For the ten years since the fall of the Berlin wall, the Czech Republic has been the darling of foreign investors. It seemed to achieve a painless transition towards a market economy while its neighbours suffered endless economic and political problems. The mid-1990s saw GDP growth reaching 6.4% and industrial output growth peaking at 8.7%. Public spending, wage levels and the value of the Czech Koruna continued to increase.
But since the start of 1997 the pressures of the burgeoning trade deficit, declining domestic demand and a currency devaluation have brought an end to the Czech Republic’s economic miracle.
Although in 1998 external imbalances have been virtually eliminated, with buoyant exports helping the current account deficit to just 1.6% of GDP (25% of 1997 levels) and external debt falling as a share of GDP and foreign exchange receipts, the severity of the downturn in domestic demand has pushed the economy into a recession that has wiped 2% off GDP in 1998.
The Republic’s neighbours in the so-called ‘Golden Triangle’, Poland and Hungary, have continued their transition processes successfully, now eclipsing the Czech Republic in terms of investor interest and foreign business. “Foreign investors have really been put off the Czech Republic,” says Anna Bossong, head of emerging Europe research at Daiwa.
Inflation reached double figures in 1998 for the first time since 1994, unemployment has been steadily rising since 1995, and industrial production is dropping. GDP declined by 2.9% in the last quarter of 1998, with 0% growth expected in 1999. To combat the growing recession, the government pursued austerity policies throughout 1998. Public spending has been cut and in a vain attempt to increase domestic demand and GDP growth, interests rates have been lowered six times since July 1998. Standard and Poors reflected its concern over the Czech recession by downgrading the Republic’s long-term foreign currency rating from A to A- in November.
The political instability arising from the fall of the Klaus government at the end of 1997 has not helped the economic situation. There had been an uneasy coalition between centre right pro-reform parties for five years, but at the end of 1997 the personal and ideological splits between factions took their toll. “There was widespread disillusionment with the Klaus government,” says Bossong at Daiwa. Privatization and restructuring plans for state-owned industries and the financial sector met political barriers and progress towards economic liberalization has been slow.
After a universally unpopular interim government led by a central banker, Tosovsky, parliamentary elections were held in June 1998.The rival to Klaus’s Citizens Party, the Social Democratic Party, won 37% of seats while the Citizens Party limped in with 31%. An coalition deal was struck between the two parties and the Social Democrats’ leader, Milos Zemen, became the new prime minister. The Social Democrats are less inclined towards privatization, but the fallout from Russia and deepening recession has given the Zemen government an impetus for change.
Slipping behind
At one time the Czech Republic was thought to be the first likely east European entrant to the European Union, and successive governments have strived to build good relations with the commission and EU leaders. However, the country has now slipped behind Poland and others in the aspiring-EU-entrants pecking order. “Poland and Hungary are certainly making more advanced in their efforts to prepare for entry,” says Bossong at Daiwa. Brussels has criticised its slow pace of reform and stated that much needs to be done before Czech accession is a possibility. Zemen laid the blame firmly at the door of the previous administration, but his government has realised that urgent action is necessary.
Mass voucher privatization was used to sell state businesses in the Czech Republic and took place in two waves in 1992 and 1994. After shares were distributed to the population, most people gave their stocks to Investment and Privatization Funds to manage, bodies that were set up to facilitate trading. This method of privatization neither generated extra capital nor encouraged foreign investment and involvement.
Many of the privatization funds were controlled by the state banks, so all the shares from the privatized companies effectively ended up under government influence again. The role of the Investment and Privatization funds is now declining, but they have left a legacy of opaque corporate governance and lack of minority shareholder rights. This has reduced the value of the companies, and foreign investor confidence is weak. Most firms are currently trading below par value on the Prague stock exchange. Legislation has been passed to open up these funds and make them more transparent and attractive to investors, including a rule that no fund can hold more than 11% in any one company.
A third wave of privatization is now waiting to happen where strategic foreign buyers will be encouraged to take over state enterprises. The main candidates for this type of privatization are the three biggest state banks; Komercni Bank, Ceska Sporitelna savings bank, and Ceskoslovenska Obchodni Banka (CSOB). “In any transition economy you need to speed up privatization and restructuring, but especially in the banking sector, which is the goal for the Czech Republic in 1999,” says, Milan Elezovic, equity analyst at Nomura. “It should increase efficiency and bring foreign money into the country.” But before the banks are sold they need to be cleaned up. Bad loans make up an average of 29% of all loans held by Czech banks, a figure that is growing.
Transparency promoted
Amendments have been made to the banking laws to untangle the complicated relationships between the banks, the investment funds and the state-owned industries. Banks will have to separate their investment banking and commercial banking activities, and representatives of banks will be prohibited from sitting on the supervisory boards of industrial companies. Regulations will limit cross-shareholdings between banks and industry. This will make the government institutions more attractive to foreign buyers and be the first step on the road to creating shareholder value.
Bank sell-offs look likely to follow the model of strategic investment used in the privatization of Investicnia Postovni Banka (IPB) in 1998. Nomura already had a minority holding in IPB, but in 1998 the Czech government let the Japanese bank increase its stake to 53%. The first bank to be released from state control, IPB is also now the largest bank in terms of capital. Since Nomura first took an interest in IPB in 1997 the bank’s income has more than doubled.
In June 1997 GE Capital of the US bought a 70% stake in Agrobanka, formerly the largest private bank in the Czech Republic which was taken into central bank administration in 1996. Some commentators thought it was strange that GE Capital would be interested in such a small, badly-managed bank, but Agrobanka has shown strong growth in market share despite its problems.
The three remaining banks in state hands, Komercni Bank, Ceska Sporitelna and CSOB, are now being readied for full privatization. Komercni Bank, the largest bank in the Czech Republic, is already consulting advisors for a sale but needs to sort out its loan book first. “Lots of bad debts have been appearing over the last 12 months, since the economic downturn,” says Bossong at Daiwa. It is a real problem for all the Czech banks, which have also been burned by exposure to Russia. A fifth of Komercni’s loans have to be written off, and the bank has yet to calculate the provision needed. It has been restructuring its balance sheet, most recently in a Kr5 billion ($168 million) deal with CSFB, but it is still possible that the state might have to step in to bail Komercni out.
CSOB, the third largest Czech bank, could also provide the first privatization of 1999. The sale of the state’s 66% stake in CSOB could be worth between $100 and $150 million. It is likely that the stake will go to a strategic foreign investor, and there are already several that have shown interest. Possible buyers include ABN Amro, Creditanstalt, BNP, Citibank, Deutsche Bank and ING. CSOB has a good profit track record stemming from its successful strategy of focusing on international trade.
Ceska Sporitelna has run into problems with Russian exposures of Kr5 billion ($168 million) incurred through a derivatives deal involving Merrill Lynch, Bankers Trust and CSFB. Sporitelna’s inadequate capitalization has been worsened by its burden of bad loans. “In the past Ceska Sporitelna tried to grow its loan book rapidly,” says Bossong at Daiwa. “Due to the fierce domestic competition it was lending money to unreconstructed industries, which was too risky.” It is expected to post losses of Kr6.9 billion ($232 million) for 1998, and will need an injection of capital of at least $150 million. Negotiations are currently under way for government help.
The cost of restructuring the banking sector was cited at the end of December by ratings agency FitchIBCA as the key factor in its decision to downgrade the Czech Republic’s long-term local currency rating from AA- to A+. “Bad loans in state-owned banks (Komercni Banka, Ceska Sporitelna and Ceskoslovenska Banka) and transformation institutions (Konsolidacni Banka, Ceska inkasni and Ceska financni) are accumulating and the fiscal costs for the restructuring of the banking sector may well exceed initial estimates of 10% of GDP. Consequently public debt is expected to rise substantially in the medium term from the currently moderate level of 15% of GDP… The challenges facing the new Social Democrat government led by Milos Zeman are daunting,” is the agency’s gloomy prognostication.
Politics drives privatizations
Privatization of Sporitelna is expected in 2000, and will be seen as a bellwether transaction, the standard by which the country’s restructuring efforts is judged. The EBRD already owns 12%, but it is not clear how the rest will be sold. A strategic sale to a large foreign investor makes sense, but might be too controversial. “It would be a very politically sensitive issue within the Social Democrat party if foreign banks were to come in and takeover the main Czech lending banks. They may have to swallow their pride, but it is more likely that a foreign bank would buy into a minority role, and then more stock is sold onto the market,” says Bossong at Daiwa.
Privatizations and modernization, if there is the political will to carry out change, could provide the key to escaping from the recessionary conditions the Czech Republic has had to bear for the last 18 months. This is the only way to restore confidence and credibility and regain the position of favourite with west European and American investors.
The main barrier to the successful launch of the bank privatizations, apart from the precariousness of the Koruna, will be the continuing volatility of the political situation. The coalition between Klaus and Zemen has never been comfortable, and at the start of 1999 the government will be faced with the challenge of getting its budget through parliament. To do this Zemen might have to rely on the support of the communist members, an option which Klaus would not agree to and might shatter the coalition for good.
