CEE Risk/Reward Ratings: Political Instability To Weaken Rewards

BMI View: Our ranking table for Central and Eastern Europe (CEE) Risk/Reward Ratings (RRRs) remains broadly unchanged this quarter. Unsurprisingly, the main changes have been reported in the score of Turkey, Russia and Ukraine where political stability has taken a hit. However, outside these countries our CEE RRRs reflect a degree of stability in the region evidenced by an improved regional average score. Having considerably improved its overall score, Poland has climbed to the top position in our rankings, outperforming Estonia. In turn, Ukraine remains at the bottom of the table - a situation unlikely to improve in the short term.

We believe that the worst is over for the construction industry in the region, after it suffered considerably due to the effects of the global financial crisis. That said, governments in CEE are still cash strapped and securing financing for infrastructure will remain a significant obstacle to project realisation - weighing on rewards scores across the region. In addition, our expectations for construction industry growth are still moderate and the risks of investing in some countries in the region have intensified as a result of corruption scandals and political instability.

Key Views In Our Central And Eastern Europe (CEE) Risk Reward Ratings (RRRs):

  • The region's average score for industry rewards has improved this quarter, with a notable impact in some of the key markets such as Poland whose score improved considerably from 50.0 to 62.5. Poland has become our new regional top market, followed by Estonia and Latvia.

  • Short-term political threats remain a downside risk to ratings for some of the countries, namely Turkey, Russia, and Ukraine.

  • Despite its enormous potential, Russia continues to exhibit severe weaknesses and sizeable risks. The country is no longer among the top three markets in the region and its score deteriorated further this quarter to 57.7. This does not come as a surprise considering the recent events in Ukraine.

  • Ukraine remains at the bottom of our rankings where we expect it to stay in the short-term. The ongoing political crisis will continue to act as a deterrent for private investors. The country registers scores that are below the regional average for all indicators - with a falling country risk score cement its limited appeal.

  • Financing - both public and private - remains a key constraint. However, initiatives such us the Projects of Common Interest (PCI), which was launched by the European Commission (EC) in 2013, provide some hope for the near future.

Poland Newly Acquired Leadership
CEE Infrastructure Risk/Reward Ratings

CEE Risk/Reward Ratings: Political Instability To Weaken Rewards

BMI View: Our ranking table for Central and Eastern Europe (CEE) Risk/Reward Ratings (RRRs) remains broadly unchanged this quarter. Unsurprisingly, the main changes have been reported in the score of Turkey, Russia and Ukraine where political stability has taken a hit. However, outside these countries our CEE RRRs reflect a degree of stability in the region evidenced by an improved regional average score. Having considerably improved its overall score, Poland has climbed to the top position in our rankings, outperforming Estonia. In turn, Ukraine remains at the bottom of the table - a situation unlikely to improve in the short term.

We believe that the worst is over for the construction industry in the region, after it suffered considerably due to the effects of the global financial crisis. That said, governments in CEE are still cash strapped and securing financing for infrastructure will remain a significant obstacle to project realisation - weighing on rewards scores across the region. In addition, our expectations for construction industry growth are still moderate and the risks of investing in some countries in the region have intensified as a result of corruption scandals and political instability.

Key Views In Our Central And Eastern Europe (CEE) Risk Reward Ratings (RRRs):

  • The region's average score for industry rewards has improved this quarter, with a notable impact in some of the key markets such as Poland whose score improved considerably from 50.0 to 62.5. Poland has become our new regional top market, followed by Estonia and Latvia.

  • Short-term political threats remain a downside risk to ratings for some of the countries, namely Turkey, Russia, and Ukraine.

  • Despite its enormous potential, Russia continues to exhibit severe weaknesses and sizeable risks. The country is no longer among the top three markets in the region and its score deteriorated further this quarter to 57.7. This does not come as a surprise considering the recent events in Ukraine.

  • Ukraine remains at the bottom of our rankings where we expect it to stay in the short-term. The ongoing political crisis will continue to act as a deterrent for private investors. The country registers scores that are below the regional average for all indicators - with a falling country risk score cement its limited appeal.

  • Financing - both public and private - remains a key constraint. However, initiatives such us the Projects of Common Interest (PCI), which was launched by the European Commission (EC) in 2013, provide some hope for the near future.

Poland Newly Acquired Leadership
CEE Infrastructure Risk/Reward Ratings

Poland has climbed to the top spot this quarter, considerably improving its score for Industry Rewards. Despite the deep contraction in 2013, we do anticipate growth in the construction sector to return to a higher growth trajectory over the medium term, averaging 5.6% per annum between 2015 and 2018. This growth outlook is driven by an expansion in EU funding for infrastructure, a recovery in the housing market, and a broader economic recovery. In addition, the country's state-owned bank and equity fund has announced plans to boost their investments in the infrastructure sector over the course of this year. Bank Gospodarstwa Krajowego (BGK) has stated that it is looking to lend as much as US$2.6bn to support the government's aim of building infrastructure to bolster economic growth in the country. Equity fund Polskie Inwestycje Rozwojowe SA has also pledged to boost its commitments to the country's infrastructure needs when considering investment over 2014. However, we do hold some concerns on an Industry Risk front, with the country's score for this segment downgraded from 75 to 60 (out of 100), over the past several quarters, based on the ongoing dispute surrounding road contracts

Now in second place, Estonia maintains a strong score. This is because of its strong macro-fundamentals (stronger economic growth following the 2008-2010 recession, lower debt burden than other EU member states and relatively stable political environment), all of which bode well for infrastructure spending. With the lowest level of risk in the region, Estonia scores a solid 71.6 in this category, well above the regional average of 56.0.

Improving Industry Rewards
CEE Infrastructure Risks Vs. Rewards

Heightened Political Risk Weakens Investor Confidence

As evidenced by the recent corruption scandal in Turkey and rising tensions between Russia and Ukraine, we see potential downside risks in the political sphere across Europe. This is relevant for the infrastructure sector because it influences access to finance, risks to public procurement and investor perception. As such, Turkey's deteriorating score has cost the country two positions in our RRRs, landing in eighth place this quarter. This is on the back of allegations of corruption, in addition to the financing headwinds the construction industry is facing as a result of a major depreciation in the lira. This 'perfect storm' of social, political and macroeconomic headwinds has resulted in the deterioration of investor confidence in the market. A corruption probe of unprecedented scale is underway in Turkey, which has seen the detention of dozens of bureaucrats and businessmen within or related to the construction industry with regards to accusations of corrupt practices during the tendering of contracts and the violation of zoning laws.

While the ramifications of the scandal are still developing, what it does bring to the fore are the close ties between construction and politics in Turkey. This renewed emphasis on opacity within the industry will raise serious questions over the value of exposure to such risks for those international investors and construction players who had begun to see Turkish infrastructure assets as an attractive source of revenue since the country gained investment grade status in May 2013.

Indeed, in light of the allegations of illegitimate practices when tendering contracts, we have moved to reduce Turkey's Industry Risks score in our RRRs. Now scoring 5 out of 10 for the indicator 'transparency of the tendering process', putting it on an equal footing with Russia, the downgrade represents serious doubts about the openness of the awarding of contracts in Turkey. As such we expect short-term political risk to weigh heavily on the investment climate, and that Prime Minister Recep Tayyip Erdogan's latest moves will have negative long-term implications for foreign direct investment in Turkey's infrastructure market.

As for Russia, the country's score has deteriorated further this quarter as a result of diminishing industry rewards and exacerbating country risks - which does not come as a surprise given the geopolitical tension derived from the annexation of Crimea in March 2014. Our Country Risk team has recently downgraded Russia's growth outlook on the back of damaged long-term investor confidence. Political uncertainty is keeping a lid on investment and accelerating net private capital outflows. On the macroeconomic front, elevated inflation (on the back of rouble weakness) is eroding private consumption and the central bank's emergency rate hike from March 2014 is bound to have an impact on lending to both households and businesses.

Having said that, we still believe there is strong potential in the Russian construction market. The government has billions of dollars of investment planned, including US$20bn for the 2018 World Cup and US$45bn to fund projects already in the pipeline. With oil prices expected to remain elevated over the short term, the government could potentially fund the majority of these projects. Furthermore, we also expect a strong showing from state banks and development banks such as the European Bank for Reconstruction and Development (EBRD), so funding is not as pressing a problem for Russia. However, our major concern centres around policy uncertainty. In order to attract private investors, guarantees of policy continuity, regulatory certainty and legal protection are needed. Russia is failing to make improvements on this front, with its business environment exhibiting high levels of corruption and red tape.

Romania's score has also deteriorated and the country has lost three positions on our RRR rankings this quarter. This is on the back of weak fixed investment levels which moderated our outlook for the construction industry sector. However, with recovery on the cards for Romania's economy and continued support from multilateral institutions, we should begin to see growth in the construction sector improve over 2014 and beyond, and this will improve the country's score in our rankings. In addition, the government has been making efforts to secure sufficient financing for some infrastructure projects - the country's transport framework (particularly road and rail networks) is among the least developed in Europe. To this end, the EBRD, for example, has finally loaned the Romanian railway operator money to pay off its debts and finance a number of new rail projects.

Promising Growth Prospects
Construction Industry Real Growth %

Limited Access To Funding

CEE was undoubtedly the region that was hardest hit by the global financial crisis, with construction activity effectively falling off a cliff. However, with a regional outlook improving, we believe that the worst is behind the industry and we have turned more optimistic towards the medium term. That said, limited access to financing will continue to undermine the potential rewards of the European market.

The EU sovereign debt crisis capped investment opportunities and the infrastructure sector continues to suffer from lack of financing. Meanwhile, governments across CEE continue to focus on fiscal austerity as state revenues remain depleted. The region's average Industry Rewards score remains below the regional average scores for Middle East and North Africa (MENA), Sub-Saharan Africa (SSA), and North America & Western Europe (NAWE).

In this context, we believe that the EU and European Investment Bank (EIB) will continue to play a crucial role in supporting infrastructure investment in Europe - as evidenced by the Projects of Common Interest (PCI). The EC has outlined 248 priority energy projects, in a move that will create significant opportunities for a wide range of players, including construction and utilities companies. Considering that both public and private financing remains a key constraint for infrastructure projects in Europe, private capital investors should be well placed to take advantage of the numerous opportunities on offer. As such, we believe that the PCI - which will be supported by seed funding from the EIB - creates upside to our RRRs.

Apart from having the support and supervision of the EU, these projects will benefit from having a single national authority responsible for granting permits, which will reduce the administrative costs and accelerate permit approval times - planning and authorisation procedures will be limited to three and half years. We believe that by increasing visibility and speeding up the implementation process, projects will become more attractive to investors. In addition, the improved regulatory conditions should help mitigate some of the risks of operating in certain markets, where a lack of transparency has seen investors flee the country.

Central And Eastern Europe Risk Reward Ratings
Rewards Risks
Industry Rewards Country Rewards Rewards Industry Risks Country Risk Risks Infrastructure BE Rating Regional Ranking
Poland 62.5 78.3 68.0 60.0 65.5 63.3 66.6 1
Estonia 52.5 77.1 61.1 75.0 69.4 71.6 64.3 2
Latvia 55.0 70.4 60.4 70.0 53.9 60.4 60.4 3
Czech Republic 45.0 79.7 57.1 75.0 62.0 67.2 60.2 4
Russia 55.0 62.8 57.7 52.5 61.3 57.8 57.7 5
Slovenia 37.5 80.0 52.4 65.0 64.8 64.9 56.1 6
Hungary 40.0 77.9 53.3 65.0 61.2 62.7 56.1 7
Turkey 50.0 64.4 55.1 70.0 48.9 57.4 55.7 8
Croatia 37.5 73.9 50.2 60.0 61.5 60.9 53.4 9
Kazakhstan 47.5 75.2 57.2 30.0 53.8 44.3 53.3 10
Romania 47.5 67.1 54.4 40.0 55.0 49.0 52.7 11
Bosnia 55.0 66.7 59.1 35.0 38.2 36.6 52.4 12
Slovakia 32.5 71.4 46.1 70.0 63.1 65.8 52.0 13
Lithuania 37.5 74.8 50.5 47.5 55.9 52.5 51.1 14
Bulgaria 40.0 74.9 52.2 35.0 56.4 47.8 50.9 15
Ukraine 30.0 70.7 44.2 30.0 36.7 34.0 41.2 16
Regional Average 45.3 72.8 54.9 55.0 56.7 56.0 55.3
Scores out of 100, with 100 the best. Source: BMI
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