Czech banks’ painful privatization

A SUPPLEMENT TO EUROMONEY/APRIL 1998: EASTERN EUROPE

The Czech government has belatedly begun privatizing three of its top banks by appointing international consultants to advise on the sale. The government aims to transfer the banks to the private sector by the end of the year, allowing strategic foreign investors to hold large stakes. But the plan could yet be knocked off course by political opposition and disputes over responsibility for the banks’ bad debts.

The one certainty is that the government will receive billions of dollars less than it would if the banks had been sold in the mid 1990s when the government’s reputation and the economy were in far better shape.

There are some optimistic signs. The much delayed sale of the state’s 36% stake in Investicni Postovni Banka (IPB) to Nomura has finally gone ahead, although Prague financial markets are awash with rumours about the scale of the government bail-out required before the sale could take place. Talks are also continuing with GE Capital on the sale of the fifth largest institution, Agrobanka, which is being separated into a good bank, which will be sold, and a bad bank, which will be liquidated by the state.

Finance minister Ivan Pilip has no doubt that by selling IPB the government is at last sending the right message to international markets. “It shows that the government means what it says and can deliver a strategy to strengthen the capital base of the privatized banks,” he says. “It also demonstrates that the bank has some positive value for foreign investors.”

Some bankers in Prague are also upbeat, insisting that conditions have improved significantly since the grim days in early December when the reformist administration of prime minister Vaclav Klaus collapsed because of a party funding scandal. The country then appeared to be facing months of political instability and damaging delays before further much-needed economic reforms could be introduced.

“The country’s position has strengthened since the start of the year,” says Boris Gomez, economic analyst at ING Barings in Prague. “There is a government of technocrats, headed by the former central-bank governor Josef Tosovsky, which has brought stability and the central bank has made it clear it will not loosen monetary policy. The government is pressing ahead with tighter regulation of the banking sector and the capital market. The economic fundamentals are also showing improvement.”

International bankers have been impressed by amendments to the banking law and changes in the investment-fund law, which Pilip hopes will stop abuses in this sector. But bankers in Prague believe that the key decision has been to press ahead with the privatization of the government’s stakes in the leading banks. Goldman Sachs is to advise on the sale of 34% of the government’s 49% stake in Komercni Bank; Merrill Lynch has a similar role for the sale of 34% of the 45% government stake in Ceska Sporitelna while Schroders will perform this role for the sale of 51% of the government’s 66% holding in Ceskoslovenska Obchodny Bank (CSOB).

Pilip has set the banks a very tight timetable; some observers, looking back at the track record of missed deadlines, say it is unachievable. The schedule is governed by the timing of the election which is planned for the second half of June. “The advisers should produce their report and have it published before the end of May,” says Pilip. “The new government will then draw up a shortlist and the banks will be sold after due diligence.”

The timing is significant. Pilip is a senior figure in the Freedom Union, the right-of-centre reformist party created by politicians who broke away from Klaus’s conservative Civic Democratic Party. Pilip hopes that the publication of these reports will force the opposition Social Democrat and Christian Democrat parties to clarify their views at a crucial stage in the election campaign on the politically sensitive issue of selling the banks.

The election result will have a critical effect on the Czech Republic’s economic prospects. At present the Social Democrats are expected to be the largest party and to dominate any new coalition government. But their lead is starting to be eroded and political analysts believe the result could still be close.

Bankers’ worst fear is a result which produces no clear-cut decision on privatization. “The result would then be three to six months of horse trading which would be disastrous for the country,” says Gomez. “Almost as bad would be a left-of-centre coalition which is anti-privatization, is sceptical of foreign investment and pursues a policy of getting the banks to make discounted loans to small and medium-size companies.”

But there are signs that the Social Democrats are backing away from their ideological hostility to selling strategic stakes to foreign investors. A delegation of senior party figures visited London recently in an attempt to reassure the markets.

Bankers in Prague believe that the market and the independent central bank will leave the government with few choices, whatever its ideological intentions. “Their credibility as economic managers depends on the market,” says one Czech banker. “The central bank will raise interest rates if the government tries to run too high a deficit. These realities are forcing them to rethink their policies. On bank privatization, I don’t believe that, whatever they say, they really believe any longer that it can be stopped. Although they will implement the policy more slowly than a reformist government.”

Some believe even a short further delay could be damaging not just to the banks but to the economy as a whole. “Our industry needs to be competitive and that requires our banks to be competitive”, says Jan Sykora, a director of the Prague securities dealer Wood & Co. “It takes time from the moment of privatization to create a well capitalized banking sector able to do this. But we don’t have much time.”

Right-of-centre politicians like Pilip now accept that the Klaus government’s biggest mistake was to keep the banks in public ownership when it embarked on privatization in the early 1990s. It also failed to open up the market sufficiently to foreign institutions. “The time delay has been damaging,” says Pilip. “Privatization is important for the whole economy, as the banks would then have a bigger capital base and could help create the functioning capital market in which companies could raise money.”

One success story has been the resale of Zivnostenska, the seventh largest bank. Bank Gesselschaft Berlin is buying the 47% stake held by BHF-Bank. Bankers say its record since the initial privatization in 1992 shows that foreign strategic ownership leads to better management standards and to a more dynamic bank.

In contrast, the still state-owned banks have spent the past five years under pressure to make loans to customers who could not afford them in order to boost industrial privatization. The result has been a deterioration in the banks’ position and value on the market.

“Their loan portfolios got worse and worse and they did not have the management to reverse the decline,” says Sykora. This view is endorsed by Jan Lamser, a member of CSOB’s board, who says the government decision to use the banks to finance privatization “was a clear example of what happens if the role of regulator and participant are mixed”.

Even more damaging to the economy, most of the shares in privatized companies are held through mutual funds which are controlled by the state-owned banks. As a result, the banks have exceptional influence as shareholders and creditors. This, say bankers, creates a potential conflict of interest and makes proper corporate governance much harder with the result that large companies have not been properly restructured.

Pilip believes that rapid privatization, creating “strong banks with a significant capital base” and with independent management procedures, is the only way to address these problems. He argues that there is no realistic alternative but to do this by selling strategic stakes to foreign institutions. “The competition is open and there is nothing to stop a Czech institution from bidding”, he says. “But there is no Czech institution capable of fulfilling this role.”

CSOB, the smallest of the three biggest banks, could, says the finance minister, take on the identity of its international stakeholder, but the other two “need to be Czech-based banks. Our banks have a good position in the market of the Czech republic and Komercni Bank is the biggest in central Europe. If foreign investors have such a strategy, they could become a leading bank in the region”.

The political make-up of the next government is not the only factor which could delay the timetable for the bank sell-off. As the delays in the sale of IPB to Nomura have shown, any purchaser will want to make a very detailed analysis of the loan book of the bank it is buying. Ceska Sporitelna and Komercni banks have higher levels of classified loans than IPB so the process is likely to be long and to result in significant reductions in the bid price, says Prague bankers.

CSOB also faces a big dispute, now stuck in the international courts, which stems from the break-up of Czechoslovakia in 1993. The ownership of the bank was split between the Czech Republic and Slovakia, and ownership of the non-performing assets was converted from private to sovereign risk by the creation of special collection companies.

While the Czech government has paid interest and principal on this debt, the Slovak government has not. According to Lamser, the original Slovak debt of Slkr8.5 billion ($242 million) has swollen to Slkr16 billion which is very close to the bank’s Slkr19 billion capital.

In desperation CSOB’s managers have started legal action against the Slovak Republic in the International Centre for the Settlement of Investment Disputes. The Czech government maintains the official position that it will press ahead with the sale of its stake even before a final judgment is made.

The ideal solution for CSOB would be privatization, with Slovakia’s profits being used to pay off its outstanding debts to the bank. “We want to stabilize the bank and then proceed in a reasonable way,” says Lamser. But bankers believe it will be very difficult to price the bank and see through the sale until the dispute has been settled.

Potential purchasers will also be examining carefully the consequences of IPB’s privatization. “There will be a real impact from the introduction of additional capital,” says Helena Jensova, IPB’s senior executive director. “The present capital is Kr5.7 billion [$169 million]. Nomura is to add in an additional Kr6 billion which will take its stake to 70% and this will then be diluted by the sale of a further Kr6 billion stake to other shareholders.”

Jensova believes the link-up with Nomura will allow IPB to become a much bigger player. “The main difference is the potential,” she says. “Western markets will be opened up. Nomura will provide the expertise, will make the bank more efficient and there will be an economic rather than a direct impact on business. Nomura also wants to develop retail banking.”

But others believe the impact of the sale will be even greater. “I think the bank will be dismantled,” says one local banker. “I would be very surprised if they do not do some radical surgery on it. It remains to be seen what the political impact of taking such a far-reaching step would be, given the popular and political nervousness there already is about privatization.