The Emerging Frontier of the Bucharest Stock Market
Since 2016, The Bucharest Stock Exchange (Bursa de Valori București - BVB) is actively seeking official recognition of emerging market status from the world’s leading providers of stock market services. In fall last year, for instance, BVB entered FTSE Russel’s “Watchlist”, the London Stock Exchange’s research and rating agency shortlist of potential emerging markets, while also being under the consideration of S&P, MSCI and Stoxx.
When communism fell, creating a functional and thriving stock market in Romania, as in the other CEE countries, was an essential and integral part of the process of building a functional and thriving market economy.
In current financial jargon, the Bucharest Bourse is characterized as a frontier market, although official bodies such as the IMF for instance already classify it as emergent. The desire to obtain this recognition from the world financial industry is not a single-minded pursuit of the BVB company, even though it is the obvious prime beneficiary. Through its group-interest coalition-building efforts, it has also involved the Romanian Government, which in its 2015 fiscal reform package acknowledged its development strategy by lowering the dividend tax and the capital gains tax to 5% and 10% respectively, far below the once flat 16% income tax rate.
Beyond a possibly naive quest for prestige, what exactly are supposed to be the benefits of this effort to develop the Romanian stock market, and are they worth the costs?
Necessary but not sufficient
In emerging countries such as Romania, where financing needs are high and savings are low, the stock market can in principle become the means by which businesses can attract foreign and domestic capital more cheaply and easier than through financial intermediaries. In turn, Romanian companies listed on the stock exchange will be forced to become more efficient, responsible and transparent under the watchful eye of their investors. Or so the theory goes…
When communism fell, creating a functional and thriving stock market in Romania, as in the other CEE countries, was an essential and integral part of the process of building a functional and thriving market economy. It meant establishing property rights in productive assets and replacing centralized state planning of the “commanding heights” of the economy with decentralized market allocation of capital. The market, and free market pricing, were generally deemed a more efficient economic mechanism than the state’s planning board targets and bureaucracy on several levels: knowledge aggregation, incentive structure and product innovation. In theory, as well as in practice, the stock exchange – with its anonymous trades, atomized buyers and sellers, and near instant response to news and events – represented the pinnacle of this capitalist efficiency in the allocation of capital to its most productive or high-valued use. The international financial bodies’ promotion of stock market development in emerging countries, alongside trade and capital liberalization, is fundamentally based on this insight, which in academic language is formally referred to as the efficient market hypothesis.
The fact that every advanced economy has a thriving stock market is superficially a good enough reason to further develop the Bucharest Stock Exchange. The business of stock markets everywhere is to raise capital and to channel it to its best use. Equity markets therefore constitute an alternative financing method for new and old companies alike alongside bonds and bank credit.
The market classification mirrored quite imperfectly the tripartite classification of the state of economic development of the various nations, even though today’s political sensitivities have completely eliminated the notion of underdeveloped countries from public discourse and the notion of developing countries has been replaced with the more positive and neutral sounding emerging economies.
In emerging countries such as Romania, where financing needs are high and savings are low, the stock market can in principle become the means by which businesses can attract foreign and domestic capital more cheaply and easier than through financial intermediaries. In turn, Romanian companies listed on the stock exchange will be forced to become more efficient, responsible and transparent under the watchful eye of their investors. Or so the theory goes among both the financial industry and international development bodies, because, in practice, issuing equity on stock exchanges accounts for a rather small share of capital financing even in advanced economies, with the possible exception of the United States which however is more of an outlier in this regard. A large stock market, moreover, can take on a life of its own, as critics of the efficient market hypothesis warn, for it is prone to fads, bubbles and irrational behavior, which can have an independent adverse effect on the entire economy. Consequently, the stock exchange’s “beauty contests” might end-up inappropriately hijacking the attention of policymakers, regulators and crucial economic institutions such as the central bank.
A stock markets primer
Before any attempt to answer the question can be pursued, it is important to note that the line separating frontier stock markets from emerging stock markets is – to an even greater degree than the one which separates advanced from emerging stock markets – a very fine line.
This expansive global financial industry, with its perches in New York, London and Hong Kong, was undergoing a dual revolution: one of scale and geographic outreach, and one of product innovation and standardization.
Initially, the terminology appeared in research conducted in the early 1990s within the Bretton Woods institutions (the IMF and the World Bank), which were heavily involved in building market economies in the former communist area as well as promoting world-wide financial integration (the so-called Washington Consensus). It basically mirrored quite imperfectly their tripartite classification of the state of economic development of the various nations, even though today’s political sensitivities have completely eliminated the notion of underdeveloped countries from public discourse and the notion of developing countries has been replaced with the more positive and neutral sounding emerging economies. From there, this tripartite capital markets classification – comprising frontier, emerging and developed stock markets – passed in the private international financial sector: a fast-growing industry since the early 1980s liberalization, which began in the United States and other Anglophone countries and then spread triumphantly and virtually unchallenged all over the world until the 2008 Global Crisis.
This expansive, global but American and Anglophone-centered, financial industry, with its perches in New York, London and Hong Kong, was undergoing a dual revolution: one of scale and geographic outreach, which came above all with lower barriers to capital mobility, and one of product innovation and standardization, which was necessary in order to manage the ever larger and more intricate cross-border financial flows. The stock market classification produced by the international financial bodies, under which worldwide capital mobility reached and maybe even surpassed late 19th century and early 20th century levels, was therefore quite handy for the financial industry, where it was used as a basic analytical tool to intellectually control the complex double process of global geographic expansion and standardization.
Although the Bucharest Stock Exchange (BVB) claims for itself a respectable, early 1880s, age, it was actually re-established only in 1995, quite late compared to other countries in the CEE region.
The criteria used to distinguish frontier capital markets from emerging capital markets remain quite blurred however. In fact, the original analysis produced by Farida Khambata of the International Financial Corporation (IFC), the World Bank’s private equity unit, viewed frontier stock markets more as a subset of emerging markets rather than a category in their own right. Even though subsequent use of the classification, particularly among private stock market trading and rating firms which took over IFC’s research, emphasizes its quantifiable nature along several key-indicators such as total market capitalization, average trading volume and the value of companies listed, a stock market can be considered frontier rather than emerging, or even developed, due to a much broader and circumstantial complex of factors.
Consequently, three broad situations – beyond the narrow analytics of market indicators – determine whether a stock market is classified as a frontier rather than as an emerging market by the global financial industry’s leading players: the stock market is quite rudimentary, unsafe or truly underdeveloped for foreign investors to be active in it; the market is in fact developed and institutionally sound but it is actually too small to have a significant role in their investment strategies; finally, the market is simply unknown or outside the cultural reach or comfort of the New York and London type of financier. In the case of the Bucharest Stock Exchange, all of these factors are in play and only by putting these objective and subjective elements together one can understand why, for instance, the Budapest Stock Market is classified as emerging by all the rating firms while the Bucharest Stock Market is classified as frontier and other such apparent non-sequiturs.
A little bit of history
In 2005, the BVB absorbed the secondary, electronic, Bucharest Stock Exchange, RASDAQ, and last year it fused with SIBEX, an exchange located in Sibiu, central Romania, which was particularly appealing for its options and futures trading. Consequently, only the Romanian commodities stock market, located in the port-city of Constanța, is currently outside of the BVB’s control.
Although the Bucharest Stock Exchange (BVB) claims for itself a respectable, early 1880s, age, it was actually re-established only in 1995, quite late compared to other stock markets in the Central and Eastern Europe (CEE) region composed of former communist countries. Thus, the Budapest Stock Exchange was re-established as soon as June 1990, followed by the Warsaw Stock Exchange in April 1991 and the Prague Stock Exchange in 1993. In fact, even much smaller and similarly tormented CEE transitioning economies such as Slovakia and Bulgaria opened stock trading markets – quintessential symbols of capitalism – about four years earlier than Romania, while Slovenia established its stock market as early as December 1989, at the same time as it gained independence. Only Estonia, a former Soviet republic – but not Latvia and Lithuania –, and Albania opened stock markets as late or even a bit later than Romania, in 1995 and 1996 respectively. This lag in reestablishing the Bucharest Stock Exchange, evidently related to the much broader hesitant transition to market economy and responsible democratic politics that affected the whole country in the early 1990s, still casts a pall over outsiders’ perception of Romania to the detriment of its capital markets and the country’s brand image more generally. Moreover, once the Bucharest stock market was established, its growth and consolidation has been slow.
Although in the first half of the 1990s a two-round mass privatization voucher program was instituted, with virtually every adult working Romanian citizen receiving shares in a state company, Romania did not end up with a class of worker-capitalists as the Liberal promoters or even Socialist converts of the scheme suggested. Quite the contrary. The vouchers were traded in informal markets with little knowledge even before the capital market was operational and the most valuable of them were amassed on the cheap by well-connected speculators, thus enriching a few persons who would later become the “robber barons” of the transition. Other privatization vouchers simply became worthless paper in household drawers because the enterprise went bankrupt during the reform process. Very few worker-owned capitalist companies emerged from these schemes, with the most successful example probably being a small beer factory or some engineering bureau.
BVB currently operates two markets: the Main Regular Market comprising 87 listed companies (85 national and 2 foreign) and the Alternative Market, called AeRO, for start-ups and SMEs, comprising 291 companies (289 domestic and 2 foreign), many of them brought over from the previous RASDAQ market.
The mass privatization programs also gave birth to five national financial investment companies, Societăți de Investiții Financiare or SIF in short, one for each historical region of the country, with initial total assets of around 30% of all state enterprises. Even today, when the privatization process is essentially complete, the five SIFs – joined since 2005 by Fondul Proprietatea designed to offer compensation for owners who suffered expropriation during the communist regime – dominate trading volumes, alongside the privatized banks and privatized energy monopolies, although in 2005 BVB absorbed the secondary, electronic, Bucharest Stock Exchange, RASDAQ, and last year it fused with SIBEX, an exchange located in Sibiu, central Romania, which was particularly appealing for its options and futures trading. Consequently, only the Romanian commodities stock market, located in the port-city of Constanța, is currently outside of the BVB’s control.
The state of the market
Although the mass shareholder privatization program, which was supposed among other things to instill a vibrant stock market culture, proved rather badly designed and ineffective, once the BVB opened its floor, late as it did, it functioned relatively free of the corruption scandals, business frauds and financial scams that plagued most of the country’s institutions and economic sectors until the middle of the 2000s and, to a lesser extent, continue to plague them to this day. The most famous Bucharest Stock Market corruption scandal, for instance, basically a case of insider trading concerning the listing of Rompetrol S.A. in April 2004 ended with an acquittal. It was orchestrated by the now deceased billionaire Dinu Patriciu, implicating or involving a usual host of prominent and interrelated characters from politics, business and the media – including a colorful broker named Cristian Sima, who would later even become President of the Sibiu Stock Exchange before its absorption by BVB and then run into client-related legal problems. With regard to clearing, depository and disclosure standards, as well as regulatory environment, at present the Bucharest Stock Exchange has in principle incorporated all of the European and international norms and best practices and therefore institutional risk should no longer be a concern for investors.
Excluding foreign companies and considering only the Main Market shares segment, in June 2018 the Bucharest Stock Exchange, with a market capitalization of 20.3 billion EUR, was the 4th largest stock exchange in the CEE region, well behind the Warsaw Stock Exchange (GPW), which has a market capitalization of 143.6 billion EUR, but comparable with the Prague Stock Exchange (PX/CEESEG), which has a market cap of 27.7 billion EUR, and the Budapest Stock Exchange (BÉT), which has a market cap of 22.8 billion EUR, and above the Zagreb Stock Exchange (ZB), market cap 19.3 billion EUR, the Lubljana Stock Exchange (LB/ZB) market cap 5.5 billion EUR, and the Sofia Stock Exchange (BSE), market cap 4.3 billion EUR.
At the end of 2017, a very good year for the Romanian stock market, the BVB total market capitalization reached 35.27 billion EUR (42.32 billion USD), representing almost 20% of Romania’s GDP that year, but with an average daily traded value of only 10.45 million EUR (11.8 million USD). In fact, BVB currently operates two markets: the Main Regular Market comprising 87 listed companies (85 national and 2 foreign) and the Alternative Market, called AeRO, for start-ups and SMEs, comprising 291 companies (289 domestic and 2 foreign), many of them brought over from the previous RASDAQ market. It also trades bonds, warrants, rights, ETF units and structured certificates and plans to relaunch the options and futures market which operated in Sibiu. Excluding foreign companies and considering only the Main Market shares segment, in June 2018 the Bucharest Stock Exchange, with a market capitalization of 20.3 billion EUR, was the 4th largest stock exchange in the CEE region, well behind the Warsaw Stock Exchange (GPW), which has a market capitalization of 143.6 billion EUR, but comparable with the Prague Stock Exchange (PX/CEESEG), which has a market cap of 27.7 billion EUR, and the Budapest Stock Exchange (BÉT), which has a market cap of 22.8 billion EUR, and above the Zagreb Stock Exchange (ZB), market cap 19.3 billion EUR, the Lubljana Stock Exchange (LB/ZB) market cap 5.5 billion EUR, and the Sofia Stock Exchange (BSE), market cap 4.3 billion EUR.
Although the market capitalization of BVB’s Main Market has grown by 43% over the span of 2007-2017, the average daily turnover has not kept pace and in fact has even declined over the same period by as much as 37%. And, more than absolute or relative-to-GDP size as measured by market capitalization, this constitutes at present one of the biggest obstacles for BVB in obtaining the coveted emerging market status from the world’s leading financial industry. The GDP weighted size of the stock market is primarily a measure of how representative it is in relation to the economy, while average daily turnover or traded value constitutes, alongside volume, a measure of the market’s liquidity. With low trading volumes and low turnover comes low market liquidity, as well as high brokerage costs, while low capitalization means that the stock market is not actually very reflective of the country’s economic activity and therefore not very suited to figure in global indices or global exchange traded funds (ETFs) which the major players of the world financial industry are building and upgrading in a permanent quest for yield and diversification.
With low trading volumes and low turnover comes low market liquidity, as well as high brokerage costs, while low capitalization means that the stock market is not actually very reflective of the country’s economic activity and therefore not very suited to figure in global indices or global exchange traded funds.
Other issues that the BVB has to solve in order to obtain emerging market status, such as the size of its blue chip companies and the fraction of their free floating shares, are basically only an outgrowth of the twin fundamental issue of market capitalization and market liquidity. A small and not very liquid market is not sought by the modal foreign investors because it is deemed not only as too volatile and prone to speculative behavior, but in fact incapable of accurately forming asset valuations, which is the main purpose of a stock market in the first place.
Two steps forward, one step back
BVB is aware of what it has to do in order to raise the profile of the Romanian stock exchange. It is trying to increase public participation in the stock market, by organizing educational campaigns. With the assistance of the European Bank for Reconstruction and Development (EBRD), it has created a Corporate Governance Institute to help companies meet requirements for public listing on the Main Market. It has also been discreetly involved, as already mentioned in the beginning, in shaping the Government’s overhaul of the Fiscal Code in 2015 in a direction favorable for stock market investment, although the Government’s support for its plans now appears contradictory at best.
With the assistance of the European Bank for Reconstruction and Development (EBRD), it has created a Corporate Governance Institute to help companies meet requirements for public listing on the Main Market.
If the Social-Democratic Government of PM Victor Ponta lowered the dividend and capital gains taxes (which along with prolonged very low interest rates nationally as well as internationally have contributed to the stellar but rather questionable performance of the Bucharest Stock Exchange), the current Social-Democratic Government of PM Viorica Dăncilă – invoking high management fees – intends to make the privately-administered capitalized “2nd pillar” of the compulsory national pension system optional, virtually reabsorbing it into the pay-as-you-go “1st pillar” in the case of many contributors. This could be a serious blow for the Romanian stock market and BVBs desire to augment its shareholder base given that the “2nd pillar” and the non-compulsory “3rd pillar” pension funds had over 1.9 billon EUR or 20% of their assets in equity investments at the end of April 2018, an increase of no less than 280% since the beginning of 2013, while asset managers kept their equity exposure relatively steady over the same period.
Conclusion
Despite its high performance during the last years, continuous modernization and consolidation, the Bucharest Stock Exchange will most likely not obtain the desired emerging market status before the decade’s end or even later. This is due to a combination of structural failings (such as low liquidity levels and lack of the required number of domestic blue chip companies with market capitalization of over 1 billion USD which meet thresholds for free float and turnover), its late start and fuzzy perceptions among the world financial centers’ closely networked elite. BVB’s promotional strategy among potential investors and the broader public, as well as its efforts and desire to increase and diversify the publicly listed companies on its Main Market, are promising, but still have to show more results. The Government’s policy towards the stock exchange has been mixed and therefore unreliable during the last years. The lower-than-standard dividend and capital gains tax rates adopted in 2015, which have generated some social justice critiques in certain corners, were overshadowed over the whole period by a permanent row over the future of the compulsory private pensions funds, which have become an important presence on the Bucharest Stock Exchange.
The Government’s policy towards the stock exchange has been mixed and therefore unreliable during the last years.
A larger, more dynamic and more internationally integrated stock market can indeed be a benefit for the Romanian economy as a whole, by increasing the potential supply of funds available to Romanian companies and improving their corporate governance and profitability. Obtaining emerging market status by BVB from the world’s leading providers of equity market services basically means obtaining an improved rating and – as with all ratings – this means obtaining the trust of people with money to buy Romanian shares based on this recommendation, either directly or through index-funds that will feature them. But a more dynamic and interconnected stock market is not without risks. For starters, although the Romanian economy is already highly integrated in the European and world economy through trade and capital flows, it will become even more sensitive to synchronized outside movements in investor sentiment, which can increase the volatility of an already volatile market. Finally, the speculative and irrational behavior that may arise on a larger stock market could pose a risk to the national financial system and consequently become a challenge for regulators and policymakers.
