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Skip Navigation LinksHome :: Back Issues :: Central Europe: the markets move on

January 1996

Central Europe: the markets move on


No fast track but getting there. The success of central Europe's emergence depends on the region's ability to maintain coherent, long-term economic and social reforms. But the past five years have produced a mixed bag of results, as Jules Stewart reports.




 Three key factors govern the progress of central Europe: the unbundling of a cumbersome and inefficient state-enterprise system, the bringing to market of privatized companies and the endowment of that market with a sufficient degree of transparency and liquidity to attract western capital.

Nearly half of the new democracies can each boast a private sector which accounts for more than 50% of GDP. Some countries have mapped out highly ambitious privatization plans. Hungary, for example, wants to boost the level of privately-owned enterprise to 75% of GDP from a present 56% within the next two years.

But investors complain that all too often the ghosts of the old regimes make their presence felt in a slow-moving and often suspicious and corrupt bureaucracy. As a result, living standards languish at about one-third the level of those in western Europe. The European Bank for Reconstruction and Development (EBRD) points out that for the next 25 years central Europe will need a growth rate of 3% above that of western Europe to bring living standards to two-thirds of those enjoyed in the west. That can only be achieved by attracting foreign investment.

Western capital will play a dominant role in central Europe's fledgling markets. Pension fund managers in the US, for instance, say that the 7% to 8% of their assets currently invested overseas will rise to perhaps 15% by the end of the decade. Emerging markets will be allocated about 10% of those assets, which in total amount to some $6 trillion.

For the present, the liquidity of central European stock markets is problematic. "The level of liquidity is such in some countries that from a trading standpoint it makes for hard work," says John Parker, head of emerging-market equity sales at Salomon Brothers in London. "The process needs to be faster. There will be new issues in Poland in the next 18 to 24 months and this seems to be the market for substantial equity issuance. We expect to be part of that process, but at the moment there are fewer than 40 companies quoted on the exchange."

Poland, with 40 million inhabitants, overshadows its central European neighbours and has been one of the region's most powerful magnets for outside capital, attracting almost $4 billion in direct foreign investment in the past five years. It is implementing a state-managed privatization programme through the vehicle of 15 investment funds set up by the state. The allocation of 413 enterprises to these funds is being carried out by selection rounds in which each fund manager can choose individual companies to be included in the portfolio. The idea is to ensure effective governance of enterprises and funds.

The region's other dynamic market, the Czech Republic, took a free-market approach. It allowed the rapid creation of private investment funds, which facilitate and promote outside ownership and governance of companies in the mass-privatization programme.

"The jury is still out as far as restructuring and corporate governance is concerned," says Susanne Gahler, emerging markets economist at JP Morgan. "We will only know in three to five years' time whether the Czech Republic or Poland has provided a more effective model to create efficient and profitable units."

A drawback Poland faces is a long delay in getting its programme off the ground. The investment funds, which are joint-stock companies owned by the Polish treasury, began distributing vouchers only last November.

Foreign investors have been less than impressed by the way the Polish government has handled the privatization of the banking system, one part of the programme already under way. Nine banks were separated from the state banking system to clean up their balance sheets and recapitalize them before privatization. All were scheduled to be placed in the private sector in 1995. So far only three have made it and the government wants to bring back one of them into the state system.

Response from foreign investors to the 1995 flotation of Gdanski Bank was also less than enthusiastic. The transaction, jointly lead-managed by HSBC's James Capel and Daiwa (with SBC Warburg, Schroders and Creditanstalt as co-managers), was the largest international share offering yet from the Polish market and the first to use international equity-marketing techniques. But it ran into a considerable degree of investor resistance. Last month, the government was quick to assuage investor anger by promising to abolish a 30% restriction on foreign ownership of domestic banks.

Poland cannot afford the luxury of an ambivalent policy on market reforms. "Revenues from enterprise and bank privatizations are a critical component of solving Poland's social security insolvency problem," says Stuart Brown, Paribas Capital Markets' senior economist for emerging markets. "Moreover the social security issue is one of the key factors in helping to balance the budget and bring down inflation in the medium term."

Hungary's policy has been more intuitive, according to Gahler. "The Hungarians benefited from direct foreign investment and sold a lot of good companies in the market," she says. Still, the Budapest Stock Exchange is thin on issues and one big purchase order can have a dramatic impact on the index.

"Hungary has been more selective than some of its neighbours," says Steven Fries, an economist for the EBRD. "They have been engineering cash sales to strategic investors to ensure good governance of privatized companies from the outset. They have also been quite aggressive in selling off state enterprises."

So far the Hungarian government has placed into the private sector assets equivalent to more than half of the country's GDP. More than $1.6 billion in foreign portfolio investment has been channelled into the market in the past four years. The government is taking the view that privatization through direct cash sales provides the know-how, management and marketing capability that cannot be achieved with a voucher programme.

"You need cash sales," says a Hungarian banker. "Investors bring in an international culture and links to the market. Changing a company's ownership is only one step in the process. What is really crucial is injecting the know-how required to run an enterprise efficiently and profitably."
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