Czech Capital Markets: a View from Abroad

Dr. Z. Sid Blaha, M.A. is a Canadian-educated financial economist. He left his country of origin - former Czechoslovakia - as a teenager in the early-1960s and soon afterwards started his career in the investment business in the U.S. and Canada. He continues working as a senior advisor and project consultant for the North American private sector: investment banks, financial corporations, mutual funds, institutional investors and other non-government entities. Z. Sid Blaha is also Associate Professor of Finance at Charles University in Prague (Institute of Economic Studies), where he teaches graduate courses in Corporate Finance, Risk Management and Financial Engineering on Developed Capital Markets. 

Investment funds and the emerging capital market in the Czech Republic
Investment funds have had a key role to play in mass privatization. But have they lived up to expectations?
The first part of the paper looks at that question in the Czech Republic, the first to experiment on a large scale with mass privatization and one of the few for which enough time has elapsed and enough data are available to permit a tentative assessment.
We argue that in both cases expectations have not been met and the initial design problems in mass privatization—asymmetric information and imperfect property rights—still remain.
In many transition economies, investment funds have been assigned an important role during both the implementation phase of mass privatization and the post-privatization development of financial institutions and capital markets. In the implementation phase, investment funds were expected to amass necessary data about companies and to develop the portfolio management expertise to make informed investment decisions.
Moreover, endowed with a pool of voucher capital (coupons) accumulated from citizens, investment funds could invest in a large number of companies and thereby diversify their own risk as well as that of their investors. Thus, investment funds were developed to help speed the process of mass privatization while ensuring that individual investors had equitable access to opportunities to invest in newly privatized companies.
Investment funds were also expected to contribute to the creation of private property rights and to capital market formation in the post-privatization environment. A potential danger of mass privatization is widely dispersed share ownership in privatized companies, which the architects of mass privatization recognized could result in a control vacuum: large numbers of investors with only small stakes in companies would be unable to monitor their management. 
The solution to this tension between broad participation and effective governance was to create financial intermediaries in the form of investment funds. By pooling investment capital, the funds would consolidate shares, essential for effective corporate governance.
Finally, the funds were expected to serve an important function as financial intermediaries in the newly emerging capital markets. By forming a link between productive assets and small private shareholders, the funds would represent the initial experience of the investing population in the development of new financial markets.
Thriving on the returns of their original investments, the funds were expected to attract additional capital from households. Moreover, by developing the portfolio management expertise to make informed investment decisions, the funds were expected to contribute to the development of credible information about attractive investment options.
The immediate goals of mass privatization— speed, equitable outcomes, and property rights formation—form the baseline for this assessment of the role of investment funds in the Czech Republic. These notes also look at the relationship between mass privatization and the emerging domestic capital market in the Czech Republic.

The former Czechoslovakia started its first wave of mass privatization in early 1991. The number of funds created (and the proportion of vouchers they accumulated) far exceeded policymakers’ expectations: more than 400 investment funds were established in the former Czechoslovakia for the first wave, and another 221 funds for the second wave in the Czech Republic alone. Despite the many differences in design between the Czech and Russian mass privatization programs and the markedly better economic environment in which Czech funds operated, the investment funds in the two countries have encountered similar problems and in some cases – in this presentation – we tend to compare the two.
Czech funds had several advantages that gave them a better chance of being active shareholders in better companies: they were able to buy up to 20 percent of a company’s shares, insiders did not gain control of large stakes, and the design of the auction system was supposed to lead to better information for making investment choices.  Funds typically hold the legally permitted 20 percent in a large number of companies in their portfolio, and several funds together often own a majority stake, enabling them to acquire board seats. But the strong representation has not resulted in significant shareholder activism by the funds, and there is little evidence that fund ownership and board representation have had much impact on restructuring.
There are several reasons to expect that a liquid capital market would develop more easily in the Czech Republic than in Russia: the absence of high inflation and the uncertainties it creates, the easier flow of information and lower transaction costs characteristic of a small country, and the lack of a highly distortionary tax regime. 
Yet even though the Czech stock market has been more liquid than the Russian market, but very illiquid and non-transparent in comparison with more developed capital markets, most trading has taken place off the Prague Stock Exchange, often through swaps between voucher funds. (Many transfers of ownership have been simply effected in the so-called Securities Center at prices which bore no semblance to market prices. These practices have discouraged many Western investors and similar practices – sometimes more, sometimes less ”shady” – will continue to do so for years if not for decades to come.) Czech funds have even mounted mergers and takeovers of several companies. But, on the whole, the market for corporate assets has been characterized by insider dealing and a lack of transparency. This may be a result of the large stakes acquired by funds during privatization, which cannot be easily liquidated on official markets without steep discounts in prices. But – in the view of some private anglo-saxon investors and academics - it reflects the lack of legal and efficient oversight of the capital market.
In the Czech Republic, more funds have been listed on the stock exchange than in Russia (in 1995, they accounted for 8 percent of stock market capitalization). But Czech funds have faced similar difficulties in raising additional capital and developing a secondary market for their shares. As a result, many of their investors are locked into their current holdings. Recent scandals – in mid-1990 and later - surrounding Czech investment funds have highlighted the control vacuum—and fund managers’ exploitation of it. 
One of the most intriguing aspects of the Czech funds has been their close relationship with the banking sector and the degree of cross-ownership in the financial sector. The largest banks in the country are owned mostly by other banks and by investment funds, including funds established by investment companies that in turn were created by the banks. Investment fund regulations that could and probably should have been interpreted as counter to this degree of cross-ownership proved ineffective. The cross-ownership between banks and funds, and between them and the companies they own, enable the participants in this network of cross-ownership to hedge against hostile takeovers and other market adversities. But evidence suggests that cross-ownership of funds has hurt shareholders because of the heavy discount at which fund shares have been trading. And many observers doubt that banks have managed to raise firewalls between themselves and the funds. In the light of several bank failures that raised concerns about funds that are – or have been - directly or indirectly controlled by these banks and that frequently also hold assets in them. 
In mid-1995, several funds in the Czech Republic were transformed from portfolio investment funds into holding companies. As simple joint stock companies, these funds were, therefore, no longer subject to investment fund regulations. They could increase their stake in companies beyond the 20 percent ceiling and freely transfer capital abroad for foreign investment activities. As company owners, it was hoped that these funds might have taken on a more proactive role, but doubts remained as to whether the funds’ investors would benefit. As it turned out, unfortunately, in many cases the proactive role consisted of covert ”asset-stripping” and siphoning off of cash of the industrial companies. The Czech word ”tunneling” (meaning stealing or asset stripping) got into the English vocabulary in the late 1990s and has been used in some ”official” literature, among other things, for example, in a report on the Czech economy by the IMF. 
Assessing the record
The Russian and Czech mass privatization programs have succeeded in privatizing a once inconceivably large number of companies in a short period. But if we are to take the goals of mass privatization seriously, other criteria must also be considered in assessing the outcomes. Did investment funds help to ensure equitable outcomes in mass privatization? The record on this is discouraging in both the Czech Republic and Russia. The discount at which fund shares were being traded—if they were traded at all—reflected the market’s perception that the funds either have been unable to enhance the value of their holdings or have failed to share any gains with their investors. Dividends, if paid at all, have been extremely low. Sadly, by and large, citizens have become owners of the worst-performing assets in Russia and the Czech Republic, while the ”crown jewels” have gone to insiders. This negative experience in mass privatization makes small investors’ lack of confidence in the Czech capital market a rational response. To be blunt, the process of ”heeling” may take years and most probably decades. Indeed, the properly functioning and efficient capital market with all of its concomitant economic functions and necessary attributes may never appear in the Czech Republic. 
Have investment funds contributed to effective private property rights? The evidence suggests that establishing property rights is a longer and much more complicated process than nominal allocation of title. Moreover, there are troubling signs—both in the Czech Republic and Russia—that the property rights created in mass privatization in a hasty attempt to ”depoliticize” property relations may be too weak to support sustainable property rights reform. Many new outside owners—including the funds—have been effectively frozen out by company insiders. Where new owners have been unable to establish their rights, companies remain in a control vacuum. There have been several documented cases of this ”limbo” in the Czech Republic which augur badly for the proper functioning of property rights. 
And the government, particularly at the regional level, has continued to play an important role as a silent owner and rescuer of last resort. In the Czech Republic, the outcome has been relatively satisfactory at least so far, but several banking failures, losses associated with savings associations and fraud surrounding voucher funds caution against too positive an assessment of the new property rights regime. 
What is the relationship between investment funds and capital markets? While markets were supplied with a large amount of equity as a result of mass privatization, they have remained undersupplied by (domestic) capital. One reason that efficient capital markets have failed to develop is the lack of an institutional framework. Investment funds had the potential to play an intermediating role in the development of new capital markets, but many have become holding companies or passive investors rather than actively engaging in portfolio investment.
Information asymmetries between small investors and large firms or insiders persist in the Czech Republic and most other countries in the region, increasing the risks of investing in their capital markets. Moreover, the negative experience of a large part of the population with voucher privatization has reduced confidence in emerging financial markets. The development of mechanisms of financial intermediation remains a serious issue in the Czech Republic. 
On certain important points there appears to be an agreement among both the ”private” and ”official” financial economists and investment professionals. The IMF in the concluding statement mentioned above in this paper has noted that, among other things, ”lack of corporate governance, disregard of investor protections, poor lending decisions by banks, and failure to acknowledge the need to close non-viable production units have resulted in the survival of large, inefficient, and excessively indebted corporations throughout the industrial landscape”. There is a broad consensus that this lies at the heart of the current economic malaise and that this legacy must be cleared and an efficient financial and industrial system reconstructed.
Some of the ”private” foreign sources contend that central to such a mammoth endeavor is the privatization of banks and, in particular, that strategic foreign investors should have been brought in to establish a sound banking and equity culture. One is reminded, at this juncture, that the populist Czech economists-turned-politicians did not even want to hear about ”foreigners owning our assets” and turned to the ”Czech way” (i.e., coupon privatization) instead. Foreign investors, analysts, and academics warned the Czech politicians about it right at the beginning of the transition in the early 1990s but to no avail. For example, the 1990 Nobel-prize winner, professor Merton Miller of the University of Chicago in his lecture in October 1991 to a distinguished Prague audience reiterated that: ”I do stress that you must put aside your national pride for a moment and draw on the capital markets and players with experience in large countries, the underwriting procedures and so on. They might perhaps even take, initially at least, a sizable chunk of the action.” Unaware that his words were leaving some members of his audience (communist-trained accountants, socialist-era economists and lawyers posing as connoisseurs of free-market economics) in thinly disguised anger, professor Miller, with wisdom, knowledge, and practical experience in North American capital markets spanning almost half-a-century, continued: ”…. That is where the capital is coming from. They (i.e., the foreign investors) have capital to invest and you have investment opportunities. I think that there is a natural synergy.” Not yet aware at this point that several of the so-called ”fathers of coupon privatization scheme” were sitting among his audience, M. Miller answered a question regarding coupon privatization asked by the then deputy prime minister (Pavel Hoffman) in the following way: ”Well, you don’t have a financial market and I believe that trading the coupons will not contribute anything. You will still be back where you were before.”  Slightly later, noting that (some of) the assorted politicians, lawyers and old-regime economists lacked understanding of the intricate web of interrelated mechanisms, including checks and balances that enable developed capital markets to function, the straight-talking professor Miller said: ”You have a very stiff idea of the capital market, see. The capital market is not a big building with three columns and so on, with a lot of people running around.  The capital market is some kind of arrangement in which the prices get established.”  When some in his audience persisted in literally singing glory about the coupon privatization, Mr. Miller – by now visibly annoyed by the perceived amateurishness of the so-called ”fathers of coupon privatization” and their apparent lack of any relevant experience in functioning capital markets – addressed this point (when pressed by Mr. D. Triska of the Federal Ministry of Finance) and retorted sternly: ”Well, I would say if that’s the route you’ve chosen that’s the route that you’re going to get. I would have urged you to have done it a little differently ….” Years later (in the second part of the 1990s), a friend and colleague of prof. M. Miller (a substantial private investor), noting the difficulties the Czech Republic was in, with bank failures and non-performing capital market with all the attendant difficulties that have been plaguing it, told us: ”Well, that’s the route they got.”
Interestingly enough, prof. Miller was one of the first academics who urged regulatory oversight, compliance with laws and regulations, built-in safeguards and other functions usually performed by the U. S. Securities and Exchange Commission. He warned his audience (to no avail): ”The danger in the privatization scheme that you have chosen is that, you know, there are no protections involved here.” As is well-known, prof. Miller’s recommendation that ”… one of the things that you must have as part of a stock market system is a suitable regulatory structure” was simply dismissed by the Czech political and economic circles at the outset. 
	Clearly, the chicken comes home to roost: in the report by the European Commission published on Nov. 8, 2000 and called ”On the Czech Republic’s Progress towards Accession” there are neat mentions about certain priorities that have not been met. One such is the issue of protection of minority shareholders and ”it remains to be addressed”.

Has is all been for nought?
However, we prefer to end on more positive note: it was clearly stated earlier in this paper that there may never develop a viable and properly functioning Czech capital market where various financial instruments would be efficiently traded. This ”window of opportunity” of domestic capital market, available perhaps for a fleeting moment in the early 1990s and having been irrevocably lost since, does not mean, however, that reasonable functioning of the ”real economy” is not feasible or could not be sustained without domestic stock and bond markets. There are other countries with fairly functioning economies and acceptable – albeit not high - living standards without any capital markets to speak of. Therefore, perhaps not everything has been for nought. For example, many official international institutions believe that the Czech economy may perform satisfactorily, especially in the longer run, and without domestic capital markets underpinning it.  In the report mentioned earlier, the IMF believes that there should be scope for a substantial economic recovery from 2000 in the Czech Republic and relatively high rates of growth over the medium-term driven by investment and exports. Indeed, the IMF mission concludes its report by noting that: ”In sum, the Czech Republic faces large challenges in the period ahead as it seeks to lay the basis for sustainable growth over the medium-term and advances preparations for EU accession down the road. The required macroeconomic and structural policies will entail difficult political choices and considerable economic and social stress in the short run, but there is no alternative in the progress from transition to convergence. While the deep-rooted structural problems in the economy should have been addressed several years ago, it is far better to press ahead this year than next. There is no time to lose.”

This paper is based on sources believed to be reliable but the material and its accuracy cannot be guaranteed. Whilst all reasonable care has been taken to ensure that the information contained herein is true and not misleading at the time of writing, we make no representation as to its accuracy or completeness and it should not be relied upon as such. 
By ”the sources” we mean, by and large, private sector financial economists and other experienced investment professionals active on the North American capital markets (and, in some cases, elsewhere).
Contrary to naïve expectations of many people in emerging markets in Central Europe and other post-communist countries, these private financiers (important members of ”international investment community”) possess a large financial clout but, not surprisingly perhaps, have chosen to avoid portfolio investments in the Czech Republic and some other transforming economies. By portfolio investments we do not mean green field investments or foreign direct investments into a well-defined entity or projects where the (foreign) shareholders wield a large interest or outright voting and operational control and/or ownership, such as ownership of Skoda Auto Company by the German firm Volkswagen.  
The seminar ”Reform of Financial Sector and Banking in Transition Countries” was understood, by this contributor, to contain attributes of an open forum intended to encourage dissemination of and debate on ideas, innovations, and best practices for expanding the private sector and capital markets in the transforming economies. This paper looked particularly on the Czech capital market, investment environment, regulatory safeguards, and the shortcomings thereof. The views published are those of the author and some private investors and financial economists in the U.S. and Canada with interest, albeit small or declining, in the post-communist countries and should not be attributed to the Seminar, VSE, nor any of its affiliated organizations. Any conclusions represent viewpoint of the author; in some cases the author interprets the views and opinions of his private contacts. None of the opinions or conclusions in this paper represent official policy in the Czech Republic, Canada, the U.S. or any other country that may have been mentioned in this report.  

Annex:  Some excerpts and observations from the ”2000 Regular Report” by the European Commission called ”On the Czech Republic’s Progress towards Accession” and published on 8 November 2000.
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Corruption continues to be a problem, as does economic crime (fraud, money laundering, institutional theft, and the phenomenon of ‘tunnelling’ or asset-stripping). Despite efforts to combat them, implementation in these areas is still far from satisfactory (see Part B.3.1., Chapter 24 on Cooperation in the field of Justice and Home Affairs).
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Civil and political rights
Since the last Regular Report, the outstanding issue regarding the citizenship of those individuals who lost their citizenship in the period between 1948 and 1990, under the Communist regime, was addressed by an amendment to the Act on Citizenship of Some Former Citizens. These individuals may now apply for acquisition of Czech citizenship on the basis of a declaration.  (Note by the author: This is one of the points of contention between the successive Czech governments and the large exile community of Czech origin in the U.S., Canada and some other Western countries. The gist of this problem lies, quite simply, in the ”exclusion” over the last ten years of many exiled former Czech citizens in the ”spoils” of restitution on the basis of their not having the Czech citizenship. The fact, that now – when it is clearly too late to ”restitute” their former property – these former Czech citizens may finally apply for their original citizenship, speaks volumes about the nature of the conduct of the successive Czech governments and decision-makers. Essentially, the exiles – many of whom hold U.S. citizenship - may finally apply for acquisition of Czech citizenship on the basis of a declaration, which makes them ”eligible” to apply for restitution of their long-lost property. As it turns out, it happens to be too late for that now. ”Elementary, my dear Watson.”) 

1.3. General evaluation
The Czech Republic continues to fulfil the Copenhagen political criteria. Recent significant developments include, in particular, a more effective collaboration between the government and Parliament.
There has been progress in setting the legal framework for regional government. However, the reform of the public administration has not advanced significantly and therefore the short term priority of the Accession Partnership in this field has not been met. The reform of the judiciary is equally a short-term priority of the Accession Partnership. Whilst progress has been made, it is regrettable that certain key parts of the reform have not yet been adopted. Administrative and judicial reforms are both essential for effective enforcement of the acquis and improved good governance. Thus efforts must be pursued in these fields, in line with the medium term priorities of the Accession Partnership.
Furthermore, the fight against corruption and economic crime has so far been insufficient. Tangible results in this field will respond to public concern and help ensure a transparent business environment. 
The Czech Republic should be able to cope with competitive pressure and market forces within the Union in the near term, provided that it keeps up and completes the implementation of structural reforms. (The Czech authorities complain about this line and want it deleted before the ratification of this report.) The authorities need to concentrate on developing a transparent and predictable environment supportive of business activity – especially in the area of small and medium-sized enterprises – and on other measures conducive to sustaining economic growth. In this respect, the further improvement of the legal framework, the strengthening of corporate governance, the acceleration of enterprise restructuring, and the continued development of the financial sector are essential. 
These measures would result in more efficient enterprise and banking sectors, and help to sustain increases in productivity and competitiveness.
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A crucial task for the Government is to overcome the cycle of dependency among state-owned banks, bank-owned funds and only nominally-privatised companies owing large sums to the banking sector.
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The legislation in the area of Company law is largely in line with the acquis but the issue of protection of minority shareholders remains to be addressed. This priority has not been met.