The economic iron curtain is slowly being lifted

By Matthew Lynn

LONDON (Bloomberg): Forget, for a moment, the technology and Internet stocks that are transforming the world. For really spectacular investment returns, look at places where people have trouble getting the electricity to work regularly, never mind installing Microsoft 2000 on their hard drive and getting it to forward their e-mails to their WAP phone.

So far this year, the emerging economies of Eastern Europe have been on a vigorous bull run. Investors are betting that what was promised to be a great success story of the 1990s, but wasn't, will pan out in the new decade.

In Poland, the WIG 20 index is up 24 percent so far this year. The Prague index in the Czech Republic, is up by 30 percent. In Hungary, the market is up a more modest 13 percent, but in Rumania the market has gained 27 percent. Even Ukraine's stock market, not usually thought of as a magnet for global capital, has jumped by 24 percent since the start of the year.

Those impressive numbers come as some stock markets around the world are going down, not up. The Dow Jones Industrial Average, for example, has dropped by 11 percent this year, same as Britain's FTSE-100 Index.

Nor are other emerging and developing markets with which Eastern Europe might be more naturally compared faring much better. Mexico's benchmark index has managed to rise by 1.5 percent this year, but Korea's is down 12 percent, and Thailand's by 19 percent. Since January, the old Communist bloc has been world's brightest region for investors.

The question remains, however, whether Eastern Europe can deliver on its promise this time around, or whether the investors who are pouring money into its markets will wind up once again feeling betrayed and disappointed.

After the fall of the Berlin Wall in 1989, money flowed into the newly liberated economies east of the old Iron Curtain. That made a lot of sense. Investors watched the tiger economies of the Far East rapidly industrializing, and had made fortunes from their surging stock markets. Why couldn't countries such as Poland, Hungary, the Czech Republic, and the new Baltic states replicate their success?

True, they may not have known much about free markets, but they had factories, roads and a skilled and well-educated workforce, and they were right next door to one of the biggest and richest markets in the world.

It didn't turn out that way. In truth, Eastern Europe is just starting to recover ground lost over the last six years.

Take, for example, the Polish WIG 20 index. Last October, it stood at just over 14,000. Now it is trading at close to 22,000. But it was last reached these levels in 1994. Or consider the Czech Republic's Prague PX 50 index, which was trading at 457 on Dec. 21 last year, and has now risen to 634. But it has still not recaptured the heights it last visited in April 1994, when it rose to 859.

In effect, investors in Eastern Europe have been losing money for the last six years -- the promise of the first few years after liberation vanished into the air.

But evidence of booming trade between Europe's two halves is now starting to come through. Exports from Slovakia into the European Union rose by 35 percent last year; exports from the Czech Republic by 25 percent; and from Poland by 14 percent.

Poland is now the EU's fourth largest trading partner, just behind the U.S., Japan and Switzerland, but ahead of China. Slowly the economic iron curtain that has run through the center of Europe for the last decade is starting to rise.

There are also signs of a generation of companies emerging that are competing based on something other than cheap labor. In Poland, three companies investors have been buying are Optimus SA, a computer manufacturer and internet company that has seen its shares double; Softbank SA, a software and Internet company whose shares have gained 125 percent; and Prokom Software SA, which is up 115 percent.

Eastern Europe still has a long way to travel, and much of its equity boom is the result of restructuring of old industries rather than the creation of new ones. In the Czech Republic, two of the best-performing stocks are Setuza AS, a food manufacturer, and Komercni Banka AS, the country's biggest bank.

Eastern Europe's most advanced countries are still a lot poorer than Western Europeans. Hungary's GDP per capita is just 37 percent of the European average, and Poland's just 31 percent.

But booming markets make a difference. Eastern Europe has plenty of people, and lots of land and raw materials. It also has markets -- or at least it will do as the European Union gradually expands eastwards over the next decade.

What the region lacks is capital -- the one commodity the developed world has in abundance right now. Capital moves where returns are best. While Eastern European markets were falling it was tough for companies to raise money for investment and expansion. In rising markets, that should become a lot easier.

There is a virtuous circle, in which rising stock markets pull in capital, which stimulates investment, which generates growth, which, in turn, pushes markets up farther. It is too early to say whether Eastern Europe has now moved into that circle. But just now it stands a better chance than at any time since the Berlin Wall collapsed.

The writer is a columnist for Bloomberg News. His views don't necessarily reflect the judgment of Bloomberg News.