For over a decade Central and Eastern Europe has enjoyed a stunning boom, with several economies achieving double-digit GDP growth in 2006. By the beginning of 2008, however, it seemed impossible for that growth to continue at anything like the same rate. The global credit crunch threatened to choke the supply of finance that has paid for the inflow of Western investment into the region; and the related decline in real estate prices looked set to undermine the industry that had been the main fuel of the region’s growth for several years.
Although the glory days are almost certainly over, it’s looking likely the region can weather the storm better than expected – and probably better than its more developed Western neighbours. With the exception of the Baltic states – where a largely real estate-dependent boom has come to a crashing halt, and high inflation has extinguished consumer demand for manufactured goods – most regional economies continue to grow steadily so far. “Across most of the region you’re still seeing average growth rates of between three and seven per cent,” points out Dorothy Hansberry-Biegu´nska, partner at Wardynski & Partners in Poland. This is still enough to make France or Germany jealous.
CEE, she notes, retains some significant advantages over the rest of Europe. “Labour costs are relatively much lower across the region.We’re a large, still quite untapped market – Poland alone has over 38 million people.We have good, skilled managers and a good understanding of Western economic systems.”
There’s no question that the global “credit crunch” has tightened the spigot of finance for investment. But many banks are sticking with the region. Andriy Grushyn, partner at Okhrimchuk Grushyn Khandurin in Ukraine, works with a range of UK and Continental banks including BNP Paribas, ABN AMRO and Deutsche Bank on financing for local projects. “Each bank sees the situation in Ukraine in different ways,” explains Grushyn. “Some have become more cautious and have begun requesting more security. But those banks who have been operating in Ukraine a long time know the biggest Ukrainian holding companies quite well. They know their credit ability, their reputation, and they’re comfortable putting significant funding into the region.”
The drivers of growth
Real estate has been central to the growth of recent years, but declining property prices, combined with the credit crunch, have frozen development in much of Western Europe. In CEE, too, the crunch has now begun to bite. “We’re feeling it more and more every day, particularly in the real estate field,” says Roman Marchenko, partner at Ukrainian firm Ilyashev & Partners. “Some developers are beginning to sell suburban residential projects at cost price, because no one is interested in them and they need cashflow for new projects. Citizens can’t get credit, and they read every day that prices are going to keep going down, so of course no one wants to buy.” Developers have been lobbying the government to offer assistance to banks to help them return lending to pre-crunch levels.
Fortunately, the effects are less intense for commercial properties. “Kyiv has a shortage of good office buildings, compared to any other Eastern European capital, so rents remain high and projects continue,” says Marchenko. In fact, though, commercial projects have proved resilient to the credit crunch across CEE. Costin Taracila, of Allen & Overy’s Romanian ally Radu Taracila Padurari Retevoescu SCA, recalls that “at the end of 2007 some of the real estate financings we were working on were put on hold for a few weeks, but they were all soon reactivated. Two months ago we received nine new financing instructions in one week.” Western European banks like National Bank of Greece and UniCredit, as well as the EBRD, continue to finance projects in the country.
In addition, foreign investors continue to eagerly eye investment opportunities in the region across a range of industries. Take retail, for example. “Most national retail chains in Ukraine are either up for sale, being looked at by private equity funds, or considering IPOs,” says Andrew Mac of local firm Magisters. It’s too early to tell how the current high food prices, if sustained, will affect the sector, but they have been a boon to the food industry, which is generating a lot of interest from investors. Ukraine’s largest juice manufacturer, Sandora, was bought out by PepsiCo last year. The soft drinks giant paid $542 million for 80% of the firm. This year, Andrew Mac predicts, sugar and meat businesses will attract the most attention.
With wage levels a fraction of those in Western Europe, manufacturing companies continue to move operations to the region. Automotive companies, in particular, have been racing to set up shop, leading to the region gaining the nickname “the new Detroit.” Fiat recently opened a factory in Poland; Volkswagen manufactures its popular Polo model in Slovakia, and Peugeot also runs a factory there. Even the high-tech sector is moving to the region: according to a recent report, the electronics manufacturing market in Eastern Europe will grow from about $9 billion in 2006 to nearly $24 billion in 2013.
With the price of a barrel of oil still hovering above $100, energy companies and projects are attracting a lot of attention from foreign investors – including some within the region. The Czech fund PPF Investments, for example, has been active across South-Eastern Europe recently acquiring private energy businesses set up by entrepreneurs several years ago, such as Gaz Sud, a Romanian private gas distributor. “Energy is the star of most big transactions in Romania,” says Catalin Baiculescu, co-managing Partner of Romania’s Musat & Asociatii. “Right across the sector, everyone wants a piece of the action.”
Those jurisdictions with more developed markets also have new investment to look forward to in the area of renewable energy. EU and non-EU states in the region have initiated subsidy schemes for renewable energy that have provided a fillip to investment. “Poland put a system in place for supporting renewable energy in 2006, and a healthy market sprang up immediately,” says Jaime Fuster, head of the Warsaw office of Spanish firm Garrigues (for more information on governmental support schemes for renewable energy, see feature, issue 24). The government has expressed support for biofuels, but the current priority for investors is wind energy. “Investors have been reluctant to invest in biofuels so far, but have been enthusiastic about wind,” explains Fuster. The government’s aim is for a tenfold increase in wind capacity in Poland by 2012, making it “a top priority for infrastructure investors.”
…but obstacles remain
Of course, while CEE offers plenty of opportunities for investors, it also presents obstacles. Across much of the region, legal frameworks remain outdated and in need of reform. In Ukraine, points out Andrew Mac, “there are no substantive rights for minority shareholders, and there are some arcane, formalistic provisions that make it hard for investors with a slim majority to act – for example, in a joint stock company, it takes 60% plus one share to convene a shareholder meeting.” The recent political turmoil in the country – 2004’s “Orange Revolution” has been followed by ongoing wrangling between coalition partners – has slowed progress further. “The ‘grand coalition’ has been a grand disaster,” said one partner at a Ukrainian firm.
PPP law is a classic example of the ways inadequate legislative reform can pose an obstacle to the development of a market. Poland and Ukraine are joint hosts for the Euro 2012 football championship, and are looking forward to billions of euros in investment in infrastructure. But preparations are seriously behind schedule. “Investment is needed across the board: in highways, railways, urban transit, refurbishing of airports,” says Jaime Fuster. “As the tournament draws nearer, there will be services contracts too, from parking to cleaning to water supply.”
Many of these projects will be supplied on a PPP basis. But Poland’s overcomplicated new PPP law is proving an obstacle to investment. “The new framework for PPP came into force in October 2007,” explains Jaime Fuster. “But the new law has so many requirements for consultation and feasibility studies, no one’s been able to put together a project that fits the requirements. The few projects that have been initiated since have been put together under the procurement laws, which date from 1994.”
In Ukraine, the government has yet to agree a new PPP framework at all. “We have seen some large development projects, but nothing like the boom we were hoping for, because of the red tape,” says Andrew Mac. “There has been talk of expanding Kyiv airport for five years, but nothing has been agreed for a variety of political and legal reasons.” Upgrade of the country’s creaking soviet infrastructure is badly required. “Most Ukrainian highways are not up to international standards. It will take a major effort and billions in investment to modernise them before Euro 2012. The same applies for the railways.” A draft law is now being discussed which, while far from perfect, will hopefully allow projects to begin. “It repeats some of the mistakes of the previous law, but it does close some of the loopholes and should make the process clearer,” says Radmila Hrevtsova of the Kyiv branch of Russia’s Liniya Prava.
The key driver of reform in the region, of course, is the EU. The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia – along with Cyprus and Malta – underwent significant harmonisation of their legal frameworks prior to joining the Union in 2004.“Most of Poland’s reforms were actually completed in the 1990s, in anticipation of becoming an EU member,” explains Dorothy Hansberry-Biegunska at Wardynski & Partners. “For example, long before we joined the EU Poland had a competition framework based on European law, so our competition rules and enforcement procedures are now well established.”
The same process that took place in Poland in the 1990s – where countries not yet formally in the EU accession process nevertheless undergo reform in anticipation of it – is now functioning in Ukraine. “About 60% of our legislation is at EU standard,” estimates Okhrimchuk Grushyn Khandurin’s Andriy Grushyn. Ironically, much of the progress in recent years was actually made prior to the pro-European Orange Revolution, under the former regime of Leonid Kuchma – with new civil, commercial and customs codes adopted. “Ukraine became a much more business-friendly place in the last few years of the Kuchma regime,” says one partner at a Ukrainian firm.
Some of the more politically difficult reforms, however, have fallen victim to the country’s institutional deadlock. “One area where reform is badly needed is taxation,” explains Radmila Hrevtsova of Liniya Prava. “Our current tax burden is too high, and too complicated.” Ukraine’s current system has low income taxes for employees, but places a high burden on employers, who pay a 37% social insurance charge. In addition, says Hrevtsova, corporate governance regulations need simplification. “Registering a company currently means notifying six different authorities. There’s been much talk of setting up a single body to deal with all registration documents, but nothing has so far been done.” The World Bank’s Ease of Doing Business Index ranks Ukraine 139th in the world, behind Uzbekistan, Lesotho and Morocco.
Of course, membership of the EU has proven to be no magic bullet for reform. While the “class of 2004” are generally considered to have completed the required reforms before joining the Union, many feel that Bulgaria and Romania, admitted in 2007, were allowed in before the reform process was complete.
In fairness, the basic legislative frameworks in Romania and Bulgaria have come a long way in a short time. “In most areas, we’re fully aligned with the EU,” says Catalin Baiculescu. “Everything an investor sees in Poland or the Czech Republic, they see here.” Perry Zizzi heads up Romania’s Badea Asociatii, who recently joined an association with Clifford Chance. “You can start a business here in five days, significantly faster than in Western Europe,” he says. But in two particular areas – judicial reform and corruption – the EU has deemed progress insufficient. In July, Bulgaria was stripped of millions of euros in EU funding by the European Commission for failing to properly stamp out corruption in government. Romania was also criticised.
“Harmonisation is essentially complete, but corruption remains a major problem in Romania,” says the managing partner of one local firm. “We don’t have government clients, for example, because it’s common knowledge you have to offer bribes to officials to get that work.” The country’s leaders, far from fighting corruption, appear to be focused on undermining efforts to combat it: an investigation into ten former ministers was blocked by the country’s parliament, and a recent attempt to move the head of the country’s anti-corruption body to Brussels has been seen as a deliberate bid to undermine its effectiveness.
More progress has been made, however, in reforming the country’s courts. “Judges in Romania are not perfect – they aren’t anywhere,” points out Catalin Baiculescu. “But our judges have benefited from a range of new training schemes, and the courts system itself has been improved by new IT systems.” New infrastructure in the country’s national courts allocates cases to judges automatically, “so it’s no longer possible to influence which judge will hear your case.” In addition, IT-based tracking allows public access over the Internet to court records. “Things are much more open now.”
In those states that entered the EU in 2004, corruption is seen as less of an issue. “If you’re going to have a market economy, you have to have transparency,” says Dorothy Hansberry-Biegunska. “This was recognised in Poland early on, and many important reforms were carried out in the 1990s.Where people do complain about public administration, it’s about the formalistic nature of some administrative and judicial proceedings, and the length of time they take.”
For those states still waiting to begin EU accession, however, there is much work to be done. “One reform we badly need in Ukraine is a real effort to tackle corruption,” says a partner at a Kyiv firm. “There’s very little serious effort to do so even though everyone knows it’s rampant from the top of the government down.” It’s a side-effect of the country’s underdeveloped democratic system. “We need an election finance law so that those public officials who don’t want to take bribes – and there are many of them – can go out and campaign and get support and fund their elections another way.”
Knowing the risks
Ultimately, low labour costs and a vast potential consumer market should ensure Eastern Europe remains a vital destination for investors over the next few years, ensuring a busy time for the region’s law firms. “The simple fact is that, as long as you take into account the risks and mitigate them effectively, you can do very well here over the long term,” says Andrew Mac. “There’s a huge amount of inefficiency in the market to be remedied. A few years ago retail was mostly open-air markets, now there are both Western and local hypermarket chains. There are a host of areas ripe for that kind of change.”