The past few weeks have been rocky for the international financial markets. The turmoil began with a panic in China, with rumors that authorities would take steps to slow speculation in the stock market. Those concerns subsequently blew over, long enough for fears about the US “sub-prime” lending market to take over. While investors do not anticipate heavy-handed moves in China, the possibility of sudden decisions remains in the back of minds, particularly after the start-stop capital controls in Thailand and the rumors of controls in Vietnam.
The main anxiety at present is the American sub-prime market, where lending to borrowers with poor credit histories has expanded in recent years. The worry is that rising delinquencies will feed into the broader economy through the following two indirect channels (along with the obvious direct channel of contraction in this sector): either lenders will be forced to foreclose on properties, leading to a glut of forced sales at a time when the resales market is already struggling; or investors will sell asset-backed securities which have these risky mortgages as underlying collateral, and this will weaken the balance sheets of commercial banks, and cause ripples across other parts of the credit markets.
It would be unwise to deny the possibility that problems in this relatively-small sub-sector could cascade and cause severe problems, particularly if it is discovered that fraud has been involved, or if regulatory oversight has been lax. When individuals such as former Federal Reserve Chairman Greenspan highlight this risk, one should take notice. Nonetheless, the probability of an economic calamity is modest. There are indeed calculable areas of spillover, but all things considered, the sub-prime market is relatively isolated. Moreover, its delinquencies have always been high, typically in a range of 10-13%. The rate is currently close to the top of the range and may rise a little more.
However, a rise from 12% to 15% would be less dramatic than a rise from 3-4%, the current delinquency rate on conventional mortgages. Lending standards on conventional mortgages have been stable in recent years and employment prospects remain sound – the unemployment rate, 4.5%, is close to the lowest level in six years. Poland’s jobless rate is more than three times higher, for reference. Therefore, it would be a stretch to predict a rapid deterioration in traditional mortgages, particularly as there is no history of opportunistic defaults by US homeowners.
In any event, the economic and social ramifications are likely to be muted, except for the few specialized lending institutions which will either consolidate or fold. Many borrowers will be forced out of their houses, but their equity losses will be limited because a feature of sub-prime mortgages is “little money down.” They will be forced to downscale out of the unconventional ownership market and back into the conventional rentals sector, but aside from losing the dream of owning one’s own home, there needn’t be significant fallout. In fact, one of the major transitions within the housing economy could be that weakness in the resales market translates into unexpected strength in rentals.
For the emerging markets, the main spillover is on the stock and foreign exchange markets, which have become fragile and volatile. Parallels with the US are few and far between. Many emerging markets have sub-prime-type lending sectors, but in countries such as Russia, high non-performing loan ratios on point of sale or revolving credits (which are generally modest in size) are a given and interest rate premiums duly compensate for non-payment risk. Risk management in emerging markets has also evolved very quickly.
Another distinction of the American sub-prime home loan market is that growth has occurred in the context of a very mature financial system, whereas in emerging markets, the systems are still evolving. For example, the retail loan to GDP ratio is 12% in Poland, compared with the European average of 62%. Separately, higher-risk loans in emerging markets are often extended to individuals outside the banking system. By contrast, only “prime” borrowers are eligible for mortgage loans (the economies are not sufficiently evolved for a sub-prime mortgage market to exist). As a result, for these and other reasons, the same type of credit market panic is difficult to envision in emerging economies.
In Poland, the legacy of the economic transition is a high level of non-performing loans, but most of the major banks are in the hands of large foreign institutions, which are well capitalized and generally conservative. Bank lending growth has been relatively high, but not nearly as explosive as in the Baltics, for example, and there are no signs of tension. The NPL ratio is about 7%, compared with close to 15% in the late 1990s, and the capital-asset ratio is a comfortable 14.5% on average.
As the figures below demonstrate, the international volatility has spread to Poland and particularly to the companies which conducted share placements late last year. Despite the hype which has followed the Eastern European IPO market, it is noteworthy that two of the three remain close to the initial offering price. (Separately, the steel company Zlomrex issued an EUR 170 million Eurobond two months ago, with a coupon of 8.5%, and it has steadily drifted below par). The outlier is Cinema City, which seems to have been the fairest priced of the three, at least as far as investors are concerned. In addition, Cinema City now seems to have better growth prospects than was earlier expected. The development of international-standard shopping malls in Western Ukraine will likewise give it cross-border expansion possibilities that many hadn’t anticipated.
Year to date, the Polish stock market (as measured by the WIG index) has risen by 7.3% in US dollar terms, which compares with a 2.8% decline for the US , and 4.7% decline for the Russian market. Last year, the WIG index climbed by 39.8%. However, one should consider 2006 the outlier rather than the norm and a product of especially benign international conditions. If not for those external factors, it is likely that a rally closer to 10-15% would have occurred. An important conclusion is that external factors have been more relevant to stock market performance than domestic factors, which given the political anxieties and public bickering, among politicians and with the central bank, was undoubtedly bearish. Moreover, Polish economic growth, at an average of 4% over the past five years, is healthy but below the outcome of the other major Central European economies, which have expanded by 0.3-1.6 percentage points more. Politicians would therefore be unwise to measure perceptions of their performance by market performance. At the same time, though, investors should not use political uncertainties as an excuse or reason to stay away from the market. The present international market turmoil may last for another 1-2 months, but for the full year, a rise of close to 20% should be in prospect. Given that most of this return will occur in the second half of the year, this implies respectably benign conditions from the summer onwards.
Richard Segal
