As the European sovereign debt crisis grinds inexorably onwards, leaving country ratings and perma-tanned heads of state mangled in its wake, spare a thought for the fledgling fund industries of central and eastern Europe (CEE).

With the exception of Russia, these countries are all in thrall to their western neighbours. Those neighbours told them to bring their debt to GDP ratios down and they did, by and large.

Now the chill wind blowing in from “developed” Europe threatens their rising prosperity and with it their fund industries.

“The debt crisis in the euro area has had a severe impact on central Europe,” says Christophe Wuyts, economist at KBC Global Services NV. “The OECD leading indicators for the CEE economies are on a clearly downward trend, while consumer as well as business confidence declined further below the long-term average.”

With 60 per cent of total exports from CEE countries going to the euro area, half of it to Germany, CEE region GDP growth softened in the third quarter after a “bleak” second quarter. And, says Mr Wuyts, “leading indicators show that the final quarter of 2011 will not be a turning point”.

This creates an unfavourable environment for local fund markets. Thus, where volumes have grown recently it is because of local money market products, which in some CEE countries now make up more than 50 per cent of assets, while investment in international equities is shrinking.

“There is no long-term horizon, no room for negative performance,” says Christa Bernbacher, head of CEE at Raiffeisen Capital Management.

With the exception of countries such as Russia and Bulgaria, most CEE investors are conservative, Ms Bernbacher adds.

“An investor will buy an equity fund for four weeks and then sell it again. Clever asset managers are introducing exit fees,” she says.

In fact, the Russian fund industry, which had looked so promising before the last crisis, is now in the doldrums.

“A lot of investment interest has faded away,” says Jacob Grapengiesser, a partner at East Capital. The breaking point will come when deposit rates become very low, and retail investors are forced to seek alternatives. Six months ago we were close to that point but it now looks more remote.”

Another problem is the deleveraging currently taking place within the European banks that are the primary owners of fund management companies in the CEE region.

It has meant stronger profit repatriation to the home countries, a process that has gone hand in hand with a decline in direct foreign investment in the CEE region. Fund management company consolidation is on the cards, says Ms Bernbacher.

However, deleveraging has not had an equal impact on all the CEE countries. “Many banks in the CEE region owned by European players are largely self funded, for example within Poland and Czech Republic,” says Mauro Ratto, head of emerging markets at Pioneer Investments.

“Similarly, the Russian banking system has a low dependence on European banks. More exposed to the deleveraging are those countries highly reliant on wholesale funding, such as the Ukraine, Hungary, Serbia, Romania and Slovenia.”

In broad terms, Hungary is the regional basket case with a debt to GDP ratio above 60 per cent, while Poland has the best prospects of weathering the crisis relatively unscathed.

“Hungary has had to pay the price of higher risk-aversion by foreign investors due to its unorthodox and erratic macroeconomic policies,” says Mr Wuyts. “Poland is coping best with the euro debt crisis as a result of its solid domestic demand and low export dependency.”

This self-reliance also extends to the Polish fund industry. “The local fund market is more pronounced in Poland,” says Simon Quijano-Evans, head of EMEA research at ING Commercial Bank. “Pension funds have to invest in Polish securities. It’s really a domestically driven fund story.”

A similar dynamic is at play in the Czech Republic, which recently introduced occupational pension funds.

Meanwhile, the convergence story – the move towards economic integration with the eurozone – which has driven so much economic development in the CEE region and been a driver for growth in the local fund industries is currently down but not out.

“The convergence process has not stopped,” says Mr Grapengiesser. “The candidate countries in the Balkans provide the clearest case. The EU is still sending them quite a bit of money. And the trend towards outsourcing might even be provided with a catalyst now. Industrial wages in some countries in the Balkans are compatible with China.”

And the European sovereign debt crisis has revealed something else about convergence: it can be two-way. “We are seeing this in the ratings convergence between emerging markets and western Europe,” says Mr Quijano-Evans.

One result of this is that Hungary and Poland now have record numbers of foreign bond holders, he says.

As to the future, growth in the CEE fund industries is likely to be driven by pensions. Trust needs to be restored for investors to come back, and that could take as long as five years.

But there is one reason to be cheerful. “Things can only get better,” says Ms Bernbacher.

The Financial Times