Need for stronger Chinese walls
The Czech Republic built a reputation as an oasis of regional economic and political stability in the first seven years after the collapse of communism in eastern Europe. But, after what one foreign banker described as its annus horribilis, during which the country was battered by floods, a currency crisis, economic austerity measures, rising unemployment and a government collapse due to a political funding scandal, the Czech Republic faces a painful new year as it tries to bring the reform process back on track.
There was some respite for the country with the appointment of the Czech National Bank (central bank) governor Josef Tosovsky as an interim prime minister. But he has to win a vote of confidence this month if his government is to survive for a limited period before elections can take place.
The key test for international bankers will be if ministers press ahead with the sale to foreign financial institutions of major stakes in the three largest state banks, ensure that there is a properly functioning capital market by enforcing new stock exchange and investment banking legislation and take further steps to diversify an economy that is still dominated by low wage, low technology industries.
But the country enters the new year with a huge question mark hanging over the future of the reform programme. Bankers and finance ministry civil servants agree that these changes are essential and are pressing ahead with the appointment of advisers for the bank privatizations. But there are fears that, given the lack of a strong government, it may be impossible to build the political and popular support necessary for the bank sales to be implemented quickly.
Failure to do so would deal another blow to a country that had until recently been the darling of western financial investors. They had watched approvingly as the then showpiece economy of eastern Europe became the first state in the region to join the OECD, is now on the verge of joining NATO and expects to be at the front of the queue to negotiate EU membership.
There have been some optimistic signs. Western investors have welcomed the government’s measures this year to cut public spending, clamp down on high wage demands and deregulate energy prices. Confidence has also grown as devaluation has helped reduce the trade deficit by sparking a more robust export performance. There is a good chance of the better trade balance being sustained as the German economy, one of the Czech Republic’s major markets, recovers. “The economic fundamentals are getting better,” says Ludek Niedermayer, chief executive director of the Czech National Bank.
The scale of the challenge needed to restore the confidence of international investors is shown by the collapse of the stock market, which is down 30% in dollar terms this year and the koruna which has fallen by 35% against the dollar. Inevitably one of the casualties has been the Czech koruna bond market which earlier this year was being heralded as the model for the emerging capital markets of central and eastern Europe. “The market has gone totally quiet with no new issues since the currency crisis earlier this year. Interest rates are very high for the issuers and there is now an exchange rate risk,” says Jan Sykora, a director of the Prague brokerage, Wood & Company.
If present conditions continue, foreign financial institutions will direct new investment towards Poland and Hungary and stay underweight in the Czech capital market. That will not change until they see clear evidence that tough economic and regulatory decisions have been implemented. “In the early years of the reform process, the Czech Republic was the international investors’ favoured market in central Europe. It is now less favoured than the other leading countries in the region,” says Danielle Downing, emerging markets’ strategist at Salomon Smith Barney.
Changing this negative perception will take time. “There have been some encouraging developments. There are smart people producing good products, they have tourism revenue and soon they will be awash with European Union funds. But the recent years have been a period of avarice and ignorance – it has been laissez-faire, but only for friends. The Czech Republic is a tale of potential and missed opportunities,” says one western banker.
Before the economy can start regaining lost ground, a further wave of reforms is needed to enable the stock exchange and the financial system to operate more efficiently and to send a message to international investors that the Czech Republic is still serious about rectifying the policy errors of the early 1990s.
The then prime minister Vaclav Klaus, who described his ambition as “to create a free market without adjectives”, paid too little attention to introducing proper regulations in financial markets and ensuring they were adequately enforced. He maintained this policy even after a financial scandal involving voucher privatization in the early 1990s convinced many local and international market participants that stricter controls were needed.
Lack of support
Klaus, who along with the rest of his government was forced to resign in December over a funding scandal, also chose not to privatize the leading Czech banks in 1994, arguing that management could develop the know-how as they competed with foreign institutions. Not only have they failed to learn but the government has lost huge sums of money as the revelation of bad loans in the banks’ portfolios has significantly reduced their market value. In recent months, when Klaus had belatedly decided to privatize, he lacked the necessary political support to implement the policy. “I have always been convinced that the privatization of the banks should have taken place in 1994,” says Jiri Kunert, chief executive of Zivnostenska Bank.
Finally, the voucher system of privatization failed to achieve its intended objective of building popular capitalism. Most of the shares ended up in the hands of investment funds, many of which were owned by the leading state banks.
According to the bank rating agency IBCA: “Market structures in the western sense are still weak, commercialization of newly privatized industries is still at an early stage and the need for regulation is still felt on capital markets after several cases of fraud and embezzlement. There are serious concerns about the quality of governance, given the lack of a shareholder culture, weak bankruptcy laws, potentially conflicting interests of some institutional shareholders, and frequent cross-ownership between investment privatization funds and (still largely state-owned) banks.”
Running late
Finance ministry executives are determined to push ahead with the sale of strategic stakes in the leading state-owned banks. Nomura is in the final stages of negotiations to purchase 29.6% of Investicnia Postovni Banka (IPB). Advisers are being appointed for the sale of 34% of the government’s 49% holding in Komercni Bank, 34% of its 45% holding in Ceska Sporitelna and 51% of its 66% stake in Ceskoslovenska Obchodny Banka (CSOB).
Although Klaus’s government had set a timetable for selling all these institutions this year and there is total support for the project from the Czech National Bank, the finance ministry and the institutions themselves, the lack of a clear political direction makes it unlikely more than one at the most will make it into the private sector on time.
The main hurdle is that only a government dominated by Klaus’s Civil Democratic Party (ODS) would easily accept foreign banks as major shareholders in strategically important institutions; yet this is the only way to sell holdings because of the lack of resources within the Czech Republic. “It is taken as gospel that the banks need capital because they are not effective and competitive enough,” says Boris Gomez, macro-economic analyst at ING Barings in Prague.
At the finance ministry, Pavel Stepanek, the director general responsible for banking privatization, says that privatization is essential to “strengthen the banks and give them the chance of achieving stability the government can no longer afford to support them. Since further stability is an objective, this implies that the new shareholders should bring extra capital, know how and access to markets. No domestic investors can do this, so, although it is not written down in legislation, there is no alternative to having foreign investors.
“The government is looking to earn revenue from the sale, to have more competition in the banking sector and to achieve both macro- and micro-economic goals. Finally, the Czech Republic is looking for EU membership so at some stage the banks will have to face more competition. It is better to face that question now as part of the major restructuring of European banking that is currently going on.”
The banks are also jostling to be at the front of the queue. At Komercni Bank, deputy chief executive Peter Budinsky says that “as a management we are clear that not only the banks but the economy can gain from privatization as long as it takes place quickly and transparently. I believe that Komercni Bank could go first as we have produced prospectuses for our GDR and Eurobond issues. We have undergone due diligence many times and information about us is well known to foreign investors. We are a blue-chip company and traded on the London Stock Exchange. We could be ready at the earliest by September 1998.”
Chinese walls
The banks could survive in the medium term if they were not privatized. But Stepanek warns that “it would be harder to sell them and it would hit the quality of their service”. At the National Bank, Niedermayer is even more pessimistic, warning that “the banks will not be able to maintain their positions – good clients will eventually go to the foreign banks and their strategic danger will be greater”.
Ultimately the strongest case for privatization is that it would effectively also privatize the companies whose shares are owned by the banks through their investment companies and also complete the process of creating Chinese walls between these investment companies and the banks themselves.
“Most of the major investment privatization funds are themselves controlled by the main commercial banks which thus have exceptional influence both as creditors and shareholders. This may lead to a potential conflict of interests and inhibits effective corporate governance,” says IBCA in its report.
Western bankers have not been convinced by protestations from the banks that the Chinese walls already exist. In recent months, the government has moved to break the chain of ownership between banks, funds and companies by a combination of investment fund reforms and changes to the banking legislation. But the key to international confidence will be the belated creation of a US-style Securities & Exchange Commission (SEC) to oversee the Prague stock exchange, a market in which abuse of shareholder rights and insider trading have become a way of life.
Plans watered down
While bankers generally welcome the new legislation and the creation of an SEC as steps in the right direction, they are concerned about the way the original plans for stock exchange regulation have been watered down.
“Having the SEC funded by the government limits the independence of the body and limits what you can pay people,” says Sykora. “You need to attract the cream from the market but they will not come for the salaries on offer. Secondly, nominations for positions will be recommended by the cabinet and appointed by the prime minister so decisions will be made on political not professional grounds.”
Some brokers argue that the key is enforcement. “You could say that there was enough legislation before the SEC was created. The authorities just accepted for too long that you could steal or asset strip. The courts did not enforce the law,” says one.
Others say that the absence of a powerful SEC could be the final straw for a market that already has limited interest for international investors. There are only three companies with a market capitalization of more than $1 billion and corporate results in the past 18 months have been poor. According to Gomez, “had there been an SEC, it would have been easier for companies to tap the capital market”.
Less radical
The challenge now is to enforce these new rules and privatize the banks. That requires a strong market-oriented government.
Ironically, the Czech Republic, which had been the only eastern European state to have the same reformist administration in office for the entire eight years since the fall of the Berlin wall, has plunged into political crisis at the very time it could least afford to. A change to a less radical government is also likely when the country needs a further raft of reforms.
The seeds of the present problems were sown at the election 18 months ago when the reformist coalition only scraped back into power with the barest of majorities. The economic downturn was blamed on the authors of the country’s Velvet Revolution which had, initially at least, created a market-friendly capitalist economy without the pain suffered by other eastern European countries.
The final straw for Klaus’s reputation with the markets and the voters came in May when a surge in domestic demand – caused as wage increases outpaced productivity – and a poor export performance led to an unsustainable increase in the current account deficit. “The resulting currency crisis exposed the myth of Klaus, revealing that structural reforms had not gone far enough,” says Gomez. “The market does not want to be fooled twice.” Klaus’s solution of a public-sector budget freeze and deregulating energy prices may have pleased the markets but it sent his stock even lower in public opinion.
It also had a dramatic effect on his style of government which became much less assertive. “The change in Klaus’s personality was pronounced,” says one senior government insider. “He used to have a certainty bordering on arrogance. But in the second half of 1997 he became much less decisive and readier to give in to advisers and other coalition members.”
There is no confidence that the elections, likely to take place later this year, will deliver a strong government committed to the reform process.
The most likely result is a coalition between the Social Democrats and the Christian Democrats, which, say political analysts, will have little enthusiasm for selling the country’s leading banks to foreign investors. The odds still look extremely poor on the Czech banks getting the sort of political stability and market-oriented government they so desperately need.
