December 2002, Volume II, Issue 11
Central European Equity Fund (NYSE: CEE
George Cole Scott, Editor

Interview with Hanspeter Ackermann, Portfolio Manager
Central European Equity Fund

The Central European Equity Fund is a non-diversified, closed-end investment company seeking capital appreciation through investment in Central European equities. Its shares are listed on the New York Stock Exchange under the symbol “CEE”. The Deutsche Bank Group manages the fund as well as The Germany Fund and The New Germany Fund. As of October 31, 2002, the Fund has invested 42% of its assets in Poland, 29.2% in Hungary, 11.4% in the Czech Republic, 1.2% in Croatia, 0.57% in Austria and 14.8% in Russia.

The ratification of the Treaty of Nice by Irish citizens in October and the agreement to admit 10 new countries by May 1, 2004 in Copenhagen on December 13 is a further milestone toward European enlargement. The expansion is the biggest in European Union history and will create a mega-Europe of 450 million people in 25 countries and an economy of more than $9 trillion, close to that of the United States. It is evidence that European Union membership is the first step towards full participation in the European Monetary Union and the adoption of the Euro currency in all the countries involved. Promoting stability is one of the key arguments for the expansion. This historic action  is seen as a logical step by many of Europe’s leaders. Following this, the possibility of membership in NATO by some countries of Eastern Europe would  add political and economic stability to the region.

The European Union’s head office says that it would spend $21 million to convince current members to support expanding the bloc. Worried that the greatest risk to expansion isn’t in the candidate countries but in the EU itself, the European Commission decided to allocate the money to print pro-expansion brochures and host conferences and debates starting in 2003. The commission will ask the EU governments to match the $21 million and lead the pro-enlargement campaign. National legislators in all EU countries must ratify the expansion treaty which EU officials would like to happen by the end of 2003 so the new members can join by early 2004. In spite of this, some observers are finding that many of the prospective members are uncertain that it is a good thing from a short-term prospective. This will give more importance to spending the $21 million to try to accomplish the expansion.

Hanspeter Ackermann is Managing Director and Chief Investment Officer of the Germany Fund, New Germany Fund and the Central European Equity Fund. Prior to joining Deutsche Bank in 1996, Mr. Ackermann was President and Managing Partner of Eiger Asset Management. His previous experience also includes serving as a managing director and Chief Investment Officer of SBC Portfolio Management International, as a portfolio manager for Swiss Bank Corporation in Basel, Switzerland, and as an investment counselor with Banque de I’Indochene et Suez in Paris. Mr. Ackermann is a graduate of the Commercial School of Swiss Association for Business Administration and was educated in Switzerland. He is a Chartered Financial Analyst.

We interviewed Mr. Ackermann on November 19 with updates in early December. Robert Gambee, Chief Operating Officer and Secretary of the fund, assisted with this interview. We were first alerted to the importance of the EU expansion by James Libera of Washington International Advisors.

Scott: Many Americans do not really understand what this European expansion is all about. Would you explain it for us?

Ackermann: We have now cleared the Treaty of Nice with the Irish vote that is necessary to have the whole process move forward. The next step was the criteria which was voted favorably at the December 12 meeting in Copenhagen. In 1993, it stipulated that the candidate country must satisfy 30 different points as well as three basic topics:

1.		Political conditions, including stability of institutions, guarantee of democracy, the rule of law, human rights and protection of minorities.
2.		Economic conditions including a functioning market economy and the capacity to cope with competitive pressure.
3.		Administrative structures necessary to implement, enforce and transpose the EU legislation into law. That is what the Copenhagen criteria require.

One of the main topics is agricultural policy. It hasn’t been negotiated yet. This is a relatively big deal because Poland, one of the larger countries in the bloc, has as much as 20% of its population working in farming. Because the farm segment in Europe is inefficient and subsidized by local governments, this is a major issue to be worked out and resolved. Poland would love to have an open market for their inexpensive agricultural products. We believe they will find a solution to this conflict. None of the other countries have cleared that hurdle although it is a lot less important for them.

Scott: What is meant by your term “Central Europe”?

Ackermann: We have defined the region for our fund to include the Eastern European countries but not Russia in geographic terms. The key countries we invest in are Poland, Hungary and the Czech Republic. The population figures for these countries are:  Poland, 39 million, Hungary, and Czech Republic, 10 million each versus 83 million for Germany. Therefore, we invest up to our legal limit in Central Europe. We also invest in Russia, even though it is not specifically a part of Central Europe.

Scott: We have seen a great deal of interest and strength in the shares of your fund recently. Is this all because of the talk about convergence of the European Union or other factors?

Ackermann: The key reason for the increasing interest in the emerging markets including Eastern Europe is illustrated in what we call a Ferris wheel (see figure 1) which is on our web site. It is called “Emerging Markets and the Global Cycle” and shows the markets in the U.S and Europe are starting to bottom-out, a sign for a turn. Except for the oil price, that is more volatile depending on what is happening in the Middle East, most commodity prices have risen recently, a sweet spot for emerging markets. The Ferris wheel shows that the emerging markets become attractive when commodity prices rise. Emerging markets bond spreads have also been dropping, relative to U.S. treasuries, generally a sign that the risk premium for these markets is starting to shrink. This also includes some improvement in such problem areas as Brazil. Therefore, we think the emerging markets should do better than developed markets.

Scott: Do the emerging markets ever work in tandem with those of the developed countries?

Ackermann: Sometimes they do. Look again at the Ferris wheel, at the top of it. When short-term interest rates start to rise, the developed markets generally have peaked. Then you have a speculative rally in the emerging markets. Since the beginning of the year, they have outperformed most developed markets in Europe as well as the U.S.

[Figure 1 reprinted with permission from Merrill Lynch]

Scott: Very Interesting. Now let’s focus on your region. When you go into a country, what are the criteria you use in finding investments?

Ackermann: We primarily look for ideas. The whole story of why we are there hinges on the convergence story. If you think it won’t happen, you have no reason to be there.

Scott: How much time do you spend in Eastern Europe each year?

Ackermann: I normally travel to Europe and the area three or four times a year, depending on events. We have a number of analysts in the area who concentrate solely on Eastern Europe, four in Frankfurt, three in London, and at least five in Poland. They provide us with investment ideas.

Scott: The growth in the region for 2002 is expected to be 4.2%. Is that still on target?

Ackermann: That is roughly in line. Some countries are growing quicker than others. Here is the economic outlook for the larger countries:

Poland: There are clear signs that Poland’s economic recovery is forthcoming. The excessive tightening by the Polish Central Bank was the main factor in reducing Poland’s economic growth from the 4%-5% range of recent years to 1.2% for 2002. Fortunately, the Central Bank has taken steps to reverse the tight monetary policy. Since December 2000, the official interest rate has been cut by 200 basis points (2%). However, in our view, interest rates are still too high, and with real interest rates (interest rates minus inflation) of +5.0%, we believe the Polish Central Bank will continue to aggressively ease interest rates in 2003. For comparison, the real official interest rate in the US is currently -0.3%. A positive effect of the sluggish economic growth and high interest rates was a spectacular drop in inflation and improvements in the current account deficit. Inflation, which was a major problem only a few years ago (10.2% in 2000), has now fallen to just 1.3% in recent months and should average 2.3% for the entire year. Similarly, the current account deficit has fallen from 6% of GDP in 1999 to about 4% this year. For 2003, we expect Poland’s economic growth to reach 3.5%, more than triple the growth achieved this year. In early October, the European Commission declared that Poland, along with nine other countries including Hungary and the Czech Republic, will fulfill the conditions of membership to qualify for joining the EU in 2004.

Hungary: Hungary has continued to be the best performing country in the region in terms of economic activity, with estimated economic growth of 3.4% this year and 4.1% next year. At the same time, there has been a significant decline in inflation, falling from 9.2% last year to 5.5% this year. Next year inflation is expected to decline to 5.0%. Hungary’s economic performance has been quite extraordinary given Hungary’s large exposure to foreign trade to Western Europe. Hungary has successfully stimulated domestic demand, particularly construction and service sectors, through loose fiscal policy. Private consumption benefited from wage hikes in the public sector and large-scale public investment projects. Many of these public projects are being funded by the substantial amounts of foreign capital that Hungary has attracted due to its high growth potential.

Czech Republic: The Czech economy has continued to perform relatively well, considering the persistent weakness in Western Europe. The main reason for its success in weathering the global economic slowdown has been their counter–cyclical economic policy. In particular, avoiding Poland’s mistake of prolonged monetary tightness, the Czech Central Bank cut short-term interest rates to their lowest level on record. An expansionary fiscal policy provides sufficient stimulus to the economy while a solid GDP growth rate of 3.2% this year and 3.8% next year would not have been possible without the disastrous flood last summer. Even though the economic impact has been mitigated by additional budget spending of about $1.2 billion and by foreign aid, real economic growth estimates for this year has been reduced to 2.6% and 3.6% in 2003. Inflation has been subdued, falling from 4.7% in 2001 to 2.3% this year. Unemployment has also been gradually declining, falling from 8.5% last year to 8.2% this year. The Czech Republic has therefore officially qualified for membership in the European Union. Moreover, its negotiations with the EU are less controversial than with Poland since it has a much smaller agricultural sector.

Russia: The economic outlook in Russia has improved in the last few months. Despite the rise in global uncertainties, the Russian economy has maintained very strong economic growth. Private consumption has been the main driving force. As a result, our forecast for real GDP growth has been raised to 4.0% for both this year and next year. Inflation, while still in double digits, has shown a steady decline over the past four years, falling from 37% in 1999 to 15.1% this year and inflation is expected to fall to 12.8% next year. High oil prices have continued to boost the value of exports and have contributed to continuing trade surpluses. There has also been some further progress in structural reforms, including a new bankruptcy law, which gives better protection to foreign investors. Inflow of foreign capital to Russia has continued unabated, boosting foreign exchange reserves. It is increasingly going into direct investments, especially in the oil and gas industries. U.S. oil companies are planning a significant rise in their Russian investments, with the encouragement of the U.S. government, which is vitally interested in expanding Russian oil production to become less dependent on Middle East oil.

Scott: We wonder why you have such a low exposure to Austria? Although it is a part of Western Europe Austria is oriented towards the Eastern Europe region.

Ackermann: We do have an exposure to Eastern Europe through the banking sector. Austria generally has been a poor performer through the past decade and is also a very narrow market because the government has a stake in most of the companies. It is, therefore, not really a free market where we could see some corporate action happening. Most of the action has been in bank stocks.

Scott: If I were to join you on one of your trips, where would you take me first?

Ackermann: I think the most impressive and biggest change has been in Russia. In Moscow, you now see an active street life, cell phones are everywhere and there’s lots of dealing going on. That is where the biggest changes are happening. Poland is also interesting from an economic point of view, but for the future of the region, I would still argue it is Russia.

Scott: I see that your largest sector is in oil and gas. Is this because of your exposure to Russia or is any of this commodity available elsewhere in the region? My concern is what if the oil prices would plunge again as they have many times over the past 20 years?

Ackermann: If the oil price collapses, that might be a reason to reduce exposure to Russia, as they are more dependent on oil revenues. I tend to agree with your concern about oil prices. However, Russia benefits even in a low price environment because they can get the oil out of the ground cheaper that other countries. Once they get the technology upgraded, they are almost unbeatable.

We also have oil and gas stocks in Poland and Hungary. The total exposure for oil and gas for the region is 23%. This breaks down to 8.1% Russia, 7.1% Hungary and 7.4% in Poland. In Eastern Europe, most of the oil revenues come from refineries rather than production. Only Russia is a major producer.

Scott: What about improvement in the structure and tax reforms in Russia? Are you satisfied with it?

Ackermann: There is progress. We can come up with a long list, and it is working out, absolutely. It may take years but remember where we came from. The credit agencies reported that they were very surprised by the tax collection progress. They have moved the credit rating up one notch, a big move for them. We think that within 12 months Russia will become investment grade or triple BBB-. So they will pull ahead of Mexico which is BB+. South Africa, which is also BBB-, has a spread over U.S. treasuries of 2.7% compared to Russia with its current spread of 4.9%. The correlation of Russia is not with the oil price, which seems counter-intuitive. The correlation comes from the tightening of the emerging markets spread. If we are right over the next 12 months, the Russian market will do exceedingly well.

Scott: What other countries in the region do you think you may invest in over the next ten years?

Ackermann: Most of these countries are small. You could invest in the Baltics such as Estonia and Lithuania. We are getting much better returns in the more liquid countries such as Poland and Hungary. Normally in the very beginning of a wave, the liquid ones are where people will invest. In the second wave, which is more speculative, then you pick the laggards such as these smaller countries.

Scott: Is corruption much of a problem in many of these countries?

Ackermann: Yes, of course, everywhere, even in the U.S. Russia has corruption which is  part of the equity pricing.  If the markets discount such risk, we don’t think this will be a big factor.

Scott: That is all very interesting. Now, moving to some corporate governance issues, I believe you have a share repurchase program. Most funds announce how many shares are authorized or the dollar amounts, but I have been unable to find any details on it. How does it work, Bob?

Gambee: We don’t publicize our program except when we have bought back shares. This is because we don’t want the traders calling us every morning and selling us back the shares. We also have a dividend reinvestment and cash purchase program.

Scott: Has the Closed-End Fund Association been helpful to you?

Gambee: It helps us to distribute information and we attend the forums.

Scott: How would you like to wrap this all up, Hanspeter?

Ackermann: I think our markets will continue to outperform this year and will continue to do so. The convergence story is on track. You can look at other emerging markets, but we think these markets will continue to roll up to the convergence date.

Scott: One concern I have is maybe they have run up too quickly and gotten ahead of themselves as markets so often do. Do you see any of that happening?

Ackermann: No, if you look at the big markets we are doing great. Poland, year to date (as of Dec. 6), is down 5% so it looks great compared to Germany whose markets are down 37.84%.

In our view, we look for these markets to double or possibly triple by the time the convergence theme is through. Our markets haven’t really moved compared to others.

For further information on Central European Fund,
call (212) 454-1695 or visit http://www.ceefund.com/.

Note: None of the information contained herein should be construed as an offer to buy or sell securities or as recommendations. Performance results shown should under no circumstances be construed as an indication of future performance. Data, while obtained from sources we believe is reliable, cannot be guaranteed.

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