “Again, looking at the way the banking market has developed, what we are now seeing, which is in complete contrast to what we were seeing in the 1990s, is that investors are coming out of some of these accession countries and looking for acquisitions, or at least the possibilities of acquisitions, in the older EU states. It was very much a one-way traffic, where one was advising on things like FDI and other types of financial investment from the West into the East, but now, while the traffic is still fairly heavy in that direction, and not as great in the other, there is definitely some two-way traffic.”

He points out that “This is not something that has happened only since accession. It has been gradually developing. The next big issue will be those accession countries looking to become part of the common currency union as well. The fact that they have managed to achieve a level of low inflation and financial stability is not to be attributed wholly to accession, but certainly accession did apply and will continue to apply financial disciplines and benchmarks on governments which give them a standard yardstick by which to measure themselves. One certainly can’t ascribe that solely to accession, but the fact that they are part of this level playing field, covering the whole regulatory side and the barriers against M&A cross-border have come down considerably for them, that obviously helps and accelerates the process.”

Signing up to the euro
One of the key elements in the process is the speed at which the new EU members become fully integrated into the single European currency. Indeed, their membership of the EU was made conditional on their willingness to accept the euro, with 2007 set as a target date for the newcomers to join the euro area.

However, as with most strands of EU endeavour, the reality is a little less clear-cut. RZB Group’s Walter Demel notes that “Of the countries that have joined already, some, such as Slovenia, Estonia and Lithuania, have fast-tracked and are already in the exchange rate mechanism, which means they are ready to join the euro in 2007, whilst Latvia will join up next year. In fact, Estonia and Lithuania have linked their currencies to the euro for a while.”

But he adds “For the largest accession states, the Czech Republic, Hungary, Poland and, to a lesser extent, Slovakia, these countries are still battling with quite high budget deficits. These countries will not meet the criteria before 2008 and, therefore, will not be in a position to join the euro before 2010 and even that will be difficult if the budget deficit, in Hungary in particular, continues to rise.”

But this does not mean that preparations are not being made to allow the new states to take advantage of the cost benefits offered by the development of a single currency and, ultimately a single payments area. ING’s Jan Zonneveld points out that “When you look at cash management for treasury purposes, there are still some local rules in the accession countries but these will be merged, to a great extent, with practices already prevailing in western Europe. For example, the accession countries are already using the euro to some extent and the ‘eurofication’ of these markets will continue in the future.”

This also means a lot more business for the established banks as well. JPMorgan’s Maurice Cleaves observes that “The expansion of the EU brings more countries into the trading community, which means there should be more cross-border trade, which in turn means more cross-border corporate activity which therefore generates more cross- border payments for us to process. From a sales perspective, we have various local sales offices around western Europe. From a processing perspective the accession countries are dealt with separately. We organise this business through partnerships with local banks, for example, our partnership agreements with ING and IBOS.” This is a commercial alliance between JPMorgan Treasury Services and ING, unveiled in November 2002, to provide treasury and cash management services to Central and Eastern European clients.

Indeed, ING has been a major player in the markets of Central and Eastern Europe for a decade and a half. Jan Zonneveld says “The green-field date for entering most of these markets was 1991, but some of our retail businesses were started even earlier, from the fall of the Berlin Wall. We were one of the first western banks into most of these countries if the not the first into some of them. We see the enlargement process as a key element of our business. ING already has a major presence in several of the new economies. We are generally well represented in the area, with large banking and insurance operations in Hungary, the Czech Republic and Slovakia as well as being the fifth largest bank in Poland through our purchase of Bank Slonsky. We are also one of the major banks in Russia and in Romania and have strong presence in Bulgaria and the Ukraine.

“The fact that we have been operating in the enlargement economies for some time shows that we want to be serious about these markets. ING is one of the few network banks that has a good presence in all of these wholesale markets, which we have achieved through a combination of start-ups and acquisitions. In particular, we are very strong in the four key areas of cash management, foreign exchange, structured lending and general lending on the wholesale side.”

Patrick Butler opines that “There is certainly more two-way traffic these days. It has been a fascinating ride so far and, doubtless will continue to be. But one sees that these markets are maturing and have the benefit, and the disadvantage, of maturing markets. Those that are looking for juicy spreads, a high return on a relatively high risk, or at least a risk that is perceived to be high, will be disappointed, because, as we know, this is a success story. So those who took risks have not lost out. Nonetheless that has changed now, the risks are perceived to be much lower and the returns have come down.”

And what of the potential for further expansion? RZB Group’s Walter Demel suggests that “Looking at the possible accession of new countries, Romania needs to finish its discussions, together with Bulgaria, whilst Croatia will start the process next year. The suggestion is that at least two and a half years are required to get the accession process resolved. They would like it earlier, but we don’t realistically see Croatia, for example, coming in before 2007. For example, Croatia is having problems at the moment with quite a high level of consumer debt. The other former Yugoslavian countries are at a different stage; Macedonia is probably the closest to joining, but Serbia, Bosnia and the like still have a lot of homework to do before they can even take the first step. They won’t be ready to join before 2013 at the earliest.”

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