Afraid of Euro Break-Up? Buy Eastern Europe Debt

While periphery euro zone countries are drowning in a sea of debt and investor reluctance, Eastern Europe — which two years ago sent shockwaves through markets — is now shining away from the limelight.

Bruno Morandi | Robert Harding World Imagery | Getty Images

Some of the countries in the region needed aid from the European Union and the International Monetary Fund, but the amounts were peanuts compared with the bailouts now needed for the weaker euro zone countries.

All, with the exception of Poland, went through deep recessions, soaring unemployment and merciless cuts in government spending, but managed to come out on the other side in much better shape than the euro zone's weakest members, according to analysts.

"I would say that the return of investment in the region is positive news, it creates much better growth potential," Juraj Kotian, the co-head of macroeconomic research at Erste Group, told in a telephone interview.

Already a year ago, credit default swaps (CDS) — or the cost of insuring against default — for Eastern European debt were much cheaper than those of peripheral euro zone economies, while rating agencies still maintained high ratings on the latter.

In the meantime, agencies have slashed the ratings for euro zone countries such as Portugal, Ireland, Greece and Spain, but have been slower to increase ratings for Eastern Europe.

Romania, for instance, is still rated below investment grade, or "junk," but its CDS are 200 basis points, while investment-grade-rated Portugal's hover at around 500 basis points. Greece's rating has meanwhile come down below Romania's and a recent report ranked its debt as the riskiest in the worldfor the second time in a row.

Markets One Step Ahead

"I think the current trend in rating downgrades shows that markets are one step ahead of rating agencies in assessing risk," Kotian said. "We expect rating upgrades (for Eastern Europe) towards the end-year, beginning of the next year."

Romania's current account deficit narrowed from 13 percent when the crisis hit to 5 percent in only two years — at the cost of painful unemployment and a severe economic contraction.

But now the country is less dependant on external funding, and it will start growing again, according to Kotian.

"Romania strikes us as particularly under-owned — net portfolio inflows since 2004 stand at only 2 billion euros ($2.8 billion), though this has been concentrated over recent quarters," analysts from UniCredit wrote in a market note.

The government is committed to continue the reform, and the IMF estimates that only "marginal measures" are needed to bring next year's budget deficit to 3 percent of gross domestic product, UniCredit said.

Hungary —once in the eye of the storm — has probably made the most progress, both on cutting spending and on reducing its current account deficit, Kotian said.

And for investors looking for German exposure without the euro risks, Czech government bonds are a good solution, he added.

"If they're looking for a safe haven and they're worried about the break-up of the euro area, they should go to the Czech Republic, which is a very good proxy for Germany, without the euro," Kotian said.

In Central and Eastern Europe, companies are "significantly less indebted" and more profitable than in Western Europe, according to research from Erste Bank, which also shows that Ireland, Spain, Portugal and Belgium have the most indebted corporate sectors.

Among the main headwinds facing Eastern Europe are the danger to exports posed by a weakening euro area — exposure faced especially by the Czech Republic and Slovakia, which are big exporters — and high oil prices, according to Kotian.

The region is also likely to suffer in the event of a reversal of the risk-on trade, when investors decide to pull out capital from the countries and assets perceived as higher risk, UniCredit analysts warned.

"Poland and Turkey have already seen more than their fair share of short-term capital inflows," they wrote. "Poland and Turkey stand out as the two countries that are most vulnerable in terms of an outflow of capital in the event of deterioration in risk appetite globally."