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11/2008

MARKETS IN CEE

Central EuropeanEquity Markets

Baltic Economies:Uncertainty Means

Opportunity

COUNTRY FOCUS

Solving Russia’s Inflation Problem

The Former Yugoslav Countries

Turkey:The Last Major EU

Convergence Story

ALTERNATIVE INVESTMENTS

max.HEDGE is a quaterly publication of Erste Group Bank AG 5th Edition: November 2008

DEVELOPMENTS AND OPPORTUNITIES IN EMERGING MARKETS

5th EDITION

NOVEMBER 2008

CONTENTS

page 3INTRODUCTION

page 4SOLVING RUSSIA’S INFLATION PROBLEMby Bill Allen, DENHOLM HALL

page 10CENTRAL EUROPEAN EQUITY MARKETSby Steffen Gruschka, EXPLORER CAPITAL

page 16 BALTIC ECONOMIES:UNCERTAINTY MEANS OPPORTUNITYby Janis Springis, GILD ARBITRAGE

page 18DOUBLE PAGE:

CEE COUNTRY STATISTICS

page 26

by Cyrus Golpayegani, QUIMCO

page 32 TURKEY: THE LAST MAJOR EUCONVERGENCE STORYby Ismail Erdem, STANDARD UNLU

page 37INFO

5th EDITION

NOVEMBER 2008

The Alternative Investments Team

Christoph

KAMPITSCHHead of Alternative

Investments

ERSTE GROUP BANK AG

Mark

CACHIAHead of Portfolio

Management

ERSTE GROUP BANK AG

Peter

BALINTPortfolio Manager

CEE Specialist

ERSTE GROUP BANK AG

Welcome to the 5th edition of max.HEDGEThe CEE region has been a favourite of Emerging Markets investors for over a decade. Investors became increasingly used to double digit stock market returns enhanced by fat gains on local currencies. Interest rates fell from the high teens to single digits in most countries, providing huge gains on local fi xed income instruments. Credit spreads tightened to unprecedented levels as abundant cash searched for any source of yield.

What began as a fundamentally sound story became a momentum story. As fundamentals didn’t matter when the market was topping, they also mean very little now. The virtuous cycle has morphed into a self-feeding vicious spiral. However, once the dust settles, we should begin to see a clear picture once again.

This issue aims to look beyond the current market turmoil, and identify the long term opportunities and risks the region presents. Once again we have enrolled fi ve hedge fund managers to paint a detailed picture of their respective markets.

Firstly we have Denholm Hall’s chief economist, Bill Allen who provides a macro snapshot on Russia’s current economic travails, he demonstrates that interventionist policies won’t defy the law of economics for an extended period without running into a state of disequilibrium. More importantly he elaborates on possible solutions for Russia’s problems.

After Bill Allen’s synopsis on the fi ner points of the Russian economy, Steffen Gruschka, the manager of the Explorer Emerging Europe Fund takes us to the CEE3 region of Poland, Czech Republic and Hungary, which have experienced unprecedented growth following their admittance to the European Union.

From these well known emerging European countries, we will look towards those that have been neglected by investors over the past few years. First, Janis Springis of Gild Arbitrage tells us how the former tiger economies of the Baltic region turned into the sick men of CEE and what can possibly be done to kick- start balanced growth again.

Next, Cyrus Golpayegani of Quimco, discusses the Balkan region. Following the political turmoil of the1990’s, the region has diverged; whilst Slovenia on the one hand has entered the EU and adopted the Euro, Serbia and Bosnia & Herzegovina have not even begun accession talks. As the whole region sees its future in the European Union, Cyrus suggests the path that convergence might take .

Following on the subject of convergence, Ismail Erdem of Standard Unlu, illustrates how Turkey’s ambitions of joining the EU have paved the way for necessary reforms that shall prove benefi cial to the country regardless of its much debated membership of the Union.

Good reading, The Alternative Investment Team

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S O L V I N G R U S S I A ’ SINFLATION P R O B L E M

Bill AllenDENHOLM HALL

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prices alone do not guarantee strong real economic growth: in fact, the evidence is that they tend to retard real economic growth1. Therefore, Russia’s strong economic growth is all the more remarkable.

In the early stages of the post-crisis recovery, Russia was helped by the fact that its labour costs, relative to those of other countries, had been reduced to very low levels by the devaluation of the rouble. In January 1999, the average monthly wage was just $52, about a third

of what it had been a year earlier. The Russian economy was super-competitive and it isn’t surprising that it grew very fast for a few years. Growth was driven by net exports, domestic demand being, not surprisingly, very weak, and the resulting inflow of foreign exchange was used to rebuild the foreign exchange reserves. This also meant that the appreciation of the rouble was contained, so that Russian industries remained highly competitive in international markets.

SOLVING RUSSIA’S INFLATION PROBLEM

Recovery and growth

Russia has sustained a remarkable rate of real economic growth since the beginning of the 21st century. Gross domestic product has risen at an annual average rate of over 7% since 1999 (see chart 1). It is true that Russia started at a very low point in the aftermath of the 1998 fi nancial crisis, when the government defaulted on its domestic currency debt and the rouble was devalued by about 70% as the offi cial foreign exchange reserves were exhausted.

Ten years later, things look a lot different. Of course, Russia has benefi ted enormously from the rise in oil and other commodity prices. However, rising commodity

Saving oil revenues

The rise in oil prices got under way in 2004. In that year, Russia established its Stabilisation Fund, which accumulated revenue from the oil export duty and oil extraction tax at times when the oil price exceeded the pre-set cut-off level of $27 per barrel. And exchange rate policy was more explicitly directed at stabilising the rouble exchange rate. As a result, the rate of accumulation of international reserves began to increase (see chart 2).

1) See Jeffrey D. Sachs and Andrew M. Warner, ‘Natural Resource Abundance and Economic Growth’, NBER working paper #5398, December 1995.

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T h e Stabilisation

Fund was initially intended to ensure that

the Russian government saved oil revenues at times when oil prices were high, so that it

would not need to cut spending so sharply when oil prices weakened. That’s why it was called the Stabilisation Fund. However, it also had the helpful effect of insulating the economy from the effect of the oil revenues, so that domestic demand growth was contained.

The policy of managing the exchange rate also contributed to containing domestic demand. The rouble has been managed by reference to a currency basket consisting of 55 US cents and 45 euro cents. The central bank has established a fluctuation band for the rouble exchange rate against the currency basket, and has bought (and occasionally sold) foreign exchange for roubles so as to keep the rouble exchange rate within the band.

In spite of these measures, domestic demand grew very fast, as chart 1 shows, and the fact that GDP also grew rapidly demonstrates that most of the additional demand was satisfi ed by additional domestic production. In other words, Russian producers were able to withstand competition from imports and increase their own output and sales at a remarkable rate.

The strength of the economy has created a very strong demand for labour. Real wages have grown by a remarkable average of 10.1% a year since 2000, and the average monthly wage in June 2008 was the equivalent of $750, roughly fi fteen times higher than in January

1999. Immigration has boomed, nearly all of it from the former Soviet republics. Net recorded immigration (ie the number of immigrants minus the number of emigrants) between 2003 and 2007 was 554,000, or about 0.7% of the labour force.

Inflation

The main economic policy problem facing Russia now is inflation. The rate of inflation fell fairly steadily until March 2007, when it reached 7.4%, but it has roughly doubled since then (see chart 3).

Much of the rise in inflation is attributable to food prices. Food inflation increased from 4.9% in March 2007 to a peak of 21.3% in June 2008. Rising food price inflation has been a global phenomenon, and it is now beginning to wane. However, non-food inflation in Russia has also risen. It was 9.3% in August 2008, having been rising steadily over the preceding year. Thus it is clear that inflation in Russia is not purely food-related, but is a more general macro-economic problem.

It is not surprising that inflation has become a serious problem in a country in which monetary policy has been directed at achieving a specifi c objective for the exchange rate. The exchange rate was managed in the

interests of protecting the competitiveness of Russian industry and (in the early stages) rebuilding the reserves. One consequence of Russia’s exchange rate policy has been that monetary growth has been very rapid, because it has not been possible to sterilise the external inflows completely. Thus the growth rate of the monetary aggregate M2 has averaged 41% since 2000. More generally, keeping the rouble weaker than the market equilibrium has stimulated the demand for Russian

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rise in interest rates on inflation may well come through an appreciation of the rouble, rather than through constraint on domestic credit. Nevertheless, a modifi ed float would make it possible for the rouble to depreciate, if that became necessary at some point in the future, without all the drama of an offi cal devaluation.

A fi scal tightening would be the most fundamental policy change of all, and probably the most effective. The reason why the government has been concerned to contain the nominal appreciation of the rouble has been that it wants to limit the real appreciation of the rouble, and thereby maintain output and employment in non-energy industries. Ultimately, though, the behaviour of the real exchange rate depends on the level of demand in the economy – the stronger the demand, the stronger the real exchange rate. On current fi scal plans, the large budget surpluses of 2005 – 2007 will be eroded over the period 2008 – 2010 as the government implements an ambitious programme of infrastructure rehabilitation in Russia. The additional spending will add to demand pressures in Russia and promote further real appreciation of the rouble. Some further real appreciation of the rouble is inevitable and perhaps desirable, but it could well be in Russia’s interests to tighten fi scal policy temporarily so as to reduce demand pressures, and bring down the rate of inflation, while the programme of infrastructure rehabilitation is at its most intensive.

In the past month, the large capital outflows that have followed the conflict in Georgia and the international reaction to it appear to have changed the situation somewhat, but it is too soon to be sure how big the change will be, and how long lasting. The rouble has weakened

SOLVING RUSSIA’S INFLATION PROBLEM

products, in both domestic and foreign markets, as it was intended to, and has thus added to the pressure of demand on productive resources. . As the economy has continued to grow, investment spending has increased very rapidly, rising even faster than GDP. Nevertheless, the economy has begun to reach the limits of its productive capacity. Thus there has been a conflict between Russia’s exchange rate policy and its inflation objective. Fundamentally, the exchange rate policy has led to a level of aggregate demand which is too high to be compatible with the target for inflation.

Economic policy issues

It follows from this diagnosis that solving the inflation problem will require a slowdown in the economy. The main issue for economic policy is how the slowdown can best be achieved. The main options have until recently seemed to be as follows:

• Continuation of the earlier policy of periodic small revaluations of the rouble against the currency basket.

• Allowing a ‘modifi ed float’ of the rouble. The float would be modifi ed in the sense that oil and gas revenues received in foreign currencies would not be sold for roubles in the market, except for the annual prescribed transfer to the budget. If the rouble were to float, even in such a modifi ed manner, then it would become possible for monetary policy to be tightened, for example by raising interest rates.

• Some kind of fi scal tightening, which might either take the form of reductions in planned expenditures or increases in taxation.

None of these options is free of drawbacks. The main objection to periodic small revaluations is that they reward speculators who are long of roubles and encourage increased speculative inflows into the currency, making the problem of monetary control even more diffi cult.

A ‘modifi ed float’ of the rouble would be a more radical change of policy. It would need to be accompanied by a large increase in interest rates, since the central bank’s lending rate, which is 11.00% at the time of writing in August 2008, is well below the rate of inflation (14.8% in the year to July 2008). However, the banking system is relatively small and the economy is not greatly leveraged, so that the main effect of a

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to the top of its fluctuation band and the central bank has supported it by selling foreign exchange. This action by itself will tighten conditions in the Russian domestic money market, and, if the relative weakness of the rouble persists, the central bank will be able to increase interest rates without the effects being frustrated by unmanageable inflows of foreign exchange. Moreover, reduced capital inflows are likely to have some dampening effect on investment and aggregate demand. Thus unexpected events may actually help the central bank in its objective of reducing inflation.

It is not yet completely clear what strategy Russia will adopt to combat inflation, but decisions already made suggest that all of the techniques listed above will be used. To be specifi c:

• The fluctuation band of the rouble against the currency basket has been widened since June 2008. That means that there has been more scope for the rouble to appreciate, but it also means that, when there have been outflows, it can depreciate further too. Nevertheless, the central bank has shown that it is able and willing to sell foreign currencies when necessary to support the rouble.

• The central bank has annnounced that it intends to float the rouble by 2011. Gradually widening the fluctuation band is a natural means of approaching a float.

• It is clear, judging from remarks by Prime Minister Putin and Finance Minister Kudrin, that containing inflation is a main priority in the discussion of the budget for 2009 – 2011 which is currently under discussion at the time of writing.

• Money market interest rates have risen quite sharply following the fi ghting in Georgia and the ensuing capital outflows.

While the precise measures that Russia will take are not yet clear, it does seem clear that Russia regards inflation as a serious problem and intends to address it effectively, notwithstanding the lack of a constitutionally-independent central bank.

Bill Allen, Denholm Hall Group’s economist, is a well respected hedge fund adviser and experienced central banker. He spent most of his career at the Bank of England, where senior positions included deputy director fi nancial market operations, head of money market operations, head of foreign exchange and deputy director monetary analysis. Mr. Allen served as Bank of England representative on the EU Economic and Financial Committee and as an alternate member of the European Central Bank General Council. Mr. Allen holds an M.Sc from the London School of Economics and a BA from Oxford University.

The DENHOLM HALL GROUP, founded by George Nianias in 1992, has offi ces in London and Moscow, with nearly all of its 35 staff based in Moscow.

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Steffen GruschkaSteffen GruschkaEXPLORER CAPITALEXPLORER CAPITAL

This year the economic outlook for Poland, the Czech Republic and Hungary (CE-3) and the broader CEE region has been dominated by sustained pressures from high levels of oil and food prices, reflected in an uplift in regional

inflation and signifi cant worsening in the current account balances. However, the latest developments in the oil price, with a plunge of more than 30% from the July highs on the back of the falling fuel consumption in the US and Europe

and slowdown of economic growth in China and India, may offer a chance of improvement for the oil-importing economies.

In addition to the oil price, the CE-3 economies are heavily dependent on their exports to Eurozone and mainly Germany, whose economic slowdown is still to be fully reflected in the economies of CE-3. The appreciating trend in the currencies that continued all this time has fi nally reversed at the end of July, and weaker currencies should help support the exports. Inflation is at worrying levels in all economies of the region and strong currencies remained the main obstacle for the CBs

CENTRAL EUROPEANCENTRAL EUROPEANEQUITY MARKETSEQUITY MARKETS

GDP Growth (real, %) 2005 2006 2007 2008E 2009E

Poland 3,2 6,2 6,6 4,8 4,5

Czech Republic 6,3 6,8 6,6 3,5 3,0

Hungary 4,1 3,9 1,3 2,2 3,0

Inflation (annual average, %) 2005 2006 2007 2008E 2009E

Poland 2,1 1,1 2,5 4,4 3,8

Czech Republic 1,9 2,5 2,8 6,6 3,1

Hungary 3,6 3,9 7,9 6,1 4,1

Current Account (% of GDP) 2005 2006 2007 2008E 2009E

Poland (1,4) (3,2) (3,7) (5,0) (4,7)

Czech Republic (1,6) (3,1) (2,5) (3,4) (2,7)

Hungary (6,9) (6,5) (5,0) (4,0) (4,0)

Source: UniCredit, Sept’08

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CENTRAL EUROPEAN EQUITY MARKETS

to signifi cantly hike the rates as an anti-inflationary measure, moreover in the Czech Republic the potential economic slowdown risk of currency appreciating further clearly outweighed the inflationary fears with CB unexpectedly cutting the rate. Now that the currencies in the region have weakened, and the GDP slowdown fears are easing, monetary policy is expected to concentrate mainly not on supporting growth but on keeping control of inflation. However, if commodity prices continue falling and inflationary pressures diminishing, we should not

expect any signifi cant monetary policy measures from the Central Banks of the CE-3 in the short term.

CE-3 Markets Overview

After falling 27-32% in local currency terms in 2008 the equity markets in CE-3 are now trading close to historical lows (2008E P/Es of 8.4, 11.7 and 13.6 for Hungary, Poland and the Czech Republic respectively). However, they do not look cheap compared to other Emerging Markets in the region.

P/E 2005 2006 2007 2008E 2009E

Poland 13,6 14,5 16,6 11,7 11,5

Czech Republic 18,1 17,2 17,4 13,6 12,0

Hungary 10,9 10,6 12,2 8,4 8,3

Source: UniCredit, Sept’08

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Poland

On the macro side, an economic slowdown seemed likely in Poland, as exports suffered from the ever strengthening PLN and weak external environment, especially the recession in Germany, the main trade partner. However, since middle of July the appreciation trend radically reversed with PLN sharply depreciating, lending support to Polish exports and easing worries about GDP growth, which is now estimated to come in around 5% this year. The Polish economy is stronger than its CE peers, with the private sector less exposed to credit and the latest strong GDP fi gures showing that the country is much more resilient to the Eurozone slowdown being less dependant on exports than other smaller countries in the region. There is an upside risk to the already high interest rates in Poland as a measure to control inflation, and while the strong PLN was an obstacle for the CB to hike the rate so far, now that it had weakened the CB still left the interest rate unchanged in its end of August decision. However, even despite correction in commodity prices, inflation levels remain worrying high fuelled by wage inflation.

The 1H earnings reported by Polish companies showed pretty good results, with positive surprises thanks to top line growth but the most common reason for lower earnings being the labour cost pressure. Thus, market is anticipating a 25bps rate hike in September/ October (and then flat until end of 2009) as inflation is still above target and wages are growing at double-digit levels (12% YoY in July). In addition, the Euro adoption in 2011 as the government’s goal would require meeting the inflation criterion, making the outlook for interest rate hikes more likely. However, we are clearly far from the repetition of the 2000-01 experience when rates had to be hiked to 19%, causing a sharp economic slowdown. And the long-term growth story is intact, given the second huge tranche of EU funds (total of EUR 67.3bn over 2007-2013) available as of now.

Poland’s WIG20 Index has lost 32% YTD, despite a slight rebound supported by the 2Q earnings season. However, still, at 11.5x 2009E earnings, Poland is the second most expensive EME market after the Czech Republic (UniCredit estimates). This has been accompanied by massive outflows from the domestic mutual and pension funds that historically have a very strong influence on the market. Pension funds (that now account for roughly 27% of WSE free float) have reduced their exposure to equities, and are currently at fi ve-year low equity weighting of 28%, approaching the all-time low of 22% at the depths of the 2000-01 collapse that saw almost a 50% decline in the index, and well below the peak of 38.6% seen in May 2007 (near the regulatory maximum of 40%). This should provide some support to the market as pension fund buying has a chance to exceed mutual fund selling. Indeed, latest August data shows that the

secondary market balance turned positive with the selling pressure from equity mutual fund redemptions abating, pension fund purchases and zero IPO supply, making us believe that the flow of funds outlook will be supportive of a gradual recovery of Polish equities. Furthermore, the interest from international funds is set to increase at least

driven by a partial re-location of funds on the back of increased risk premium in Russia.

The biggest sector on the exchange is banking. The polish banking sector is considered to be the most robust in the CEE region and the macro environment of the country remains quite benign. This makes Polish banks the most expensive in CEE, trading at P/E multiples of 12.6x and 11.3x for 2008E and 2009E implying respective premiums of 34% and 35% vs. their CEE peers. Polish banks trade at P/B multiple of 2.8x for ’08E and 2.4x for ’09E, 54-55% above CEE banks (all UniCredit estimates). The sector is attractive as the primary benefi ter of falling commodity prices which make further rate hikes less likely.

Most banks like Bank Pekao and Getin Holding will benefi t from decreased/ stable interest rates, if not so much on earnings side but on the general investor sentiment and lower cost of equity. PKO Bank is the only one to benefi t from rising interest rates due to the structure of its balance sheet as it has the biggest branch network and the highest share of retail current account deposits that do not bear any interest. While at the beginning of


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Czech Republic

The economic condition of the Czech Republic has been considered rather robust with 1Q08 GDP growth coming in at a solid 5.2%. However, in 2Q08 growth dropped to 4.5% (from a 6%+ average in 2006/07) showing a slowdown in economic growth attributable to the previous excessive currency strengthening, deteriorating foreign demand and weaker growth of private consumption as the continuous high growth of consumer prices dampened real wage growth. This signals that the economic performance in 2H08 could be weaker than previously expected and for the remainder of 2008 GDP growth is expected to further decelerate below 5% mainly due to continued weaker exports and slowing growth in the domestic demand. In the beginning of August the CB unexpectedly cut rates by 25bps to 3.5% which pushed the CZK over 1% weaker vs. the euro and clearly showed that the potential growth slowdown risk from the currency appreciating further outweighed the inflationary risks for the CB. And although the weak 2Q GDP fi gures would have implied a higher probability of further

interest rate loosening, the recent developments of the exchange rate with CZK depreciating similarly to other CE-3 currencies, and still high inflation make any further rate cuts unlikely.

Despite falling 32% YTD, the Czech PX Index still remains the most expensive in the EME universe, trading at an estimated 13.6x 2008E earnings.

The most liquid Czech banking stocks are Komercni and Erste Bank. Komercni Bank is one of the safer EME banks given its strong cash position yet it is quite expensive (2008E P/E of 10.4 and P/B of 2.3). Erste Bank is cheaper (2008E P/E of 8.2 and P/B of 1.1 (Bloomberg)) and offers good exposure to Emerging Europe, in addition to being a potential takeover target as it still remains independent. Another potential opportunity in the market is the electricity generator and distributor CEZ which is to benefi t from the scarcity of electrical capacity in the region. The telecoms play Telefonica 02 is supported by 10% dividend yield.

the year few analysts expected earnings growth from the banks due to the loss in fees from their mutual fund businesses, the recent fi nancial reports showed an above-consensus increase in earnings. This is mainly driven by gain in deposits as customers pull funds out of mutual funds which partly substitutes for the loss in fees. This is also making the banks almost completely self-funded which favourably differentiates them from their global peers and allows for growth in cash

loans given. Further falls in oil prices will support banks, making a rate hike less likely, however, any negative growth surprise in Poland, with the expected slowdown in the GDP growth in 2H08, will curb banks’ outperformance as well. However, from bottom up, Polish banks have many features that investors are looking for currently, like low loan/deposit ratios, no dependence on wholesale funding, strong capitalization and no subprime exposure.


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Steffen Gruschka has been an investor in Emerging Europe since 1998 when he joined DWS (Deutsche Bank Group) to head up investments in this part of the world. Under his management DWS became one of the biggest investors in the region with dedicated assets of 5 billion US Dollars.

With his partner Ashwan Khanna they founded EXPLORER CAPITAL in 2006 in order to achieve maximum flexibility investing in the region. From launch in November 2006 to September 2008 their Long Short Equity portfolio - the Explorer Emerging Europe Fund - returned 26%, outperforming the region’s indices with signifi cantly lower risk.

Hungary

The macro situation of a slow-down in Hungary (that in the recent years has the lowest growth rate among the CE-3) is well-understood and is probably now well priced into the market leading to the underinvestment in the country. Hungary’s GDP growth was a mere 1.3% in 2007 below all forecasts, although it is estimated that Hungary is past the trough and can accelerate to around 2% this year if consumption and investments growth manages to outweigh the slow down in exports. However, so far domestic demand still remains very weak and industrial production data surprises on the downside. Despite inflation pressures from energy and food, disinflation is continuing and consensus expectations are for only a slow rebound in growth and decelerating inflation into 2009, thus opening room for rate cuts. However, the suggested 25bps cut in the base rate was not approved and it is diffi cult to see the CB rushing in with rate cuts to support domestic demand as similar to other CE-3 currencies the HUF has reversed its appreciation trend since the end of July. At its July meeting the Hungary’s Monetary Policy Committee stated that although the short-term inflation fi gures were in line with the CB’s projections, there is some degree of uncertainty regarding the inflation and wage outlook. In addition the below-potential real GDP growth could continue and the economic outlook could deteriorate further due to the drop in export demand and more intense import competition. The market expectation is however for no rate moves this year and for a fi rst cut in 1Q09.

The growth in exports, the main driver for Hungarian economic growth, is deteriorating due to the slowdown in the country’s main trade partners. Latest export sales data show the lowest annual growth rates since December 2004. GDP releases for Hungary’s main trade partners are not in favour of exports; Eurozone GDP declined by 0.2% QoQ in 2Q08 and increased by 1.5% YoY, down from 2.1%, while Germany’s GDP fell by 0.5% QoQ in 2Q08. The recovery could be very slow

which is crucial for Hungary given that around 28% of total exports go to Germany and slightly more than 50% to the Eurozone. The slowdown in the Eurozone and especially in Germany greatly affects Hungary’s exports and, given the weak domestic demand, increasingly so its overall economic performance, signifi cantly more than for the other two CE-3 countries.

The Hungarian BUX Index fell 27% YTD, performing marginally better than its CE-3 peers, and being the cheapest market of the three it is currently trading at an estimated 8.4x 2008E earnings.

Magyar Telecom has performed relatively well lately and is still the cheapest telecom in the CEE (P/E of 9.7 for ‘08E and 9.2 for ‘09E (Bloomberg)). Although the revenues in both fi xed voice and broadband remain under pressure due to unfavorable dynamics of disposable income and increased competition from cable operators, there is scope for upside revisions in earnings on the back of strong operating effi ciency improvements. OTP Bank is expected to have a continuation of profi table growth from its foreign subsidiaries in Bulgaria and acceleration of growth in Russia and Ukraine, however it might be vulnerable due to its high reliance on external funding.


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BALTIC ECONOMIESUNCERTAINTY MEANS OPPORTUNITY

THE DAYS WHEN THE BALTIC ECONOMIES (ESTONIA, LATVIA AND LITHUANIA) WERE CONSIDERED “TIGERS” ARE ALL BUT GONE BY NOW. WHILE ONLY A FEW YEARS OR EVEN A YEAR AGO THE THREE ECONOMIES WERE POSTING SOME OF THE FASTEST GROWTH RATES IN THE EUROPEAN UNION, CURRENTLY WORDS LIKE “SLOWDOWN”, “RECESSION”, “HARD LANDING” ARE OFTEN USED TO DESCRIBE THE ECONOMIC ENVIRONMENT, WHAT IS HAPPENING AND WHAT HAS TO A LARGE EXTENT ALREADY COME TO PASS. THE OPTIMISM OF THE MANY ANALYSTS, WHO WERE ONLY RECENTLY ISSUING PREDICTIONS OF POSITIVE GDP GROWTH RATES, HAS BEEN REPLACED BY PESSIMISTIC MOODS. LET US TAKE A STEP BACK TO TRY TO UNDERSTAND WHAT HAS HAPPENED IN THE BALTIC COUNTRIES. THIS WILL ALLOW US TO COMPREHEND WHAT IS HAPPENING NOW AND MAYBE TO SOME EXTENT PROVIDE A SKETCH OF WHAT MIGHT HAPPEN IN THE FUTURE. WE WILL ALSO CONSIDER WHAT OPPORTUNITIES THE CURRENT ECONOMIC ENVIRONMENT MIGHT PRESENT TO A SAVVY AND AGILE INVESTOR.

Janis SpringisGILD ARBITRAGE

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How we got where we are now?

The fi gure below illustrates the sheer rapidity of economic growth of the Baltic economies up until 2007. GDP growth rates at times reached double-digit fi gures with industries such as construction, fi nancial intermediation, transportation, and retail trade leading the way. To a large extent the fact that the Baltic countries entered the European Union contributed substantially to the pace of economic development. The favorable business environment attracted a large number of investors who perceived high expected returns with relatively little risk and made substantial investments in developing various businesses. Initially, low labour costs and the well educated population had a very favorable impact on these activities.

The fast pace of GDP growth in the Baltics has also been aided by the lending carried out by the local commercial banks - the biggest commercial banks in the Baltics such as SEB and Hansabank (Swedbank) are owned by their Swedish counterparts. What, in effect, happened was that the residents of the Baltic countries were able to shift a part of their future income to the present via borrowing money from the banks and spending it on goods, services as well as real estate. The influx of mostly Swedish capital for a while allowed the borrowers to spend more than they were earning. As an illustration consider the dynamics of Estonian kroon loans issued by the local commercial banks in Estonia (the dynamics of lending in other currencies, e.g. Euro, and in other Baltic countries is similar) – while the amount of lending was relatively stable from 1999 to 2002, rapid increases started

immediately after that period and high double digit growth rates of lending were a “normal” phenomenon.

As a result of more money chasing a relatively stable amount of assets, rapid growth of lending in the Baltics resulted in asset price inflation which is probably best illustrated in the real estate market. As an instance, if a one room flat in any of the capitals of the Baltic countries cost, say, EUR 5’000 or even less in 1999, then the price of such premises was tens of thousands of Euros in 2006 and the fi rst part of 2007. The lending by banks also set off a self-feeding mechanism where the increasing value of collateral allowed the owners of these assets to borrow more money and invest it in additional assets – this led to a positive spiral in asset prices and, as an example, a business model of buying real estate,

BALTIC ECONOMIES - UNCERTAINTY MEANS OPPORTUNITY

p.20

POLAND 1999 2000 2005 2007Population (m) 38.6 38.4 38.1 38.0

GDP (PPP, bn) 371.1 395.3 517.9 620.8

GDP per Capita (PPP) 9,599.3 10,280.4 13,571.3 16,310.7

Real GDP Growth (%) 4.5 4.2 3.6 6.5

Inflation Rate 9.8 8.5 0.7 4.0

CA as % of GDP -7.4 -5.8 -1.5 -3.6

Market capitalization (USD bn) 95.4 208.3

CZECH REPUBLIC 1999 2000 2005 2007Population (m) 10.2 10.2 10.2 10.2

GDP (PPP, bn) 144.8 153.4 207.5 248.9


Real GDP Growth 1.3 3.6 6.3 6.4


CA as % of GDP -2.4 -4.7 -1.6 -2.5


HUNGARY 1999 2000 2005 2007Population (m) 10.2 10.2 10.0 10.0

GDP (PPP, bn) 114.6 123.1 171.6 191.3




CA as % of GDP -7.8 -8.3 -6.7 -5.6


CROATIA 1999 2000 2005 2007Population (m) 4.5 4.3 4.4 4.4

GDP (PPP, bn) 39.5 41.5 58.7 68.9


Real GDP Growth -0.8 2.8 4.2 5.7


CA as % of GDP -7.7 -2.8 -6.1 -8.5


SERBIA 1999 2000 2005 2007Population (m) 7.5 7.5 7.4 7.4

GDP (PPP, bn) N/A 44.3 64.3 77.2

GDP per Capita (PPP) N/A 5,897.6 8,846.0 10,375.2

Real GDP Growth -18.0 5.5 6.2 7.3

Inflation Rate 45.4 111.9 17.6 10.0

CA as % of GDP N/A -1.7 -8.4 -16.5


ROMANIA 1999 2000 2005 2007Population (m) 22.2 22.1 21.7 21.5

GDP (PPP, bn) 103.7 136.4 202.6 245.5




CA as % of GDP -4.1 -3.7 -8.9 -13.9


CEE COUNTR

RY STATISTICS Russia 1999 2000 2005 2007Population (m) 147.5 146.9 143.5 142.1

GDP (PPP, bn) 996.9 1,120.5 1,697.8 2,087.8


Real GDP Growth (%) 6.4 10.0 6.4 7.4

Inflation Rate 36.5 20.2 10.9 11.9

CA as % of GDP 12.5 18.0 11.0 5.9


ESTONIA 1999 2000 2005 2007Population (m) 1.3 1.3 1.3 1.3

GDP (PPP, bn) 12.0 13.5 22.4 28.3


Real GDP Growth -0.1 9.5 10.1 7.1


CA as % of GDP -4.3 -5.4 -9.9 -15.9


LATVIA 1999 2000 2005 2007Population (m) 2.3 2.3 2.3 2.2

GDP (PPP, bn) 16.6 18.2 30.4 39.7


Real GDP Growth 4.6 6.9 10.5 10.2


CA as % of GDP -8.8 -4.7 -12.4 -23.3


LITHUANIA 1999 2000 2005 2007Population (m) 3.5 3.5 3.4 3.3

GDP (PPP, bn) 27.6 29.3 48.0 59.6




CA as % of GDP -11.0 -5.9 -7.1 -13.0


TURKEY 1999 2000 2005 2007Population (m) 59.9 62.7 67.9 68.8

GDP (PPP, bn) 468.8 511.4 747.3 887.9




CA as % of GDP -0.5 -3.7 -4.6 -5.7


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borrowing money against the asset and then investing it in yet additional real estate was quite a popular and common approach to making money.

All this fast economic development and ever increasing extension of credit contributed to aggregate demand induced inflation which accelerated pretty quickly from relatively acceptable levels in 2002 and 2003 to high single digit rates as year 2007 approached. To be fair, it must be appended that the increasing energy and commodity prices were another factor that had an effect on the inflation rates.

Given that the Baltic currencies are pegged to Euro, the local central banks have limited ability to affect the economy through contractionary or expansionary monetary policy by regulating the interest rates. While

the local economies were heating up, the central banks could do only little (e.g. increasing commercial bank reserve requirements) to allay the ongoing inflationary processes.

Together with the increasing inflation and credit expansion, rapid economic growth was also accompanied by steadily decreasing unemployment rate as the key industries which were driving the growth (e.g. retail trade, fi nancial intermediation, construction) absorbed the economically active population which had for various structural or other reasons been unemployed in

the beginning of the new century.

D e c r e a s i n g unemployement rates in the Baltic countries were accompanied by wage pressures - both nominal and real wages increased relatively rapidly from 2002 to 2007 on their way to converging with the wage levels in other European Union countries. The free movement of labour between the Baltic countries and other EU countries such as the United Kingdom or Ireland contributed to this process, because the working population had a possibility to substitute away from their jobs in the Baltics towards better paying jobs in some other European Union countries. To provide an incentive for the employees to stay, the companies were forced to increase wages. The wage pressures were felt not only by the employers who employ skilled white-collar workers, but also by the employers of less skilled workers

– the rapid development of the economies absorbed a lot of the less skilled workers in, as an instance, retailing or various service industries. At times during the last few years the companies operating in various industries

reason and explore it further when discussing the possible future scenarios for the Baltic economies). Eventually the devaluation stir-up or discussion settled down and so far no major or discussion worthy issues have arisen in this regard.

The bottom line of the foregoing discussion is that the Baltic countries have experienced a rapid credit expansion which was one of the key drivers of the economic development during the more recent past. The economies have also benefi ted enormously from the EU accession in 2004 with the accompanying

perception of reduced risk and attractive expected return from various investment projects. The

investments made during this time period have contributed to the economic growth, job

creation and eventually also a consumer who is better off and can afford to spend more

money than before on various goods and services.

Having gained a general insight in the economic developments in the

Baltic countries over the more recent past, i.e. the last 5 to 6 years, let us go further and consider the situation in which the Baltic economies are in currently.

As a side note, when Baltic economies are discussed, it is worth keeping in mind that the economic development or how the events unfold for historical reasons follow a path wherein Estonia usually goes fi rst, Latvia follows and Lithuania is generally the last in line to exhibit the overall economic patterns of the

Baltic economies.

The current situation in the Baltic economies

The optimism among the general population is gone. The growth in the Baltic economies has screeched to a halt and most of the observers or analysts have been surprised about how fast this has happened. As an instance, the gross domestic product of Estonia grew by 0.1% in the fi rst quarter of 2008 (y-o-y) and actually declined by 1.4% in the second quarter of 2008 (y-o-y). The situation is similar in Latvia where GDP expanded only by 0.2% in the second quarter of 2008 (y-o-y). Lithuania still managed to post a y-o-y GDP growth rate of 5.5% in the second quarter of 2008, but is likely to slow down as well. To sum up, the economies are in or are in the process of quickly approaching a recession.

At the same time the statistical information indicates that the inflation in the Baltic countries at the moment is still running high – it reached 12.1% in Q2, 2008 y-o-y


felt shortages of such employees. A number of the less skilled workers used the opportunity to emigrate to other EU countries in search of better paying jobs.

Aside and in addition to the above, it is necessary to add that the rapid economic development of the Baltic economies created some imbalances as well. Chief among those are probably the current account defi cits in all three Baltic countries. As an instance, the current account defi cit in Latvia in the fi rst quarter of 2007 reached a glaring 25.7% of the quarterly GDP. Imports exceeded exports by a wide margin in other Baltic countries as well as consumers were actively spending money on such imported goods as cars. The current account defi cits were offset by the capital account surpluses – the frenetic consumption of the Baltic consumers was for the most part fi nanced by the subsidiaries of the Swedish banks (e.g. Swedbank, SEB) in the Baltics which, as illustrated in one of the previous graphs, increased their claims against the local populations quite rapidly.

Given the large current account defi cit, in the fi rst half of 2007 some economists in Latvia started to discuss the possibility of a devaluation of Latvian lat which created a small panic in the general population and some agitation among foreign investors. Some rumours about possible currency devaluation later appeared in Estonia as well, but no major discussions about these issues arose in Lithuania. These events and the uncertainty associated with them provided an attractive opportunity for perceptive investors to capture the relatively large interest rate differential between Latvian lat and Euro while speculating against the devaluation of the currency – at that stage devaluation of Latvian lat was not particularly likely for a number of reasons: it was close to impossible to carry out a speculative attack against the currency, because it was very diffi cult to borrow a large amount of lats to sell and the cost of doing so was prohibitive; Latvian central bank has big foreign currency reserves and can meet large amounts of lat selling while maintaining the peg to Euro; the majority of the stakeholders in the economy would be hurt by the devalution (we will return back to this

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in Lithuania, 11.4% in Q2, 2008 y-o-y in Estonia. The situation in Latvia is even more alarming where inflation was as high as 17.7% in June, 2008 y-o-y before inching down a bit to 16.7% in July, 2008 y-o-y. It appears that the high inflation numbers indicate that the domestic demand is showing signs of peaking. The pressures on the cost side may have reached their maximum and have also been affected by the high commodity and energy prices which have lately shown signs of easing. Unemployment still remains low (Q2, 2008: Estonia – 4%, Latvia – 5.7%, Lithuania – 4.3%) which supports the hypothesis about the cost pressures as wages still keep going higher among labour shortages – there are, however, some signs that this situation is changing - for example, one local employment agency in Estonia has noted that the number of job applications has doubled in the second quarter of 2008. Similarly, it is already common knowledge in the Baltics that the cooling down of the construction sector has resulted in some layoffs and even bankruptcies especially among the real estate development companies. It is also becoming easier for the retailers to fi ll their vacancies where employees with relatively low skills are required.

During the last year or so, the Baltic asset markets have suffered quite large declines as investors and the general population have gradually became aware of the unsustainability of the credit driven asset price inflation and the wealth effects that this has had on the amount of the personal consumption. The fact that some types of real estate (e.g. residential apartments or land) have fallen by roughly 20-30% in price during the last year in Estonia and to a large extent also in Latvia serves as good contradictory evidence to those who believed that real estate could only go up in value. Furthermore, as an example, in Estonia OMX Tallinn stock market index is down by about 50% since peaking in the fi rst half of 2007 as the graph below illustrates. Latvian and Lithuanian stock markets have

also fallen, but not as much as Estonia – both are down by about 30% from their respective tops reached in 2007.

The listed companies that have suffered the most represent the sectors that are likely to be hit the hardest from slowing domestic demand. Take, for instance, Baltika, a local fashion retailer, which has fallen by more than 75% from its highs or Olympic Entertainment Group which has declined by more than 65%. Domestic demand is indeed slowing – a good illustration is the retail trade numbers – in June, 2008, Latvian retail trade turnover decreased by 8.3% y-o-y while Estonian retail sales dropped by 7%; similarly, retail sales inched lower by 0.5% in Lithuania as well. The slowing domestic demand has also slowed down the growth in imports as people simply spend less money on foreign goods such as cars. For example, in April, 2008, Estonian current account defi cit was equal to 2.4 billion kroons (EUR 153 million) and subsequently dropped to 2.1 billion kroons (EUR 134 million) in May.

Lately the local Baltic banks have become more careful with lending money. Given that the Baltic current account defi cits are for the most part funded by the Swedish banks (i.e. with the capital that they give to their subsidiaries here in the Baltics), they eventually also determine to a large extent how much money the local consumer can borrow and spend. The more careful the banks become, the more likely it is that the consumer will have less money to spend.

On the positive side, it must be noted that the government budgets in the Baltics are quite well balanced. Even though there have been budget defi cits over the last few years, these have been relatively small and the governments did not have to borrow large amounts of money to support their spending. Consequently the government debt has also been quite low and, if needed, more government borrowing would be possible which could in turn bolster an expansionary fi scal policy if it were judged that there is a need for such a course of action.

To sum up, it is quite apparent from the currently available data that the Baltic economies are moving in the


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direction of a recession which is

typically defi ned as two consecutive quarters of negative gross domestic product growth. Domestic demand is declining quite heavily which is nicely reected in the declining retail sales. The bottom line is that it is not possible for the consumer to go on borrowing and spending money indefi nitely. That said, let us continue and explore what the future might have in store for the Baltic economies and the various stakeholders of those economies. We will also try to speculate about the possible investment opportunities that may emerge as the future unfolds.

Looking forward – some speculations about the future

Any economy is in a way a social process and the economic outcomes are the aggregated result of actions of acting individuals or the participants of the particular economy. In order to understand an economy, it is not enough to tamper with the data, run some regressions and generally project the continuation of an ongoing trend. Such a course of action has probably landed more people in trouble than we might be willing to acknowledge. It is possible that a more qualitative and commonsensical analysis of a situation at hand may yield a better understanding of

what the possible

future scenarios are and what are the risks that may have an effect on

the development of a particular economy over time. Hopefully such an approach can also do a better job of identifying what opportunities the future may bring and how to possibly capture them. In any case, anything that we dare to say about the future is just a hypothesis – asking more from inherently imperfect human beings with limited understanding is clearly on the verge of asking for trouble.

Given the currently prevalent general recognition that the Baltic economies are slowing down and are about to enter a recessionary phase, the uncertainty that is associated with the economic processes in the countries has had and is likely to have some effect on the consumer confi dence. In such conditions people are likely to delay some purchases and generally prefer to save money instead of spending it on various goods and services. Viewed from one perspective, the reduced consumer confi dence is likely to continue to influence the growth of GDP in the short to medium term. On the other hand, less consumer spending also implies that the current account defi cits are likely to become even smaller – this process already appears to be happening. Another positive aspect of a more cautious consumer is lower inflation – the abating domestic demand is likely to contribute to lower inflation rates as we go forward. Of course, at some point the consumer will be ready to spend actively again, but as of now and in the near future this appears unlikely.

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In these conditions it is important to watch what is happening with the unemployment rates in the Baltic countries. As noted before, at this point in time they still remain low, but there are already some signs that they may start to increase. If unemployment rates go up, it is likely that the consumer will become even less willing to spend money especially if looming layoffs emerge as a realistic future scenario. There is thus potential for a more pronounced slowdown in the economies especially if a vicious circle of low consumer spending and consequently higher unemployment, which would result from low consumer spending, would be followed by even less consumer spending. To arrest such a scenario if it were to occur, the local governments might engage in a fi scal stimulation of the economies – this may provide the necessary impetus to push the economies forward and prevent them from experiencing more pronounced declines.

Another important issue or a risk factor that merits attention is what is happening with the loan portfolios of the local Baltic banks. As an example, in June Swedbank which owns one of the largest commercial banks in the Baltics, Hansabank, said that it expects Baltic credit losses to reach 0.5% - 0.7% of loans in 2008. It is feared that these numbers could in reality be higher especially if unemployment picks up and more people have trouble with paying back their loans. Statistics from the Bank of Estonia (Estonian Central Bank) indicate that loans past due or with unpaid interest have reached 6.4% of the total loan portfolio at the end of June, 2008, which is an increase from 3% at the same time a year ago. In the light of these developments, Swedbank, which is listed on Stockholm Stock Exchange, has declined by more than 50% since the beginning of 2007. If the worst case scenario plays out and unemployment increases, the local banks may get stuck with bad loans or assets that have been foreclosed upon and are diffi cult to sell. This may in turn exert some downward pressure on the local asset prices if the banks try to free themselves from such assets and recover at least a part of their value.

The foregoing discussion would not be complete if the issues associated with the Baltic currencies were not discussed. As noted before, there have been some discussions about their devaluation (especially about Latvian lat and Estonian kroon) starting from the fi rst half of 2007 and some of the arguments put forward have focused on the current account defi cits as well as the benefi ts that devaluation might bring to the exporters. However, there are a number of reasons why devaluation, in spite of numerous scares, has not happened (these were briefly discussed above) – the same reasons diminish the likelihood of a devaluation going forward. As noted before, we are returning to discuss the aspect that there are very few stakeholders who would benefi t from the devaluation. First, given that most of the loans issued by the Baltic banks are in Euro (for example, 77% of the loans issued in Estonia were in Euro at the

end of 2007), the devaluation of a local Baltic currency would put a substantial pressure on the households (as well as businesses) the revenues of which are in the local currencies – if the local households default on a massive scale, the local fi nancial systems are likely to fall into a deep crisis. In a similar vein, given that the Baltic economies are relatively small and open, it is not true that the exporters would immediately benefi t from it since many exporters use foreign inputs to produce their products. In the light of these factors, it becomes apparent that at this stage any devaluation would create more problems than it would solve, hence, the relevant decision makers are not likely to favor the devaluation of local currencies. Yet, devaluation may become a realistic scenario if the local economies plunge in a deeper recession while, maybe, experiencing stagflation at the same time – in such a case devaluation might be used as an expedient tool for eliminating the imbalances and letting the market forces correct the situation – obviously this is not a foregone conclusion and the developments of the economies have to be monitored in real time when trying to understand what might happen.

To summarize the discussion, it must be noted that while the times in the Baltics as far as their economies are concerned are currently uncertain and the economies appear to be slipping or already in a recession, this does not mean that investors have to give up and throw in the towel. It is in times of uncertainty that the opportunities are likely to be the greatest. It must be kept in mind that the Baltic economies are small and flexible and easily recovered from the Russian crisis of 1998. The general population is interested in bettering their living standards – it is likely that the convergence with the rest of the Europe will continue. While there has been a credit expansion in the Baltics and now the phase of the slowdown has set in, at some point the economies will embark on a rising trend again – only patience is required. Let us next conclude and consider where the most attractive opportunities in the Baltics might be as we move forward in time.

First of all, it is necessary to keep in mind that in diffi cult times best opportunities are usually associated with distressed assets which appear on the market as their owners for some reason cannot keep them and are forced to sell often at prices which provide bargains for the new owners. As an example, such assets may include various types of real estate or even functioning businesses which may have run into temporary diffi culties. Furthermore, given that the commercial banks have become more careful with issuing new loans and are likely to remain careful for some time to come, opportunities for other capital providers emerge. It can even be possible that such capital providers become able to require higher returns from various attractive investments, because of the lack of substitute sources of capital. Third, while the Baltic stock markets are relatively small, it would be a sin to overlook the opportunities that may and to some


extent are already gradually emerging there – while two years ago when the expectations were running high listed companies were quite expensive, the same businesses can be acquired at only a fraction of their former values. If it were not for the uncertainty and the macroeconomic issues, then these opportunities might not be available today or might not become available in the future. As always, in turbulent times it is best to be cautious and selective – nevertheless, a savvy investor is likely to fi nd a number of good opportunities.

Sources used in preparing the article: central statistical offi ces of the Baltic countries, Baltic central banks, OMX NASDAQ Baltic stock exchanges, local media outlets.

Janis Springis, Associate in Alternative Funds unit of GILD Bankers, has signifi cant experience in Baltic option market making. He is currently responsible for the market based investments of hedge fund GILD Arbi-trage. He has also been Co-fund Manager of GILD Arbi-trage, Emerging Europe multi-strategy hedge fund which has provided its investors with average annual net return of more than 23% since inception in April 2001 and over the same period annualized volatility has been less than 8%. In 2006-2007 he was the Co-fund Manager of multi-strategy fund of hedge funds GILD Global Opportunity. Mr. Springis holds an M.Sc. from the Swedish School of Economics and Business Administration in Finland and a B.Sc. from Stockholm School of Economics in Riga.

GILD Bankers is the leading Baltic investment bank ac-tive in Emerging Europe. The core services of GILD are management of alternative funds, investment banking and private banking. GILD Alternative Funds team spe-cializes in tailored and active investments. Assets under management in hedge fund GILD Arbitrage, GILD Long Haul private equity funds and GILD Real Estate funds surpass EUR 160 million. GILD active investment funds have provided investors consistent average annual net returns of 23-31%.


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FYCFYCTHE FORMER THE FORMER

YUGOSLAV COUNTRIESYUGOSLAV COUNTRIES

The convergence and return potentials of these markets are embedded in a double layered process. The fi rst layer is based on the fact that the FYC enjoyed higher GDP/Capita ratios than CEE (Central & Eastern Europe - Poland, Czech Republic and Hungary) at the beginning of the nineties. The civil war and the breakup of Yugoslavia wrecked havoc to the economy, and are the main reasons why FYC had built up major economic disadvantages vs. CEE and had become a laggard in Eastern Europe within the last decade which builds the base for the small convergence (as we like to call it). This refers to the catch up process of these countries vs. CEE.

The second layer of the convergence process is based on the overall expected catch up process vs. developed Europe. This, to a large extent, will be fi nanced by fi nancial investors (Investment, Pension Funds) and political institutions (EU - structural fund disbursements). The economic performance of FYC is clearly gaining

Economic and political convergence in Eastern Europe and the subsequent admission to the European Union of the so called fi rst wave countries in 2004 yielded tangible results for investors. Further EU expansion proved to be very supportive for Eastern European capital markets which in most cases have appreciated in a range between 200 – 300% in the last fi ve years. A striking feature was to observe that a large portion of the market performance was generated in a relatively short period of time prior to the offi cial admission dates.

For many investors who had the chance to profi t from the fi rst wave of EU expansion, a vital question remains; will the region, and Eastern Europe as an asset class provide further outperformance in such a manner as experienced in recent years? The answer to this question may be found in the enormous growth potential of the Southeastern European markets and especially in the FYC (Former Yugoslav Countries).

ECONOMIC CONVERGENCE UNFOLDING DUE TO HUGE MARKET INEFFICIENCIES, SOUND FUNDAMENTALS, AND YET UNDER- OWNED BY INTERNATIONAL INVESTORS

Cyrus GolpayeganiCyrus GolpayeganiQUIMCOQUIMCO

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FYC - THE FORMER YUGOSLAV COUNTRIES

momentum and traction (7-8% annual real GDP growth), of course also stemming from a very low base, in comparison to CEE (3-4% annual real GDP growth).

Indications for the nascent nature of these markets are measured by the fact that these countries on average only earn a quarter of the GDP in developed European economies. The capital markets in FYC are, at best, markets with miniscule market caps. For example, the top 50 Serbian companies have a market cap of less than €5 bn., which proves the enormous needs of further investment in all sectors and aspects of the FYC economies.

A crucial element concerning successful future economic development is the pace of reforms in these countries. It might be surprising to learn that the Serbian economy has been rated as the most reform oriented economy by the World Bank in 2006. Wage levels in FYC are also very low, especially when compared to CEE (Minimum monthly wage in Serbia = 100€, average monthly wages in Serbia = 300€). This is another factor which of course bolsters FDI (foreign direct investments) which already make up for more than 10% of GDP.

The mentioned potential may only unfold when the pace of reforms still remains robust. A good example is necessary real estate reform in Serbia. Real estate cannot be purchased but only leased (99 year leases). This

reform is crucial in order to establish a mortgage market. The fi nancial sector is also clearly one of the major benefi ciaries of the ongoing economic transformation in FYC since they provide the fi nancial means for, and profi t the most from, the outstanding growth potential. Another example for growth can be found in the insurance sector. In Bosnia the average household spends 42€ annually on insurance premiums. In comparison an average Austrian household spends more than 2000€ for insurance premiums. There are many examples which highlight the highly nascent stage of nearly every aspect of the economies in FYC. There is enough evidence that these markets are hardly owned by foreign investors, and the majority of market participants are local players.

Stock market performance in FYC, so far this year, has been very poor, due to a combination of factors such as rising global risk aversion, liquidity crisis in the fi nancial system, and political uncertainties concerning the conflicts surrounding Kosovo’s independence. These factors have undermined the positive macro economic outlook and very attractive company fundamentals resulting from a huge correction lasting more than one and a half years. This is much longer than most developed and emerging markets and also much more severe. Year to date (end of August 08) most indices have lost more than a third of their values such as the Serbian Belex Index (-38,5%), Croatian Crobex Index (-31%), Bosnian SASX10 Index (-44,4%).

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Although most companies still manage to report very strong earnings growth, with most companies managing to display earnings growth exceeding 50% YOY in 1H08, the focus of interest clearly lied within the political tensions arising from Kosovo, and subsequently Serbia holding early elections on May 11. Even though Serbian President Boris Tadics’ pro EU party won the election and a coalition with socialists took over offi ce quite quickly, the positive impact on fi nancial markets in the country eroded quickly. A major task of the newly formed government will be to bring Serbia back on track towards EU accession, and the rapid implementation of necessary reforms as mentioned earlier. The aim is to achieve real GDP growth rates of 7%, attract further direct investments, resolve issues concerning cooperation with the international war crimes tribunal in the Hague. The signing of the Stabilization and Association Agreement (SAA) in May was made possible after the Netherlands and Belgium dropped their opposition on condition that it would not be ratifi ed nor any of its benefi ts granted to Serbia until the country showed its full cooperation on extradition of war criminals. The recent arrest of Mr.

Karadzic and the swift extradition to the Hague, where he is brought to trial, has been marked as very substantial and important progress in the relations between the EU and Serbia.

The rising levels of risk aversion in light of the political uncertainties in Serbia also had a negative impact on currency performance, whereby the Serbian Dinar (RSD) lost more than 10% of its value versus the Euro, but the RSD could manage to recoup the losses after the pro EU coalition was formed in Serbia. Economic growth in FYC still remains very robust. Forecasted growth for Serbian real GDP in 2008 lies at 6,2%, even though real GDP growth in the fi rst quarter of 2008 was at 8,2%. The global trend of rising inflation has also hit the region, and forced the Serbian National Bank to increase interest rates, currently standing at 15,75%, which is also menacing corporate Serbia with rising costs of capital. In a regional context, real GDP growth in other countries in our region such as Slovenia, Croatia and Bosnia, are also very robust ranging from 4 – 6%.

Generally speaking, economic growth should be higher than growth rates observed in many other Eastern European countries and signifi cantly higher than Western Europe. Most companies in FYC should be able to benefi t from improving macro economic conditions in the region. The major corrections in our markets provide investors with great opportunities, even though we must admit, that liquidity of most markets has also suffered from the correction. Nevertheless the fundamentals have improved signifi cantly and already display huge discounts to Eastern European levels.

The following table displays another striking feature of equity funds that focus on FYC, which certainly lies within the very low correlation to global equity markets and even to CEE markets. This also stems from the fact that most international investors who have already been active in CEE markets have not yet decided to opt for investment in the Western Balkans, in many cases resulting from diffi culties in custody and settlement, which at the end of the day also limits the number of participants in these markets. We think that going forward, signifi cant progress regarding this issue will prompt a further broadening of the international investor


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retail investors who do not really pay too much attention to the values of their funds, neglecting huge discounts to the NAVs. The main reason lies within the fact that most people get rid of their funds whenever they are short of liquidity and cash is needed. The resulting discounts offer a perfect opportunity to buy cheap assets at even lower prices which in many cases will yield highly visible and substantial returns in 3 – 5 years from now. The current regional breakdown looks as follows;

Huge discounts and pricing anomalies not only refer to valuation comparisons but especially apply to so called „Privatization Investment Funds“ (PIFs) that currently display discounts to their NAVs of up to 70%, and which are the result of mass voucher privatizations, very common in former communist/socialist countries. 51 PIFs were established during the privatization process which were subsequently transformed into holding companies and closed end funds. The bulk of the shareholders are

MSC

I WO

RLD

MSC

I NO

RTH

AM

ERIC

A

MSC

I EUR

OPE

MSC

I PAC

IFIC

CZE

CH

REP

UBLI

C

HUN

GA

RY

POLA

ND

SLO

VAKI

A

ROM

AN

IA

BiH

BA

NJA

LUK

A

BiH

SA

RAJE

VO

CRO

ATIA

SERB

IA

SLO

VEN

IA

MSCI WORLD 1,00 0,95 0,90 0,66 0,63 0,50 0,58 0,06 0,48 0,05 0,16 0,31 0,21 0,31MSCI NORTH AMERICA 1,00 0,77 0,50 0,50 0,38 0,44 0,04 0,38 0,01 0,10 0,23 0,20 0,22MSCI EUROPE 1,00 0,54 0,68 0,58 0,67 0,10 0,51 0,07 0,20 0,36 0,16 0,33MSCI PACIFIC 1,00 0,59 0,48 0,47 0,02 0,24 0,07 0,17 0,30 0,20 0,36CZECH REPUBLIC 1,00 0,61 0,70 0,04 0,50 0,12 0,15 0,42 0,13 0,37HUNGARY 1,00 0,63 0,21 0,38 0,04 0,07 0,33 0,15 0,20POLAND 1,00 0,08 0,47 0,05 0,14 0,34 0,11 0,33SLOVAKIA 1,00 0,06 -0,05 0,04 -0,06 0,02 -0,11ROMANIA 1,00 0,11 0,22 0,37 0,13 0,54BiH BANJA LUKA 1,00 0,47 0,25 0,25 0,17BiH SARAJEVO 1,00 0,40 0,49 0,23CROATIA 1,00 0,33 0,49SERBIA 1,00 0,15SLOVENIA 1,00

FYC EQUITY FUND 0,21 0,17 0,21 0,26 0,25 0,20 0,16 -0,10 0,30 0,44 0,60 0,62 0,79 0,35

Source: Bloomberg, 104 weeks, weekly data

ORIGIN OF PRIVATIZATION INVESTMENT FUNDS (PIFs)

Voucher Privatizationof formerly state-owned assets

Creation of 46 PIFs in:

Croatia (9) Montenegro (6)

Bosnia & Herzegovina (24) Slovenia (7)

Transformation of PIFs into holdings and closed-end funds:

Croatia 7 holdings and2 closed-end invesment funds

Banja Luka 13 Privatisation investment funds

Montenegro 6 Privatisation investment funds

Sarajevo 11 closed-end investment funds Slovenia 7 closed-end investment funds

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the funds are mainly invested in energy companies and in telecommunication companies, which results in a broader sector diversifi cation. Funds in Montenegro are mainly invested in utility companies, tourism, Jugopetrol and Port Bar. Slovenian closed end funds invest on the stock market and are often poorly diversifi ed.

Analysis of the current portfolios yields the following results; Portfolios of Croatian holding companies mainly contain investments in the tourism industry and real estate holding companies. Croatian closed end investment funds invest into liquid stocks listed on the local exchanges. In Bosnia and Herzegovina,

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Cyrus Golpayegani, CFA is a Senior Portfolio Manager, and also Chief Investment Offi cer of Qimco. He has been responsible for managing Eastern European and Emerging Market Funds for more than 10 years with institutions such as Raiffeisen Capital Management and Bank Gutmann. He has joined forces with three other partners (Joachim Waltl, CFA; Alfred Kober, CFA; Axel Schuster, CFA) to establish Qimco.

QIMCO is an investment boutique specializing in FYC (Former Yugoslav Countries) equities. It has been established in 2007. The company has launched UCITS III and offshore products, which are primarily bottom up managed, with a clear focus on market ineffi ciencies in the FYC region.

Privatization funds were also popular investment vehicles in Romania (SIF1 – SIF5) and were often seen as liquid proxies for the market. Especially prior to Romania’s EU accession these funds were the preferred investment vehicles for foreign investors to gain exposure to the Romanian equity market, lacking

Country Discount min

Discount max

Market capitalisation

# of companies

Not listed companies

CROATIA 20 % 35 % 350

BiH SARAJEVO 40 % 67 % 200 22 - 148 1 - 30

BiH BANJA LUKA 40 % 75 % 200 10 - 225 0 - 42

MONTENEGRO 35 % 50 % 200 22 - 93 0 - 25

SLOVENIA 20 % 30 % 700

Average / Total 31 % 51 % 1,650 EURmn

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suffi cient liquidity at that time, which even lead to the paradox situation of investors willing to pay a premium to NAV. Even though history has repeatedly shown the performance potential of such funds, the discounts to NAV, especially among Bosnian funds have widened to extreme levels.

We still observe certain negative trends that resulted in lower turnovers and liquidity. The major reason why performance has been very disappointing also lies within the fact that some retail funds were under pressure and were forced to reduce their holdings in PIFs due to redemptions.

Facing the short term negatives in relation to the very sound fundamentals, the region should only need minor catalysts in order to unlock the hidden value in a niche market that is under owned by most international investors.

HEDGE

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OPPORTUNITIES IN EMERGING EUROPECENTRAL AND EASTERN EUROPE: AN OVERVIEW

TURKEYTURKEY

Ismail ErdemSTANDARD UNLU

TURKEY IS A PECULIAR COUNTRY. MOST OF ITS LAND LIES IN ASIA, BUT IT CONTROLS THE TURKEY IS A PECULIAR COUNTRY. MOST OF ITS LAND LIES IN ASIA, BUT IT CONTROLS THE MOST STRATEGIC WATERWAYS OF EUROPE AND HAS LONG LASTING HISTORIC RELATIONS MOST STRATEGIC WATERWAYS OF EUROPE AND HAS LONG LASTING HISTORIC RELATIONS

WITH EASTERN EUROPE, DATING BACK TO THE OTTOMAN CONTROL OF THE BALKANS. ON WITH EASTERN EUROPE, DATING BACK TO THE OTTOMAN CONTROL OF THE BALKANS. ON THE ECONOMIC SIDE, TURKEY LIVED WITH AN INFLATION FIGURE IN THE 60%-100% RANGE THE ECONOMIC SIDE, TURKEY LIVED WITH AN INFLATION FIGURE IN THE 60%-100% RANGE

FOR MORE THAN A DECADE IN THE 90S WITHOUT FACING HYPERINFLATION. HOWEVER, AFTER FOR MORE THAN A DECADE IN THE 90S WITHOUT FACING HYPERINFLATION. HOWEVER, AFTER 2002, IT STAGED A REMARKABLE COME BACK WITH A SIGNIFICANT IMPROVEMENT IN ALMOST 2002, IT STAGED A REMARKABLE COME BACK WITH A SIGNIFICANT IMPROVEMENT IN ALMOST

ALL MACROECONOMIC INDICATORS. THE COUNTRY CONSTITUTES A ROLE MODEL AS DEMOCRATIC ALL MACROECONOMIC INDICATORS. THE COUNTRY CONSTITUTES A ROLE MODEL AS DEMOCRATIC MUSLIM COUNTRY WITH A FREELY FUNCTIONING MULTI-PARTY POLITICAL SYSTEM.MUSLIM COUNTRY WITH A FREELY FUNCTIONING MULTI-PARTY POLITICAL SYSTEM.

THE LONG TERM INVESTMENT CASE FOR TURKEY IS VERY SOLID, BUT HIGH VOLATILITY IS AN INHERENT THE LONG TERM INVESTMENT CASE FOR TURKEY IS VERY SOLID, BUT HIGH VOLATILITY IS AN INHERENT CHARACTERISTIC OF THE TURKISH MARKET, WHEREBY ANNUAL VOLATILITY HAS DECLINED FROM AROUND 55% CHARACTERISTIC OF THE TURKISH MARKET, WHEREBY ANNUAL VOLATILITY HAS DECLINED FROM AROUND 55%

LEVELS IN THE 90S TO 45% IN THE PAST SIX YEARS. IN THIS ARTICLE, WE ATTEMPT TO SUMMARIZE THE GROWTH LEVELS IN THE 90S TO 45% IN THE PAST SIX YEARS. IN THIS ARTICLE, WE ATTEMPT TO SUMMARIZE THE GROWTH DRIVERS FOR THE TURKISH ECONOMY, GIVE A SNAPSHOT OF THE TURKISH EQUITY MARKETS AND DISCUSS THE FUTURE DRIVERS FOR THE TURKISH ECONOMY, GIVE A SNAPSHOT OF THE TURKISH EQUITY MARKETS AND DISCUSS THE FUTURE

OF THE COUNTRY’S MACROECONOMIC FRAMEWORK.OF THE COUNTRY’S MACROECONOMIC FRAMEWORK.

THE LAST MAJORTHE LAST MAJOR

EU CONVERGENCE STORYEU CONVERGENCE STORY

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Turkey’s Growth Drivers

The last major EU convergence storyTurkey started offi cial accession talks with the EU in 2005. The negotiation process is acting as a major anchor for Turkish fi nancial markets as Turkey’s rules and regulations are being brought in line with EU standards. Turkey’s accession process will probably take about 7-8 more years, but this should be considered normal given the country’s large size. The eventual membership of Turkey is still debatable as certain EU countries are strictly opposing Turkey’s full membership and plan on holding a referendum on the topic when the time comes. In our view, what really matters is the continuation of the related reform process in Turkey, which should bring Turkey’s level of development somewhere close to EU averages by the time of actual membership.

Political stabilityTurkey has been a western style parliamentary democracy since 1923. The system has been functioning healthily as evidenced by the emergence of the current ruling party AKP in the 2002 general elections, when almost all the political parties belonging to the previous coalition government suffered a major defeat and were left out of the parliament. Under the rule of a strong single party government, Turkey successfully completed a number of reforms. In the general elections held in August 2007, AKP won a landslide victory and will be ruling for a second term until 2011, which underpins the continuation of the reform process.

Recent reforms Turkey escaped from the debt trap in 2002, carried out a series of reforms and as a result started to grow very rapidly. Turkey’s GDP growth averaged 6.8% for the past 5 years, making it one of the fastest growing economies in the world. These reforms included, but were not limited to, a comprehensive restructuring of the banking sector, reduction in the obstacles against foreign direct investments, signifi cant reduction in red tape and a genuine commitment to privatisation.

Low penetration in many sectorsThe penetration rates of many sectors in Turkey are very low compared to developed markets. For instance, penetration levels in banking, insurance, automobiles, white goods and processed food are signifi cantly below developed market averages indicating strong long term growth potential.

The only Muslim country with a western style democracyTurkey is a role model for many developing Muslim countries. Turkey is a secular country, which means that religion has no interference with government affairs, although 99% of the population are Muslims. This

nature of the country enables a more suitable business environment for many global fi rms.

Young populationThe young population and the relatively high fertility rate are favourable demographics, which should support long-term growth of the economy. 50% of Turkey’s total population of 70.5mn is below the age 25.

Accommodative business infrastructureTurkey’s business infrastructure is well developed to accommodate world-class multinational companies. Many global brands have been operating in Turkey for a long time. These names span from many multinational manufacturing companies to well known global service sector names.

Strong core industry baseTurkey has a well established base in core industries such as steel, oil refi ning, petrochemicals, glass and cement, which makes the flourishing of other industries much easier. Most of these manufacturing facilities have recently been privatized, paving the way for more effi cient supply of raw materials and intermediate inputs to the economy.

Strategic geographical locationTurkey’s geographical location makes it a natural hub for many business lines. The Bosporus and Dardanelle Straits separate Asia from Europe. Pipelines, which carry Caucasian oil and gas to the Mediterranean Sea, pass through Turkish soil. Neighbouring the EU countries on the West and the rapidly developing Middle Eastern and Caucasian Regions in the East, Turkey offers strong potential in logistics, fi nancial services and transportation sectors, among many others.

Strong FDI flows in recent yearsFDI flows hovered around $20bn in recent years, supported by increasing M&A activity and privatisations. Although global credit crisis led to a slowdown in 2008, there are number of privatisations in the pipeline such as the privatisations of state owned banks, energy distribution, and national lottery.

A very liquid and transparent equity market with no restrictions for foreign investorsTurkish stock market has no restrictions for foreign investors. On the contrary, foreign investors enjoy certain privileges such as exemptions from capital gains tax, which applies to local investors. The average daily turnover of the Istanbul Stock Exchange is $1.2bn, which makes it one of the most liquid emerging markets. The stock exchange’s infrastructure is up to modern standards, with fully automated trading systems and remote access.

TURKEY - THE LAST MAJOR EU CONVERGENCE STORY

Turkey’s Key Macrooeconomic Indicators

ACTUAL DATA ESTIMATES

GROWTH 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

GDP (US$ mn) 1 196,736 230,494 304,901 390,387 481,497 526,429 658,786 798,800 857,771 986,240GDP per capita (US$) 1 2,878 3,326 4,341 5,487 6,681 7,214 9,333 11,188 11,877 13,501GDP growth rate (%) -5.7 6.2 5.3 9.4 8.4 6.9 4.5 3.8 4.5 6.0Population 68,365 69,302 70,231 71,152 72,065 72,974 70,586 71,398 72,219 73,050INDUSTRIAL PRODUCTION 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Industrial Production (annual-%) -8.7 9.4 8.7 9.8 5.4 5.8 5.4 4.0 4.5 6.3Capacity Utilization Rate (av-%) 71.6 76.2 78.7 81.6 80.4 81.2 81.9 81.5 81.0 81.0INFLATION 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

PPI (annual-%) 88.60 30.80 13.90 13.84 2.66 11.58 5.94 5.80 4.00 3.50CPI (annual-%) 68.50 29.70 18.40 9.32 7.72 9.65 8.39 6.50 4.50 4.00Benchmark Rate (end-%) 70.04 56.00 25.39 20.29 13.83 21.15 16.62 15.00 12.80 11.25O/N rate (end of period-%) 56.00 44.00 26.00 18.00 13.50 17.50 15.75 14.25 12.50 11.00

FOREIGN CURRENCY (CB Bid Rates) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Depreciation (US$-annual av%; nom) 115.3 22.9 -0.8 -4.7 -5.7 6.7 -9.1 -3.3 6.6 -1.5TRY/US$ (end of period;CB Bid Rate) 1.4396 1.6345 1.3958 1.3421 1.3430 1.4131 1.1593 1.2900 1.3400 1.3000RESERVES (US$ mn) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Total Foreign Reserves 30,192 38,067 44,957 58,749 75,066 101,169 117,731 135,000 138,000 145,000Central Bank Reserves 18,892 27,006 33,724 36,006 50,518 60,845 71,263 77,500 81,000 87,000CB Net FX Position -10,930 -1,559 404 2,730 15,462 20,493 32,827 28,000 31,500 36,500

BALANCE OF PAYMENT (US$ mn) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Export (f.o.b.) 31,334 36,059 47,253 63,167 73,476 85,528 107,154 134,000 148,000 168,000Import (c.i.f.) 41,399 51,554 69,340 97,540 116,774 139,480 169,987 212,000 232,000 256,000Exports/Imports (%) 75.7 69.9 67.1 64.8 62.9 61.7 63.0 63.2 63.8 65.6Trade Balance -10,065 -15,495 -22,087 -34,373 -43,298 -53,952 -62,833 -78,000 -84,000 -88,000Current Account Balance 1 3,393 -1,519 -8,036 -15,599 -22,604 -32,193 -37,996 -50,000 -55,000 -59,000Trade Balance / GDP (%) 1 -5.1 -6.7 -7.3 -8.7 -8.9 -10.2 -9.5 -9.8 -9.8 -8.9Current Account Balance / GDP (%) 1 1.7 -0.7 -2.6 -4.0 -4.7 -6.1 -5.8 -6.3 -6.4 -6.0CONSOLIDATED BUDGET (TRY mn) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Revenues 51,543 75,592 100,250 110,721 137,981 171,309 189,617 207,500 234,000 265,000Taxes 39,736 59,632 84,316 90,077 106,929 137,474 152,832 170,000 190,000 214,000Expenditures 80,579 115,682 140,455 141,021 146,098 175,304 203,501 225,000 253,000 282,520Interest Expenditures 41,062 51,871 58,609 56,488 45,680 45,945 48,732 56,500 60,000 62,500Non Interest Expenditures 39,517 63,812 81,846 84,532 100,418 129,359 154,769 168,500 193,000 220,020Primary Balance 12,026 11,781 18,405 26,188 37,563 41,951 34,848 39,000 41,000 44,980Budget Balance -29,036 -40,090 -40,204 -30,300 -8,117 -3,995 -13,883 -17,500 -19,000 -17,520Budget Balance / GDP (%) 1 -12 -11 -9 -5 -1 -1 -2 -2 -2 -1Primary Balance / GDP (%) 1 5 3 4 5 6 6 4 4 4 3Taxes / Interest Expenditures (%) 1 97 115 144 159 302 373 314 301 317 341

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Source: Turkish Government Data and Standard Unlu Asset Management

Turkey has demonstrated remarkable economic improvements over the past fi ve years. GDP grew at an average rate of 6.8%, while GDP per capita rose from $3,326 in 2002 to above $9,300 in 2007. These fi gures make Turkey the 17th biggest economy in the world.

Turkish Lira appreciated signifi cantly over this time period as strong capital inflows both in the form of portfolio inflows and foreign direct investments entered the country. Inflation declined from an astonishing 68.5% in 2001 to single digits in 2007. Solid fi scal austerity measures brought the budget defi cit down from 12% in 2001 to around 2% by 2007. As a by-

product of this clear improvement in the macroeconomic picture, CB reserves quadrupled to $71bn.

Turkey’s current account defi cit is still high, hovering at around 6% of GDP. This is a rather structural problem as Turkey is a heavy importer of intermediary goods and oil, which leads to deterioration in external balance at times of rapid economic growth. The government is

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TOP 20 Stocks in the Istanbul Stock Exchange

Name

($ mn)Market Cap. Description

1 Turkcell 14,741 Mobile Telecom

2 Akbank 14,791 Banking

3 Enka 11,833 Construction & Real Estate

4 Isbank 12,662 Banking

5 Garanti Bank 12,531 Banking

6 Halkbank 7,269 Banking

7 Yapi Kredi Bank 9,526 Banking

8 Eregli 7,843 Steel Manufacturing

9 Sabanci Holding 7,585 Diversifi ed Holding

10 Tupras 6,121 Oil Refi ning

11 Koc Holding 7,192 Diversifi ed Holding

12 Vakifbank 4,678 Banking

13 Anadolu Efes 4,513 Regional Brewing

14 Migros 3,151 Retailing

15 Petrol Ofisi 2,967 Petroleum Distribution

16 Asya Bank 2,078 Participation Bank

17 Dogan Holding 2,263 Diversifi ed Holding

18 Sisecam 1,357 Glass Manufacturing

19 Aksigorta 1,264 Insurance

20 Sekerbank 769 Banking

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fully aware of this problem and is working on important structural measures to bring down the CA defi cit over the medium term. These measures are aimed at supporting export-oriented industries with high domestic content and increasing tourism revenues.

Stock Market in Turkey

Turkey enjoys fairly developed capital markets. The Istanbul Stock Exchange (ISE) has a total market capitalisation of $200bn with more than 320 listed companies. ISE is one of the most liquid stock markets in the emerging market universe with daily trading volume of $1.2bn. Foreigners’ investment in the Turkish equity market has increased substantially in the past decade, making Turkey a highly recognised market in the global investment management community.

A broad range of industries including banking, telecommunications, oil refi ning, petrochemicals, construction, retailing, steel, insurance, textiles and real estate, among many others, are represented in the ISE.

Turkey stands out in the EM universe with its high long-term growth potential, improving political structure and EU convergence story. However, short-term volatility has been a proven characteristic of this market. Still Turkish stocks delivered a solid 17% compounded annualised return in USD terms in the past decade.

Still attractive valuations

Turkish equities trade on attractive valuation multiples. The market’s P/E ratio based on 2008 forecast earnings is 7.6, while the EV/EBITDA multiple is 4.9. Although volatility is an inevitable characteristic of the market, long-term investors have always been richly rewarded in Turkish equities.

HEDGE

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Ismail Erdem, CFA, is CEO of Standard Unlu Asset Management. Previously Ismail was Head of Research and Institutional Sales at TEB Investments, Head of Research and Institutional Sales at Finansinvest and Senior Research Analyst at ING Barings.

Education- MBA, University of Rochester, Rochester, NY,

USA

- B.S. in Electrical Engineering and Physics, Bogazici University, Istanbul, Turkey

STANDARD UNLU ASSET MANAGEMENT is the asset management arm of Standard Unlu Group, a subsidiary of Standard Bank and is the leading investment banking group in Turkey and offers a wide range of investment banking services.


The macroeconomic picture ahead

The robust FDI inflows, foreign borrowing by the private sector stemming from supportive conditions in global capital markets, and portfolio inflows attracted by high local interest rates all gave way to a very strong Turkish currency in the past fi ve years. Currency appreciation helped disinflation but amplifi ed the competitive challenges that industry faced from lower-cost countries. Certain industries lost market share and faced sharp import penetration. The resulting rise in current account defi cit rendered the economy more vulnerable to shifts in external conditions, despite an overall improvement in macroeconomic fundamentals.

Turkey has the resources required for a more balanced and stronger growth path. However, this can only be achieved by irreversibly consolidating the macroeconomic policy framework and providing the entire business sector with a signifi cantly more growth and employment-friendly microeconomic business environment. This is a more medium term endeavour and we believe that the government will start taking more measures towards this direction.

Fiscal discipline to be maintained with a pro-growth tone

Turkey followed very tight fi scal policies in recent years, where the target primary surplus was around 6.5% of GDP. This contributed to the restoration of macroeconomic stability, debt sustainability and investor confi dence in the aftermath of the 2001 crisis. Now Turkey is faced with a fi scal policy challenge where the three objectives below should be simultaneously targeted:

i) Preserve fi scal discipline

ii) Improve the quality and cost-effi ciency of key public services and develop the country’s infrastructure

iii) Reduce the most distortive aspects of the Turkish tax system.

In response to this challenge the government is trying to develop a new pro-growth fi scal strategy. This strategy can be expected to make a major further contribution to macroeconomic stability, competitiveness, social equity and sustainable growth.

Some of the burden to be taken off monetary policy

Monetary policy has been one of the main pillars of the post-2001 stabilisation programme. Fiscal consolidation backed monetary policy, reducing fi scal dominance and reinforcing the independence of the Central Bank. Improved fundamentals and a benign global environment led to a reduction in the risk premium, strong capital inflows and currency appreciation, which also helped disinflation.

The Central Bank shifted from implicit to explicit inflation targeting in 2006. However, inflation inertia and surge in global commodity prices hampered disinflation efforts. Inflation materialised at signifi cantly higher levels than the targets and the Central Bank was forced to tighten. On the other hand, real interest rates remained high, continuing to fuel strong capital inflows and currency appreciation, and undermining the competitiveness of labour-intensive segments of the economy.

Since monetary policy is focused on inflation, addressing this challenge requires support by broader policies. Complementary tools should be utilised to this effect, such as proactive competition policy to reduce costs and prices in services, a credible multi-yearly spending framework to consolidate confi dence in fi scal stability, and elimination of backward indexation in wage increases. Success with such policies would help shift the burden away from the Central Bank’s policy rate as the only available instrument to increase the credibility of the inflation target. We believe that enforcing these will be the key items for the government’s economic agenda.

More efficient combat against the informal sector

In the presence of pressures on competitiveness, the business sector’s capacity to accelerate productivity growth, moderate wage increases, and successfully differentiate products are longer-term sources for improving competitiveness for Turkey. Important competitiveness reserves remain dormant in the business sector, and should be mobilised. The fact that a large part of economic activity is still being carried out in the informal sectors is responsible for this. Firms that operate in the formal universe use modern technology, skilled labour and capital much more effectively. Facilitating the growth of formal fi rms requires a purposeful strategy. Two top priorities are a reform of labour market regulations, and further progress in the modernisation of capital markets. We expect the government’s policies to be more action oriented in these areas from 2009 onwards.

INFO

max.HEDGE November 2008

Published by: Erste Group Bank AG / Alternative InvestmentsBörsegasse 14, A – 1010 Vienna, AustriaTel.: +43 50 100 84972, Fax.: +43 50 100 84705

Editor: Christoph Kampitsch >> [email protected]

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Printing: SPV-Druck, ViennaCover: Modern Building in Prague, Photo © Ilja Mašík

max.HEDGE is a quaterly publication of Erste Group Bank AG, intended for informational purposes and based solely on information and data supplied by either investment managers or qualifi ed third parties. No information contained in this review should be interpreted as a solicitation for an investment and mention of a particular manager or product under no circumstance represents an endorsement of the product or the manager by the publisher. A prospective client for any product or service mentioned in this publication should independently investigate the investment manager and/or service provider and consult with independent, qualifi ed sources before engaging in any activity. Investors should also be aware that historical performance numbers presented herein are not indicative of future performance and furthermore, investments in hedge fund vehicles involve signifi cant risks, including loss of capital. Opinions expressed in the publication are not necessarily those of Erste Group Bank AG and Erste Group Bank AG assumes no responsibility for the contents of contributed articles.

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