May 6 2009

On the road to market economy

Analysis of the transition process of the Czech Republic

Prague, Dartmore Institute, May 6 2009

Martin Pospisil

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Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic crisis

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When did you here first about the Czech

Republic/Czechoslovakia?

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For the understanding of the transition process it is

necessary to understand the modern Czech history

•Reforms •Velvet revolution •EU

1918 1939 1948 1968 1989 2004

•Democracy •Nationalisation •Normalisation •Transition
•Land reform •Stagnation
•Dictatorship •Occupation

Comments

• History matters
• Czechoslovakia’s interwar income was higher than Austria, Belgium (after 40 years of communism less half of
theirs)

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Path dependency is the key principle in social sciences

and it can help to understand the problems of the
transition

Path dependency is produced by learning and cultural transmission

Formal rule transfer is not a condition of good performance

Formal vs. Informal rules

Differences between post-socialist countries can be tracked to informal norms

diversity

Privatisation will not improve performance if informal constraints remain unchanged

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 May 6 2009

Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic crisis

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 May 6 2009

MOTTO
“The rise and fall of the Soviet Empire can not be explained by the tools of the neoclassic
analysis. We need institutional and cognitive approach to solve current problems of
development.“ (North, 1997b)

Douglass North (born 1920) is an American economist known for his work in the history of economic thought. He is the co-recipient (with Robert
William Fogel) of the 1993 Nobel Memorial Prize in Economic Sciences. In the words of the Nobel Committee, North and Fogel were awarded
the prize "for having renewed research in economic history by applying economic theory and quantitative methods in order to explain
economic and institutional change."

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The Theoretical Background of the Transformation was

affected mostly by the standard neoclassical economics

Aims of the transition program:

• Liberalisation of prices
• Macroeconomic stabilisation policies
• Privatisation of state owned corporations
• Development of the market infrastructure including an adequate institutional framework
• Temporary stabilisation and anti-inflationary administrative regulations

Washington Consensus (WB, IMF)

Even very liberal economists proposed temporary stabilisation and anti-inflationary administrative
regulations

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Washington Consensus was not suitable for former

command economies

Set of policies for promoting economic growth was prepared for Latin America first

Not suitable for the former command economies, as they did not take into account different
historic and institutional differences

“Second generation reforms” were needed

Washington Consensus did not succeed because it did not involve institutions

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The Theory of Property Rights did not play a significant

role during the transition

Erik G. Furubotn, Svetozar Pejovich (1974)

Enforceability of law, importance of public moral and social ostracism too

“A property right is the exclusive authority to determine how a resource is used,

whether that resource is owned by government or by individuals. Society approves
the uses selected by the holder of the property right with governmental
administered force and with social ostracism” (Alchian, 1965)

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Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic crisis

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From the beginning it was Vaclav Klaus who pushed his

views forward

Vaclav Klaus Vaclav Havel

• Minister of Finance, Prime Minister, • President

President • Moderate reforms, gradualism
• Thatcherism, Milton Friedman
• Rapid privatisation

Source: Brada, 1991 13

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There was no capital present at the beginning of the

transition which made the process much more difficult

Financial sector and especially capital market was only forming, property right were
not well defined, market-oriented management was absent->Privatisation without
Capital

Czech privatisation has not been a result of spontaneous evolutionary processes in

the market explained by Hayek

Strong neoliberal concern

Fiscal conservatism: no big foreign debt, no high inflation

Not many capable economists, no capable lawyers prepared for the change

Country was unprepared and ill-equiped to develop a comprehensive reform

package

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Price allocation mechanism was totally missing

Distortions

• Ineffective allocation of resources because of irrational administrative price system

markedly contributed to the collapse of the command economy
• Most distorted retail prices, energy prices -> inflation (BUT 38% in 1991 only)
• Wages set centrally
• No private sector (vs. Hungary, Poland)
• No unemployment

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The transition required a fundamental change of the

macroeconomic environment
Exogenous factors

• Collapse of trade with socialist countries, particularly with USSR

• Input shortages
• Consumer manufacturers and weapons lost a major part of their sales
• Little success of redirecting the trade to the West

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Problems with the banking sector were present until 2000

Banking sector distortions

• In the CPE, enterprises operated without the working capital, paying each
other on the basis of permanent credits issued by the state bank

• The reform of the banking system created monetary restrictive central bank,
while enterprises devolved to commercial banks->liquidity crisis->supply
disruption->bancruptcies

• Lack of information on the financial status of individual firms

• Faced with massive withdrawal by the population the CB increased the interest
rate to 16%

• Failure to create effective bancruptcy law that would drive inefficient

companies out of the market was a big shortcoming of the reform

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Czechoslovakia was pursuing a two-track policy of “little

privatisation” and “big privatisation” (1/2)

Small privatisation

• Small businesses and shops not returned to their original owners under the Restitution
Law were being auctioned off to the public
• Privatization through restitution of real estate to the former owners was largely completed
in 1992

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Czechoslovakia was pursuing a two-track policy of “little

privatisation” and “big privatisation”(2/2)

Big privatisation

• Since most large businesses had been nationalised by the pre-Communist regime, few
large industrial enterprises were restored to the original owners
• Voucher privatisation
• Most state-owned heavy industries
• Every citizen was given the opportunity to buy a book of vouchers that represents
potential shares in any state-owned company
• The voucher holders could then invest their vouchers, infusing the chosen company
with valuable capital

Share of state owned/private companies

1989 1998
Private
State owned
3%
20%

80%
97%
Private
State owned 19
 May 6 2009

Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic crisis

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 May 6 2009

Foreign direct investment was the only option how to

bring capital to the Czech economy
Share of US in the FDIs 1990-1998 Foreign investment

• Czechoslovak citizens were accused

of fronting for foreign investors
• The government has revamped the
US legal and administrative structure
governing investment in order to
13% stimulate the economy and attract
foreign partners
• Volkswagen: Skoda
• Although foreign direct investment
(FDI) runs in uneven cycles, with a
12.9% share of total FDI between
1990-1998, the U.S. was the third-
largest foreign investor in the
77% Czech economy, behind Germany
Other countries and the Netherlands

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The transition required a fundamental change of the

macroeconomic environment
Exchange rate

• Radical reformers sought to raise the rate from 15 Kcs/$ in 1989 to 36 Kcs/$ to
stipulate exports, opponents sought to a rate close to the PPP 10 Kcs/$
• The result was a rate 28 Kcs/$ with a 20% surcharge on imports
• Following a series of currency devaluations, the crown has remained stable in
relation to the U.S. Dollar
• The Czech crown became fully convertible for most business purposes in late
1995

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The transition process was not easy and smooth as had

been first expected

Consequences of the Velvet revolution

Was it worth it? Velvet revolution

• ..1989

• ..offered a chance for profound and sustained

economic growth.

• ..high expectations

• ..the idea was a fast and smooth change from the

command economy to the market economy and
democracy

• Signs of economic resurgence began to appear in the

wake of the shock therapy that the (IMF) labelled the
"big bang"

• ..initial liberalisation and stabilisation of the

Czech economy led to recovery and the economic
growth rose favourably

• ..however, later transition costs rose unexpectedly

• The Czech Republic had a good start because of

relatively better macroeconomic conditions than
neighbouring Poland or Hungary. However it
looses its position in the mid 1990s
Source: aMEDA
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BACKUP: comparison of transition countries

GDP in CEE transition economies 1989-1999 (1989=100)

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 May 6 2009

Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic crisis

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 May 6 2009

The goal of the transformation was to create an economy

based on markets and private property

Consequences of the Velvet revolution

Successes Drawbacks

• Liberalization of 95% of all price controls
• Annual inflation in the 10% range
• Modest budget deficits
• Low unemployment
• Positive balance of payments position
• Weak microeconomic and especially institutional
basis of the Czech economy were recognised
late
• Standards of behaviour that were formed under
communism were different from those formed in
democracy

• Stable exchange rate

• Shift of exports from former communist economic

bloc markets to Western Europe

• Relatively low foreign debt

• This success has enabled CR to become the

first post-communist country to receive an
investment-grade credit rating by international
credit institutions

Source: aMEDA
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 May 6 2009

Sources of the problems were the disharmony and

occasional conflict between formal and informal rules

“Changing merely formal rules will produce the desired results only when the informal
norms are complementary to that rule change, and enforcement is either perfect or at least
consistent with the expectations of those altering the rules” (North, 1997a: 16)

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The underestimation of institutional economics was
crucial
Neoclassical and institutional economics
Neoclassics
• Neoclassical economy assumes that
the market economy is based on a well-
defined ownership rights, proper rules
and no transition costs
• Neoclassical economics is interested in
allocation effectiveness
• It does not involve institutional
changes, evolutionary changes.
• Standard neoclassical analysis can not
explain institutional changes.
May 6 2009
Institutional economics
• American economist Armen Alchian
argues that people are not capable to
solve an economic problem by standard
paradigm of maximisation of the utility
under a condition of uncertainty
• The transition from the command economy
to the market economy, when legislation
changes every day and new regulation or
deregulation is imposed, is a very good
example of uncertainty
• For a long-term growth, adaptive
effectiveness is more important
• This development can not be compared
to any Western economy
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Even though several criticisms arose during the

transition, the overall performance was good
Overview of the transition

Transition process

Excessive transition costs were due to fragile microeconomic bases of enterprises

Real value of the enterprises was unclear as accounting provided only virtual numbers

Privatisation program lacked any creation of an institutional framework that could minimalize those
microeconomic weaknesses and supported macroeconomic policy

The theory says that during time ineffective institutions leave and they are substituted with effective ones

The transition process was unique; there was no previous experience with such a big change of
the whole system

Overall the transition process was succesful; though many mistakes were made
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 May 6 2009

Agenda

Recent history of the Czech Republic

On the road to liberal democracy and market economy
• Theoretical background
• Transition
• Results
• Evaluation of the transition

Overview of the Czech economy and the impact of the economic
crisis

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 May 6 2009

Czech Republic is dependent on services

Structure of the Czech Economy in 2009

Variable Amount Unit

GDP 143.0 $ bn
Economy
GDP per capita 12,790 $

Agriculture 2.7 %
GDP by Industry 39 %
sector
Services 58.6 %

Agriculture 4 %
Employeme Industry 40 %
nt
Services 56 %

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Czech Republic trades mostly with Germany

Czech foreign trade in 2009

Variable Amount Unit

Economy Total amount of imports 85.8 EUR bn

Electronics 14 %

Machinery 12 %
Import Chemicals 9 %
Goods
Fuels and lubricants 9 %

Motor vehicles and parts 9 %

Germany 28 %

PR China 8 %
Top 5
countries of Poland 6 %
import
Slovakia 5 %

Italy 5 %

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 May 6 2009

Czech Republic export is higher than imports

Foreign trade
Variable Amount Unit

Economy Total amount of exports 88.9 EUR bn

Motor vehicles and parts 17 %

Machinery 14 %
Export Electronics 14 %
Goods
Electro-technology 9 %

Chemicals and chemical parts 6 %

Germany 31 %

Slovakia 9 %
Top 5
countries of Poland 6 %
export
France 5 %

Austria 5 %

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WE and CEE are strongly interlinked via the banking

system. However the crisis has exacerbated the divide
within the EU

The strong link

Strong presence of Western banks in the CEE
• Eastern Europe has become Europe’s version of the subprime market – Asian
crisis 1997?
• WE banks (via subsidiaries) in CEE hold 60% to 90% market share, depending
on the country
• Banking systems in the region are likely only as strong as their weakest country
("common lender" phenomenon).
• As many CEE countries share foreign parent banks, problems in one of country
may have ripple effects on other CEE countries. So even a relatively healthy
economy and banking system like the Czech Republic's--with a reasonable
loan-to-deposit ratio and scant foreign exchange-denominated lending to
households--is still vulnerable
• Austria is most heavily exposed to the CEE region, via Raiffeisen and Erste
Bank. These banks' collective exposure to the region amounts to over 70% of
Austria's GDP. Other WE countries' total exposure is far less.
• Belgium and Sweden are the next in line after Austria; their lenders' total
exposure to the region amounts to a still significant 20% to 25% of GDP.

Source: CEP News, Kenneth Rogoff: http://www.nytimes.com/2009/02/24/business/worldbusiness/24euro.html?_r=1&ref=business, forbes.com 34

 May 6 2009
Country profile – Czech Republic

Czech Republic’s banking sector remains strong; Careful

economic policy leads to no strong imbalances

Economy and banking overview

Czech economy Banking sector

• Czech economy entered recession from a relatively • Czech banking sector was not largely affected with
strong position the crisis

• low government debt • Czech banking system is largely foreign-owned

(97% of assets), small (private credit/GDP is 50%) is
• strong banking system well-capitalised

• few of the macroeconomic imbalances • Real credit growth has been moderate

• Fitch Rates Czech Eurobond A+ • Lending in foreign currencies to unhedged

domestic borrowers has not been a feature of credit
extension
Interest rate development
• Loan/deposit ratio is below 100%
4% Lowest
2.75% 2.50% rate • The sector as a whole is a net external creditor
3% 2.25% 2.50% ever1)
1.75% 1.75% • The Czech National Bank gradually decreased the
2% 1.25%
2.00% 0.75% discount rate by 2 p.p. over only one year
1%
0% • Banks need no help. Guarantees to support
Jun- Jul-07 Aug- Nov- Feb- Aug- Nov- Dec- Feb- operating financing to help to finance credit
07 07 07 08 08 08 08 09
1) Only in April 2005 the discount rate equalled to 0.75% as well.
Source: Press review, Czech National Bank
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Country profile - Austria

Austria is perceived as highly risky due to huge exposure

to CEE region

Economy and banking overview

Austrian economy Banking sector

• High Credit Default Spreads • Banking package of EUR 100bn

• High Exposure of banking sector to CEE – EUR 75bn – State guarantees

– EUR 10bn – Capital Infusions
– EUR 15bn – Deposit Insurance

• Recipients of Aid
– Erste Bank (capital + state-guarantees)
– Raiffeisen Zentral Bank (capital)
– Discussion with Bank Austria (UniCredit)
Interest rate development
– Smaller banks

• Banking sector
6.00% – Bank Austria (UniCredit), Erste Group, RZB
3.00% 3.25%
4 2.00% – Huge exposure to CEE – 70% of GDP for Austria-
2 1.00% 0.25% based banks, more than 100% of GDP when Bank
Austria is considered
0.00%
I- II- III- IV- V- VI- VII-VIII IX- X- XI- XII- I- II- III- IV-
08 08 08 08 08 08 08 -08 08 08 08 08 09 09 09 09

Source: Press review, ECB

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 May 6 2009
Country profile - Hungary

Hungary had to be bailed out by IMF and their outlooks

are worrying

Economy and banking overview

Hungarian economy Banking sector

• EUR 20bn Bailout by IMF,WB and EC • Recapitalization and state-guarantee programme for
systemic banks
• High currency volatility
– OTP
• 70% of debts denominated in foreign currencies – FHB

• Huge drop of GDP expected – MFB

• Reactions of Banks
– Restricting FX loans
– Limiting Loan to Value ratios
Interest rate development – Tightening lending standards

• Banking sector dominated by OTP

11.00%
9.50% • Banks are still profitable
10 7.50% 8.00% 8.50%

0.00%
I- II- III- IV- V- VI- VII-VIII IX- X- XI- XII- I- II- III- IV-
08 08 08 08 08 08 08 -08 08 08 08 08 09 09 09 09

Source: Press review, Magyar Nemzeti Bank

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 May 6 2009
Country profile – Poland

Poland has weathered the crisis better than most of its

neighbours

Economy and banking overview

Polish economy Banking sector

• Poland set up a $20.5 billion credit line from the IMF.
This was not a bail-out like those for Ukraine,
Hungary and Latvia.
• It was a precautionary and unconditional overdraft
offered only to top-quality borrowers
• Anti-crisis package includes bank guarantees, loans
to business
• Credit crisis has mainly affected the Warsaw Stock
Exchange.
• The zloty has fallen by 30% from its peak

• Polish banks have been relatively careful in

lending

• People have withdrawn money from investment funds

Interest rate development and this is starting to have an effect on banks'
financial results
Lowest
rate ever • Banks have begun to offer high-yield CDs, and these
5.25% 5.75% 5.75%
6.00% 4.25% 4.75% 4.25% 3.75% products may help to alleviate financial difficulties
4% 5.50% 6.00%
• Liquidity so far in the sector remained healthy
2% 4.00%
0.00% • More than 10 Polish banks will likely post a first-
Feb Ma Jul- AugNov Feb Mar Apr Jul- DecDec Jan Feb Mar quarter loss as earnings in the sector halve
-07 y- 07 -07 -07 -08 -08 -08 08 -09 -09 -09 -09 -09
07
Source: Press review, Czech National Bank
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 May 6 2009
Country profile - Romania

Romania had to be bailed out by IMF and expects

moderate drop

Economy and banking overview

Romanian economy Banking sector

• EUR 20bn Bailout by IMF,WB and EC • No banking package

• Outflow of Capital • Reactions of Banks

– Aim at deposits collection
• Huge Current Account deficit
– Tightening lending standards
• Moderate drop of GDP expected
• Banking sector
• Weakening consumption
– Dominated by BCR (Erste)
– Second BRD (Societe Generale)
Interest rate development – A lot of small players

9.00% 10.00%10.25% 10.00%

10

5 7.50%
0.00%
I- II- III- IV- V- VI- VII-VIII IX- X- XI- XII- I- II- III- IV-
08 08 08 08 08 08 08 -08 08 08 08 08 09 09 09 09

Source: Press review, Banca NaŃională a României

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 May 6 2009
Country profile – Russia

Russia provided state support mostly through currency

reserves - the banking sector received over US-$ 45bn

Economy and banking overview

Russian economy Banking sector

• Real GDP growth forecast to contract by -3.9% in • Central Bank lowers interest rate in April 09 to
2009 12.5% - accordingly, the worst of the financial crisis
is over and lower inflation allows for decrease of
• Sharply hit by drop in prices of resources interest rate

• Rouble depreciated 40% • Market not yet consolidated, only three banks
(Sberbank, VTB and Gazprombank) above 3%
• The US-$ 530bn currency reserves are now partly market share
being used for anti-crisis measures. Overall support
to revitalize the economic situation: US-$ 230bn • Most significant state support: Pumping US-$
45bn into threse three largest banks
Interest rate development • Additionally, numerous smaller banks (e.g. Soyuz
Bank, the Russian Agricultural Bank and Alfa Bank)
13.0% received state aid
12.0%
11.0% • Local banks experienced severe liquidity drains as
foreign investors pulled out billions from Russian
stock market

0.0%
Jan.- Apr.- Juli- Okt.- Jan.- Apr.-
08 08 08 08 09 09

Source: Central Bank of the Russian Federation; European Commission Economic Forecast Sprin 2009; Individual country slides
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 May 6 2009
Country profile - Ukraine

Ukraine received IMF rescue package of EUR 13bn to

restore economic stability

Ukraine received economic stimulus package of 8,3% GDP (Oct 08)

Bailout of EUR 13bn Anti-Crisis Package

• The Hryvnia has come under very strong pressure

IMF with the Central Bank unable to maintain the rate
within a corridor

• The economic instability has resulted in declining

EUR 13bn confidence in the banking system
– Nearly USD 6bn of deposits has been withdrawn
from the system since the start of October

• Increased deposit insurance coverage to EUR

20,000 covering 99% of individual accounts

Macroenvironment issues • Ukraine’s plan includes:

– Monetary and exchange rate policy shifts
• The Ukrainian economy slowed down considerably as – Banking recapitalization
the global economic weakness and financial market
turmoil affect growth momentum – Fiscal income policy adjustments
• Economy under triple pressure: current market • Viable banks have access to liquidity
turmoil, political instability and gas prices hikes
• Flexible exchange rate regime

Source: BusinessWeek, J.P.Morgan Research, Roland Berger Strategy Consultants

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