Prague, 22 November 2019
Dr Zdenek Drabek
30 years of transformation of post-communist Czech Republic is certainly a moment to reflect and to appraise. Lidove Noviny has recentkly invited some of the key “architects” of the transformation such as Triska, Klaus, Dyba, Kysilka, Dlouhy who have, not surprisingly, all sang an ode on the successes of the process. I agree with many of their conclusions. Economic recovery and growth, a spectacular reduction in unemployment, taming of inflation, low debt ( by international standards), healthy fiscal position, large and rising foreign reserves – these are all indicators of a relatively healthy process. One should also add that the economic transformation took place with social peace and no violence, which is also no minor achievement! But as positive these results are they are not spectacular. The current economic growth is modest and nowhere near the rates achieved over long periods in , for example, South East Asia and in China in particular. Moreover, the current rates are roughly comparable to countries such as the US so that the gap against advanced countries such as the US is not narrowing very fast. It is narrowing rapidly in comparison to China but in the wrong direction! Moreover, none of the quoted architects mentioned anything about the costs of the transformation. Were they high? Could they have been lower?
The successful transformation has been achieved by policies built on three pillars:
(1) liberalization of prices ( though not necessarily liberalization of markets !)
(2) strict macroeconomic policy to protect the economy from inflation and
(3) privatization.
These are the standard recommendations and elements of the classical stabilization programs and structural policies of the Breton Wood institutions with one major exception, or rather a specific feature of the program – privatization of a large share of state assets by means the so-called voucher privatization. While the protagonists of the transformation model were patting themselves on their shoulders and congratulating themselves for the success, it is remarkable how little they have talked about the costs of the transformation. Were the costs so minimal that they could be dismissed as irrelevant? The answer to the question is – yes, the transformation was associated with high costs, the effects of which are seen primarily 20 years later.
Costs of Mistakes.
In 2008, the former president of Czech Republic Vaclav Klaus published jointly with Vladimir Tomsik a text in which they wanted to look at the performance of the transformation process with almost a 20 years hindsight. “Makroekonomická fakta české transformace”, NC Publishing 2008). They focus entirely on economic analysis and somewhat “relegate the discussion of institutional and political issues into the background. By dropping the latter they have limited themselves to the analysis of comparative economic data, and it would not be fair to criticize them for what is missing in the text rather than for what is in it. Nevertheless, it is important to keep in mind that economic policy is not operating in a vacuum and that both institutions and politics are critical for matters of importance to economics and to modern economists such as formation of expectations, economic priorities, implementation capabilities of policies, stability of policies etc.
The main argument of Klaus and Tomsik is that the Czech transformation took place with the lowest costs, by which they presumably mean the lowest in comparison to transformations elsewhere in the post-communist world. They point to the good macroeconomic figures such as low rate of inflation or mild drop in GDP following the strict stabilization measures or relatively small job losses and low level of unemployment. By focusing on macroeconomic indicators, their approach is clearly very limited. It leaves aside a whole range of indicators such as those related to innovations or governance or international competitiveness, effect of policies on incentives etc.
Be it as it may, the authors’ treatment of macroeconomic indicators itself is problematic. While it is true that the “shock” of transformation was not dramatic, it is arguable that the mild depression was entirely due to the successful strategy. The initial conditions existing in 1990 also mattered, and those conditions were in the Czech Republic far more favorable than in most transition economies. This takes me to the specific problems of the transformation process.
Costs of stabilization policies.
Much has been said about the successful stabilization policy post 1990. And successful it was. The costs of financial stabilization – even though they were high by Czech standards – were impressively low compared to costs of disinflation in most other post-communist countries. This was partly achieved by stabilization policies of the government but also by “luck” – or rather by the fact that the inflationary pressures in the country in 1990 – at the start of the stabilization policies – were far milder than in other post-communist countries. (The evidence was provided by Drabek, Janacek and Tuma in their article in the JCE in 1994).
Nevertheless, policy mistakes were also made policy makers, and those mistakes were mistakes of economic ignorance and political expediency. Given the objective of opening markets and liberalize prices, the key question was fixing the exchange rate. The decision was taken to fix the rate at 28 Kc/1$, even though the IMF was suggesting 32 Kc. To some, the difference of about 15% may appear small (but how about you earning 15% on your deposit account?), the actual rate was clearly not sustainable. In order to maintain the ER the government was, therefore, obliged to support the rate by additional protective measures against imports by means of perhaps the worse policy choice – imposing additional import surcharges. This measure has installed a highly anti-export bias – strong incentives against exports – a policy mistake that was probably one of the reasons for the devaluation 20 years later.
Financing privatization.
Much has also been written about the privatization experiment of the Czech policy makers. The strategy consisted of direct sales of state enterprises to investors, transforming state enterprises into corporate entities – and the Czech invention – the voucher privatization. There is no doubt that the strategy has enabled a massive transfer of state assets into private ownership or at least into entities operating on commercial principles. Economically, that was the relatively easy part even though, technically, the system was quite sophisticated and well executed. However, speed of the transfer of assets is one thing – it is essentially a political matter – the efficiency of the transfer is another. And in discussing the efficiency, that is where the praise takes some beating.
( 1) Bank failures.
Privatization of state assets is difficult in situations when there is shortage of domestic capital. We just have to remember that the country was coming from a deeply communist system in which private capital was all but wiped out. Klaus government “championed “ Czech interests but there was a “minor” problem – Czechs had no capitalists, entrepreneurs and, in general, no domestic private capital. Privatization required, therefore, either foreign capital or – bank credit. As L. Mlchoch nicely writes : “The government chose a mix, heavily favoring the latter – and has paid the price and we are now bearing the consequences. “ It has led to an increasingly important role of banks due to the extremely poor role of “privatization funds” that were created to help consolidate capital ownership. The absence of a strong non-bank risk capital has significantly distorted the risk – reward appetite by banks that faced little competition from privatization funds. Moreover, the biggest banks were privatized much later and state owned banks and their close ties with politicians ended up, not surprisingly, in serious difficulties. Many collapsed, a huge share of non-performing loans was generated and several had to be rescued with the costs of rescues running into billions of crowns.
(2) “Tunneling”.
At the same time, poor oversight over privatized state firms, poor regulatory system over privatization funds, poor regulations of financial transactions and poorly functioning judiciary system have led to another Czech invention – “tunneling” (Czech contribution to the dictionary of financial terms) – or asset stripping as it would be called in a country with established capital markets. These shortcomings allowed managers of state enterprises to borrow from their own enterprises to acquire control (“Mostecka”?), or to transfer assets into other firms under their personal control, or permit investors to purchase state enterprises by means of other methods that would elsewhere qualify as “insider- trading”. The system provided room for investors to avoid paying taxes and, for some of them, to hide illegal activities or sources of their funds and so on.
(3) Minority shareholders.
The architects of voucher privatization were boasting about the merits vouchers – the vouchers were expected to offer a share of state assets to each adult citizen and thus provide for popular support of privatization. Now fast-forward 10 years. The consolidation of ownership of privatized assets has led to a massive “squeeze out” of minority shareholders often without any compensation. One should recall that vast majority of minority shareholders were Czechs! The result must have been a deep sense of disappointment among “DIKs” (owners of vouchers – citizens),a buildup of frustrations and, quite clearly, it has led to a loss of support for government policies – exactly to the contrary of the main objectives of voucher privatization!
(4) Poorly developed capital markets.
In his presentation to the panel on “Democratic revolution 1989 -30 years later” in the Czech Senate (6-8 November 2019), professor Mlcoch criticized the privatization strategy as “privatization without capital and as privatization on credit” and called voucher privatization the greatest “business game” ever played globally. Not much has changed 30 years later. Corporate financing is dominated by bank lending, government borrowing is taken up mainly by banks and foreign investors and partly by parastatal organizations, funding, for example, the government retirement schemes! The Czech stock market currently trades 11 titles, not a great advertisement of trust of Czech firms to raise capital in stock market. When one of the most successful Czech firms – AVAST – sought a new capital, it organized its IPO in London. IPOs of Czech firms such as NWR or Domus went through the Amsterdam stock exchange. The largest private holding – PPF – is registered in Amsterdam for obvious reasons – ease of doing business and friendly business environment. In contrast, the Polish stock market (Warsaw Stock Exchange –WSE) listed 432 domestic companies, and their capitalization amounted to EUR 152 billion at the end of 2017. Stock markets of other emerging economies such as Hong Kong or Shanghai are almost like from another planet.
Concentration of capital.
Privatization has stimulated another feature of the transformation process – extremely high concentration of industrial and financial assets. Czech Republic is not unique in this respect but it is probably one of the extreme examples. It may be interesting to note that precise numbers are still difficult to come by; looking for any indication in Google search brings no results and, to the best of my knowledge, there are no studies available to cover the issue in depth. Nevertheless, firms like PPF, EPH and Agrofert, big enough to make it of interest to Forbes’ rankings of wealthiest businesses and businessmen, are vast holdings covering a large number of economic activities. EPH – holding of K. Kretinsky’s activities include such diversified businesses as oil, media, waste management or trading (Metro). Kellner’s activities in PPF and Babis’ in Agrovert are even wider.
It is difficult to imagine that such a great concentration of capital is conducive to efficiency. All of these successful businessmen are clearly dominant players in their markets severely distorting their relations with their contractors and other clients. Bank lending is inevitably oriented towards these companies increasing exposure of banks to credit risk. The size of PPF and Agrofert is already big enough to make them “too big to fail” and the companies could soon become a systemic risk. Their capacity to attract talent is enormous and it takes away those skills from domestic startups and from the development of domestic entrepreneurial class.
Social and political costs.
Perhaps the most damming condemnation of the transformation is the dent into public confidence and into the support for market – oriented solutions. Similarly badly fares the support for government policies other than those that appeal to the basic human needs. Numerous scandals involving Czech politicians has undermined the trust in government. In addition, government policies are seen as favoring the rich and crooks even though Czech society is one of the most egalitarian societies in Europe and beyond. Corruption, tax evasion, bribery, and even blatant theft or “tunneling” of privatization funds have seriously affected trust in private investment. They are undoubtedly some of the biggest impediments to the reform of the social security system. Procrastinating court proceedings, unresolved legal cases and corrupted judges have undermined trust in the law and in the judiciary. Last but not least, cynicism among both older generations and even young ones is widespread. In such a mood, people become easily attracted to populist measures and have little interest in big pictures and noble values.
Dr. Zdenek Drabek is an expert in trade policy and foreign investment. His primary professional aim is to help governments, private sector companies, consumers and civic society at large to understand appraise and decide about the value of trade and investment rules and trade and investment governance. His expertise is driven by his unique background skills, and experience which combine practical experience in top policy advice with deep economic analysis and strong academic origin.