Risk premiums in Central Europe during the Covid
Les Nemethy and François Lesegretain look at risk premiums in the four countries of Visegrád (V4) during the Covid era.
The risk premium can be defined as the interest rate differential payable on the bonds of a particular country compared to the least risky country. Usually, the 10-year bond rate is used as a basis for comparison. For decades, the risk premium of all currencies in the world has been measured against the US dollar. More recently, European countries have started to calculate their risk premiums against the yield of German bonds, the least risky European country, with an AAA credit rating.
Usually, in times of crisis, there is a flight to safety. Investors, fearing the worst, invest more in the least risky countries; therefore, the interest rate premium in high-risk developing countries becomes higher.
This means both that (a) a higher interest rate is needed to keep lenders interested in investing in developing countries and (b) that the cost of capital increases in developing countries. It is the same “cost of capital” that underlies company valuations.
Because the so-called discounted cash flow valuation method discounts future capital flows to a net present value, the higher the cost of capital, the lower the value of businesses. For example, in past financial crises, the value of companies on stock exchanges in developed countries has fallen, but the value of companies in developing countries has generally fallen much more, on average. A similar phenomenon exists of course for private companies but is less visible since they are not listed on the stock exchange.
One would have expected risk premia to increase in developing countries and V4 during the covid crisis of 2020. Let’s look at the evidence.
According to countryeconomy.com, major trends show that risk premiums have increased in the Czech Republic, relative to Germany, but have fallen considerably in Poland and a little in Hungary (data for Slovakia no. were not available).
This contrasts sharply with the 2008-2009 crisis, where the risk premium for Hungarian 10-year bonds was 10% higher than German bonds.
It is also interesting to note that, according to an analysis by PwC, overall there appears to have been a larger increase in risk premia in developing countries than in Central Europe.
While in the first quarter of 2020, risk premiums increased on average only 0.5% in Europe, they increased by around 2.7% in North Africa and the Middle East (MENA ), according to PwC. Some emerging markets are likely to have lower fiscal capacity to respond to the shock (less ability to spend to recover from a crisis, delayed access to vaccines, etc.); they are therefore more vulnerable to a general economic slowdown.
Central bank effect
It is not necessary to look far for an explanation of the behavior of risk premiums. The European Central Bank (ECB) has had a significant effect in mitigating the severity of the COVID-19 crisis, through quantitative easing. The ECB also announced the creation of the Next Generation EU (NGEU) fund, a huge budget of 750 billion euros.
Even though the NGEU is only in the early stages of disbursement, the wait for this stimulus has also had an effect on the dynamism of the markets. As the graph below shows, European GDP is expected to rebound fairly well in 2021.
The allocation of the EU Recovery Fund or the NGEU instrument remains very favorable to EU member countries of Central and Southern Europe. Around 20% of NGEU grants and guarantees are expected to go to this group of countries, while their share of EU GDP stands at just under 10%. This is good news because the region clearly benefits from elements of redistribution within the NGEU.
It should be borne in mind that, alongside the NGEU, there has been a decrease in subsidies and guarantees intended by the EU for the EEC region, from 100 to 80 billion euros, which still represents some 6 to 7% of regional GDP for 2020. The net effect remains very positive for the region.
In conclusion, COVID-19 has not been catastrophic for the risk premium and cost of capital of Central and Eastern European countries. The ECB (like the US Fed) was much more stimulating than during the 2008 financial crisis, which had a beneficial effect on reviving economic growth and reducing risk premiums.
However, there is no free lunch: as discussed in previous articles, the massive level of stimulus in the developed world, including Europe, could lead to a period of inflation or stagflation. Central banks have been successful in reducing short-term risk premia. But will the stimulus lead to inflation? The jury is still out, but chances are it will be more than transient.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance company. A former global banker, he is the author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.
This article first appeared in the print issue of the Budapest Business Journal on September 10, 2021.