altic States Good, Better, Best.

It is a measure of the success enjoyed by Estonia, Latvia and Lithuania that they are rapidly shedding their "ex-Soviet" tag. Although economic performance varies sharply, all three countries are now solidly on the path of reform. The biggest threat faced by all three is from Russia but diminishing.

Western sales will grow.

Combined sales from the OECD countries in 1996 may reach $3bn. Demand for investment goods will increase as newly privatized enterprises start overdue modernization. Elite groups' appetite for luxury goods may tail off slightly, but consumer goods will continue to sell well. Competition from local or other East European brands, especially in foodstuffs, beverages and household chemicals will mean leaner profit margins for Western companies and greater emphasis on reliable distribution.

More scope for investment.

Outside interest in Baltic companies will grow substantially and local financial markets will become more sophisticated, although stock exchanges will remain small and illiquid (see BEE Dec 12 `94). Riga's importance as an off-shore haven for Russian money will continue to grow. Estonia will be the most attractive prospect, thanks to an ambitious three-year privatisation programme involving utilities and transport enterprises. German and Danish investors will feature more prominently, although Finnish and Swedish interest will remain high.

Infrastructure will improve slowly.

Delays on the intra-Baltic borders eased significantly during 1994 and will continue to improve. Progress on the extremely congested and corrupt Lithuanian-Polish border will be slower. Modernisation work at ports and airports in all three countries will bear fruit, as will investment in the telephone system.

Currencies will stay solid and easily-convertible.

The kroon, lat and lit are among the hardest currencies in Eastern Europe. Estonia and Latvia already operate very liberal currency and banking regimes; Lithuania will catch up in 1996. Inflation will fall in all three countries, to 10-15%% in Latvia by end-1996 and 20-25% in Estonia.

More services, less agriculture.

Despite protectionist efforts by the governments, the farming sector will continue to be squeezed by high input prices and low efficiency. Services, however, will grow in importance, especially tourism, retailing and the financial sector.

Relations with neighbors will stabilize.

Moscow will continue to bark its dissatisfaction and impose costly trade sanctions on Baltic exports. Otherwise, however, there will be probably little real bite. Cutting off gas supplies and provoking unrest among local Russians in north-east Estonia are the most plausible worst-case scenarios and even these would not be disastrous. More likely is that ties with nearby Russian regions such as Pskov, Kaliningrad and St Petersburg will improve, as will in any case Lithuania's previously scratchy relations with Belarus and Poland. Western countries may exert some pressure on Latvia to administer its citizenship law more fairly.

Crime and corruption high and increasing.

Although nothing like as bad as in Russia, crime in the Baltic states gives Western companies pause for thought. Lithuania has the most violent and unpredictable criminal gangs; Estonia has done best in tackling organized crime and also recently was the scene of a unique and very positive development in Eastern Europe: a government losing office because of corruption allegations. Bureaucratic hassles continue to plague business, especially in Lithuania. Municipal and customs regulations, as well as taxes, are enforced with little rationale or explanation.

Costs are rising.

Inefficiency and monopoly make some goods and services in the Baltic states more costly than in the West. Western companies will find their labour, energy, telecommunications and transport costs will rise above the inflation rate in 1996. Overheating is a problem in Estonia, where a currency board ties the money supply strictly to the central bank's foreign exchange reserves something which led to a nasty inflationary blip in early 1994.

Governments could change.

All three countries currently have pro-business governments. Lithuania's ex-communists have the strongest grip on power. Prospects are less certain in Estonia (where elections are due this March) and Latvia (in October). But independent central banks and constraints imposed by the IMF mean that at worst reform will only be slowed, not reversed.

Baltic states.

Estonia remains the most attractive country for now but Riga is fast becoming the region's financial centre.

Some of the most attractive acquisitions prospects in the Baltic will be coming onto the market in 1996 as privatisation efforts in Estonia and Lithuania bear new fruit, and Latvia launches its own, belated programme.

Securities' markets in the Baltic states have made patchy progress so far: only Lithuania boasts a functioning stock exchange and even that is very illiquid, with a monthly turnover of around only $1m. Estonia has attracted most outside interest, thanks to a dynamic sell-off programme run by a German-style privatisation agency, which has sold off EEK1.37bn (about $100m) of state assets in the past two years. Lithuania has privatised most small businesses and housing locally, but outside investment has been conspicuously absent (Lithuania has less GDP in the private sector than its Baltic neighbors, see table). Latvia's privatisation programme has been muddled and half-hearted.

In all three countries, the investment landscape is set to change:

Estonia.

Outsiders who appreciate the country's stable regulatory environment and business-minded government might be surprised to know that a recent opinion poll ranked the Privatisation Agency almost as low as the police in public esteem. Despite criticism (the agency is accused of putting speed above the rights of pre-war owners and the long-term interests of the economy) the privatisation process itself is the best-entrenched in the Baltics and should survive a change of government in the elections next march. The programme is meant to finish by end-1996 (apart from whatever companies are deemed "strategic"); among next year's potential offerings are utilities and the large Rakvere meat processing plant, as well as possibly the highly profitable distillery Liiviko. The method of privatisation will be different: for the first time minority stakes in companies will be sold for privatisation vouchers.

Remaining government stakes in four especially attractive companies have been selected already: the national tobacco firm, the Kalev chocolate factory, the capital's main department store and the highly successful Saku brewery. These plans may fall foul of objections by existing foreign shareholders who have already committed considerable time and energy to their acquisitions and would like to buy the remaining shares themselves.

If implemented, however, the voucher sales may increase public interest in mass privatisation, which has so far been minimal: "People don't bother with these vouchers, they leave them in drawers at home," says Elaine Walters of Broker Baltic, a local securities firm. Some 44,000 Estonians (of around 900,000 citizens) have so far turned their privatisation points into vouchers. A stock market should be in place by 1996, but whether a country as small as Estonia can support much liquidity is unclear: larger companies will almost certainly seek foreign listings.

Latvia.

Riga has already established itself as a principal off-shore centre for Russian money. This, combined with size and location, make the city the natural financial capital of the Baltics. So far, however, privatisation has been very limited (a 49% stake in the state telephone company being the most notable exception). Investment in publicly available Latvian securities such as commercial paper is seen as riskier than in Estonia, while the much-awaited privatisation programme (which resembles Estonia's mix of strategic stakes for outsiders and minority involvement for the public) has yet to show results.

Joakim Helenius, chairman of Hansa Investments (which advises Cresvale's (UK) $30m Baltic Republics fund) says Latvia is offering a "mixed bag". Prices may be attractive, but company managements are often better in Estonia. It is also unclear what criteria the authorities may use when deciding between tenders. As in Estonia, the authorities' view of the interests of the workforce and the country can outweigh the cash size of the bid. Elections are due next autumn, continuing the political uncertainty which has dogged the privatisation process from the outset.

Lithuania.

Suspicion of foreign ownership and control has hampered Lithuania's efforts to attract outside capital. Many firms have been privatised to local owners; most are now looking for outside cash for modernisation plans. Local financial markets deal mainly with short term government debt; lack of property registries is a major hindrance for lending to companies.

Understanding of corporate finance is also patchy: "no volume, no research," sniffs one venture capitalist. So is government commitment: "all talk and no action," says another outside financier. Others are even more caustic about Lithuania's chances: "no export potential, no foreign reserves, no foreign investment," says a Baltic-based broker. This may be unduly harsh: foreign investment is rising from a drip to a trickle (it stands at $56m this year and $125m overall); Western auditing standards are being adopted and the government is preparing, with EBRD help, a new privatisation list, which will probably include utilities ("always interesting" says Hansa Investments' managing director Auli Kumpulainen) as well as industrial companies involved in potentially attractive sectors such as paper. The government estimates that around $500m-worth of state assets will be auctioned next year. Later this month, minority stakes will be sold in the country's five key energy companies: the Ignalina nuclear power station, the Mazeikiai oil refinery, the oil pipeline company Naftotekis, the state energy company LVES and the natural gas distribution network Lietuvos Dujos. All the shares are expected to be bought by the five companies' employees.

Buying Baltic.

Baltic securities markets will never be as big and exciting as the Moscow roller-coaster. But they are also less risky. Stock exchanges should be functioning (with varying degrees of liquidity) in all three countries by end-1996, creating new opportunities for portfolio investors. Both there and in public tenders, more active outsiders will find plenty of potential acquisitions, especially in labour-intensive manufacturing, services and utilities.

Funds of experience.

A range of analysts polled by BEE say specialization will be the key to success in 1996.

Tight monetary policy at home, and burnt fingers among investors with unhappy experiences in other emerging markets, will prevent East European stockmarkets bounding ahead in 1996. But there will be some impressive bright spots, including funds dealing with less well-known countries, specific regions of Russia (Urals, Far East and Siberia) and sectors such as energy.

Lawrence Brainard, director of research at Chase Emerging Markets expects a mixed performance across the region following the corrections experienced in 1994, most notably in Poland. He warns that investors' risk tolerance in emerging markets is declining, and that commitment to eastern Europe will depend on the progress made in Russia.

Glenn Wellman, managing director of Credit Suisse First Boston Investment and portfolio manager of CSFB's Central European Growth Fund, is more optimistic about central European markets, thanks to widespread GDP growth and progress in privatisation. Institutions will have an easier entrance into the market while hot money has virtually evaporated. "These factors taken together form the basis for a decent market environment," he says. He also expects unquoted shares to attract more investor interest. In Russia, he says that the outlook, while confusing, is better than expected. Custody mechanisms are being set up and in one or two years there should be broad institutional investor interest. He highlights the most interesting question for 1996 as whether merger and acquisition activity will develop for example in the overcrowded Czech market.

A different view is put forward by Paddy Shanahan, director of equities at Cresvale. He expects the number of funds to grow more slowly and there will be few new openings outside some specialized fields and Russia. He notes a move away from funds to direct investment, for example through the depository receipts which some large Russian companies (Gazprom being the most notable example) are now planning to issue in international markets. "Why do investments through funds when you can do it direct?" questions Mr Shanahan.

Cresvale is now looking at opening a Russian fund and is currently talking to a Russian adviser about a possible partnership. "People know the big names like Lukoil and Rostelecom but these companies trade relatively expensively compared to other companies in the same sector. That's the anomaly we want to exploit," he says. Cresvale is also bullish about the Baltic states, where it operates an investment fund. Although some outsiders believe the region is too small to be interesting, Mr Shanahan thinks Estonia, Latvia and Lithuania will have a banner year in 1996. "The legal framework is there; the cheap assets are there and the market is about to open. Growth forecasts are continuously revised upwards," he argues. "Riga is poised to be the offshore banking centre while Tallinn will be the trade front for Russia as Hong Kong is to China," says Mr Shanahan. "Taken as a whole, it is an outstanding investment."

Off the beaten track.

Investors and some investment funds are beginning to look at other less popular markets. More companies are examining prospects in Romania, Bulgaria and Ukraine. Tim Chadwick, emerging markets analyst at Smith New Court, expects to see a fall off in overall interest in 1996, but more money flowing to some of the less well-known countries, such as Slovakia, Slovenia, Bulgaria and perhaps Croatia. But he too stresses the role played by direct investors rather than funds. Hungary's big privatisations will attract trade investors (such as OMV of Austria, a likely candidate to take a large stake in Hungary's oil distributor, MOL).

Mr Chadwick is also optimistic about Slovenia, which combines strong growth with a relatively underdeveloped financial market. Neighboring Croatia, seen as a marginal market in the past also has "impressive" achievements, he says. "We like what we see, but we need to get it right. There are some cheap stocks, but it's an unevolved market with not even one stock listed, with all transactions on the over-the-counter market."

Most analysts agree, however, that the main focus of investment attention in 1996 will remain the core central European states. Smith New Court's weighting for portfolio investment for 1996 targets Poland (35 per cent), the Czech Republic (25 per cent) and Hungary (20 per cent) with only 2 per cent of investment in its hypothetical portfolio going to Slovakia, Slovenia and Bulgaria.

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