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East Europe to Benefit as ‘Neighborhood Risk’ Wanes, Citi Says

East European assets, worst hit by the euro region debt crisis, are bound to outperform as investors return to emerging markets and “neighborhood risk” diminishes, Citigroup Inc. said.

“Central and eastern Europe was home to the world’s worst-performing currencies in the second-quarter sell-off, so the recent return of risk appetite in global markets could see” the region’s “asset prices do particularly well,” David Lubin, Citi’s London-based head of emerging markets, wrote in an e-mailed note today.

The Hungarian forint was the world’s worst performer in the second quarter, sliding 6.7 percent against the euro, followed by the Polish zloty, which lost 6.6 percent and the Romanian leu, with a 6.2 percent decline. Since June 30, the region’s currencies have made some of the biggest gains globally, led by the Czech koruna, the zloty and the leu as appetite for riskier emerging-market assets has returned.

The former communist countries of Europe and Central Asia are recovering from their deepest recessions since switching to free-market policies two decades ago. The growth outlook in the euro area, the largest export market for most of eastern Europe, damped recovery prospects as the 16 countries sharing the common currency grapple with a sovereign-debt crisis.

Easing Concern

Demand at recent auctions of Greek, Spanish and Portuguese debt and a report that showed European economic confidence rose to the highest in more than two years eased concern that Europe’s debt crisis may derail the recovery.

That helped European stocks rally this week and pushed German 10-year government bond yields to near their highest in more than two months, signaling increased willingness to buy risky assets.

Euro-area governments are in the process of approving a 750 billion-euro ($981 billion) financial-stability fund designed to boost confidence in the single currency and support euro members in need of funds. Since the euro-area rescue was announced on May 10, the euro is up 2.3 percent against the dollar. The euro has lost 14 percent against the dollar since a Nov. 25 high.

Emerging-market stocks climbed for an eighth day, currencies strengthened and government borrowing costs fell today. The MSCI Emerging Markets Index advanced 0.3 percent to 993.57 at 12:57 p.m. in London, extending the longest stretch of gains in five weeks.

‘Disproportional’ Benefit

The extra yield on developing-nation debt over U.S. Treasuries dropped 3 basis points to 2.79 percentage points, according to JPMorgan Chase & Co.’s EMBI+ Index.

The current sentiment of “risk on” should benefit emerging Europe “disproportionately, especially since asset prices are relatively cheap” Lubin said.

The forint this month has also been in the top 10 performers globally versus the euro after talks with the International Monetary Fund and the European Union on a loan review broke down two weeks ago.

There are still threats to emerging Europe’s financial stability, Lubin said. The region’s vulnerability stems from possible financial contagion that stressed western European banks might be reluctant to roll over debt on the balance sheets of their east European subsidiaries, he said.

Slower euro-region growth that may have “nasty implications” for exports from the region also contributes to risk, according to Lubin.

The European Bank for Reconstruction and Development, which helped limit the impact of the financial crisis in eastern Europe by persuading banks such as Italy’s UniCredit SpA, France’s Societe Generale SA and Austria’s Erste Bank AG to remain in the region, warned last week that the worst isn’t over for the banking industry, which will slow credit expansion.

The EBRD also lowered its forecast for growth in the economies of eastern Europe and Central Asia, citing increased risks from budget cuts and volatile financial markets in the euro region. The development bank expects an average of 3.5 percent growth this year in the 30 countries in which it invests, and 3.9 percent next year.

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