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CAPITAL MARKET

Market dead despite continued economic growth

During the two week period ending July 8, the market saw a paltry gain of 3.1% as the SAX climbed to 111.25 on the last day of the period on the back of steel and financial industry stocks' appreciation.
On the other hand, Slovakofarma's share price remained flat and our most favorite stock, Slovnaft, experienced a 6.2% decline to close at 610 Sk.
We maintain that the current market valuation is very low compared to market fundamentals and is caused by overly negative market sentiment induced by pre-election uncertainty. While we see a possibility for a partial appreciation of certain blue-chip stocks before the September election, as foreign investors may realize the severe undervaluation of some stocks, we do not believe that the market could see an across-the-board recovery prior to the elections.

During the two week period ending July 8, the market saw a paltry gain of 3.1% as the SAX climbed to 111.25 on the last day of the period on the back of steel and financial industry stocks' appreciation.

On the other hand, Slovakofarma's share price remained flat and our most favorite stock, Slovnaft, experienced a 6.2% decline to close at 610 Sk.

We maintain that the current market valuation is very low compared to market fundamentals and is caused by overly negative market sentiment induced by pre-election uncertainty. While we see a possibility for a partial appreciation of certain blue-chip stocks before the September election, as foreign investors may realize the severe undervaluation of some stocks, we do not believe that the market could see an across-the-board recovery prior to the elections. The market's development after the elections will largely depend on the ability of the newly-elected administration to provide credible signals that it is going to undertake radical reforms of the capital markets.

Recently released data by the Slovak Statistical Office confirm that domestic demand and economic growth remain robust. Annual industrial output recorded in May edged up to 5.8%. In spite of a 1.8% annual decline in construction output, that output actually grew at a rate of 7.9% in the first five months of this year.

Real industrial wages went up only 1.8% in annual terms, far below labor productivity growth, which jumped to 6.9% during the same period. Retail sales swelled by 9% annually in real terms during the first five months of 1998, this despite a considerable slowdown in real wage growth this year. The strong domestic demand has translated into a growing foreign trade deficit, which reached 32.3 billion Sk during the first five months of 1998. The trade deficit as a share of GDP hence has entered dangerous double-digit territory and we estimate it at 11% at the end of this year.

According to the NBS Report on the Banking Sector, the restructuring of Slovak banks is proceeding too slowly. The capital adequacy of banks operating in Slovakia (excluding branches of foreign banks) dropped 50bps point to 9.6% during 1Q98 and the number of banks that are failing to meet the 8% capital adequacy ratio increased from last year's four to five.

Classified bank claims grew by 3% to 123.7 billion Sk in the quarter, while loan provisioning dropped from 54.4% to 52.9%. In 1Q98, the share of classified loans of total loans was 31.5%.

In our view, financial sector problems remain serious and if no systematic solution is adopted, sooner or later they will surface with accordingly damaging effects on the entire economy.

Corporate developments

At its EGM, the shareholders of IRB approved the bank's closing balance, according to which the bank lost 3.25 billion Sk ($930 million) last year and its equity was a negative 1.35 billion Sk at the end of 1997. The auditor, Ernst & Young, recommended that the bank create additional provisions worth 2 billion Sk, adding that last year's loss and negative equity raised doubts whether the bank was able to appreciate its assets and cover all its liabilities from its operations in the near future. Moreover, tax inspection may bring in a requirement for an additional 750 million Sk ($21.4m) tax. Suspicion exists that the former bank's management violated the bank's internal rules, articles, and bylaws, the report concluded. We reiterate our sceptical attitude of the bank's future unless an entry into the bank of a strong foreign financial institution is not allowed soon.

According to Slovenská Poisťovňa (SP) Marketing Director, Ľubomír Belfi, SP shareholders are planning to increase its registered capital by 1 billion Sk to 2.5 billion. The current shareholders will have an option to exercise their pre-emptive rights for a period of one year, which is an unusually long period most likely tailored to the needs of the biggest shareholder, FNM privatisation agency, which suffers from serious liquidity problems. We do not recommend small investors to exercise their rights until the insurer provides credible signals that its future business strategy is consistent with maximizing shareholder's value.

Vladimír Zlacký is an equity analyst with ING Barings.

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