- During the “crisis of sentiment” that swept global markets during the summer of 2011, the market response often did not match up with the fundamentals of the marketplace. Specifically, there were some European economies that were being punished by global investors even as their fiscal positions were stronger than that of our own. While we understand Europe faces some tough decisions that will affect all nations in the region, we had some questions that required a research expedition. Among them were the following: Could economic dependence upon, and skepticism about, greater Europe really be the driver that wiped out so much capital in these economies? What about their citizens’ perspective on the Euro after months of being on the edge?
- In order to answer these questions, we planned a trip to periphery economies in Europe in order to get a view from within. Please note that the Western part of Europe was not studied – we are aware of their problems, and companies there are followed globally in well-developed capital markets. Rather, we wanted to visit at some overlooked economies.
- A brief note about what each country represents in our research:
- Poland: Could it be the Brazil of the East?
- Hungary: A Victim of Politics; it shows promise but never lives up to its potential.
- Austria: The Intellectual and Financial Capital of Central Europe
- Let’s start with Poland… why is Poland interesting to us? First, Poland is an unheralded market with attractive near-term demographics and a strong natural resource sector. It is the 21st largest economy in the world and the 33rd largest nation by population, making for a large domestic market. We tend to think of Poland as a rusty Eastern European legacy of Communism – it is not. Poland is a modern, sophisticated northern European nation that was under Communist rule for fifty years; this was the anomaly in their history. Their historical governmental structures and culture of education have simply been obscured by this period.
- Just as important to our investment thesis is the fact that Poland is one of the few Western (or even global) economies to avoid recession during the recent economic downturn. It tends to be a safe haven during crises among emerging economies, and it avoided recession partially through luck and circumstance and partially by being in a good position prior to the economic collapse.
Steps to avoiding recession during what we hope was the major market event of our lifetime:
- Uncomplicated banking- Polish banks are healthy, and there appear to be no problems with funding or capital. These banks are primarily smaller and invested domestically under traditional banking principles with lower leverage and minimal trading activities rather than complicated investment banks with global exposures.
- Infrastructure spending for stimulus that was already in place. The construction of roads, bridges, stadiums and extended subway lines is in preparation for Euro Cup 2012.
- Strong fiscal position – There are limits to debt in the Polish Constitution (public debt to GDP = 60%), and these are not easy to change. Add to that similar ideas such as simplified tax systems for personal, value-added and corporate taxes. These policies are part of what has led to substantially increased per capita GDP in the past decade.
- Access to Eurozone benefits yet operating with their own currency (the zloty). There are EU funds available for new business and existing development, and the multiplier effect of these funds represents a large percent of Polish GDP growth. These benefits are part of being in the Eurozone and may be greater than the potential costs of the joint currency. While the Poles will be using the joint currency, the timing of adoption of the Euro is as-of-yet undetermined.
- Long-term, the Poles are facing the same issues as all Western nations – an aging population that is not being adequately replaced. This problem is not as marked as other neighboring nations, though, and it can potentially be bolstered by immigration, especially from those who are of Polish descent or shared ethnicity. Before World War II, Poland was far more multicultural, and its territory included Ukraine, Lithuania and a large Jewish population. Some of these ethnic Poles may find emigration appealing. During the near-term, however, the second Polish “baby boom” generation will offer demographic support for internal consumption as members of this generation form households (though the 3rd baby boom should be happening now and has underwhelmed expectations).
One question we had asked with respect to demography was related to the anecdotal “talent drain” of younger, more educated Poles. When Poland joined the EU, its students went to the first places opened to them, primarily England and Ireland. After their studies, many would stay, especially bankers, engineers, and IT specialists. Now that some of the trade-offs have become more expensive and there is a desire to return home to raise families in Poland, any talent drain has reversed itself making this no longer a significant concern.
Culture and Observations on Life in Warsaw
- Traveling to Poland, I was unsure of what to expect. Krakow had always been on my list of cities to visit, but my impressions prior to entering investment management were of a dreary, cold society with Soviet block buildings and an in-progress economic rehabilitation. Instead, there was a lot of redevelopment in Warsaw with all buildings over 15 floors having been built in the last fifteen years (with one obvious and glaring exception). A must- see during a visit to Warsaw is the Warsaw Rising Museum, which chronicles the destruction of that city during World War II. Almost everything in modern Warsaw was rebuilt after the war (in keeping with its historical nature) due to the total decimation of the city. To me, this speaks volumes about the Polish people.
- One of the most impressive aspects of this trip was the observation that the Poles are European – in mindset, in governance, in arts, science, culture, and in economic models. Yet even more impressive is the fact that the Poles are hardworking and highly educated. The years from 1940 to 1990 are a historical aberration for Polish society; they have historically been governed under much more Western and less autocratic forms of governance.
The Polish Economy Going Forward…
- Exports represent 25 – 30% of GDP, and Germany represents one-fourth of Polish international trade. In many cases, Poland is the first stage of the German economic manufacturing process, and Polish manufacturing can be a leading indicator for the whole EU. While much of my time was spent in Warsaw (which serves as a magnet for Polish talent, and unemployment is under 5%), there are some advantages other parts of Poland have as well. Poland has a large agricultural component to its economy and has benefited from EU programs for that sector, and it ranks behind France in terms of agricultural funds received. As well, according to recent studies, Poland has the largest potential shale gas reserves of any European nation as shown in this map.
Some Challenges for Poland
- While Poland’s strong European orientation has been heralded in this report with respect to its culture and resurgence, it can be a double edged sword. There is a considerable amount of bureaucracy and regulation within the Polish economy. Specifically, the tax and regulatory burden faced by individuals and businesses is onerous – the tax rate for individuals can approach 50% when all measures are considered. In addition, the government can get involved in specific industry taxation and regulation; witness the copper tax and its affect on KGHM. As well, there are discussions of a specific banking tax now in the works. This is in addition to increased European capital requirements and the threat of repatriation of funds from Polish banks to their international “mothers” as they face their own challenges.
- There are some strong positive trends for Poland that should not be dismissed, and there are some attractive opportunities here for long-term investors. However, like all Western nations, there are some policy decisions that must be addressed in order to truly be on solid economic footing. Among those is the timing of the adoption of the Euro; if Poland is to continue to benefit from its association with the EU, it will have to remain on track to adopt the Euro as its currency.
- Shortly after the fall of the Berlin Wall, there were two places that were “hot” among investors and tourists: Budapest and Prague. Investment in Central Europe (including Foreign Direct Investment) followed these two paths the most quickly. The transition from Communism to democracy was an easier transition in some places than it was in others, and it was relatively easy in Hungary given their ethnic differences from their neighbors and their exceptionalism under Russian influence.
- Budapest was the place citizens from other Soviet satellites wanted to be in the 90s, however the city and the opportunity has stayed the same for twenty years. Many of Hungary’s problems are the same as much of Europe: middling growth, high external debt, and unfavorable demography. To this, add poor governmental decisions, including populist tendencies. Much of this is a problem of politics, the management of the nation and the resultant international perception of the country’s economy. The current state of the Hungarian economy is a function of a number of these legacy decisions.
Challenges: Politics and Policy
- Hungary’s external debt has been volatile and has been a source of challenges for the country at the most inopportune times. There have been recent historic periods when debt was within target ranges, but more recently it has been excessive relative to these amounts. Part of this is a function of politics, specifically taxes, possible governmental reductions and stimulus, both historic and present. Unfortunately, many of the issues are interrelated. Take, for example, the Hungarian “carry trade” for home ownership, an idea that solved an economic problem and served as a social good. During the early 2000s, Hungary had a large budget deficit that was crowding out private savings, including local real estate. A practical solution offered and underwritten by the government was to encourage purchases in neighboring currencies. Why borrow in local Forints at 8% when you can borrow in Swiss Francs at 2%? After the initial period of governmental support, the program continued because the banks had the infrastructure in place for a highly sought product that offered strong profits. All worked fine as long as the Hungarian currency remained within a certain trading range of the alternate currency. Unfortunately, when the currency weakened, Hungarians were paying off their mortgages in currencies much stronger than their own; this affected household budgets significantly and weakened the banks as many of these loans became non-performing.
- In addition, Hungarian policy decisions can lean towards populism at all the wrong times. From a capricious tax policy (both questionable supply side policy and targeted, industry specific taxes) to a potential lack of independence by the Hungarian Central Bank and questionable economic statistics by the official governmental agencies, the global marketplace questions the nation’s seriousness in dealing with fiscal issues. One of the primary causes for these issues is the lack of political choice in the country. Even as the major political party loses credibility in the eyes of the populace, there’s not a viable alternative. As one analyst said during our meeting “There’s not a lot on the menu.”
- At present, Hungary has applied for an IMF loan; this is not their first time to do so recently. The previous time, repayment was made, but the agreed upon conditions for the loan were ignored as soon as it was repaid. Between this and the violation of their EU covenants, Hungary is analyzed far more extensively than its peers. However, the nation needs these inflows to make any progress on its fiscal challenges. So the most recent application of the government to the IMF is meant to serve as a signal that the nation will accept and adopt more market-friendly policies. The preconditions for this loan are associated with deficit reduction and growth as well as Central Bank independence, and they are strong because the IMF is not sure Hungarian officials are truly serious this time.
- Part of the reason, I have to admit, is that Budapest is one of the most spectacular cities in the world, and the food is fantastic. It also served as a perfect bridge between my two primary stops – and one that would offer a significant contrast to each nation and perhaps serve as a warning to other nations of intelligent, hard-working and talented people who are frustrated by lack of political wherewithal and poor governmental decision making. There are some really good companies headquartered here that are globally competitive, and the ability of the Magyars to design and engineer elegant solutions is unparalleled. Yet, as long as they are under a political structure that offers minimal choice and a party that makes bad choices, it will continue to be seen as the “land of perpetual opportunity.”
Austria: Not as Stodgy as You Might Think…
- Austria is an interesting case study of the Eurozone and its opportunities. The name is Anglicized from the German name for the country “Oster Reiche,” literally East(ern) Realm. And, we often think of the nation economically as a “Germany in miniature” and a small satellite in the German orbit. But, it is so much more than that in terms of its historical significance. Vienna is the capital city to a small nation of roughly 8.5 million people, but its scope reflects its prominence at the turn of the prior century as the capital of a major European empire. To understand Austria as an investment opportunity, you must understand this history.
Vienna is competing with Berlin to be the gateway to the East.
- Part of what we do when we take these trips is to learn about an economy from local investment managers or business owners. When in Vienna, I had some free time between these meetings, so I visited a museum- not just any museum, though, the Military History Museum of Austria. The Austro-Hungarian Empire was a major force at the turn of the century as the following map shows, and Vienna was its epicenter.
- What is most interesting about this map is not only the extent of the empire over a broad region, but its cultural and ethnic reach as well. This legacy is present today as the country serves as the source for the region’s intellectual capital and financial resources. For example, when an entity expands its plant in Slovakia, they may do so with consulting assistance from Vienna. When a startup in Bosnia is looking to broaden its scope, it does so with the financing of an Austrian bank. This cultural legacy is difficult to overstate, and it allows Austria much more prominence in global capital markets as its former “empire” still includes about 73 million people. A sample regional flight map of Austrian Airlines from the Viennese airport confirms this legacy.
- Today, Austria is one of the richest nations in the EU. Its economy is strong with the lowest EU unemployment rate of 4.1%, and the labor force is well-educated, flexible and productive. The country’s growth is stronger than Germany, and its governmental debt ratio is relatively low (71% of GDP) while private sector debt remains very low partially due to a very affordable housing market and a disproportionate number of renters to owners. While this should be a bastion of safety for global investors, Austria has a high risk factor due to the exposure to emerging Central Europe, which is one of the few growth stories in the region. As well, two large banking stocks with their leverage to this story have distorted market returns for the country.
- There are a lot of small and medium size businesses in the Austrian economy. 99% of Austrian businesses are in this category, and 50% of Austrian companies have 1 employee. Many are family owned and managed for the next generation. Obstacles to small business are not excessive, especially if you can obtain early stage financing with a well-considered business plan. You are your own obstacle as it is relatively fast to start a company, but the challenges come later when you have to expand. People are expensive to employ between vacation time, social benefits and complex rules for layoffs, but they are hard-working, highly motivated and loyal.
Challenges for the Austrians: Social, Banking and Other
- The same challenges you have across Europe apply to Austria as well. Demographics are not favorable, but they are better than in most of their peer countries. There were some recent introductions of austerity policies, and Austrians are dealing with the same challenges as everywhere – everyone is aware of these problems and knows what needs to be done. At least in Austria there is decent immigration, something that was evident around Vienna, even if the retirement age is 59.
- There has been a fear of having to re-capitalize Austrian banks primarily due to overexposure of their out- of-country daughter banks. Central European banks are generally well capitalized, especially relative to their counterparts in Western Europe. The bigger issue for bank capitalization is the new EU capital constraints, which are stricter than Basel III with a shorter time period for implementation (this summer). This can be a different sort of credit crunch since banks may become reticent to make new loans that could be detrimental to capital levels, yet it is something that is politically difficult to change even as most agree that the changes need to be made.
- Finally, as with all of Central Europe, there is a dependence upon Germany. Approximately 30% of Austrian exports go to Germany, and their economic health is critical to the overall health of the Eurozone.
Where does that leave us?
- We are of the opinion that the world is being divided into three blocks of global economic influence – one dominated by Europe, one by the United States and an Asian realm primarily driven by China. Based on this trip, it seems that the European block is beginning to focus inward in many ways. When the output of the entire Eurozone is considered, it is comparable to the other blocks – its GDP exceeds that of the US.
- The European Union is accomplishing its goal of peace and unity on the continent. As we have pointed out previously, its challenge is that it is a monetary union (with a single mandate) but not a fiscal union, and it unites a number of different cultures. Because of these issues, progress in the face of crisis is slow. The EU makes it such that war is very difficult which is why Europe will retain the Euro and why people will be patient with their politicians. The EU moves slowly because it is democracy in action which can be painful to watch, especially when policy makers do not have all the tools needed to accomplish their task. But, there is another side to this. There appears to be a waning American influence. For Europeans, it is far easier to access and trade with other member nations within the EU than it is the US. Some of this movement to a more Eurocentric approach is reasonable as the Europeans begin to serve as resources for each other and solve their problems in a peculiarly European way. Some of it is a reaction against the political climate in the US. The people with whom I spoke supported the Euro currency and its ultimate goal of bringing prosperity and peace through trading partners and a united currency. The process is slow, but the people working at it are smart and capable of the needed solutions.