East Europe Nations Prone to Default Suffer Lack of Freedoms

For Denis Oleinikov, the breaking point came last September when policemen trashed his company’s offices in Kiev.

The owner of Prostoprint.com, which sells custom goods designed by its clients, packed up his family a few weeks later and moved to Croatia from Ukraine. Authorities pursued Oleinikov after he printed a t-shirt mocking President Viktor Yanukovych. He’s now fighting a legal battle from the town of Porec on Croatia’s Adriatic coast.

“I lost it all,” Oleinikov said in a telephone interview. “If Yanukovych decides to destroy something, that’s not a question of discussion.”

Ukraine has the 13th-worst “democracy score” among 29 eastern European and central Asian nations tracked by Freedom House, a Washington-based group that advocates democracy and human rights. Credit markets are signaling the country has a 45 percent chance of default. Former eastern bloc nations are finding that freedom, the ideal they chose over communism more than two decades ago, is dividing the winners from the losers.

Slovenia, the highest-ranked eastern European nation by Freedom House, has a 23 percent probability of failing to adhere to its debt commitments within five years, credit-default swaps indicate. It is the richest country in the former eastern bloc with gross domestic product per capita of $22,893. Ukraine is the sixth poorest with GDP per head at $3,007.

Default Swaps

“Political freedom and the stability of the political environment have been directly linked to the way they have progressed economically,” said Otilia Simkova, an analyst at Eurasia Group in London.

In Croatia, where Oleinikov now lives, the cost to insure government bonds for five years using credit-default swaps is 539 basis points, compared with 857 for Ukraine and 573 for Hungary. A basis point on a credit-default swap contract protecting 10 million euros ($12.6 million) of debt from default for five years is equal to 1,000 euros a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its agreements.

Ukraine and Hungary are facing threats to their ability to attract international funds as their democratic credentials slip, according to Freedom House. In Ukraine, the pace of foreign-direct investment fell to an average annual pace of $4.7 billion in the past two years from $6.3 billion between 2005 and 2010, according to the statistics office in Kiev, the nation’s capital.

Investment Flows

Total inflows to Hungary since communism ended in 1990 have declined to 65.3 billion euros at the end of last year from a peak of 70.9 billion euros in March 2010, central bank data show.

Russia, Ukraine and Belarus, the eastern European countries with the worst democracy scores from Freedom House, were the lowest recipients of foreign-direct investment per head among 13 former communist nations between 1993 and 2010, according to data compiled by Bloomberg based on World Bank figures.

“It would appear that ‘good politics’ and ‘good economics’ go together,” Alan Rousso, a managing director at the European Bank for Reconstruction and Development, said in a phone interview.

The European Union, which is seeking to stem the rise of authoritarian rule along its eastern border, is battling Hungarian Prime Minister Viktor Orban over laws it says erode the power of independent institutions such as the central bank. The EU also has stalled Ukraine’s drive for closer ties because of the jailing of former Premier Yulia Tymoshenko last year.

‘Democratic Decline’

Hungary and Ukraine are “at the forefront of democratic decline” in eastern Europe, raising “serious questions about the durability” of the region’s young democracies, Freedom House said in a June 6 report.

Orban and Yanukovych “under the pretext of so-called reforms, have been systematically breaking down critical checks and balances,” David J. Kramer, president of Freedom House, said in the report. The trend “has been made easier by Hungary’s particular political circumstances, among them a weak opposition and an illiberal ruling party with an unusual parliamentary supermajority,” according to the report.

Hungary ranks eighth among the 10 eastern European Union members, down from joint fourth place with the Czech Republic as recently as 2008, according to Freedom House. Hungary is “the most glaring example of decline” among Europe’s new democracies, Freedom House said, citing a regression in national democratic governance, independent media, judicial framework and civil society.

Hungary’s Response

The conclusion is “unfounded” and built on argumentation “lacking credibility,” Hungary’s government said June 7 in a statement on its website.

“Freedom House fails to understand that eastern Europe and Hungary require numerous changes and reforms because of faults in the legal framework as a legacy of communism the region left behind 20 years ago,” the government said.

Freedom House was founded in New York in 1941 to advocate democracy and human rights. Its first leaders were Eleanor Roosevelt, the wife of former U.S. President Franklin D. Roosevelt, and Wendell Willkie, who ran for president as the Republican candidate in 1940. The organization lists the U.S. government among its biggest sponsors and has been criticized by countries such as Cuba and Russia for serving primarily American interests.

‘Important Barometers’

In Hungary, Orban, 49, has increased control over independent institutions since he came to office in May 2010. He used a two-thirds parliamentary majority to oust the chief justice of the Supreme Court, narrow the jurisdiction of the Constitutional Court and pass a new constitution.

The European Commission, the EU’s executive body, has started infringement proceedings against Orban’s government, while signs that the government is encroaching on central-bank independence have held up financing talks with the International Monetary Fund since November.

“Those are important barometers for many investors of the investment climate in Hungary,” Blaise Antin, who helps manage $7 billion in emerging-market debt, including Hungarian bonds, at TCW Group Inc. in Los Angeles, said in a telephone interview on May 24. “The risk premium attached is somewhat different than it would be otherwise.”

Fading Relations

In Ukraine, relations with the EU are fading. To protest the jailing of Tymoshenko, the EU indefinitely postponed last year the signing of an association agreement that would have established a tariff-free exchange for a range of goods between Ukraine and the world’s largest trading bloc.

Tymoshenko, a leader of the 2004 Orange Revolution, says Yanukovych backed her seven-year prison sentence to block her from elections this year. While previously insisting Ukraine’s future should be with the EU, Yanukovych, 61, said as recently as May 11 that Ukraine will benefit from a pause in relations with the bloc.

Mykola Tolmachev, chief executive of Kiev-based real estate developer TMM, is finding that potential business partners are being scared away.

“We’re in talks now with Chinese and Slovenian investors about their possible participation in some projects, but they’re afraid,” Tolmachev said in an interview.

To spur investment, Ukraine adopted anti-corruption legislation last year, introduced a new tax code and made it easier to register companies, Yanukovych said Feb. 24.

‘Managed Economy’

In neighboring Russia, foreign companies battle corruption and political meddling in the legal system, when seeking to gain a foothold in the world’s largest energy exporter, said Edward Mermelstein, a New York-based attorney who has represented Russian investors in the U.S. and the U.K. as well as western clients doing business in Russia for 19 years.

“Russia is a managed economy and managed politically as well, so who gets to succeed is determined by the current administration,” Mermelstein said in telephone interview.

Russia has the sixth-worst democracy score among eastern European countries, according to Freedom House, which classes it as a “consolidated authoritarian regime.” Russia is one of 47 countries Freedom House ranks as “not free” among the 194 nations it tracks globally.

Capital Flight

Capital flight from Russia reached $42 billion in the first four months of 2012, compared with $80.5 billion during all of last year, which was the second-highest amount since the central bank started keeping records in 1994.

Outflows are tied to Russian banks’ needs to meet creditor obligations in outside countries and a move out of the emerging markets by global investors, central bank Governor Sergei Ignatiev told lawmakers on May 16.

Russia’s dollar-denominated RTS stock index has declined 7.2 percent this year, compared with the 0.5 percent decline of the MSCI Emerging-Markets Index.

While Russia defaulted on its debt in 1998, its credit- default swap spread at 245 basis points give a 16 percent chance of the country not meeting its commitments to its creditors within five years. An almost fivefold jump in Urals crude since 2000 swelled state coffers, helping squeeze government debt to 9.6 percent of GDP by the end of 2011.

Ikea AB, the world’s biggest home-furnishings retailer, suspended expansion in Russia in June 2009 after local officials withheld permission for two outlets in the cities of Samara and Ufa. The Swedish company had invested $4 billion in Russia over 10 years.

‘Quite Some Concerns’

Vladimir Putin, who was elected president for a third term in March, said he aims to boost labor productivity, add 25 million “high-quality” jobs and push Russia to 50th from 120th in the World Bank’s Doing Business ranking by 2015.

“In Russia, we have quite some concerns about the accountability of political, economic and legal institutions,” Kai Stukenbrock, a Frankfurt-based director at Standard & Poor’s (SPY), said today, adding that this is holding back the country’s BBB sovereign-credit rating. “Corruption is an issue, the business climate, the investment climate -- these are all issues. There is still not a decisive drive to tackle these.”

Putin wants to consolidate his power following the biggest street protests in more than a decade against alleged fraud during December’s parliamentary elections, said Michael Ganske, head of emerging-market research at Commerzbank AG in London, in a phone interview.

Putin’s Priority

That’s his priority rather than making Russia more attractive to foreign investors or reducing the nation’s dependence on revenue from natural resources, Ganske said. Russia relies on oil and gas sales for about 50 percent of its government revenue.

The biggest drag on foreign investment is “the rule of law issue and the next most important part is the political factor,” Ganske said.

While a freedom deficit may be holding Russia back, economics Nobel laureate Joseph Stiglitz said China shows the relationship between democracy and development isn’t linear.

“There was a view that democracy is necessary and sufficient for strong economic growth,” Stiglitz said in Vienna on April 26. “Now the question is viewed in a more nuanced way. China is very successful in its economy and I don’t think that anybody would say that it’s fully democratic. The relationship between the two is far more complex than some of the critical rhetoric would have it.”

China Standout

Communist China surpassed Japan as the world’s second-largest economy in 2010, helped by investment from companies such as Germany’s Volkswagen AG (VOW) and the U.K.’s Tesco Plc. (TSCO) Companies have overlooked concerns by watchdog groups about human rights violations and instead been lured by the prospect of doing business in a country of 1.3 billion people.

New York-based Human Rights Watch called on the EU in February to speak out against “the Chinese government’s widening attacks on freedom of expression, human rights defenders, civil society activists, and government critics.”

China received about 20 percent of all foreign-direct investment in emerging markets during the past decade, according to the World Bank.

In Slovakia, where autos account for more than a fifth of exports, foreign investment jumped 21 times since Vladimir Meciar was ousted in 1998 after dominating the country’s politics for almost six years. Meciar was criticized by investors and international organizations for cronyism and suppressing human rights.

Foreign-direct investment in Slovakia totaled $47.2 billion at the end of 2010, compared with $1.8 billion 12 years earlier, central bank data show. Volkswagen bought its first factory in Slovakia in 1991 and plans to add 1.5 billion euros in the next five years to 2.1 billion euros of investment so far as the company manufactures a record 400,000 cars this year in the country.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

To contact the editor responsible for this story: Balazs Penz at bpenz@bloomberg.net

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