TABLE OF CONTENTS
2. The Velvet Revolution was a peaceful one, deeply in contrast to some of its neighbours, which allowed a smoother transition. Vaclav Havel has brought political stability and a vision that has promoted broad support for Western political and economic reforms. His vast popularity continues today and is a symbol of Czech commitment to constant advancement in creating a fully functional market-based economy. The vast foreign investment in the country has reflected the confidence in his stewardship and in the rapid reform policies of Prime Minister Vaclav Klaus.
3. More importantly, the citizens of the Czech Republic are more strongly in favour of liberal market reforms and mass privatizations of state-owned industry than in any other country in the region. This broad public support in critical reforms has brought needed political consensus on economic policies that envision membership in the European Union by the year 2000. Poland and Hungary, the other two countries considered well advanced in economic reforms, have neither had the political stability nor the widespread public backing for making the difficult break from state-control as enjoyed in the Czech Republic.
4. In addition, the Czech Republic also has the advantage of inheriting relatively low debts, a balanced budget and extremely low unemployment rates which have all facilitated its progressive transition. In comparison, the large debts of Poland and Hungary continue to put strain on their fiscal and monetary policies, making reforms far more difficult while unemployment surges.
5. The result of these advantages and subsequent reforms has been a fast growing market economy. At present, private sector output is 65 per cent of GDP and increasing rapidly. Unemployment is at 3 per cent, significantly lower than any other country in the region and a growth rate of approximately 3 per cent in 1994. It is clear that the Czech Republic has the best macroeconomic fundamentals of all transition countries.
6. However, even with these inherent advantages and subsequent market reforms, the Czech Republic faces several dangers. The rapid transformation of the Czech economy from central control by the state to a thriving market-based economy has outpaced the required government regulations and protections found in Western economies for investors, depositors and pensioners. Government corruption scandals have plagued the privatization process over the past year, and investigations have been launched into political party donations.
7. Interestingly, the great attractiveness of the Czech economy has also created a situation where the huge influx of foreign currency over the past couple of years has put severe inflationary pressure on the Czech currency, the koruna. The government will have to make some very difficult choices between devaluing the currency to maintain export growth, making the koruna fully convertible while at the same time holding down inflation and wages. The Czech Republic has a unique situation where the koruna is under devaluation and re-evaluation pressures concurrently. The Central Bank, which pegs the koruna to the dollar and the mark in a narrow trading band of 0.5 per cent, would like to keep the koruna at today's exchange rate of approximately 26 to the dollar. By keeping the currency undervalued, which many analysts believe to be 58 per cent below its purchasing power, the Czech Republic is able to keep unemployment low through low wages, while attracting foreign capital necessary for private sector restructuring and spurring exports to continue economic growth. However, the Central Bank is also facing sharp inflationary pressures from the high level of foreign capital which would call for strengthening the koruna to maintain the decreasing levels of inflation achieved over the past couple of years. The Central Bank currently has a hard currency reserve of $7.8 billion.
8. While privatization in the small- and medium- sized businesses is almost complete according to government statistics, with approximately 80 per cent of all companies privatized, the more difficult large industrial privatization has yet to be implemented on the same scale. However, when further analyzing privatization in the Czech Republic, the programme appears to be more broad than it is deep. Critical restructuring in newly privatized companies has still to be completed and, in many cases, has yet to even commence.
9. Although the Czech budget is currently in surplus, the overriding concern is to keep it in balance without consideration of possibly providing a "trust fund" for worker retraining, additional housing to promote labour flexibility and general welfare benefits. A balanced budget law recently enacted has produced a highly inflexible budget structure toward tax rates and expenditure to meet any unforeseen crisis. An argument could be made that the missed opportunity provided by the current surplus in providing such a flexibility could have significant long-term impacts, as expected increases in unemployment and continued inflation raise the casts of public safety-nets. At the same time, the government has recently defeated a proposal to provide inflationary adjustments for social security recipients that may cause public distress, as corporate restructuring in labour intensive areas proceeds.
10. Therefore, a review of the economic transformation of the Czech Republic provides a particularly interesting guide to other countries as to what is desirable but with potentially significant costs.
12. Through privatization and greater efficiencies, together with foreign investment and assistance, the Czech Republic has increased its exports during this period. Unfortunately, imports are expected to rise faster than exports, creating increasing current account deficits. On the positive side, exports to Western European countries, primarily to Germany, continue to expand. Czech exports will remain the engine of economic growth.
13. Through an expansion of exports and increased foreign investment, the Czech Republic expects to have a growth rate of approximately 3 per cent in 1995. The rapidly developing private sector, additionally spurred by a vast increase of tourism, is expected to continue the trend of sustained growth. These factors help explain the extremely low unemployment rate of 3 per cent; however, there are several other reasons for this low figure explained in a latter chapter of this Report.
14. The Czech National Bank has followed tight monetary policies and has implemented a policy of pegging the koruna to a basket of foreign currencies to ensure stability. Through these policies, the koruna is widely believed to be highly overvalued to keep inflation down. The Czech inflation rate is expected to hover around 10 per cent in 1995. However, the influx of foreign capital and the possible convertibility of the koruna in 1995 or 1996 will continue to place inflationary pressures on the currency.
15. The banking sector is highly developed with over 50 financial institutions licensed in the Czech Republic. A securities market is in its initial stages and a futures market is planned. While the domestic banking industry is dominated by Czech banks with substantial government ownership, foreign institutions have been increasing their activities. In 1994, the government created an export bank to provide critical insurance to Czech export industries.
16. The Czech budget has not only been able to sustain and pay prior debts but is now in surplus. Government revenues have benefited partly from the rise in the growth rate but have come primarily from the highest tax rates in the region. The recent introduction of a value-added tax has brought additional revenues. At this time, the government is re-examining the tax structure and has made proposals to lower rates - particularly in corporate taxes.
17. This cursory overview of the Czech economy gives the impression of a fast growing and robust market economy which is projected to enjoy continued growth while limiting unemployment and inflation. However, with a deeper investigation of each of these key sectors and reforms cited above, a different picture emerges that shows potential threats to the advancements made over the past few years.
18. The government of Vaclav Klaus has championed a free-market economy more than any other transition country in the region. In some areas this is indeed the case. It has ensured that government regulation is kept at a minimum. The privatization programme has encompassed the largest percentage of the economy of any other country, and foreign participation is widely encouraged without discrimination.
19. However, in its zest for speedy economic transformation, the Czech Republic has built a market economy that contains several dangerous deficiencies. These deficiencies could lead to a wholesale reassessment of the economic reforms taken and serve as an example to other countries in the region not to pursue market reforms without sufficient protections. A review of the key reform policies highlights these deficiencies and proposes much stronger governmental oversight and divestiture than has been provided to this date.
21. Government statistics show roughly 80 per cent of the economy is now in private hands with the sale of assets of 1,500 state-run companies. Privatization came primarily through one-time vouchers given to Czech citizens for a nominal price. More than two-thirds of these citizens, unfamiliar with private investment, entrusted their vouchers to newly created investment funds that grew to over 600 during the process. Each investment fund is allowed to hold up to 20 per cent of a company. With the newly acquired "mandate" through the people's investment in these funds, investment funds have taken the responsibility of making the key decisions on what to buy and how much.
22. To get a clear and complete picture of the privatization process it is important to understand the definition of a privatized company. A privatized company in the Czech Republic only requires limited private participation. In fact, cases where the controlling interest is held by private concerns are relatively rare. Privatization by means of restitution and smaller direct sales has established majority-held private companies. However, the government's National Property Fund, created to assist in the disposal of state assets, continues to control on average 40 per cent of all stock in the privatized companies - placing the state as still the primary stockholder. Several other sectors have not been placed in the privatization altogether.
23. When reviewing the Czech privatization process, the main focus must be on the new investment funds. Most of these funds were created by new Czech entrepreneurs who have relatively little experience in a market economy and even less in the buying and selling of company shares. But the dominant investment funds are subsidiaries of Czech banks, only partially privatized by the state. Through the introduction of these investment funds, privatization moved in an even more rapid and "efficient" manner than the government had projected when first developing the programme. Approximately 80 per cent of all eligible Czech citizens participated in the voucher process. Recent public opinion polls show that those who have entrusted their one-time chance of earning a profit from 50 years of state-control are confident in the decisions made by these investment funds. This is an important factor as the public will undoubtedly turn against the programme if losses ensue.
24. Thus, real dangers loom over the functioning and control of Czech investment funds and their parent banks who now appear to be the guardians of the economic reform process.
26. The most powerful of the 600 Czech investment funds are subsidiaries of state-influenced banks. It is estimated that Czech investment funds hold in upwards of 70 per cent of all shares issued in the two waves of mass privatization with 80 per cent of those shares owned by four investment firms. Three of the four investment funds are owned by former state banks that remain heavily influenced by the government which possesses substantial or controlling stock positions. This percentage constitutes one of the highest concentrations of ownership in any market economy.
27. Government law restricts ownership by any one institution of a newly privatized company to 20 per cent. They argue, quite rightly, that these funds could take dominant positions in companies that would have to acquiesce to an individual fund's global interests rather than those of the market or industry. Unfortunately, the dominant market position of just a few investment funds and their ability to bypass restrictions on the percentage of ownership through collaboration has produced a highly centralized system with continuing substantial state influence in the privatization process.
28. While investors are restricted to 20 per cent ownership per company, there are no laws restricting collaboration between investment firms in acquiring controlling stock positions. There have already been several cases where investment funds have pooled their stocks in an effort to either change corporate strategy or dictate personnel decisions. Unlike investment firms in Western Europe and North America, these investment funds have immense authority within the individual companies in which they invest. They frequently have representatives on the board of directors as in the West, but they go a step further by making more day-to-day decisions creating a highly distorted corporate structure. Interestingly, in those companies in which rising debts rather than profits are occurring, funds tend to take a less active role. This phenomenon is attributed to the investment funds owners' (banks) other interests. Due to the fact that the banks have extended often large credits to the very same companies now in control by their investment fund subsidiaries, they are extremely hesitant for the funds to engage in dramatic downsizing, restructurng or initiate bankruptcies because of the risk of loan defaults.
29. There is clearly a real possibility of monopolistic practices with such a concentration of wealth and market share by just a few institutions. This concentration, coupled with little experience in corporate governance or strategic business decision- making with regard to individual companies and industrial sectors creates a dangerous threat to the efficiency of the Czech private sector. In cases where the investment funds have taken an active role, several managers in newly acquired companies have been replaced through collaborative efforts by individual funds. Funds have also been highly successful in placing pressure on the government to reconsider privatization offers to foreign entities which could erode their dominant position in some markets. The most glaring example of the funds' growing power has been the threat by three investment firms to derail a proposed sale to foreign buyers of SPT, the Czech state-run telephone company, the largest attempted privatization to date.
30. While, there are over 600 investment funds participating in the Czech privatization programme, this number will surely be significantly decreased over the next couple of years. Already, there have been several purchases of investment funds by other investment funds - mostly those held by banks. Therefore, concentration of business ownership through these financial institutions should increase rather than decrease in the future.
31. This can also be partly explained by the fee structures implemented in Czech investment funds. The vast majority of the fund managers have little experience and are not as interested in rewarding investors as in the West. Fund managers are paid when they achieve an increase in the worth of holdings rather than the return to shareholders. Thus, investment funds are often more interested in acquiring as many assets as possible rather than measured by expectations of profitability. The banks which own privatization funds have an inherent interest in those companies who could default on the bank's loans. Therefore, the bank's indirect ownership of these companies serves as a way to protect themselves from loan defaults.
32. Therefore, the great fear is that the investment funds owned by banks will not restructure or declare bankruptcy when they are also the primary lenders. While there is little debate that several newly "privatized" companies should either be drastically restructured or dissolved altogether, the number of bankruptcies have been minimal. This is an additional explanation to the Czech Republic's extremely low unemployment rate. While investment funds argue that they have built "chinese walls" to ensure that the two businesses are not collaborating, most market observers say that this is simply not true. This view is corroborated by the limited number of bankruptcies brought by the banks.
33. Strong concerns also remain with the extent of restructuring in the newly privatized companies owned by investment funds who are in turn owned by banks. As mentioned above, investment funds enjoy far more influence over corporate decision-making than their counterparts in the West but have shown reluctance to undertake such initiatives due to either the lack of investment capital required or their parent bank's concern over loan exposure. At the same time, as in the West, banks are inclined to be more interested in credit worthiness than profit-making or large-scale investment to provide needed improvements to increase competitiveness.
34. Thus, there is a serious systemic problem in the Czech Republic with regard to its lack of transparency in the market-place. This lack of transparency also endangers real competition in the market and potentially could postpone much needed private sector restructuring. While the continuing strong presence of the state in the Czech Republic market adds greatly to the systems lack of transparency, it may also be in a position to substantially improve and accelerate the restructuring process. Therefore, a positive role by the state would be to work closely with the banks to provide either soft loans or tax incentives for corporate restructuring.
36. As stated above, investment funds have purchased companies that have outstanding debts to each other and are now "controlled" by banks that are also their primary lenders. This situation causes great complexity in assessing a company's actual worth. In some cases, the bank's investment fund has conducted debt-equity swaps within its own portfolio but has not actually provided debt relief. Therefore, inter- enterprise debts are simply put aside as investment funds attempt to tinker in the restructuring process. In fact, banks instead provide additional loans to these heavily indebted industries.
37. The Czech Trade and Industry Minister described the process this way: "The privatization process has not been completed, and the new owners are not making the restructuring very rapidly. This is also the result of internal insolvency, which creates a kind of vicious circle in which everybody is indebted toward somebody else, which prevents any flow of payment. Moreover, we can cannot deny that it is also the result of the fact that some investment funds are owned by banks. These institutions that hold shares in companies in difficulty do not want to push them into bankruptcy but are trying to carry out their financial restructuring".(1) Some estimates of the inter-enterprise debt in the Czech Republic reach 400 billion koruny or almost 50 per cent of GDP.
38. Again, these types of policies provide a market that is highly distorted and produces great risks to its investors. These risks are even higher when considering the financial stability of Czech banks and the new role of the Czech Republic's stock market, both of which will eventually determine if the million of Czech citizens that participated in capitalism will actually profit from it. Taking an even broader view, if key banks become insolvent, the whole privatization process will be in jeopardy.
40. However, the banking sector remains dominated by the "big four" banks which still have significant ownership in state hands. These "big four" banks account for 70-75 per cent of all banking activities and 78 per cent of the banking sector's assets. Therefore, while the industry has grown in terms of the number of banks and employees at a startling rate, the actual market share is minimal for the new financial companies.
41. The role of foreign banking institutions is barely visible in this growing sector. While foreign banks have taken an increasing role in the Czech Republic, their main function is to facilitate international exports and strategic investments in large companies attractive to foreign buyers. However, foreign banking activity is expected to increase with the convertibility of the koruna, possibly in 1996 or 1997.
42. In 1994, the Czech Government placed a "timeout" on all new licences for banking services. However, many observers believe that this policy was implemented too late. Western market analysts believe that the Czech banking sector has expanded to a point where there will have to be significant consolidation in the future. For a country of approximately 10 million, the number of banks currently granted universal licences to conduct banking activities is far too many in view of the limited number of customers they are required to service. This overexpansion has other effects on the economy and the stability of the banking sector that are not so clear.
43. Through the liberal granting of licences and the strong growth in investment funds created through banking subsidiaries, fund investors and corporate debtors are in potentially precarious positions. Most likely, many of these investment funds tied to smaller under-capitalized banks will be taken over by the larger ones - primarily the "big four". However, the outstanding loan portfolios in these small institutions will be more difficult to absorb. The government created the Consolidation Bank with the responsibility of disposing the assets and liabilities from bank defaults.
44. Although there have been few bank failures in the Czech Republic, an increase in this number is widely expected. In a couple of cases, recent bank failures have been associated with fraud. With the current lack of regulations or enforcement in the conduct of banks, there is a justified fear that more banks will be found performing illegal or irregular activities - particularly in the new banks which have limited expertise. The most prolific case has been the Bank of Bohemia where top management of the bank attempted to sell K1.2 billion worth of fraudulent "bank guarantees"(guaranteed minimum returns on credits and investment) on the international market. The Czech National Bank, aware of the illegal issue for three months did not respond until finally approached by the United States Securities and Exchange Commission.(2) The bank was later bailed out by the Czech Trade Bank where 90 per cent of its shares are held by the government.
45. Although in the wake of this scandal and other similar events, the Central Bank increased its supervisory staff from 30 to 50 investigators, the government is still opposed to creating an independent inspectors office as in Western countries. The reasons for this stance is a further example of how the state, the banks, the investment funds and essentially insolvent companies are all interconnected in the complex web of the Czech marketplace.
47. The Czech Savings Bank holds approximately 50 per cent of all deposits and 85 per cent of all household savings accounts. It also has the largest investment fund in the Czech Republic. The Trade Bank holds approximately 65 per cent of all assets in the foreign financing market. The Commerce Bank is the largest commercial lender with 28 per cent of the loan market and has the second largest investment fund.
48. Thus, the future solvency of these banks is critical to the future growth and stability of the Czech economy and, indeed, the entire economic reform process. Therefore, it is imperative that these banks make sound choices based on the purely economic principles to ensure essential capital reserves, limit losses on current debt and provide adequate protection to investors and holders of savings accounts.
50. A plethora of bad loans issued during the early 1990s at the beginning of the reform process are now just showing on bank balance sheets. According to Czech National Bank figures which are considered conservative estimates, over 35 per cent of all loans by Czech banks were overdue in August 1994 with an additional 15 per cent considered in default. This is a 32 per cent increase over the previous year, and the percentages are expected to climb.(4)
51. Fortunately, today the largest of the Czech banks have sufficient capital reserves to cover expected losses. However, there is a fear that many of the smaller institutions will only be able to cover approximately 40 per cent of the necessary capital reserves recently mandated by the Czech National Bank (CNB). This reserve floor was introduced after the collapse of three banks last year, one being the 15th largest bank which was later rescued. This new policy certainly has benefits as it will encourage greater consolidation in a bloated banking sector. However, the Czech government may have to intervene on several occasions to protect assets and/or depositors of failed banks which are not bought by larger institutions. These institutions have largely absorbed smaller banks by offsetting their losses through rights issues on the Czech stock market and issuance of subordinated debt. However, if this current strategy fails to acquire sufficient capital, and the government is forced to intervene on a wide scale, a serious blow in confidence in the Czech banking sector will occur. This would undoubtedly have ripple effects that could provide further closures. The Czech government and the Czech National Bank will have to closely monitor the health of many of the banks in operation. Limited to only 50 supervisors, the CNB will be hard pressed to provide that monitoring function effectively, especially considering the many dealings Czech banks perform in a very much unregulated stock market.
52. A fear among banking experts is that the largest banks with dominant ownership by the state will simply continue to provide easy loans to failing companies to avoid company bankruptcies, resulting in capital reserves remaining at the absolute minimum. Experts also contend that while the largest banks have sufficient reserves to cover expected losses, if the economy experiences a steep drop, creating far more losses than expected, the banks will not have anywhere near the level of reserves needed. Unfortunately, as illustrated by the privatization process, much larger losses could occur more easily than many expect.
53. A new banking law that came into effect February 1995 requires the largest banks to scale down their vast majority of the financial activity in the country. The law calls for a maximum of 30 per cent of the total lending and deposits by all state- influenced banks. However, again observers are extremely doubtful that these banks will undertake the necessary steps to reduce their market share, and enforcement will be difficult without creating great turbulence for both depositors and lenders.
54. Additionally, some observers believe that the political landscape will in fact promote a slow-paced restructuring process conducted by the banks through the bankruptcy process due to the highly sensitive climate in the country over unemployment. Obviously, with strong state ownership in these very banks, it will be difficult to ignore political considerations towards a wholesale restructuring programme which will eventually have to be undertaken. Czech officials point to their extremely low unemployment rate as proof of their worthiness to enter the European Union. A string of bankruptcies and corporate downsizings would certainly eliminate this political tool in the Czech Republic's external relations.
55. Lastly, the bankruptcy laws of the Czech Republic are extremely vague and are highly difficult to execute due partly to poor judicial training in such cases. Even in the cases where banks have introduced bankruptcy proceedings, very few businesses have actually been foreclosed. This is due primarily to a lengthy bankruptcy process that often takes years and a provision in the bankruptcy law which requires companies or individuals to prove insolvency rather than the banks. Obviously, individual companies facing closure and the seizure of their assets are not particularly forthcoming with the information required to prove their insolvency. Additional legislation to streamline the bankruptcy process is planned and urgently needed. But unfortunately it is unlikely any new law would actually be implemented if banks do not introduce bankruptcy proceedings under the current climate. Thus, as stated by Czech Minister of Industry and Trade, Mr. Dlouwy, "there is a vicious circle".
57. Immediately following the introduction of stocks coming from the first wave of privatization, widely considered the most attractive in the Czech Republic, the Prague stock market experienced a substantial rise. This rise was led primarily by two stocks, the Czech Commercial Bank and CEZ, the Czech utilities company. While this rise was cheered as a sign of the growing market economy, it also had the effect of vastly overvaluing stocks.
58. Investment funds subsequently began to sell their holdings as they looked to capture large profits from the rising stock prices. They have continued this trend, thereby depressing the market as well as essentially halting all foreign participation which led to much of the rise in the stock market's first few months. As is the case throughout the region, additional capital was also lost due to the flight of foreign investment in the market in the wake of the Mexico crisis. Foreign investor confidence in the market continues to be low, with several Western financial institutions waiting for regulatory reforms and share prices to reach levels nearer their real value.
59. Today, most observers see a systemic liquidity problem that prevents many potential investors from taking large lots in privatized companies. Investment funds largely stay out of the market due to a lack of capital. In an effort to attract the largest share of vouchers from the public, investment funds have spent large amounts of money on advertising. More importantly, investment funds do not see shares in companies as investments but simply as disposable assets and therefore are more prone to sell rather than buy on the stock market.
60. However, they also point to several structural problems. First, the lack of regulation which the government is the first to applaud has actually caused more alarm than incentive for investors. Although there are financial disclosure rules in the Czech Republic, enforcement is considered generally weak and the rules often open to interpretation. With an illiquid market and poor financial disclosure of publicly traded stocks, it is not surprising that approximately 90 PER CENT of all transactions are performed off-market at unpublished rates. With almost all trading performed off-market, it is easy to understand investors' reluctance to buy large stakes on the stock exchange. while it is true that Western markets also have high percentages of off- market trading, they also have comprehensive reporting requirements and independent oversight institutions which do not exist in the Czech Republic.
61. Secondly, the Czech Republic does not have an independent authority, such as a Securities and Exchange Commission in the United States, to monitor trading. Cases of abuse have been rare, but this is not surprising due to the lack of business actually performed in publically-traded exchanges. The Czech National Bank, the Ministry of Finance and the National Property Fund have joint responsibility in overseeing the market. Again, it is the largest privatization funds controlled by the largest Czech banks and substantially owned by the state which bring the most influence on the stock market. Thus, from an outsider's point of view, this structure of numerous inter-weaving interests with vast insider dealing does not give the impression of a dynamic, independent and therefore attractive market.
62. One other significant reason for a wariness on the part of potential investors is that the Czech market is simply unable to cope with 1,600 new issues, the vast majority of which are unrestructured. As pointed out in the review of the privatization process, Czech investment funds are simply not restructuring their newly acquired "assets". Thus, they hope to find buyers in the stock market who will be willing to take significant shares of these many times non-performing companies rather than have to make the hard decisions themselves that could lead to bankruptcies and loan defaults to their parent company - the banks.
63. Lastly, share prices for Czech stocks have long been considered dramatically above their real market value. A fund manager at CS First Boston is quoted as saying about the prices of Czech stocks, " Some of these prices are in never never land".(5) While exchange officials argue that prices were calculated based on demand during the initial bidding process, many outside observers who have conducted their own studies have seen no such relationship. With the government unwilling to adopt significant regulatory controls on the market, the market itself is attempting to establish financial oversight themselves through informal dealer networks and reporting.
64. Thus, only $10 million worth of shares are traded daily on the Prague Stock Exchange which has a total "value" of $15 billion. Therefore, only a few stocks are traded per day with hundreds that remain untouched. At the same time, the most interesting trading is done off-market. The government had hoped that the second wave of privatized companies released on the market would act as a needed stimulus. Unfortunately, while this Report is being compiled, the Prague stock market continues to fall.
66. Immediately following the defeat of Adolph Hitler and the Third Reich, approximately 3 million Sudeten Germans were expelled from the country. Following the collapse of the communist regime in 1989, large scale migrations proceeded west. In 1992, the Czech Republic split with Slovakia leaving the latter with the vast percentage of large non- performing industries. In 1993, the government reduced the retirement age to 56 from 64 and tightened criteria for unemployment benefits. And lastly, the Czech Republic has the lowest birth rate in Europe which is expected to actually reach a negative growth rate in the next couple of years.
67. However, with a privatization process which essentially transferred the responsibility for employment from full state control to de facto state control through investment funds and state-controlled banks, much of the corporate downsizing required to compete in a market fast reorienting itself toward the West has yet to be done. Most government officials acknowledge that the current low rates of unemployment are temporary and that as the market becomes more competitive, particularly through the influences of direct foreign investment and banking, many companies will eventually fail. Prime Minister Vaclav Klaus has stated that their will be no government bail-outs. While there have already been government-inspired bail-outs, these were in large companies considered to be competitive in the future. Most of the others, without such an attractive portfolio, will not be so lucky if creditors discontinue lending.
68. Lastly, the Czech Republic has been able to keep an effective control over wages. The wages in the country are far lower than in Hungary or Poland. These low wages have kept operating costs down and attracted critical foreign capital. This policy has also helped the Czech Republic continue to be a strong exporting country on which its industries are now becoming solely reliant for revenue. The number one destination for Czech goods is Germany. Unfortunately, the recent growth in exports has been overcome by an increase in imports over the past year. With the prospects of a rising trade deficit and industrial restructuring put on hold, the OECD has recently forecasted a doubling of the unemployment rate from 3 to 6 per cent in 1995.
70. However, while industrial production has risen over the past year, vital improvements in capacity and efficiency have been delayed or have been abandoned. While the giant investments, such as in Skoda by Volkswagen, carry the headlines, hundreds of companies remain ill-equipped to compete in the global marketplace as competition intensifies and the level of Czech wages increases. Therefore, the OECD and the EBRD expect Czech production levels to fall in 1995 and 1996.
71. The lack of restructuring in Czech companies is primarily due to the government's privatization policies as previously discussed. The government has made it clear that it wants the new owners of these industries to make the investments. Unfortunately, in many cases, the new owners are the state supported banks in control of key privatization funds who are now the owners of the Czech corporate world. Of those companies which have more traditional private control, few have seen any modernizing, restructuring or streamlining of their facilities. This is due to the fact that the new private owners in the Czech Republic prefer to pursue short-term strategies with little investment to reap quick profits.
72. Therefore, the long-term outlook for Czech industry and export growth are unknown. If many industries are to survive in the long term, either investor philosophy will have to change or the government will most likely have to intervene to stimulate investment. This latter policy has both positive and negative effects. If the government chooses to intervene by either providing low-cost loans or direct subsidies, much-needed market liquidity may be achieved. However, any dynamic intervention by the government would be a significant reversal in policy and could potentially deter outside investors attracted to the Czech Republic's "hands-off" policies. The government will probably have to make some very difficult choices in the future, particularly if predictions are correct that its current account deficit is likely to expand greatly.
73. At the same time, the Czech Republic still faces significant obstacles to trade with industrialized countries in its key exports such as textiles, agriculture and metallurgical products. Therefore, it is looking to re-establish prior trading ties with neighbouring countries and in particular boost exports to Slovakia where it is now experiencing a trade deficit. In addition, prior to 1989, the Czech Republic had good trading ties with the Middle East. However, the recent exports to that region cause some concern as they have also included armaments. Even with this more global export strategy, the current overall trade deficit is expected to increase substantially in 1995 and 1996.
74. However, the overriding interest in Prague is the future membership of the European Union and the substantially favourable trading relationship which comes with it. Unfortunately, realizing that EU membership provides a "two-way street" for trade, the government as recently introduced anti-dumping legislation on EU goods to protect uncompetitive industries.
75. The Czech Republic has a difficult task ahead to ensure continued growth in its exports. With a projected doubling of the trade deficit expected in 1995, essential industrial privatization and restructuring has still to be done while at the same time facing continuing obstacles in exports of its most competitive products. Quite clearly, the government must address both the challenges of restructuring while ensuring continuing export growth through the phasing-out of external trade barriers. However, they should focus on the issues that they can control more directly - ensuring that the long- term effectiveness of its domestic industry will be assured.
76. One factor which has negative effects on Czech exports is the high value of the koruna compared to the currrencies of other countries in the region. In fact, some transition countries are beginning to use the koruna as a reserve currency. However, the possible re-evaluation of the koruna due to the mounting inflationary pressure coming from huge inflows of foreign currency has forced the government to consider further strengthening the koruna. At the same time, the government has also considered the future convertibility of the koruna. The Czech government and parliament are preparing to take the initial step of loosening its grip on the currency by instituting current-account convertibility which will probably produce appreciation in the koruna. With an inflation rate of 10 per cent, the government has pursued a tight monetary policy. Unfortunately, any future strengthing of the koruna will make exports more expensive. The government has a very difficult choice ahead as it considers devaluation of the currency to boost exports while at the same time combating inflation.
79. However, government divestiture of those companies which have already been partially privatized would provide a clearer playing field for foreign as well as domestic investors. At the same time, in order to accelerate restructuring of these companies, the government should use its stock positions to influence privatization funds to make the necessary tough choices. Simply blaming the investment funds for refusing to restructure is neither entirely accurate nor beneficial to the long- term strength of the economy. It is important to remember that on average, roughly 40 per cent of every company is owned by the government.
80. The government could provide this stimulus by more actively pursuing mergers and acquisitions between companies of which it possesses partial ownership to promote consolidation of industry. However, the government must also make sure that any future consolidation is based on economies of scale rather than the development of monopolies. The government may also expand the role of the Consolidation Bank which was established to acquire defaulted debts from former state enterprises. The government could also create foreign and domestic investment incentives either through debt write-offs or attractive land sales/leases. This strategy should only be considered short-term as the Europe Agreements and possible future entry into the European Union will force a cessation of active government financial assistance unless exceptions are provided.
81. However, the most productive would perhaps be a government/business partnership in industries considered viable for long-term growth. Rather than the current partial government ownership of industry, the government should divest itself but with significant tax and/or subsidies to ailing industries that require short-term capital investment. North America and Western Europe use this approach with great effectiveness such as SEMATECH in the United States and aircraft production in Europe.
82. Lastly, bankruptcy laws should be strengthened and enforced. The dramatic rise in inter-enterprise debt through continuing loans to non-performing companies will subvert any process to restructure industry. Therefore, bankruptcy law should be changed to allow financial institutions to bring bankruptcy proceedings with more ease as well as a stronger oversight role by the Czech National Bank or independent agency to ensure bankruptcies are carried out. This could be done by creating disincentives for such practices through raising the capital reserve requirements for banks which continue to make loans to non-performing industries or through full- fledged government takeovers of these industries where the state has a significant share of ownership. These industries would be given to the Consolidation Bank which could initiate a long-term restructuring programme to limit eventual unemployment from future liquidations.
83. The judicial system should also be given greater resources for the training of judges and their staffs in bankruptcy cases. The European Union and the United States have already invested resources in such a programme. This work should be expanded to accelerate a bankruptcy process that currently takes years.
84. Unfortunately, none of these proposals will work under the current environment. The banking sector, and more specifically the investment funds, must be decentralized and fully privatized in order to promote greater competition and efficiency. While countries in Western Europe, such as Germany and France, have active government or banking involvement in business activity, their economies are far more transparent, they have strong safeguards on practices of collusion, an independent anti-cartel institution and well developed legal systems capable of adjudicating illegal business activities. Although the Czech Republic on the surface has a similar mixed economy, or social market economy as it is called in the Federal Republic of Germany, it does not have the corresponding appropriate safeguards which are also present in these countries.
86. First, the government could facilitate buy-outs of smaller banks by the larger banks which is already taking place. It may also place limits on the percentages of loans and assets any one bank can hold. There are regulations currently in place to institute such a maximum percentage but which are not enforced. Most importantly, the government should divest itself from the banking industry. Due to its immense ownership of the primary banks in the Czech Republic, banks can not be considered immune from political influence. Such immense influence from the state in these banks also suppresses essential competition in the sector as loan rates remain high and savings rates remain low. Due to the extremely large amounts of capital required for such investments, the government should encourage Western investment in this critical sector. Direct foreign involvement in the leading banks would also bring valuable technical expertise to the industry.
87. While new legislation providing for limited deposit insurance has been passed, this should be monitored carefully to ensure that when bankruptcies in the sector do occur personal savings are not threatened. As wage growth continues, the current deposit insurance of roughly $3,500 should be adjusted upward. Unfortunately, the Czech Republic does not have a federal insurance agency that would rescue depositors if a financial institution failed. This is a major deficiency that should be rectified.
89. Legislation should also be passed mandating tougher disclosure rules for all companies with publicly traded stock. The lack of company information has frequently halted trading of certain stocks, thereby artificially depressing the market. The market should also publish a daily trading summary so that investors have a better understanding of buying and selling patterns. Several traders are attempting to introduce a similar publication themselves but without universal assistance.
9. Although the damage has already been done, in future the government should not introduce equities in the market in one lump sum. The multitude of stocks issued at once after the two mass privatizations weakened a market that was incapable of handling the vast number of issues. Therefore, in the future, stocks should be introduced on a gradual basis.
91. Lastly, the market should further develop ties with other stockmarkets in Europe. Several prime Czech issues are currently trading on the Vienna exchange. A stronger relationship with established European and North American exchanges would greatly help investor confidence.
93. First, the government must make sure that these funds are not investing more than the maximum 20 per cent in any one company. Currently, 12 investment funds are under investigation for exceeding that limit. Secondly, new legislation should be drafted to mandate strong "fire walls" between the business performed by the investment funds and their parent bank in the cases where this applies. While there are laws currently requiring this separation of interests, they are considered weak and additionally suffer from poor enforcement.
94. A combination of banking activities and the ownership of investment funds should only be acceptable if the government constructs a powerful independent anti-cartel organization, more comprehensive and regular financial reporting requirements and strengthens commercial and banking law and enforcement. Unfortunately, due to the fact that the state holds substantial ownership in the banks with the largest investment funds, these firewalls will be difficult to construct to be effective. Thus, the prior recommendation for government divestiture in Czech banking should be considered.
96. This critical analysis of the Czech economic reform process is intended to show that there is no such thing as an easy transformation from a command society to a market economy. The Czech "employment miracle" and the mass privatizations are examples of policies which on the surface appear to provide a case for far simpler remedies to the painful experiences of its neighbours in their efforts to bring market reforms. Unfortunately, there are significant dangers in the policies developed by the Czech Republic that other countries who wish to emulate their reform process would be well counselled to consider.
97. Time will tell whether some of the potentially dire predictions contained in this Report will come true. However, there is no doubt of the serious systemic deficiencies in the Czech banking, privatization, industrial restructuring and exchange policies. Clearly, the NATO countries have a responsibility to point to these deficiencies and provide technical resources to promote a transparent, market-based economy that will bring the necessary foreign investment and production efficiencies the Czech Republic requires.