Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

CEE Bond Market Outlook 2012

CEE government bonds provide a reasonable reward to investors at a time when government bonds of the core euro area countries have become extremely expensive and bear very low yields (if any). CEE countries have, in general, a higher threshold for the yields they can afford to pay on their debt, without triggering the debt spiral.
Juraj Kotian juraj.kotian@erstegroup.com Sovereign ratings
S&P Croatia Czech Republic Hungary Poland Romania Slovakia BBBAABB+ ABB+ A Fitch BBBA+ BB+ ABBBA+ Moody's Baa3 A1 Ba1 A2 Baa3 A1

The ongoing sovereign debt crisis in the Euro Area and increased risk aversion dented demand for CEE government securities at the end of 2011. However, we have not seen any sizable sell-off comparable to the postLehman shock. Surprisingly, even Hungary, which lost its investment grade and escalated disputes with the EU and IMF over controversial laws, did not witness any massive sell-off. Governments in CEE6 (Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia) are also to continue in their fiscal consolidation this year and, after the reduction of the deficit from 6.4% in 2010 to an estimated 4.1% of GDP on average in 2011, the deficit is to further shrink to 3.6% of GDP on average in 2012. Interest rates will remain low both in the US and the Eurozone, plus the generous LTROs conducted by the ECB will keep demand for govies strong, especially for short-term securities. The ECBs 3Y long-term refinancing operation has obviously eased tensions in the European banking sector and reduced borrowing costs for governments, not only in the Eurozone, but through improved sentiment also in CEE. Extension of the average maturity of outstanding debt is one of the main reasons why debt agencies in CEE are looking abroad to issue Eurobonds. The average maturity of government securities still remains relatively short in CEE, about four years on average, compared to about 6-7 years for major Euro Area countries. Poland, Romania, Turkey and Slovakia already tapped the foreign markets in January with Eurobonds and syndicated bond issues. The Czech Republic and Croatia could issue Eurobonds soon. The ratings of many CEE countries have been improving in relative terms against the widening group of downgraded Euro Area countries. Given that many funds and insurance companies have investment restrictions based on sovereign ratings, the pool of countries in which they can invest has been shrinking. The Czech Republic, Poland and Slovakia may benefit from their relatively good rating and low level of both private and public debt. Extremely low yields have enabled many advanced countries to stay above water and service their high stock of debt without serious problems. But the turmoil in the Euro Area increased pressure on yield spreads and opened discussion about the yield level, which would still be affordable from the solvency/liquidity point of view. The Czech, Romanian and Slovak governments have the biggest breathing space for spikes in yields among CEE countries.
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Source: Bloomberg

Long-term yields (%)

current Croatia Czech Republic Hungary Poland Romania Slovakia 7.7 3.2 8.8 5.6 7.2 5.1 Dec-2012 7.5 4.0 7.9 6.0 7.2 5.0

Source: Bloomberg, Erste Group Research

Implied critical yields (%) average yield at which the interest costs would exceed 10% of government revenues
16 14
10.7 Romania

12 10

4 2 0
1.8 2.5

3.3

3.4

4.0

4.1

5.0

5.1

5.3

5.6

6.0

6.2

6.9

7.1

7.5

7.7

7.7

8.6

Czech Rep.

UK

Hungary

Turkey

Italy

10.0

Slovenia

10.2

average interest on outstanding debt

United States

Source: EC Autumn Forecasts, Erste Group Research

Find our full set of forecasts in our weekly CEE Insights

Erste Group Research CEE Bond Outlook 2012

Netherlands

Germany

Slovakia

Greece

Portugal

Belgium

Finland

Croatia

France

Austria

Poland

Ireland

Japan

Spain

11.4

implied critical rate

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Juraj Kotian juraj.kotian@erstegroup.com

Supply of government securities in 2012

With the exception of Hungary and Croatia, CEE6 countries have been advancing in their fiscal consolidation. Although there is some slippage in the pace of consolidation compared to their original plans in countries where general elections were held (Poland, Croatia in 4Q11) or will soon take place (Slovakia in March 2012), we have seen decisive action being taken by governments to curb the gap right after the elections (Poland). Governments in CEE6 are also to continue in their fiscal consolidation this year and, after the reduction of the deficit from 6.4% in 2010 to an estimated 4.1% of GDP on average in 2011, the deficit is to further shrink to 3.6% of GDP on average in 2012. The newly-formed the six pack should strengthen budget surveillance and thus make the consolidation process less vulnerable to sudden turnarounds in politics in the years beyond 2012. Fiscal deficit in CEE6 (% of GDP)
10% 9%
7.8%

Fiscal consolidation advances further in 2012

Fiscal deficit 2012F(% of GDP)

10% 9% 8% 7% 6% 5%
4.2% 4.7% 4.8% 3.6% 3.4% 3.4% 3.5% 5.0% 5.9% 5.4%

8% 7% 6% 5% 4% 3% 2% 1% 4.1% 6.4%

4%
3.1% 3.1%

3.6%

3%
2.2%

2.5%

2%
1.0%

1.5%

1% 0% Germany Czech Rep. Ukraine Austria Romania Poland Serbia Slovakia Croatia France Netherlands Hungary Belgium Turkey Spain Italy UK

0% 2011E 2012F 2010

Source: EC Autumn Forecasts, Erste Group Research Treasury funding needs should total EUR 35bn in CEE6 When we translate the deficits into monetary terms under conservative assumptions that governments will not raise money through the sale of state assets, CEE6 governments would need to issue about EUR35bn of new debt in 2012. That is a slightly lower volume than in 2011 and a relatively small portion compared to estimated net issuance in the Euro Area of about EUR 300bn, excluding Ireland, Greece and Portugal, which are under the IMF program. French government securities will contribute about one third of overall net issuance in the Euro Area in 2012. On top of the new debt, CEE6 governments have to rollover redeeming debt worth EUR 72bn (about 8% GDP on average), predominantly in the local currency. A more challenging situation will be the rollover of maturing Italian, Spanish, French and Belgium debt worth 13.5-20.5% of their GDP, where any slippage in fiscal consolidation may be penalized by a reduced rollover, especially by non-residents. Of course, the ECBs generous LTROs will boost demand, but mainly at the short-end.

Rollover of redeeming debt will be challenging mainly in Euro Area

Erste Group Research CEE Bond Outlook 2012

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Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Redemptions in 2012 (% of GDP)

25%
T-bills in LCY T-bonds in LCY FX debt
20.2%

20%
16.1%

15%
10.2%

13.5% 13.9%

10%
5.9% 6.6% 6.8% 7.0% 7.2% 7.4%

7.6%

8.1%

8.3%

9.1%

9.2%

5%

3.0%

0% Hungary Czech Rep. Slovakia Netherlands Germany Romania Belgium

20.7%

Turkey

Ukraine

Austria

Croatia

Poland

Serbia

Spain

Source: EC Autumn Forecasts, Erste Group Research

Hungary, France and Belgium will be watched carefully by markets due to their high gross issuance

In total, we assume the gross issuance of government securities in CEE6 to be EUR 107bn (or 12% of GDP in average). From the perspective of the Euro Area sovereign debt crises, high gross issuance and strong dependence on demand from non-residents represents the major rollover risk. High combinations of these two factors are seen in Hungary and, from the Euro Area, in France and Belgium (if we do not count those countries which are under the IMF program). However, the risks could materialize only if investors lose faith in the fiscal discipline of that country or any global event (i.e. a Greek default) hits sovereign debt as an asset class. Estimated gross issuance (% of GDP)
25%
Redemptions in 2012 Fiscal deficits in 2012
19.2% 19.4% 22.5%

20%
15.0%

15%
11.0% 11.0% 11.5% 9.4%

12.5% 12.7% 12.0% 12.4%

13.3%

10%
5.5%

8.1%

9.0%

5%

0% Hungary Czech Rep. Netherlands Turkey Germany Romania Slovakia Belgium Austria Poland Ukraine Croatia France Serbia Spain Italy UK

Source: EC Autumn Forecasts, Erste Group Research

Erste Group Research CEE Bond Outlook 2012

France

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Italy

UK

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

CEE government will issue Eurobonds in order to extend average maturity

Extension of the average maturity of outstanding debt is one of the main reasons why debt agencies in CEE are looking abroad to issue Eurobonds. The average maturity of government securities still remains relatively short in CEE, about 4 years on average, compared to about 6-7 years for major Euro Area countries. The longest average maturity is seen in the Czech Republic, where inflation is more predictable and the domestic investor base much broader than in countries which still have to liberalize prices (i.e., Romania) or develop their local capital markets.

Average maturity of government securities (years)

12 10 8 6 4 2 0 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011

Average maturity of outstanding government securities (years) Average maturity of outstanding Eurobonds (years)

Romania

Turkey

Hungary

Slovakia

Ukraine

Croatia

Poland

Czech Republic

Slovenia

Source: Bloomberg, Erste Group Research

Poland, Turkey and Slovakia tapped foreign markets in January...

... Czech Republic and Romania will follow soon

Actually, all CEE governments tapped foreign markets with Eurobonds or syndicated loans last year. The Polish government has been the most active; they already placed two new tranches of their existing EUR and USD Eurobonds in January (EUR 750m and USD 1bn, respectively). Romania and Turkey managed to place EUR 1.5bn and USD 1.5bn in 10Y Eurobonds in January, while the Slovak government placed EUR 1bn of 5Ysyndicated bonds in January. The Czech government, for which the supply of Eurobonds has been particularly benign so far, indicated its intention to tap foreign markets in the next couple of months, depending on market conditions. The main reason for foreign issuance would be the diversification of the investor pool and perhaps the further extension of maturity (which is already the longest in CEE), The following chart shows that the Czech Republic gets almost no interest rate discount from Eurobonds compared to locally-issued T-bonds.

Erste Group Research CEE Bond Outlook 2012

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Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Average interest on government securities (%)

14

Average interest on T-bonds (%)

12 10 8 6 4 2 0 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2009 2010 2011 2011

Average interest on Eurobonds (%)

Poland

Hungary

Czech Republic

Slovakia

Romania

Slovenia

Turkey

Croatia

Ukraine

Source: Bloomberg, Erste Group Research

Who is going to buy government bonds?

Foreign demand
No big sell-off comparable to post-Lehman so far The ongoing sovereign debt crisis in the Euro Area and increased risk aversion dented demand for CEE government securities at the end of 2011. However, we have not seen any sizable sell-off comparable to the post Lehman shock. Non-residents in HUF securities (HUFbn)
4500
recent turmoil

4000 3500 3000 2500 2000 1500 Jan-2008 Jan-2009 Jan-2010 Jan-2011 Jan-2012 Apr-2008 Apr-2009 Apr-2010 Apr-2011 Oct-2008 Oct-2009 Oct-2010 Oct-2011 Jul-2008 Jul-2009 Jul-2010 Jul-2011
post-Lehman crisis

Source: AKK, Erste Group Research Erste Group Research CEE Bond Outlook 2012 Page 5

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

ECB 3Y LTRO had positive effect on CEE assets

We expect that the environment of very low interest rates both in the US and the Eurozone, plus the generous LTROs conducted by the ECB will keep demand for govies strong, definitely for short-term securities. The ECBs 3Y long-term refinancing operation has obviously eased tensions in the European banking sector and reduced borrowing costs for governments, not only in the Eurozone, but through improved sentiment also in CEE. CDS on CEE sovereign debt narrowed by about 50-100bp in January and bond yields collapsed further. We expect that there might be some downside risk in the next couple of months, given that the Eurozone sovereign debt crisis is far from resolved and Greek default could hit sovereign bonds as an asset class globally. It is important to mention that the bulk of foreign investors who buy CEE bonds are definitely not banks. The detailed breakdown of non-residents buying holding the CEE government securities has been published only for Polands T-bonds so far. It shows that foreign banks hold only 1/10 of foreign holdings of T-bonds. The foreign insurance companies and funds (mutual and pension) are a far more important player, with an 85% share among non-residents holding Polands T-bonds. Thus, potential deleveraging in the European banking sector should have a very limited direct impact on Polish bonds. Breakdown of investors in Polish government bonds
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Banks Funds Others Banks Funds Others Foreign banks are not the major buyer but funds (pension, insurance&mutual) Domestic investors Foreign investors

Foreign demand for CEE bonds is not dominated by banks, as one would have thought

Source: Ministry of Finance, Erste Group Research

Investment grade matters, country has access to broader pool of investors

High demand from the non-bank financial sector can be associated with relatively stable ratings of many CEE countries which have been improving in relative terms against the widening group of downgraded Euro Area countries. Given that many funds and insurance companies have investment restrictions based on sovereign ratings, the pool of countries in which they can invest has been shrinking. The Czech Republic, Poland and Slovakia (all three with investment grade) may benefit from their relatively good rating and low level of both private and public debt. Size and liquidity speaks in favor of the Polish market. Hungary, due to its recent downgrade to Junk, might lose this large investor group. Croatia has to speed up fiscal consolidation in order not to lose its investment grade (Croatia is at the last notch of investment grade scale with a negative outlook from two rating agencies) Romania is on the edge, given that S&P ranks Romania one notch below investment grade, while Fitch and Moodys keep Romania in investment grade with a stable outlook. An upgrade by S&P would substantially broaden the pool of investors who could buy Romanian debt.
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Erste Group Research CEE Bond Outlook 2012

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Despite huge progress in fiscal consolidation carried out by the Romanian government, an upgrade would be feasible only after Novembers election, if the current course in fiscal policy is maintained. Relative ratings of CEE countries have improved
Czech Rep.

Rating by

Romania

Slovakia

Portugal

Hungary

S&P
AAA AA+ AA AAA+ A ABBB+ BBB BBB-

Fitch
AAA AA+ AA AAA+ A ABBB+ BBB BBB-

Moody's
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3

Investment grade

BB+ BB+ Ba1 BB BB Ba2 BBBBBa3 B+ B+ B1 B B B2 BBB3 CCC CCC Caa CC CC Ca blue/white/red = stable/positive/negative outlook change between Jun 2008 and Dec 2009

Speculative grade

the rating as of mid 2008 change since Jan 2010

Source: Bloomberg, Erste Group Research

Domestic demand
Moderation of credit supply will free up liquidity for bond purchases Domestic demand for government securities will be determined mainly by net increase of deposits over loans and growth of assets under management of mutual funds, pension funds and insurance companies. In past two years the net annual inflow of deposits hovered between 1-4% of GDP in CEE countries. Deposits were primary used for funding new credits in the past, reducing the liquidity which could be invested into the bonds. But given likely moderation of credit supply (due to denting demand and increased regulation), banks can allocate much higher fraction of deposits into the government securities (which consume less capital).

Erste Group Research CEE Bond Outlook 2012

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Ukraine

Austria

Croatia

Greece

Poland

Ireland

Turkey

Spain

Italy

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Annual increase of private deposits (as % of GDP, average 2010-2011)

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Croatia Czech Rep Hungary Poland Romania Slovakia 0.9% 2.1% 1.7% 3.2% 3.0% 4.5%

Source: Central banks, Erste Group Research, adj. for FX moves

About half of net issuance will be financed by non-residents

A non-negligible part of domestic demand for government securities comes from non-banks mutual & pension funds plus insurance companies. However, there are big differences in the market size and thus their relevance. The Czech, Polish and Slovakian markets have the most developed non-bank financial sector in the CEE. It is unfortunate that Hungary has eliminated pension funds from the market by forcing people to return back to the state-run pay as you go and thus cut demand for the longterm. It has done so, especially for those with long maturities. Overall, we reckon that organic demand of domestic financial institutions for government securities should vary between 1.5-2.5% of GDP in CEE, thus financing about one third to one half of forecasted fiscal deficits (net issuance). The rest will be financed by non-residents or from the liquidity surplus which banks have accumulated over past years. What if non-residents do not buy? Governments would need to reduce their cash deficit much faster and shorten maturities to attract more demand from domestic banking, which would need to dig deeper into their pockets and buy govies. Czech, Hungarian and Polish banks have at their disposal excess liquidity worth about 7-13% of GDP deposited in the central bank, which provides enormous breathing space to finance locally issued T-bills and T-bonds. In the remaining markets, banks do not park so much excessive liquidity at the central bank; Slovak banks are even in a net refinancing position.

Czech Republic, Hungary and Poland have enormous buffer to absorb locally issued short-term securities

Erste Group Research CEE Bond Outlook 2012

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Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Net assets of commercial banks in the central bank* (% of GDP, 2011)

14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Croatia Czech Rep Hungary Poland Romania Slovakia -1.4% 0.9% 10.0% 7.8% 13.0%

0.1%

Source: Central banks, Erste Group Research, * adjusted for reserve requirements

Besides committed credit lines, governments can spend their cash, sell their liquid assets and last but not least privatize state-owned assets. Deposits and cash of general government (% of GDP, uncons. 3Q11)
12 10 8 6 4 2.3 2 0 Germany Romania Netherlands Czech Rep. Slovakia Italy Hungary Austria Poland France Spain Belgium Finland 3.6 5.9 4.8 4.9 6.0 6.6 8.0 10.0 8.8 10.6 10.9 11.2

Source: Eurostat, BCR (Dec2010), Erste Group Research But what if demand and supply meet at a high price, causing a debt spiral? What is an affordable interest rate?

Costs of financing and critical rates

Financing costs leveled up in autumn Further escalation of the Euro Area debt crisis also elevated risk premiums on sovereign debt for CEE countries. CDS increased by 100-300bp over the last year for CEE6, however, the absolute level of bond yields for Poland, and the Czech Republic even declined. The reason is that the swap curve in the Euro Area went down and, due to the economic slowdown, the expectations on rate hikes vanished in Poland, the Czech Republic. Hungary, Ukraine and Turkey faced an increase of interest rates and yields,
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Erste Group Research CEE Bond Outlook 2012

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

given that their currencies came under strong pressure and central banks had to tighten their monetary policy (Hungary, Turkey) or sell FX reserves (Turkey, Ukraine) draining local currency liquidity from the market and pushing yields higher anyway. CEE countries are in fundamentally better fiscal position than Euro Area Three years ago, at the peak of the post-Lehman stress, we were advocating that risk premiums on CEE debt are not justified and investors should shorten some heavily indebted Euro Area countries vs. CEE sovereigns. At that time, we argued that the debt level of CEE countries is much lower, not only in the public sector, but also in the private sector. However, extremely low yields have enabled many advanced countries to stay above water and service their high stock of debt without serious problems. But the turmoil in the Euro Area increased pressure on yield spreads and opened discussion about the yield level, which would be still affordable from the solvency/liquidity point of view. Instead of looking at the debt sustainability criteria, which are a function of the nominal GDP growth, primary balance, the debt level and the average interest costs, we have opted to look at the ratio of interest costs on state debt to government revenues, as watched by the rating agencies in their heat maps. Interest costs to tax revenues (2012F)
16%
11.2% 15.3% 2.5% 3.6% 4.0% 4.6% 4.7% 5.2% 5.2% 5.4% 5.8% 6.7%

Heavily indebted countries stay above water thanks to very low yields

18%

14%
9.6%

12%
6.8% 7.2% 7.3% 7.5% 7.9%

10% 8% 6% 4% 2% 0% Euro area

8.7%

12.3%

12.3%

Hungary

Czech Rep.

Netherlands

Germany

United States

Finland

Slovakia

Slovenia

France

Austria

Croatia

Poland

Source: EC Autumn Forecasts, Erste Group Research

Hungary still stays below 10% threshold of interest costs to tax revenues

This simplified approach better explains how much governments feel the pressure from servicing their public debt. Despite the fact that solvency is defined as the ability of the country to repay the whole debt in the long-run, 1 we like Otmar Issings view (the former chief economist of the ECB and one of the fathers of the single currency) that solvency of a sovereign debtor is traditionally defined as the state being able to service its debt by collecting taxes, which is roughly the ratio we mentioned in the previous paragraph. We arbitrarily set the critical level of interest costs at 1/10 of tax revenues That is far from thresholds that would lead to default, but high enough to trigger market fears among investors and cause discomfort for governments with high interest payments. We calculated the implied critical average yield for individual countries at which the interest costs would exceed 10% of tax revenues.
1

FT article on Nov 11 , Moral hazard will result from ECB bond buying
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Erste Group Research CEE Bond Outlook 2012

Romania

th

Portugal

Ireland

Turkey

Greece

Spain

Japan

Italy

UK

16.7%

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Critical rates and the average interest costs (2012F)

16 14 12
7.7 7.7 8.6

implied critical rate

11.4

average interest on outstanding debt

10.0 10.2 10.7

10
6.0 6.2 6.9 7.1

8
4.0 4.1 5.0 5.1

6
1.8 2.5

4 2 0

3.3

3.4

5.3

5.6

7.5

Poland Netherlands

Czech Rep.

Ireland United States Italy

UK

Hungary

Slovenia

Slovakia

Portugal

Greece

Germany

Belgium

Source: EC Autumn Forecasts, Erste Group Research Romania, Czech Republic and Slovakia have biggest breathing space for yield increases, Hungary should avoid financing at 6%+ The critical rates have fallen over the past years for all European countries (the US and Japan, too) as the growth of tax revenues has been lagging behind debt dynamics Mounting debt has increased the importance of the average interest rate at which the debt is financed for state debt. In the case of sudden market turbulence, the debt spiral can be triggered via higher borrowing costs. Fortunately, Romania, the Czech Republic and Slovakia have much higher thresholds of average interest rates on state debt that would put the public finances under heavy pressure and they are more distant from it. Hungary should avoid any heavy financing above 6% in order to stay below the critical rate. It seems that the policy of low interest rates will remain in place in major economies for a while (in the US, the FED said at least until late 2014). We forecast that the ECB will even cut interest rates further, to 0.5% and continue in providing long-term unlimited liquidity through LTROs. That should stimulate demand from T-bills and short-term bonds, keeping the yield curve relatively steep. In CEE, we expect the easing bias to reemerge soon. It seems that the Hungarian central bank does not need to rush into hiking interest rates at the moment (just a couple of weeks ago, about two 50bp rate hikes were priced in) and it might even cut rates to 6.25%, from the current 7%. The Polish central bank is to cut interest rates in the second half to 4%. With the exception of Turkey, inflation eased across the CEE region in the last month of 2011.There is a chance that the Romanian central bank will cut rates as well, but the last rate cut was commented on by the IMF as premature and there are still risks associated with general elections scheduled for November 2012. We forecast the sharpest decline of yields in Hungary (about 90bp), while for other countries we expect the long-term yield to remain flat or even increase (the Czech Republic (+80bp), following the steepening of the yield curve in the Euro Area.

Further monetary easing and generous liquidity provision by ECB might provide temporary relief

Erste Group Research CEE Bond Outlook 2012

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Romania

Finland

Croatia

Austria

France

Japan

Spain

Turkey

Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Conclusion
We think that CEE government bonds provide a reasonable reward to investors at a time when government bonds of the core euro area countries have become extremely expensive and bear very low yields (if any). Despite a successful 3Y LTRO and its positive impact on sovereign spreads both in the euro area and CEE, we see some upward risk for yields in the European benchmarks and a steepening of the yield curve. A global credit event (i.e., a Greek default) or frustration from mounting public debt, higher capital requirements for holding the sovereign debt could have a negative impact on bonds as an asset class worldwide. Fortunately, CEE countries have, in general, a higher threshold for the yields they can afford to pay on their debt. Of the CEE countries, Hungary provides the most appealing interest carry: there is further potential for capital gain, especially after the new program with IMF is agreed. On the other hand, Hungarian public finances are more vulnerable in terms of spikes in yields compared to the other CEE6. We see Polish bonds as still attractive, given the very strong and diversified demand side (between banks and funds). Croatia, which faces relatively high FX redemptions this year, has to speed up fiscal consolidation in order to avoid rising financing costs and a ratings downgrade. Slovakia will remain focused on issuing syndicated bonds this year, with the intention of diversifying the investor group, and will extend the average maturity. In the event of higher volatility on the bond market, Slovakia should benefit from access for its financial sector to the ECBs LTRO and by being more distant from its critical rate compared to its euro area peers. Despite monetary easing, we see Romanian yields as flat. Uncertainty about the continuity of the current course of fiscal consolidation after Novembers elections will prevent Romania from being upgraded, despite the significant progress which has been made under the IMF program. Czech bonds are definitely the most conservative investment out of the CEE6. Czech bonds have the longest average maturity out of the CEE6, with an advanced economic and domestic financial market which enjoys a huge liquidity surplus. The Czech Republic has one of the lowest ratios of interest costs to tax revenues in the EU, comparable to the best AAA in the euro area (Finland, the Netherlands). Nevertheless, we see some upward risks for LT yield increases associated with the steepening of the euro area yield curve. However, in the event of extreme volatility on global bond markets, having the critical rate for average interest costs at 10% (almost twice as high as Germany or the UK could afford) would pay off.

Erste Group Research CEE Bond Outlook 2012

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Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Contacts
Group Research
Head of Group Research Friedrich Mostbck, CEFA Macro/Fixed Income Research Head: Gudrun Egger, CEFA (Euroland) Adrian Beck (AT, SW) Mildred Hager (US, JP, Euroland) Alihan Karadagoglu (Corporates) Peter Kaufmann (Corporates) Carmen Riefler-Kowarsch (Covered Bonds) Elena Statelov, CIIA (Corporates) Macro/Fixed Income Research CEE Co-Head CEE: Juraj Kotian (Macro/FI) Co-Head CEE: Birgit Niessner (Macro/FI) CEE Equity Research Co-Head: Gnther Artner, CFA Co-Head: Henning Ekuchen Gnter Hohberger (Banks) Franz Hrl, CFA (Steel, Construction) Daniel Lion, CIIA (IT) Christoph Schultes, CIIA (Insurance, Utility) Thomas Unger; CFA (Oil&Gas) Vera Sutedja, CFA (Telecom) Vladimira Urbankova, MBA (Pharma) Martina Valenta, MBA (Real Estate) Gerald Walek, CFA (Machinery) International Equities Hans Engel (Market strategist) Stephan Lingnau (Europe) Ronald Stferle (Asia) Editor Research CEE Brett Aarons Research, Croatia/Serbia Head: Mladen Dodig (Equity) Head: Alen Kovac (Fixed income) Anto Augustinovic (Equity) Ivana Rogic (Fixed income) Davor Spoljar, CFA (Equity) Research, Czech Republic Head: David Navratil (Fixed income) Petr Bittner (Fixed income) Petr Bartek (Equity) Vaclav Kminek (Media) Jana Krajcova (Fixed income) Martin Krajhanzl (Equity) Martin Lobotka (Fixed income) Lubos Mokras (Fixed income) Research, Hungary Head: Jzsef Mir (Equity) Bernadett Papp (Equity) Gergely Gabler (Equity) Zoltan Arokszallasi (Fixed income) Research, Poland Tomasz Kasowicz (Equity) Piotr Lopaciuk (Equity) Marek Czachor (Equity) Research, Romania Head: Lucian Claudiu Anghel Head Equity: Mihai Caruntu (Equity) Dorina Cobiscan (Fixed Income) Dumitru Dulgheru (Fixed income) Eugen Sinca (Fixed income) Raluca Ungureanu (Equity) Research Turkey Head: Erkin Sahinoz (Fixed Income) Sevda Sarp (Equity) Evrim Dairecioglu (Equity) Ozlem Derici (Fixed Income) Mehmet Emin Zumrut (Equity) +43 (0)5 0100 - 11902 +43 (0)5 0100 - 11909 +43 (0)5 0100 - 11957 +43 (0)5 0100 - 17331 +43 (0)5 0100 - 19633 +43 (0)5 0100 - 11183 +43 (0)5 0100 - 19632 +43 (0)5 0100 - 19641 +43 (0)5 0100 - 17357 +43 (0)5 0100 - 18781 +43 (0)5 0100 - 11523 +43 (0)5 0100 - 19634 +43 (0)5 0100 - 17354 +43 (0)5 0100 - 18506 +43 (0)5 0100 - 17420 +43 (0)5 0100 - 16314 +43 (0)5 0100 - 17344 +43 (0)5 0100 - 11905 +43 (0)5 0100 - 17343 +43 (0)5 0100 - 11913 +43 (0)5 0100 - 16360 +43 (0)5 0100 - 19835 +43 (0)5 0100 - 16574 +43 (0)5 0100 - 11723 +420 956 711 014 +381 11 22 09 178 +385 62 37 1383 +385 62 37 2833 +385 62 37 2419 +385 62 37 2825 +420 224 995 439 +420 224 995 172 +420 224 995 227 +420 224 995 289 +420 224 995 232 +420 224 995 434 +420 224 995 192 +420 224 995 456 +361 235-5131 +361 235-5135 +361 253-5133 +361 373-2830 +48 22 330 6251 +48 22 330 6252 +48 22 330 6254 +40 37226 1021 +40 21 311 2754 +40 37226 1028 +40 37226 1029 +40 37226 1026 +40 21311 2754 +90 212 371 2540 +90 212 371 2537 +90 212 371 2535 +90 212 371 2536 +90 212 371 2539 Research, Slovakia Head: Juraj Barta, CFA (Fixed income) Sona Muzikarova (Fixed income) Maria Valachyova (Fixed income) Research, Ukraine Head: Maryan Zablotskyy (Fixed income) Ivan Ulitko (Equity) Igor Zholonkivskyi (Equity) +421 2 4862 4166 +421 2 4862 4762 +421 2 4862 4185 +38 044 593 - 9188 +38 044 593 - 0003 +38 044 593 - 1784

Treasury - Erste Bank Vienna

Saving Banks & Sales Retail Head: Thomas Schaufler Equity Retail Sales Head: Kurt Gerhold Fixed Income & Certificate Sales Head: Uwe Kolar Treasury Domestic Sales Head: Markus Kaller Corporate Sales AT Head: Christian Skopek Institutional Sales International Head: Christoph Kampitsch Institutional Sales Austria Head: Thomas Almen Martina Fux Michael Konczer Marc Pichler Institutional Solutions Head: Zachary Carvell Brigitte Mayr Mikhail Roshal Institutional & High End Sales Head: Patrick Lehnert Antony Brown Abdalla Bachu Lukash Beeharry Ulrich Inhofner Margit Hraschek Institutional Sales Germany Head: Jrgen Niemeier Marc Friebertshuser Sven Kienzle Michael Schmotz Sabine Loris Carsten Demmler Jrg Moritzen Rene Klasen Klaus Vosseler Milosz Chrustek Andreas Goll Mathias Gindele Institutional Sales CEE Head: Jaromir Malak Sales CEE Pawel Kielek Piotr Zagan Ciprian Mitu Institutional Sales Slovakia Head: Peter Kniz Sarlota Sipulova Institutional Sales Czech Republic Head: Ondrej Cech Pavel Zdichynec Milan Bartos Radek Chupik Institutional Sales Croatia Head: Darko Horvatin Natalija Zujic Institutional Sales Hungary Norbert Siklosi Institutional Sales Romania Head: Valentin Popovici Ruxandra Carlan +43 (0)5 0100 - 84225 +43 (0)5 0100 - 84232 +43 (0)5 0100 - 83214 +43 (0)5 0100 - 84239 +43 (0)5 0100 - 84146

Fixed Income & Credit Institutional Sales

+43 (0)5 0100 - 84979 +43 (0)50100 - 84323 +43 (0)50100 - 84113 +43 (0)50100 - 84121 +43 (0)50100 - 84118 +43 (0)50100 - 83308 +43 (0)50100 87481 +43 (0)50100 87487 +43 (0)5 0100 - 84259 +44 20 7623 - 4159 +44 20 7623 - 4159 +43 (0)50100 - 84125 +43 (0)50100 - 84324 +43 (0)50100 - 84117 +43 (0)50100 - 85503 +43 (0)50100 - 85540 +43 (0)50100 - 85541 +43 (0)50100 - 85542 +43 (0)50100 - 85543 +43 (0)50100 - 85580 +43 (0)50100 - 85581 +43 (0)50100 - 85521 +43 (0)50100 - 85560 +43 (0)50100 - 85522 +43 (0)50100 - 85561 +43 (0)50100 - 85562 +43 (0)50100 - 84254 +48 22 538 62 23 +43 (0)50100 - 84256 +43 (0)50100 - 84253 +421 2 4862-5624 +421 2 4862-5629 +420 2 2499 - 5577 +420 2 2499 - 5590 +420 2 2499 - 5562 +420 2 2499 - 5565 +385 (0)6237 - 1788 +385 (0)6237 - 1638 +36 1 235 - 5842 +40 21 310-4449 - 59 +40 21 310-4449 - 612

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Erste Group Research Special Report | Fixed Income | Central and Eastern Europe 06 February 2012

Published by Erste Group Bank AG, Neutorgasse 17, 1010 Vienna, Austria. Phone +43 (0)5 0100 - ext. Erste Group Homepage: www.erstegroup.com On Bloomberg please type: EBS AV and then F8 GO
This research report was prepared by Erste Group Bank AG (Erste Group) or its affiliate named herein. The individual(s) involved in the preparation of the report were at the relevant time employed in Erste Group or any of its affiliates. The report was prepared for Erste Group clients. The information herein has been obtained from, and any opinions herein are based upon, sources believed reliable, but we do not represent that it is accurate or complete and it should not be relied upon as such. All opinions, forecasts and estimates herein reflect our judgment on the date of this report and are subject to change without notice. The report is not intended to be an offer, or the solicitation of any offer, to buy or sell the securities referred to herein. From time to time, Erste Group or its affiliates or the principals or employees of Erste Group or its affiliates may have a position in the securities referred to herein or hold options, warrants or rights with respect thereto or other securities of such issuers and may make a market or otherwise act as principal in transactions in any of these securities. Erste Group or its affiliates or the principals or employees of Erste Group or its affiliates may from time to time provide investment banking or consulting services to or serve as a director of a company being reported on herein. Further information on the securities referred to herein may be obtained from Erste Group upon request. Past performance is not necessarily indicative for future results and transactions in securities, options or futures can be considered risky. Not all transactions are suitable for every investor. Investors should consult their advisor, to make sure that the planned investment fits into their needs and preferences and that the involved risks are fully understood. This document may not be reproduced, distributed or published without the prior consent of Erste Group. Erste Group Bank AG confirms that it has approved any investment advertisements contained in this material. Erste Group Bank AG is regulated by the Financial Market Authority (FMA) Otto-Wagner-Platz 5,1090 Vienna, and for the conduct of investment business in the UK by the Financial Services Authority (FSA) and for the conduct of investment activities in Croatia by the Croatian Financial Services Supervisory Agency (CFSSA). Please refer to www.erstegroup.com for the current list of specific disclosures and the breakdown of Erste Groups investment recommendations.

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