A Great Transformation

Országok listájaHungaryBudapesti Corvinus EgyetemGazdálkodástudományi KarNemzetközi gazdálkodás (angol nyelven)Economic PolicyVizsgákA Great Transformation

MES SCHRIFTENREIHE Masterstudiengang Europastudien

A Great Transformation?
Banking and Capital Markets in `Transition Countries'

Péter Á. Bod

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Vorwort zu Heft 3 der MES-Schriftenreihe: "A Great Transformation? Banking and Capital Markets in Central and Eastern Europe"

Mit dem Jahr 2005 hat der Master of European Studies die MES-Schriftenreihe ins Leben gerufen. In der Schriftenreihe werden nach und nach Grundlagenthemen der Europa-Studien, häufig aus dem Bereich der Europäischen Integration, aufgegriffen. Unser Ziel lautet, den Studierenden des MES an der Europa-Universität zusätzliches Unterrichtsmaterial an die Seite zu geben. Dies soll der Begleitung solcher Lehrveranstaltungen dienen, die häufig von Lehrbeauftragten abgehalten werden und die daher nicht regelmäßig an der Europa-Universität anzutreffen sind. Weiterhin hätte die MES-Schriftenreihe jedoch ihren Zweck erfüllt, wenn ihre einzelnen Hefte über die besuchte Lehrveranstaltung hinaus Wissen und Anregungen vermitteln, die während des Studiums und danach nützlich sind. Die MES-Schriftenreihe widmet sich einzelnen Ausschnitten oder Modulen aus dem Bereich transdisziplinärer Europa-Studien. In Ergänzung zu diesen wichtigen, in ihrem Gegenstand jedoch auch begrenzten, Themen geben einige Lehrende im Master of European Studies beim VS Verlag für Sozialwissenschaften zudem eine Reihe mit Lehrbuchtexten heraus. Den Anfang macht der Sammelband "EuropaStudien. Eine Einführung", dessen Texte derzeit redaktionell bearbeitet werden und der im Herbst 2005 erscheinen soll. Weiter geht es dann mit Lehrbüchern zur "Wirtschaftspolitik in Europa" von Daniela Schwarzer und zur "Einführung in die Europäische Policy-Forschung" von Elsa Tulmets. Weitere, ähnlich gelagerte Projekte befinden sich im Planungsstadium. Das dritte Heft der MES-Schriftenreihe behandelt einen zentralen Aspekt der ökonomischen Systemtransformation, die Veränderungen in den Banken- und Finanzsektoren der postsozialistischen Staaten Europas. Prof. Péter A. Bod, der seinen wissenschaftlichen Werdegang an der Budapester Universität für Wirtschaftswissenschaften begann, dürfte einer der kompetentesten Autoren überhaupt auf diesem Gebiet sein. In den Wendejahren war er Mitglied des Demokratischen Forums und fungierte in der ersten postsozialistischen Regierung unter József Antall als Industrie- und Handelsminister. 1991 wechselte er ins Amt des Präsidenten der Ungarischen Zentralbank, wo er bis 1994 den Umbau des ungarischen Währungs- und Finanzsystems an vorderster Front mitgestaltete. Seither hat Péter Bod die Transformation an häufig wechselnden Orten begleitet und beobachtet, unter anderem bei der Europäischen Bank für Wiederaufbau und Entwicklung und an der Universität Veszprém nördlich des Balaton. Wir freuen uns, dass er nun auch die Europa-Universität Viadrina als eine seiner Stationen gewählt hat. Peter Bod geht in seiner Schrift zunächst auf die Geschichte des Banken-, Währungs- und Finanzsektors während und nach dem Sozialismus ein. Ein weiteres Kapitel widmet sich dem externen ­ also westlichen ­ Einfluss auf die Finanz- und Kapitalmärkte in Mitteleuropa. Eine seiner Thesen lautet, die inhärente Schwäche der staatlichen Akteure in den Transformationsstaaten habe zur Folge gehabt, dass einheimische Firmen und Konzerne im Bank- und Kapitalsektor zu wenige Chancen

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gehabt hätten. Im Seminar wird zu erfahren sein, ob es sich dabei um eine Kritik am eigenen Wirken in den frühen Transformationsjahren handelt. Eine andere Einsicht von Péter Bod lautet, die postsozialistischen Staaten Mittel- und Osteuropas könnten nicht als Einheit angesehen werden. Bod spricht von einer "artifiziellen Homogenität". Während die Voraussetzungen nach dem Sozialismus ähnlich waren, haben die Staaten wegen des unterschiedlichen Gewichts ihrer Volkswirtschaften, aber auch wegen glücklichen oder weniger glücklich agierenden Politikern und entsprechend eingesetzter Policies unterschiedliche Erfolgsprofile aufzuweisen. Im Lehrprogramm des MES lässt sich auch an vielen anderen Stellen die Erkenntnis wiederfinden, dass nicht einmal die Länder Mitteleuropas, geschweige denn die des gesamten postsozialistischen Raums, als allzu ähnliche Gebilde aufgefasst werden sollten. Der Lehrauftrag von Péter A. Bod im Sommersemester 2005 ist eine besondere Ehre für den Master of European Studies der Europa-Universität. Das Programm, durch das sein Wirken möglich gemacht wird, trägt den Titel "Forschung zu einem neuen Europabegriff". Persönlichkeiten wie Péter A. Bod verkörpern mehr als einen Begriff des neuen Europa. Sie stehen dafür, dass sich wissenschaftliches Arbeiten und der Bezugsrahmen für wissenschaftliche Begriffsbildung auf historisch hergebrachten Bahnen, nämlich gesamteuropäisch, normalisieren. Timm Beichelt, Hans-Jürgen Wagener

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Contents
Introduction............................................................................................................... 6 Chapter One: Money, finance, and banks before the system change ........................ 7 1.1. The role of financial institutions in economic development .............................. 7 1.2 Money in a passive role ­ banking sector in centrally planned economies ..... 12 Chapter Two: The long and costly transformation process in CEE finance and banking.................................................................................................................... 16 2.1 Types of financial systems ­ are there models for the CEE countries? .......... 16 2.2 Sequencing of financial liberalisation and market-building.............................. 24 2.3 Legacies from the planning past and the initial conditions for the transformation .............................................................................................................................. 25 Chapter Three: Foreign direct capital and foreign banks in CEE countries...... 33 3.1 Early birds in fragile CEE markets .................................................................. 33 3.2 Privatisation methods as powerful policy instruments ..................................... 39 3.3 Patterns of FDI inflows in CEE countries ........................................................ 41 Chapter Four: Penetration of foreign capital in CEE financial markets ­ a sign of modernity or of weakness?............................................................................... 47 4.1 Changing size and composition of the banking sector .................................... 47 4.2 Foreign banks in CEE financial life ................................................................. 53 4.3 Banking sector transformation in CEE countries ­ more than one avenue but similar end-state.................................................................................................... 55 4.4 And the rise of the domestic Bourses...for how long?..................................... 62 Chapter Five: Conclusions .................................................................................... 64

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Introduction
The countries of Central and Eastern Europe (CEE) abandoned the socialist centrally planned system in 1990 and embarked on a long journey (or rather, return) to the market economy with the ultimate aim of creating (or re-creating) institutions and structures similar to those of the West. This change of system is generally called `transition' in the academic literature and in the parlance of the international banking community, and the measures undertaken are called `reforms'. Yet the argument that the reader will find here is that transformation is the proper term for the changes that have taken place in the region, and it is a `great transformation' at that ­ to borrow a term from Karl Polányi. Transition is too uni-linear a concept for a change of regime that has so many national particularities. In this study, reform will mostly mean changes made under the planned system, before the change of regime took place. In this context, we will discuss the profound transformation of financial life in the CEE countries. Nowhere has the need for institutional innovations, reforms and re-starts been as great as in the financial sector, which was badly neglected during decades of central planning. Looking back over the events of the last fifteen years, we can conclude that banks and capital markets have mostly been transformed or recreated according to a fairly universal conceptual pattern (the so-called Washington consensus). Yet even after a decade and a half there are still significant differences among the countries; implementation will always be more diverse than theory. This study gives in outline: (i) a review of the starting positions of the CEE countries at the point when the change of regime was set in full motion; (ii) an assessment of the banking sector and capital developments in the region; and (iii) a discussion of the policy choices that decision makers are currently facing now that these states have entered the European Union. An overview of the large body of academic literature and statements made by practitioners identifies strategic issues such as the entry of new, foreign banks as a powerful force for change towards a competitive banking sector, the re-establishment of capital markets; the privatization of businesses and banks; and the inflow of foreign direct investments (FDI). The author argues that the extremely fast development of the banking and insurance sector, and the extremely widespread input of FDI and portfolio investment have all contributed to the swift modernization of the region, but the speed of this process can also be read as a sign of some inherent institutional weaknesses in state-orchestrated bank restructuring exercises, and/or the failure to support domestic firms during the initial shock of transition. Inherited old debts surfaced during the change of regime, and new bad debts have emerged for various reasons in the course of the transformation, making bankruptcy procedures and work-outs unavoidable in most countries of the region. The study discusses bank privatization, banking supervision issues, the role of stock exchanges, and other related issues that are important as these countries become part of the European Union. The author, a student of the subject as well as a one-time participant in these events, aims to provoke discussion of the major policy options; history cannot be rewritten, but others now facing similar options may avoid making the same mistakes.

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Chapter One: Money, finance, and banks before the system change 1.1. The role of financial institutions in economic development
It is our everyday experience that persons and organizations have temporary financial surpluses while other economic agents (`players') may experience periods during which their financial needs exceed the funds available for them. Financial funds are being transferred daily even within a family; in a similar fashion, money flows within all societies in one way or another. The particular forms and rules of such transfers are the traits that define and characterize the society and its financial life. The parallel with families can be useful in understanding the financial systems of countries. Some families, as we may witness in our daily life, manage to make ends meet, the thrifty even save on a regular basis, while others can hardly keep their family budget together for a single month, and there are those who miss payment deadlines, get into arrears with utility bills, and we all know the notorious ones who end up tapping relatives and neighbours for short-term loans. Real families thus vary greatly, and so do real societies in the way they manage their finances. Some economies save enough to provide the funds for their domestic investments, and they may even generate surplus funds for net borrower economies ­ all these funds are channelled through the national and international financial markets. Other economies under-save or over- invest, and thus they depend on the international financial markets for short or long term borrowed funds. Whether borrowers on net savers, national economies will profit more from the international money and capital markets if their inner financial systems are actively linked to each others; the national regimes may differ a lot from each other but they should be able to communicate effortless with all the major players of the international markets. The particular structure, size and characteristics of a national financial system say a lot about the society in question, even if the basic functions of money, capital markets, and financial institutions look similar all over the world. That is, these functions and forms do look more and more alike in our globalized world, yet there still remain significant national and regional differences of substance even after decades of convergence of banking practices. Convergence in financial life is driven by the spread of internationally accepted paying instruments (cheques, credit cards, electronic money transfers), and the presence of large, multinational financial institutions in practically all countries of the globe. The countries that lead ­ and often dictate ­ the process of the dissemination of common, rather universal financial practices and norms are often referred to as the core, while the less developed countries constitute the periphery and the semi-periphery. During their independent existence, the countries of Central and Eastern Europe (CEE) have mainly belonged to the latter category.1 The term `periphery' is less generally used for these particular countries; peripheral may be seen as not "politically correct" any more. They are more commonly referred to in the business
See interesting studies on the issue of enlargement of the EU and the peripherality of the `cohesion countries' (Greece, Spain, Portugal and Ireland) and the newest member states in papers introduced by Frank Barry (2004): Enlargement and the EU Periphery: Introduction. World Economy, No. 6. pp. 753-759.
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media as transition countries, and banking analysts discuss the economies of the CEE region among the so-called emerging markets. The term accession country has also been in use during the process of their accession to the EU. Whatever one thinks of the merit of these terms, the essence of all this labelling is that the countries of the region do not yet belong to the core. This is not surprising: they have been left out of the European "mainstream" for a long time - a fact that has still long lasting consequences for their present conditions.2 The CEE countries, in addition to their historical belatedness which dates back much longer than the last couple of decades, were more recently burdened with geopolitical handicaps, as until the 1990s they belonged to a particular socio-political system: they were planned economies under a non-democratic one-party political regime. According to some opinions, the Communist system in the region was in a sense the continuation of state interventionist policies that are so typical on the periphery: "the planned economy of state socialism was only a new, bitter, and extremist version of economic nationalism or, perhaps more accurately, a modernization dictatorship".3 This may be a too deterministic view, which underrates the importance of the Soviet military and political presence in the CEE region. It is hard to deny the significance of the external factors both in the emergence and later the decline of state socialism in the region. With the collapse of the Soviet Union as a global power, all state collectivist regimes disappeared in the CEE region. What has been left behind, however, is a region that is, and for a certain time will be, less developed in terms of material well-being. The region consists of countries with about or less than half the level of GDP per capita vis-à-vis Western Europe. But the CEE region is not made up of `developing countries'. The countries of the region may be in many respects well behind the countries constituting the `old' European Union (EU 15), but only a couple of decades ago they were on par with some of the least mature present member states of the EU, and they were at about the same level of economic development as the Nordic or the Southern European semi-periphery in the 19th century and even in the first half of the 20th century. Historically, the eight new CEE member states returned to, or re-entered, `institutional Europe' through the May 2004 enlargement of the EU, rather than simply joined it. Certainly this is the way most inhabitants in the new member states feel about their accession. Whatever one's view of the causes and lineage of the socialist regimes in Central and Eastern Europe, the consequences of living under a planned regime for four decades are still being felt in the region. Where institutions and personal attitudes are concerned, the legacies of that era influence the present social order of the new EU member states. Their social institutions, societal norms and behavioural standards still differ to varying degrees from those of the countries of Western Europe. Yet since the regime change determined efforts have continuously been made by governments, businesses and millions of ordinary people to assimilate Western ways into their life. The media slogan "Joining Europe" is particularly misplaced or a-historic in the case of the Poles, Czechs or Hungarians who never
The development literature frequently compares CEE transformation to the changes in Latin America, another region on the periphery of the global `mainstream'. Yet such parallels should not be taken too seriously, since past history and present conditions differ. See for example George Kopits (2002): Central European EU accession and Latin-American integration: Mutual lessons in macroeconomic policy design. North American Journal of Economics and Finance. Vol. 13. pp. 253-277. 3 Berend I.T. (2000): From regime change to sustained growth in Central and Eastern Europe. In: Economic Survey of Europe. Economic Commission for Europe. 2000. No. 2/3.
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stopped regarding themselves as part of Europe; for them, it is much more about rejoining than joining Europe. Most people in the region regard the economic conditions, social institutions and lifestyles of the more developed western countries as attainable goals or models. It is not at all surprising that financial life in a former centrally planned country differs from that of a mature Western state; the starting position of the financial sectors in the CEE region differed greatly at the time of the regime change. Not even fast progress can eliminate such differences in a relatively short period. The catch-up may proceed systematically, but the process of transformation itself further differentiates the latecomers from those in the lead. In order to understand the present conditions and prospects for the future, it is important to take stock of the starting conditions and the past periods of the mentioned countries. On discussing the deep changes and shocks that have taken place in the former planned economies of the CEE countries, the students of the transformation process can rely on the vast knowledge of research dealing with institutional changes. A whole literature on transformation has come into being in the last two decades; "transitology" seems to have taken the place of "Kremlinology" and related academic and semi-political studies. But the economics profession has also a lot to offer. Institutional economics aims to incorporate the theory of institutions into mainstream economics, emphasising the significance of culturally determined, historically shaped behaviours, habits, memories, as well as the role of organizations - all under the heading of institutions. Institutions can be regarded as the rules of the game of a society, either formal rules (laws) or informal (habits, conventions).4 The term `institution' is wider than that of `organization'; the letter is a relatively stable structure within society ­ itself a particular form of institutions. Institutions whether formal or informal change with the passage of time, but will only change incrementally: they are path dependent. Path dependence - in the words of Douglass North - "makes it difficult to alter direction of an economy once it is on a particular institutional path. The reason is that the organizations of an economy and the interest groups they produce are a consequence of the opportunity set provided by the existing institutional framework."5 Changes thus take time, since actors cannot immediately modify the rules (constraints) of the game, the structures of the social fabric, even if all individually so wish. Informal institutions in particular will only change slowly. This fact has important implications for countries whose authorities, businesses and social elites want to adopt new formal institutions from other countries. You can import products and financial funds, and similarly you may wish to `import' ideas and institutions. But simply transferring formal institutions is not enough for attaining similarly good social or economic results; tensions do emerge between new formal institutions and existing, old informal institutions. Eight countries of the CEE/Baltic region joined the EU in 2004, and others are also determined to follow suit. In this context it is important to note that EU
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"Institutions form the incentive structure of a society and the political and economic institutions, in consequence, are the underlying determinant of economic performance. /.../ Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behaviour, conventions, and self imposed codes of conduct) and their enforcement characteristics." Douglass C. North: Prize Lecture. Lecture to the memory of Alfred Nobel, December 9, 1993. Source: www.nobel.se 5 Douglass C. North (1997): The contribution of the New Institutional Economics to an Understanding of the Transition Problem. WIDER Annual Lectures 1. UNU/WIDER

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membership is very much about assimilating institutions. Banks and capital markets are regulated institutions with detailed formal rules, but also dependent on important informal norms. On discussing the economic development of the CEE countries, and particular the modernization of their financial life, the institutional aspect of transformation will be as important in our arguments here as macroeconomic data and variables are. But do institution really mean that much for progress? There is a lively ongoing debate on the pages of the academic papers that offer food for thought for the students of the transformation of the CEE region. Some regard the quality of institutions vital for the successful take-off. Dani Rodrik is one of those who stress the importance of the institutional preconditions in his papers and in works published with similarly minded economists; his message is clearly stated in the title of one of their papers: Institutions Rule.6 Modern growth theories deal with the endogenous nature of economic events, and acknowledge the importance of government policies, economic institutions, and variables such as national savings propensity ­ a variable that has a cultural component behind it. Gylfason draws his conclusions from the wide variety of successes and failures of country cases: "With appropriate policies and institutions, rapid economic growth is, or at least ought to be, achievable almost elsewhere".7 Based on the above logic, institutions (or, for that matter, policies) can be put into a cause-effect model. There is no strong consensus on what kind of institutions as variables ought to be included, but property rights, social trust and calculability and financial market arrangements are most frequently named. The causation can be direct in some models, while other authors hypothesise indirect channels through which social order and rules affect income level and the growth rate of material wellbeing.8 Others question whether the term `institutions' provide a convincing enough answer to issues of economic development; they rather state that geographical conditions explain a lot.9 Sachs is a leading proponent of the "geography counts" school, naming geographical conditions as a most important factor explaining differences in growth rates. Yet, he importantly comments that regions that are relatively well endowed geographically may have, for historical reasons, poor governance and institutions: "These include the central European states, whose proximity to western Europe brought them little benefit during the socialist regime. For such countries, institutional reforms are paramount".10 Others regard integration into the world trade system as powerful explaining factor, rather than `geography' as such (Dollar and Kray, 2000).11

Rodrik, Dani ­ Subramanian, Arvind ­ Trebbi, Francesco (2002): Institutions Rule: The Primacy of Institutions over Integration and Geography in Economic Development. IMF Working Paper, WP/02/189 7 Thorvaldur Gylfason (2004): Institutions and Economic performance. To grow of not to grow: Why institutions must make a difference. CESifo DICE Report 2/2004 8 Jütting, Johannes (2003): Institutions and Development: A Critical Review. OECD Development Centre, Technical papers No. 210. 9 Jeffrey D. Sachs (2003): Institution Matter, but Not for Everything. Finance and Development. June. Pp. 38-41. 10 Op. cit. p. 39. 11 Dollar, D. and A. Kray (2000): Institutions, Trade, and Growth. Paper prepared for the Carnegie-Rochester Conference Series on Public Policy.

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Figure 1 How Institutions Affect Growth and Income

institutions indirect effect direct effect Investment Trade/integration Social capital Political stability Conflict management Policies

Income and growth

What seems to be a fruitful insight into the problems that students of the CEE transformation face is the classification of Williamson: there is a hierarchy of institutions.12 There exist: (1) deeply rooted (mainly informal) social institutions related to the social structure of the society ­ Level 1 ­ that do not change easily; (2) institutions related to rules of the game (Level 2) that also take a long time to change, such as rules defining property rights and the judiciary system; (3) Level 3 rules shape the play of the game (e.g. contractual relationships), and finally Level 4 institutions that relate to allocation mechanisms (capital flow control, trade flow regimes) and they are those that can be changed in the short term. We can regard banking reform and creation (re-creation) of capital markets in Central Europe as institutional changes belonging to levels 3 and 4, while contractual behaviour, law-abiding attitudes, the choice between honesty or corrupt practices seem to belong to Level 2 (rules of the game), or even Level 1 in the hierarchy of the social institutions. In what follows we will discuss the particular role of finance in the planned economies, the changes in the rules of the game during their first phase of transformation, and the ideas and mental patters that influenced the changes of financial markets and institutions. The present author is strongly convinced that such a historical overview is vital for all who want to understand and assess the present tendencies and consider the outlook of the financial markets in the CEE region.

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Williamson O. E. (2000): The New Institutional Economic: Taking Stock, Looking Ahead. The Journal of Economic Literature. Vol. 38. No.3. pp. 595-613.

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1.2 Money in a passive role ­ banking sector in centrally planned economies
It is important of take note of the characteristics of banking and finance in centrally planned economies (CPE) as legacies affect the development of the financial sector during the transformation process. Let us start the study of these particularities with the role of money under central planning as a particular socio-economic system. Planning mostly relied on non-monetary signals, but still used monetary terms and forms even if money played a reduced role under the centrally planned system, particularly in its un-reformed, `classical' phase.13 In a planned economy the textbook treatment of the functions of money is formally valid; money fulfils three functions, namely that of (a) unit of account, (b) a means of payment, and (c) store of value. In a market economy, money, as a unit of account, is vital for negotiating transactions, quoting prices, setting rents and wages, and in general, for performing business calculations. Based on these calculations, a large number of individuals and organisations provide signals for each others within the extensive social division of labour. As a means of payment, money promotes exchanges in the marketplace, and as a store of value it allows members of the society to make purchases in the future. Overall, money is an institution that allows various agents to communicate: to speak the language of money. These text-book functions, however, do not fully work in a planned society where another common language prevails: the political language of the hierarchically organized party-state. Firms are in public ownership, and public institutions higher up in the hierarchy (e.g. planning office, sectoral ministries) decide on what to produce and how much to produce. In such a system, daily uses of money terms are still needed by the planning authorities for aggregation purposes: even if top level authorities determine the composition of the production, they still need aggregate values as targets in the form of p×q for lower level bureaucracies, where q stands for physical quantities and p for (official) prices. Who sets the prices? In the `classical' variant of central planning, prices are either determined by the relevant public agency (Price Office), or publicly owned firms are instructed to calculate them under some formulas ­ mostly based on historic costs. Real life planned economies never worked exactly like that, not even in the Soviet Union, and even less in the CEE countries. Once the Soviet rule was extended during the Second World War on the lands west of Russia, and the ideology was also exported to the conquered countries, varieties of planning practices emerged. In spite of the efforts of the authorities who stood behind the forced Sovietisation of the CEE countries, their drive had failed to result in an identical Soviet-type economic system in all countries. The variances were partly due to differences in local conditions, partly to the fact that the countries conquered by the Red Army during the second World War had previously gone through different
A `classical' CPE is also referred to in the literature as orthodox or un-reformed communism. The Soviet Union under Stalin once the mixed-economy experiments of the 1920s had been terminated, certainly matched this classification. Technical `improvements' in the 1960s did not really bring about structural changes in the soviet regime. The Yugoslav version, however, meant a much larger role for corporate autonomy and broader room for product markets, thus justifying the use of the term reformed communism (reformed socialism).
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development paths, and widely differed in 1945 as for their economic and social development; compare, say, the Czech or east German territories with Albania or Bulgaria. The communist regimes may have been rather similar in their ideology and loyalty to the centre of the empire, but the social institutions across these states functioned quite differently even if the same type of political rule had been forced on society and economy under the so-called Warsaw Pact (1955) throughout the region. To start with, the Yugoslav regime was different from the very start, since domestic forces rather than the Soviet army liberated the country from German domination at the end of WW2. In other countries of the region (Czechoslovakia, Poland, Hungary, Romania) the Soviets certainly intended to introduce a uniform regime ­ one based on the repression of the civic society and of the market. The more developed a country was at the moment of the forced introduction of the Soviet-type regime, the less this new system seemed to work, and the sooner it became known for the general public that the regime was alien for them. It is not surprising that dissatisfaction, even popular revolt against Soviet rule, broke out in the most developed part of the conquered region: in Berlin (1953), Poland (1956) and in Hungary (1956). Box 1 Reformist communism versus the orthodox version The massive uprising and freedom fight in 1956 in Hungary was crushed by Soviet tanks, but the broad popular support from all segments of the society, workers included, made it clear for all ­ even for the Communists themselves ­ that Communist rule is not legitimate and could only be maintained through force. The rulers understood all over the Warsaw Pact empire after 1956 that they could not rule the way they did before the revolution; reforms were introduced gradually in countries where the public expressed social dissatisfaction. At that time, there was already one particular case: that of Yugoslavia, a case which influenced the thinking of reformers within the Soviet `camp'. Later reform efforts appeared in some other countries. Gradually two versions emerged: the "reformed" and the "orthodox" sub-sets of Socialist/Communist regimes; with Yugoslavia, Poland, Hungary (and for a while, until the sudden collapse of the Prague Spring in 1968: Czechoslovakia) on the one hand, and Bulgaria, Albania, Romania, the GDR, the Soviet Union itself, on the other. At the outset, the strategy of the Communist transformation of the societies was rather similar (but national differences remained even widened with the passage of time). The overall `forced modernization' strategy everywhere included nationalisation of the private banks, and the drastic reduction of the functions of money. Under central planning the financial system was little more than a bookkeeping mechanism for documenting the planning authorities' verdicts about the allocation of resources among sectors, enterprises and products. The banks ­ all in state ownership after the forced nationalization of private sector bank during the comprehensive Sovietization of the economy - were part of a de facto one-tier banking system: a national (central) bank still existed in all countries, but a central bank in a planned economy only superficially resembled its

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Western equivalent. The real central bank, the `bank of the banks', functions within the structured financial system of a market economy where the central bank presides on the top as tier one, responsible for the money supply and the stability of the financial intermediation, while commercial banks, savings businesses and others constitute the second tier. The contrast is stark: in planned economies both the central bank and the other few remaining specialized financial institutions constituted a conveyor belt for the heavily centralized state management. All the financial institutions were meant to serve the production plans as laid down by top party organs and detailed (to varying degrees in the various socialist countries) by the planning authorities. A national bank typically conducted most of the (limited number of) banking operations that a planned system still needed, including operations one would call retail-banking transactions: transfer of funds; allocation of foreign exchange to enterprises, public institutions, and citizens. A central bank typically provided working capital finance for (state owned) firms and co-operatives, and conducted treasury services for budgetary establishments. In addition to the central (national) bank, post offices acted as intermediaries for the general public (particularly important in rural areas where postal services were the only financial institutions). Financing of foreign trade was the task for a specialized bank (modelled after the Soviet Vnesheconobank) in all socialist countries. The Soviet Sberbank served as a model for a centralized Savings Bank. Generally, a State Investment Bank was established and made responsible for providing the needed finance for the investment project outlined in the Plan. This financial and banking system actually was not a mono-bank financial system (as it is sometime referred to in the literature14), rather than that it constituted a one-tier regime with specialized (monopolistic) financial institutions not really worthy of the term `bank'. There remained quite significant differences between the CEE countries as a group on the one hand, and the Soviet Union on the other, in terms of the size and structure of the financial system. The countries of Central Europe being much more developed before the Sovietisation, still managed to keep some of the infrastructures of their previous financial life, while in Russia the human capital and professional infrastructure of the pre-First War finance had vanished during the long Communist rule. Differences among the CEE countries themselves also existed from the very start of the new, Soviet era, and a process of divergence had evolved with the passage of time, mainly due to two, interconnected, factors. One was the mentioned cautious economic reforms in some of the countries (Yugoslavia, Hungary, Poland) ­ reforms that relied more on the autonomy of enterprise management, and as a consequence on a bit more active use of loans, foreign exchange, and other markettype instruments. The other strong incentive was later, in the 1980s, the influence of foreign creditors, primarily the IMF and the World Bank (their role will be shortly discussed in Chapter 2). Whatever had driven reforms before the final disintegration of the centrally planned one-party state, even the most reformed countries did not qualified for the
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See e.g. in the otherwise excellent paper of de Haas (2001): "Generally, banks were specialised on a geographical or functional basis and together with the central bank they made up a monobank system." De Haas, R. T. A (2001): Financial development and economic growth in transition economies. A survey of the theoretical and empirical literature. Bank of Netherlands.

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term `market-economy' before the change of regime. Some commentators tried to depict the transitional non-system in the late 1980s as "socialist market economy", but that did not fit reality. As we could state in spring 1989, at the outset of the reforms, discussing the Hungarian case: "Money does count, but only to a certain extent. The Hungarian economy is certainly not a fully monetized economy as presumed by Lange".15 The banking and financial institutions under the transitional communist regimes were, at most, `quasi banks' and `quasi capital markets', to use János Kornai's term.16 Moreover, a sort of financial liberalisation in the `reform socialist' period preceding the system change led to much unwanted but very grave side-effects. As McKinnon put is:" None of the (previously) socialist economies of Eastern Europe, China, and Vietnam have established sufficient financial equilibrium to support the desired marketization of their economies. Indeed, smaller Eastern European economies, such as Yugoslavia and Hungary, that have been struggling to create "socialist market economies" for more than a decade are threatened with severe internal inflation and very large external debt."17 He also suggests a logical sequence of liberalization measures: "Before direct central government controls are fully dismantled, the monetary-financial-fiscal system has to be converted from the passive mode that had simply accommodated the planning mechanism into an active constraining influence on the ability of decentralized enterprise, households, and even local governments to bid for scarce resources."18 Academics and some of the decision-makers of the day knew very well that the optimal sequencing of fiscal, monetary and foreign exchange policies is of critical importance in order to minimize the social costs of what one calls transition or transformation. The short and somewhat fruitless debate in early 1990s on shockversus-gradualism testifies that; however, real life decision making, as we will see, it, could not follow the logical path. Regime change was driven by internal politics and external constraints, pressures and influences. Not all external sources of influence and pressure shared the views so convincingly expressed by, among others, McKinnon concerning a thought over sequencing; the political and economic policy mainstream demanded an instant break with the past and expected of the (new) governments simultaneous liberalization measures. Advice from donor countries, the IMF, World Bank, and Western think-tanks counted much more than simple intellectual contributions, particularly in cases of countries with heavy foreign debt. It is not surprising that Poland and Hungary were in the vanguard of liberalizing their financial sectors, prices, dismantling state support to industrial sectors, and following other recommendations reflecting the so-called "Washington consensus". They were countries critically dependent on foreign currency coming from official funds. Others, like Slovenia and the Czech Republic, did not enter the regime change phase heavily indebted, and could therefore elaborate and execute transformation blueprints of their own.
Péter Á. Bod (1990): The troublesome micro-macro link in an economy with national planning: Hungary. In: Kovacs J. and Dallago B. (Eds) (1990): Economic Planning in Transition, Dartmouth Publishing. USA Reference here is made to Oscar Lange and his once influential paper on the concept of rational central planning based on monetary calculations: Lange, O. (1936): On the Economic Theory of Socialism. The Review of Economic Studies. October 1936 and February 1937. 16 János Kornai (1990): The Road to a Free Economy. Norton and Co. New York & London. 17 McKinnon R. I. (1991): The Order of Economic Liberalization. Financial Control in the Transition to a Market Economy. The Johns Hopkins University Press, USA 18 McKinnon, ibid. p. 3.
15

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External advice and foreign finance were influential even before the political change, but they became vital once the system change in the CEE region suddenly erupted, in a historically short period of time: from late 1989 through 1991 everyday life, domestic politics, and relations to the external world - all changed suddenly. We entered into a new age: the age of the regime change as compared to the piecemeal reforms of the 1980s.

Chapter Two: The long and costly transformation process in CEE finance and banking 2.1 Types of financial systems ­ are there models for the CEE countries?
The main functions of a financial system include the allocation of funds between the present and the future (intertemporal redistribution) and the allocation of moneys among agents, locations, currencies, risk categories. Allocation of funds can be done either directly, through financial markets, or indirectly, through financial intermediaries. A company, for example, in need of more funds for expanding the business may "go to the market" by announcing the public offering of new shares for cash. An alternative way of external finance would be to borrow the needed funds from a bank, that is, from a financial intermediary. This latter institution collects funds from agents with surpluses (savers), and passes the funds to various types of debtors. Financial markets (e.g. stock exchanges) and financial intermediaries (thrifts, banks, finance corporations) therefore perform the same similar financial functions but under different institutional, legal and regulatory framework. In highly developed market economies one can find both types of financial institutions. The less developed economies and countries in transformation, however, are typically rely more on the intermediated agents; it is generally the bank that plays the predominant role in a peripheral country. In a real life economy both types of institutions take part in transmitting the funds, yet the economic literature distinguishes market-based and bank-based systems. The financial systems of the "Anglo-Saxon" countries (United States, United Kingdom) are regarded as marketbased, while the financial system in Germany, France, Japan are characterised as based on the central role of financial intermediaries. In fact, the financial life of most countries reflects a mixture of the elements of the two systems, and real life countries do not always conform to the classification. This will be the conclusion if one looks at the relative size of various financial market segments within the overall stock of financial assets in major countries (see Table 1 reflecting the proportions of the late 1990s).

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Table 1 Compositions of financial assets
1998

Stocks United States Japan Germany United Kingdom France Italy Hong Kong Finland Mexico Hungary 43 25 14 36 20 17 37 68 58 21

Bonds 41 39 21 12 19 44 2 18 23 23

Bank loans 16 36 65 52 61 39 61 14 19 56

D. Hale: Rebuilt by Wall Street. Financial Times, January 25, 2000; MNB: Annual report, 1999.

In a bank-based system the stock of bank loans represents the majority of all financial assets, while where the stock market and the bond market dominate the financial scene, it must be a market-based financial system. The size of stock market is measured by market capitalisation of stocks at year-end, the size of the bond market is measured by market capitalisation of all bonds at year-end, and the entry `banks loans' reflects the size of outstanding loan assets of banks at year-end. If one judges by the composition of the financial assets of the above countries, Finland seems to be the most "Anglo-Saxon", since in this economy the relative shares of the stock exchange and of the bond market combined overshadow that of the loan portfolio of the banking sector; in fact, this is the country in the sample with the highest percentage of stocks. On the other hand, UK does not at all seem to be an "Anglo-Saxon" country according to that classification: banking assets rather than bonds or shares represented the dominant form of finance at that particular point in time (end of the 1990s). The entry `bonds' include both government and corporate bonds; thus counties with high public sector debts tend to be stronger in this respect (Italy, Japan, US, Hungary), while countries with less indebted governments tend to have a relatively smaller bond market ­ other things being equal. It is certainly true that Germany or France does belong to the continental model. Interestingly, Japan with its sizable bond market (not the least due to high, and growing, public sector debts) would rather classify as "Anglo-Saxon". The above figures warn us that we have to be cautious about the usefulness of clichés; if the adjective Anglo-Saxon does not seem to apply fully to Britain but applies to Mexico or Finland, than this particular classification is of not much help in understanding financial regimes. Aggregate figures, of course, cannot tell the whole story: in the case of Finland the presence of the Nokia on the domestic stock exchange explains a lot about the relative size of capital market in this small Nordic country, while the unexpectedly high relative share of banking assets in the UK is partly explained by the fact that London is a global financial-banking centre with domestic and very important non-domestic banks functioning in the City.

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Yet, if we accept the general classification, the former centrally planned countries are expected to belong to the bank-based sub-set. The figures of Hungary certainly rank the country among the bank-based systems, and, as see shall see later, other CEE economies also belong this category. What, of course, counts in understanding the nature of a financial system as much as the relative shares between capital markets (shares and bonds) and banks, is the financial depth of a particular economy. Depth of the financial system is generally measured through the relative sizes of monetary aggregates (M2 or M3) compared to the national income (GDP). Also, financial deepening can be measured by comparing banking assets to annual GDP. Since, as we have seen, relative importance of banks and bank loans vary country by country, this latter definition of financial deepening may be misleading for countries with high market capitalisation of the stock exchanges. Empirical research proves that financial deepening (measured through M2/GDP ratio) and the private-public credit ratio provide a good forecast for future economic growth.19 The rationale behind this is that a more developed and larger monetary transmission regime improves the allocation of scarce resources, reduces and re-allocates risks and in consequences reduces transaction costs. All this, of course, requires a functioning legal system.20 Capital markets are generally characterized through the following variables: number of instruments (stock and bonds) quoted; market capitalisation measured to GDP; some form of liquidity measurement such as turnover/capitalisation. The CEE countries inherited a rather shallow depth of monetization from their socialist planned past; banks were nationalised and stock exchanges were closed at the time of the communist take-over. Therefore, at the start of their deep transformation, the financial sector of Central European countries was less developed than one could expect knowing their general level of economic development and their capitalist traditions dating back to the period between the mid19th century and the mid-20th century. As a strange result of the socialist industrialisation during the 1950s and 1960s, these countries became undermonetized while they became over-industrialized. The knowledge of this pre-history helps us to understand why certain policy instruments that work so effectively in a fully fledged market economy, even if the country is not highly industrialized, did not deliver the hoped for results for the region in the years immediately after the change of the system. A former centrally planned economy with even a relatively up-to-date financial sector, such as in the case of Hungary or Poland, was in reality less monetized at the start of the transformation process than a developing country with similar per capita income. The incongruence between level of economic development and level of financial development is predominantly due to the four decades of physical planning (seven decades in the Soviet Union). Central planning did not utilise much of the banking and financial instruments, therefore economic agents during and immediately after the political changes had first to learn how to adjust to changes in monetary signals. A central banking rate increase, for example, may elicit instant reactions even in a relatively poor developing country but, as we witnessed in 1990 in the otherwise rather
19

Fabrizio Coricelli (1996): Finance and growth in economies in transition. European Economic Review. Vol. 40. pp. 645-653.: 20 Katharine Pistor, Martin Raiser, Stanislaw Gelfer (2000): Law and Finance in Transition Economies. Harvard University CID Working Paper, No. 49.

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sophisticated Central-Eastern European countries, such a conventional policy measure did not critically affected agents at first in the post-communist era. Box 1 Western advice: was it important? Was it useful? Advisors and donors with their conceptual models or computer modelling based on their previous experiences gained in the Third World inundated the CEE region after 1990. But their policy models and advices did not always work in postsocialist countries. It has become obvious by now that the former planned economies differ a lot from each other and, due to their particularities and pre-history, from the emerging countries of other continents. Yet, at the very start of the transformation, the need for differentiation was not the received wisdom in major capitals and at the international financial institutions. This was the time when foreign advice played a rather important direct impact on the way reform measures were conceived and timed. One of the few recollections by policy makers was published by Blejer and Coricelli in their book containing interviews with key policy makers in the early 1990s (Blejer and Coricelli (1995)21). Balcerowicz of Poland claims that foreign advisors such as Michael Bruno, Stanley Fisher, Jeffrey Sacks played an important role in strengthening his own belief "about rapid privatization and other fundamental institutional reforms"; Czech minister of finance at that time Václav Klaus said that he preferred "listening to domestic economist as they knew better the real situation in the country", adding "Foreign experts could give us good advice on how to develop market institutions and instruments, rather than how sequence and time our reform policies or how privatize our enterprises". Central Bank president of Hungary at that time Bod adds that advisors from the World Bank and the IMF could be criticized for giving textbook recipes for countries in different circumstances (but admits that decision makers in all countries tend to believe that their problems are totally unique, although in most cases they experience recurrent economic difficulties).22 Others look at the role that the IMF and World Bank played before and during the transformation process more positively: "The inevitable collaboration with these institutions helped to a great extent to design and successfully implement may of the positive reforms."23 But they also add that these international financial institutions (IFIs) were also vital in preserving the solvency and credit-worthiness of an indebted country (such as Hungary during the liquidity crisis during the 1980s); advices carry an additional weight if monies are attached to them. What is interesting to recognise is that some of the centrally planned economies had built a rather intensive relationship with Western private sector financial institutions and with the IFIs long before the democratic changes took place. Looking back, the question arises: why did Western banks keep financing Poland, Romania, or Hungary in spite of the fact that these CEE countries ran high structural
21

Blejer M. and Coricelli F. (1995): The Making of Economic Reform in Eastern Europe ­ Conversation with Leading Reformers in Poland, Hungary and the Czech Republic. Edward Elgar. Aldershot. 22 Blejer & Coricelli (1995): op. cit. pp. 61-63. 23 István P. Székely, David M. G. Newbery (1993): Hungary: An Economy in Transition. CEPR. Cambridge University Press

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trade deficits as a consequence of their inherent inefficiencies? Some still think that there must have been some strategic `grand scheme' to make smaller states belonging to the "Soviet camp" heavily indebted, and thus making them dependent on borrowed funds. Yet, there is a quite simple explanation: the banks needed clients, and state-controlled economies under the Soviet military (and supposedly: financial) umbrella did not seem for the bankers to represent a high risk at that time. It was not until the collapse of the Polish modernisation efforts in the late 1970s, and its eventual default on the external debts of Poland in 1981 that the financial world had to learn: there was no such financial umbrella. From that moment on creditors considered all CEE debts as very risky. As a consequence, bank loans dried up for the region, particularly after the outbreak of popular demonstrations in Poland, followed by a coup d'état in December 1981. This turn came as a cold shower for countries with high debt. The Hungarian party and government, rejected by Western banks and markets, turned to the Soviet Union for hard currency soft loans; the application was rejected. Party and government, and central bank officials decided that if bankruptcy was to be avoided, Hungary had rather to turn to the lender of last resort in international finance: the IMF and World Bank. The Soviets did not object this time: in November 1981 Hungary, and soon after that, Poland formally applied for membership at the two institutions. Hungary was admitted in early 1982, but the martial law in Poland blocked their entry. It was only in 1986 that member states accepted Poland's return to the IMF. Box 2 CEE and the IMF CEE countries had a complicated relationship with the IMF. At the time of the Bretton Woods conference in July 1944, some of the countries in question were still allied with Nazi Germany (Romania, Hungary, Bulgaria), others were already under Soviet control, some others represented in the West by governments-in-exile. The founders in the Bretton Woods conference in July 1944 included Czechoslovakia and Poland, represented by their governments-in-exile. It seemed, though, that once the war is over, nations of the region will all join global institutional structures such as the International Monetary Fund and the World Bank (International Bank for Reconstruction and Development ­ IBRD). Yet, soon after the end of the hostilities, the rift between the Allies began to show. The Soviet Union decided at the end of 1945 not to join the IMF, and pressurised its satellites to stay out of the multinational institutions. Poland and Czechoslovakia had to leave the Bretton Woods institutions, others were not given the permit to join. With the departure of the Socialist countries, the Bretton Woods institutions could not claim any more to cover the whole globe. But that was a costly tactical victory for the Communist-run governments. The national interests of the small, potentially trade-dependent CEE countries would have been better served by belonging to these institutions. Yet, the Hungarian coalition government ­ formed initially by non-communist, civic parties that had won the free elections right after the war ­ which was about to apply in 1946, did not get the permission from the Soviets and their local collaborators. Not that later a formal application would have been received well in Washington DC; with the advent of the Cold War, the political support on the part of the US and other major members of the

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IMF disappeared for a country regarded as a Soviet satellite.24 Eventually the Soviet forced the Czechoslovak and the Polish authorities either to withdraw or be expelled for not paying in the quota. Other CEE nations were barred from conducting serious negotiations. Yugoslavia, however, kept its membership, and later the maverick Romania under Ceausescu joined the Washington twins. The real change in attitudes took place in the 1980s, for various reasons. One was that the Western powers recognized the People's Republic of China (PRC), rather than Taiwan, and as a result, PRC became a member in both the IMF and the World Bank. A mighty Communist country thus entered the international financial institutions - such an event paved the way for other, smaller, states whose leaders were anyway thinking about to do the same. Poland and Hungary were in such a financial situation by the time of the Chinese entry that called for a quick IMF application. The motivation in both cases was the growing difficulty to keep financing the disastrously high external debt. After the piecemeal opening to the West, imports started to grow fast, particularly after 1973, the first oil price hike. Export products marketed by state-owned Socialist firms could simply not compete in Western markets, which unavoidable led to widening trade deficits. The deficits at first were easy to finance at a time when the oil producing (mostly Arab) states offloaded their windfall dollar revenues in the international foreign exchange markets. Later, however, as world interest rates rose external debts became more and more expensive to service for Poland, Hungary, and Yugoslavia. The problem was not only the cost of finance but also availability of borrowed funds: private banks started to get cold feet about the Socialist countries. Indebted sovereigns had no option other than to turn to the IMF. Membership in the Bretton Woods institutions had profound but complex effects on the policies and institutions in these countries. Their entry, first, re-opened their access to international borrowing. But that also led to a strange consequence: the rather indebted Hungary was thus made able to keep accumulating more debts after 1982, this time both from the IFIs and the private sector. The latter read the presence of the IMF in Hungary as a sign of credit-worthiness and took Hungarian membership in the Fund for a certain guarantee of reliable economic policies. Poland turned out to be a different case. The Polish authorities were not able to go the Hungarian way; they had to wait five more years before being admitted to the IMF. Before that, Poland could not help but defaulted on international debts. The ensuing bankruptcy procedure meant that while re-scheduling talks went on at the London Club of private lenders and at the Paris Club of sovereign lenders, commercial banks and other businesses refused to take up more Polish risks. The debt of Poland still kept growing as unpaid interests were added to the original claims, while no fresh money was offered for the country. Interests in arrears were nevertheless registered as items that are added to the stock of Polish debt. In contrast, for the Socialist Hungary as member of the IMF for nearly a decade before the change of regime, the stock of gross foreign exchange debt doubled due to new borrowing ­ a dubious achiev

24

Boughton James, M (2001): Silent Revolution ­ The International Monetary Fund 1979-1989. IMF. downloadable at: www.imf.org/external/pubs/ft/history/2001/index.htm

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ement under IMF tutelage. It is not easy for a Communist regime to be a member of an IFI - The case of Hungary's misreporting to the IMF in the 1980s The general conditions of joining the IMF as an international financial institution include (1) supplying macroeconomic data, (2) paying in the country's quota; (3) concluding the so-called Article 4 consultations about the exchange rate regime; and (4) accepting the Fund's conditionality as a prerequisite for borrowing from the Fund. It may now come as a surprise that the hardest challenge for office holders in Communist Hungary was not forking out the cash, but the very first condition: providing true data on the economy. All Communist regimes were secretive: how much the country owned to external creditors was never made public in communist countries or the public figures were untrue. Admitting the true figure, however, was made hardly possible by the fact that the authorities did not tell the truth about budget deficit (officially non-existent) to their public, thus the Hungarian authorities felt in the 1980s than they could not admit the whole truth about the stock of foreign debts that financed the government deficit. So they kept doctoring the data as long as they could, until they were forced to admit the true size of foreign debts when political dynamics in late 1989 opened the way for free, multi-party elections. "Once the decision was taken in October 1989 to hold democratic elections, officials in the National Bank and the government began to worry that an end to official secrecy would expose the long-standing distortions in the data, that they would be accountable for it, and that it would damage their electoral prospects."25 The IMF staff realized that the stand-by arrangements of the 1980s had been based on fraudulent data. The falsification of data resulted in underreporting of domestic and external debts of the government and in overstating the international reserves. The IMF required Hungary to repay disputed amounts that were still outstanding before the parties could possibly enter into a new arrangement. The historian of the IMF dryly adds: "Hungary was not the first member to be out of compliance with that decision ­ that is: Executive Board's year 1984 guidelines on the provision of information to the IMF - , but this was by far the most extensive and widespread, and it was the first in which the Board declined to grant a waiver for the required early repayment of affected credits." 26 All over the CEE region, the profound upgrading of the financial system was high on the agenda of the new authorities immediately after the political changes. Yet, there was no model to go by. They had a past history, but the new democracies could not return to their pre-war conditions in their search for banking and capital market models; what domestic conditions and external advice called for in 1990 and after, was already very much different to what these nations had in the first half in the 20th century. The financial regimes in Poland, Hungary or Czechoslovakia in 1930s and early 1940s were themselves impaired during the years of the war preparations and the war, and after that the Communist takeover drastically altered the financial life. Forced nationalisation of banks and insurers after 1945 changed the financial landscape beyond recognition.
25 26

James M. Boughton (2001): Silent Revolution - The International Monetary Fund 1979-1989. IMF. Op. cit. p. 986.

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In short, in 1990 there was no way to return to the roots ­ history once again blocked organic capitalist development in the region. Therefore, a search for applicable models was set into motion. An interesting aspect of foreign advice concerned the debate on financial models: should the former planned economies introduce the bank-based or should they opt for the market-based version? Authors still differ in their views concerning the merits of the two basic models. The so-called "marketeers" argue that banks, being debts issuers, may have a bias towards caution, thus hindering innovation, while stock markets may stimulate competition. The often strong links between banks and debtors may unduly protect inefficient managers from outsiders, and inefficient firms from takeover.27 "Banketeers", on the other hand, claim that banks facilitate savings mobilisation, are much needed to provide a proper payment system, and ­ in contrast to the above view about the inefficiency of banks in corporate government - banks can exert corporate control over industrial firms even better than the often fragmented shareholders can. The seminal work of Gerschenkron (1962) determines that the role of the banks was vital earlier in economic development, particularly in the German context, and concludes that active banks (and active states) are necessary at an earlier stage of development.28 The development ­ as we will see it later in some detail ­ of the transformation countries involved both the creation (re-creation) of the stock exchange and also the thorough reform of the banking system. Yet, the central institution was, and still is, the bank, in spite of the fact that bourses were called to life early in the transformation as advised. The relative role of the capital markets mostly depended on factors other than the conceptual models of the advisors or the domestic decision makers; what really shaped the events were: 1) the way large scale privatization took place, and 2) the role of foreign direct investments. Foreign strategic investors that took part in privatising state-owned enterprises do not generally enter the local capital markets. Similarly, multinational firms as direct investors in a CEE economy typically avoid local capital markets, while in their home markets in the US or in Western Europe they may be listed as public entities. Large firms entering the CEE region mostly brought with themselves their banking relationships, and even if they were incorporated in the local economy, they hardly tapped the domestic capital markets for their needs for funds. The technique of privatisation therefore critically influences the relative significance of the capital market in the CEE countries. FDI-centred industrial transformation does not support a large and lively stock exchange. If, on the other hand, privatisation takes the form of initial private offer (IPO) for the general public, local stock exchanges and domestic financial markets would play a relatively larger role. The consequences of privatization and the attitude to FDI will thus have to be discussed in order to understand better the most important shapers of the eventually emerging financial system (see later Chapter 3 and 4).

27

Ross Levine (2000): Bank-Based of Market-Based financial Systems: Which is better? World Bank. Financial Structure and Economic Development, Washington DC. 28 Alexander Gerschenkron (1962): Economic Backwardness in Historic Perspective. Harvard University Press, Cambridge, MA.

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2.2 Sequencing of financial liberalisation and market-building
The vast literature on the subject of the financial models for development can be read as suggesting a certain pattern of sequencing: although establishing securities markets may be useful, such markets themselves depend on the existence of efficient banks; and given the limited financial and human resources in developing countries, priority should be given to creating adequate banking systems first.29 A similar argument may hold for the countries in transformation, too. It is logical that the return to a fully market-based system should start with banks ­ that is: continental type universal banks ­ in the centre of efforts. Yet, as we will see it, the banking laws were much influenced by the so-called `Anglo-Saxon' banking regulation school, which looked at the continental (universal) banking with some reservation. Advisors at first recommended a banking system where commercial (deposit taking) banks were distinguished from investment banks. Later on this separation started to weaken in real life, particularly when major foreign banks settled in the CEE countries, and won over financial market shares from domestic (initially state-owned) banks, and shaped the whole financial life in CEE countries after their own image. It is important to notice that the sequence of measures in the CEE countries after 1990 did not follow a strict logic, and certainly not the above `academic' logic. The timing and content of policy steps were very much influenced by the mainstream formulae of the IFIs. Their logic differed from the one suggested by academics in and outside of the region. McKinnon, for instance, took strong position, recalling lessons learnt in the developing world: before inflation can safely phased out, and before the capital market is opened for free borrowing and lending, the first and foremost need is to balance government's finances. "Fiscal control should precede financial liberalization. ... The sine qua non of successful reform government is an internal revenue service capable of collecting taxes in a decentralized market setting. ... Only with a very broad tax base can the government raise sufficient revenue to avoid inflation without resorting to arbitrary ex post seizure of enterprise profits or personal property, which results in the adverse incentive effects that currently bedevil the socialist economies" ­ wrote McKinnon in 1990. We know that events did not go this direction: tax base shrank, it took a lot of time for the governments to build a more or less reliable tax regime, and thus they could not avoid either inflation, or budget deficits. They did seize some of the enterprise profits (through inflation, rather than directly), but instead of expropriating better-off citizens, governments rather borrowed heavily in the international money and capital markets. Some of the countries in transformation sold a very high proportion of national assets to foreigners through privatization deals. János Kornai writings dating back to year 1990 also express caution concerning the speed of liberalisation and the necessary preconditions of a successful stabilisation exercise: efficient tax collecting, and real banks - as opposed to "pseudo-credit system, pseudo-bank system, and pseudo-capital market".30 Given the lack of an appropriate banking infrastructure ­ or at most, a quasideveloped system in some countries - , and given the homogeneity of policy advice,
Ralf de Haas (2001): Financial development and economic growth in transition economies. Research Series Supervision. 37, Netherlands Central Bank 30 Kornai J. (1990): The Road to a Free Economy. Shifting from a Socialist System - the Example of Hungary. Norton C Co. New York, London.
29

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it is not surprising why the events in most CEE countries followed the same broad paradigm for transformation of the banking sector ­ "a paradigm associated with, but not confined to, the policy advice of the International Monetary Fund and the World Bank. ... The so-called Washington consensus on banking transition called for separation of commercial banks from the central bank, abolition of restriction on internal convertibility of money, liberalisation of interest rates, restructuring and privatisation of state banks and their enterprise borrowers, and entry of new private banks. At the same time, the state had to take on important new roles to provide effective prudential regulation and supervision of banks."31 The problem with this broad paradigm is not what it contains ­ to reject this advice or to do the opposite would have been useless and dangerous. The problem is rather with what has been left out of these commandments: the social institutions in charge of the societal and economic order, such as a strong enough state to collect revenues; public institutions and human skills to police the goods and financial markets; contract enforcement; and catching criminals and crooks. The above texts says: "at the same time" the state had to take on important regulatory roles ­ but in reality states (governments, Parliaments, public agencies) always function under time pressure and with limited human and financial resources; regulatory reform in most of the cases started only after the first set of measures to liberalise banks and financial markets had been taken. The IMF attitude was for pressing for a stabilisation package, or applying "simultaneous approach to macroeconomic stabilization, price reform, and property rights reform" ­ that is: no sequencing effort was supported by influential actors.32

2.3 Legacies from the planning past and the initial conditions for the transformation
The commonplace view of the countries in transformation (transition) was ­ and probably is ­ that the legacy of a reform-socialist past is an advantage, and the lack of thereof is a disadvantage in the process. The rationale behind such a view is that the more open, reformed planned economies were more prepared for the changes. You may think that countries with a reform-communist past had an easier task when facing the challenges of the 1990s; a bit easier than in countries with previously a non-reconstructed socio-economic system. The reverse argument also sounds logical: closed planned economies had had fewer contacts with market economies, and therefore certain key skills and institutions were not available at the time of the initial changes, and thus the shocks accompanying the regime change are expected to have been deeper. On the whole, this hypothesis has proved right in one particular context: that of the CEE region versus the former Soviet Union. The Central European region in fact suffered a much less transition decline than the CIS. Measured by the change and level of GDP per capita, the CEE countries (more specifically those that are referred to as the Visegrad 4) followed a U-shape, while Russia, the Ukraine and other former
31

Fries Steven. and Taci, Anita (2002): Banking reform and development in transition economies. EBRD, Working paper No. 71. 32 Michael Bruno: Stabilization and reform in Eastern Europe: preliminary evaluation. In: Blejer ­ Calvo ­ Coricelli ­ Gelb (eds.): Eastern Europe inn Transition: From Recession to Growth? World Bank Discussion Papers, 1993. No. 196.

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Soviet republics (with the notable exception of the Baltic nations) rather followed the shape of an L: deep decline first, and a longish stagnation after that.

Chart 1 Transformation contraction: the U-shape and the L-shape countries Stylised output pattern of the V4 Y Stylised output pattern int he CIS

t

t

Within the CEE, however, the one and the half decades since the advent of the system change have not proved the commonplace wisdom wholly: the "orthodox" Czech Republic was not much handicapped from the very start compared to "reformed" Yugoslavia or Poland, and the Baltic republics managed to develop fast in spite of their poor initial conditions. Similarly, a reform agenda before the change of regime, as we will see, has turned out to be a mixed blessing rather than a clear advantage in the transformation of the financial sector. The countries with a reformcommunist past certainly enjoyed certain advantages over the orthodox regimes, but their particular past had produced by-effects and unwanted symptoms that countries previously under orthodox communist policies had not experienced to that extent. Therefore, it is useful to look critically at the legacies in the region, and the different paths that these countries have taken since the start of political changes. Countries of the former centrally planned economies differed during their entire history. Still it is not easy to describe their conditions under the former regime with simple grades, or classify them for the characteristics of their politico-economic structures. It is not only that simple classification is not easy in the case of a changing organism; what is more, a post festa classification can only based on a rather particular point of view: what has proved to help and what has delayed transition to a market mode after the regime change. This viewpoint is obviously a-historic. Reform measures taken or avoided had been motivated by the wish of the powers-that-be to retain and perpetuate their control over society. Some present political actors may claim that reform initiatives

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had been launched to pave the way for a transition to the present political-economic system, but such claims go against the logic of the planned system, and must only serve personal interests (or such recollections only testify faulty memory). Reforms ­ whether technical such as the "perfecting the planning methods /'ulutchenie'/" in the Soviet Union or in the German Democratic Republic (GDR), or quasi-market type of the Hungarian or Polish variety ­ aimed at perpetuating the rule of the regime. Economic reforms in particular served to counterbalance the decline in growth rate and the loss of international competitiveness. A successful defence of the existing socio-political order depended upon local conditions, though the policies applied in particular Communist regimes were crucially influenced by the perceived changes in the directions of the Soviet policies. Execution of such reforms also depended to a great extent on the imagination or the lack of it of those in decision making positions. What emerged by the end of the 1970s were two sets: orthodox and reformed versions, different in their reliance on some economic institutions but very similar as far as power relations, security and foreign policy orientation were concerned. Countries can be classified as follows in respect of their economic reform orientation: the ones where strict hierarchical planning was complemented or substituted with a control mechanism applying monetary incentives and higher degree of enterprise autonomy, and the other countries where the political rulers kept the central planning system intact. The former regimes, as a rule, allowed their enterprises to trade more with Western partners, and as a consequence, they tended to be more open to world trade and finance flows. Note that foreign policy openness did not necessarily go together with an economic reform orientation. Attitude to the capitalist core was partly influenced by geographic position of the country, or the strength of the bonds between the national communist party and the Moscow centre of the movement, and also by tactical consideration. It is also true that a governing party in a CEE country could possibly introduce rather bold economic liberalisation measures and yet insisted on keeping the Soviet foreign and security policy line. Such a policy made sense: a decisive move towards market elements could provoke suspicion in Moscow. All in all, two subsets had emerged during the period that preceded the latent crisis of the 1980s (starting with the 1980-81 Polish crisis, and followed by the emergence of domestic opposition and inner disputes within the ruling class, leading to the disintegration of the Communist rule at the end of that decade): the reformsocialist countries (Yugoslavia, Hungary and Poland), and the rest of the class.

27

Chart 2 Degree of openness and attitude to economic reform Approximately at 1980
openness Yugoslavia Poland Hungary Romania GDR Czechoslovakia Soviet Union Albania Bulgaria

economic reform

This classification maps the one time central planned economies in a two dimensional space: openness in foreign economic relations, and attitude to reforming the central planning. Both dimensions are of importance for what happened to the countries later, during their transformation. The mapping cannot, however, reflect all their national particularities relative to each other. Openness describes the frequency of organized (trade, technological, diplomatic) and personal (tourist, family) links to market economies. In this respect the Yugoslavs enjoyed the most freedom: the citizens could even go abroad for work, and foreign firms had a presence in the country long before the collapse of the Communist rule. A large number of Poles also held passports to go abroad as tourists, and the Polish Diaspora kept rather extensive links with the motherland. Hungarians gained their small liberties some time after the defeat of the 1956 revolution: citizens (not all) received passport every 3 years; managers of state owned enterprises were gradually allowed to build business link with Western partners. These were the same countries with the most extensive economic reform (liberalisation) measures: · foreign trade not fully centralized into the hands of a few state monopolies, · use of price signals and financial instruments (bank credit to households and firms). · acceptance of (limited) private property. Countries of this subset differed a lot among them. The Yugoslav regime provided a lot of independence to the (nominally labour-managed) public sector firms, and tolerated private ventures of a limited size. In Poland the agriculture still remained mostly private (even if suppressed by state regulations), but not in Hungary. On the other hand, in Hungary a limited number of private artisans and

28

small businesses were allowed to function ­ until the early 1980s when further reforms legalized establishing small businesses (without legalising the establishment of larger scale private enterprises).33 Hungarian firms (state-owned, that is) enjoyed nearly as much managerial freedom as enterprises in Yugoslavia (perhaps more than in Poland). Importantly, all three countries belonged or were to belong to the IMF/WB by the early 1980s. Entry into the Bretton Woods institutions and application for membership in GATT and similar UN agencies also meant that the external openness of the reform-minded countries increased during that decade. The speed of changes, such as the extent of price liberalisation and experimenting with Western type banking and capital market solutions, were initiated (others would say: dictated) by the Fund since their entry. The other sub-set of countries consists of otherwise very different cases such as Czechoslovakia versus Romania or Albania. The former, after the collapse of the Prague Spring in 1968, which forced reform minded thinkers into inner or outer exile, and blocked almost any efforts to change the regime, returned to the strict planned version, under politically orthodox Communist Slovak and Czech politicians who were orthodox also in fiscal sense: they refrained from borrowing from the West. The Czechoslovak Communist regime had not changed until the very end; hence the particular initial conditions of Czechoslovakia: the country could start with a clean sheet at the end of 1989, drawing a clear dividing line between the Communist past and the future the Czech (and somewhat less, for history reasons, the Slovak) Republic. Romania ­ a maverick in foreign policy aspect under the despotic rule of Ceausescu ­ was still kept under a strict centrally planned regime throughout the decades before the fall of the dictator. The economic system of the regime, in spite of becoming a member of the IMFin the 1960s, remained under-monetized and strictly state-controlled. Albania, also under despotic rule, tried to build bridges to the Chinese Communists; otherwise the country was strictly cut off from the West. Bulgaria, never allowing itself any liberties or diversions towards the Russians under the long rule of party boss Zhivkov, had toyed with the idea of some economic reform, noticing the better life standards in Yugoslavia and Hungary. The other eager communist regime was that of the GDR (under the first secretary of the Party Ulbricht, and later Honecker); in their efforts to maintain the "Soviet line", they did not venture to upgrade the system. The Soviet Union was not, interestingly, the most orthodox in the attitude to economic policy corrections; mild reforms of the planning regime in the mid-1960s introduced more room for the price mechanism (only to be withdrawn under the years of stagnation of Brezhnev). This is past history, but the consequences were very important at the start of the political changes, and are still a bit with us. The starting positions are hard to measure, yet this is what researchers at the UNECE attempted. Their verdict is not beyond doubt, but their overall ratings are worthy of notice. The relative liberalisation order of countries they suggest is hard to dispute, while the overall assessment of the initial conditions is more subjective. What is certain: some countries had a better general economic position than others at the start of the regime change (see Table 2).
33

See Jacob Naor-Peter Bod (1986): Socialist Entrepreneurship in Hungary: Reconciling the Irreconcilables. The Columbia Journal of World Business. Vol. XXI. No. 2.

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Table 2 Institutional Reform in Selected Transition Economies Country Bulgaria Czech Republic Hungary Poland Romania Slovakia Slovenia Estonia Initial Liberalization Liberalization Institutional conditions index, 1989 index, 1997 qualities, 1997-1998 2,1 13 79 0,1 3,5 93 6,8 3,3 34 93 8,7 1,9 24 89 7,0 1,7 75 -0,8 2,9 86 2,8 3,2 41 89 8,5 -0,4 7 93 6,1

Source: UN ECE (2001) 34

The entry `initial conditions' applies to successor countries under the present status quo (in 1989 the Soviet Union, Czechoslovakia and Yugoslavia still existed, but later all three federations fell into parts). Interestingly, the ratings of successor countries of the same former entity could be quite different: the part of the former Czechoslovakia that later emerged as the Czech Republic is given the highest relative grade of all the countries assessed, while the initial conditions in the other part of the same country (the present Slovak Republic) were rated much lower ­ below that of Hungary but above the Polish grade. Poland, one of the reform countries, and as such even a star in some respect, was to be found in 1989 in the middle of an economic crisis with physical shortages, a bankrupt state that could not service its foreign debts, and with obsolete heavy industries; hence the low overall rating. In the base year of 1989, Slovenia was soon to become independent, but at that time as part of the bankrupt Socialist Republic of Yugoslavia, this small subalpine country still faced difficulties. A later "convergence star" Estonia was still under Soviet rule ­ hence the negative, and the lowest, rating of its initial conditions. The other variable (liberalization) seems somewhat easier to measure and quantify: consumer and wholesale (producer) prices are either set by an authority or by market agents; foreign trade is either state controlled (through administrative pricing, quotas or other quantitative restrictions) or liberalized; interest rates and bank lending can be liberalized or managed. However, such a separation of the liberalized and the controlled is mechanical and formal. In real life, there was a large grey area: a formally administered price could be "influenced" by enterprise managers in some cases, and nominally free price bargains could be controlled through hidden mechanisms (such as through the Party structure as long as the establishment party managed to exercise this influence). Pricing may be official classified as marketdetermined, but bargain between two state-owned agents under close watch by a still active establishment party differs a lot from the free price bargain in a fully fledged market economy. The picture is not full, but the above figures underline that countries classified as reformers had by year 1989 reached a certain degree of liberalisation in term of domestic prices, foreign trade, and banking. But even Yugoslavia was not liberalized
34

UN ECE (2001): Economic Survey of Europe, No. 2

30

enough to qualify as a market economy by the standards of the GATT and other international conventions. Hungary, Poland and the others were still regarded "state trading" regimes. As such, these countries could not have access to the most modern technologies (ones that were listed on the so-called COCOM list of NATO countries), not before the sweeping political changes were accomplished. Let us note that while Yugoslavia, Hungary and Poland had become relatively (compared to other Communist controlled countries of the region) liberalized in economic affairs, they did not get automatically a high grade for the overall initial conditions in the above table. According to that assessment, Bulgaria still had better conditions than Poland, and Hungary was somewhat behind in 1989 relative to the Czechs who were to leave behind decades of an orthodox political and economic regime. This may come as a surprise for those with superficial knowledge of the centrally planned system, but may not shock those who knew these systems from the inside. Outsiders, as mentioned earlier, could presume that belonging to the reformed-communist subset, a country would automatically enjoy a better starting position in the "transition", on the strength of higher openness; yet, the assessment reveals that lack of reform was not an automatic handicap, and reform past did not deliver advantages only. What is the cause for such a contradiction? For the answers, one has to carefully weigh the pluses and minuses of reformed socialism. The pluses certainly include more exposure to foreign influences (both professional and private) in the case of a reformed planned economy. Additionally, the use of the price mechanism educated the economic agents about banks, taxes, accounting, pricing and other institutions of the market. More price liberalization in the 1980s also meant that physical shortages were somewhat eased in a reform country ­ higher price level, that is open inflation, made visible what had been hidden in other regimes in the form of suppressed inflation. State-owned firms conducted business with satellite small private ventures through outsourcing contracts ­ again something that was supposed to make production more efficient and competitive. What, then, are the minuses? Mostly the back side of the same factors should be mentioned. A bigger openness is a plus ­ but it also meant that state owned firms were more exposed to the world market competition. Their managers were given the right to sell and buy; unfortunately it soon became clear that an SOE even in a reformed planned economy was not competitive enough to sell its products and services in highly competitive markets; propensity to export had always been a problem in reform-socialist economies. On the other hand, no manager resisted the opportunity to import good quality materials and products, or modern technology from Western markets. That is, technology which was not on the COCOM list: access to most modern industries (IT, precision machines, nuclear technology) was delayed or forbidden for firms from the Communists-dominated countries. The overall macroeconomic consequence is a high import propensity which, coupled with the weak export performance, lead to a structural foreign trade deficit. As long as foreign suppliers and banks were willing to finance the deficit, the trade imbalances could persist; at the price of accumulating current account deficits of structural nature. Thus the fact that two out of these three countries classified as reform-socialist have gone insolvent on their foreign debts and the third was at the border, should not be seen as incident or mere result of bad economic policies. It is better to acknowledge: structurally and systematically

31

uncompetitive economic systems can only conduct external market relations with more competitive agents at their own risk. But why did not the SOEs become more competitive as had been hoped for on launching the reforms? The answer is partly provided by the mixed nature of the blessings on the list of the pluses. Use of the price mechanism: yes, but... First, liberalized pricing applied to some sectors and some product lines, and not for others. Second, with no strong competition domestically among sectors and firms, the pricing mechanism cannot deliver its effect on allocative efficiency: firms (note: state owned ones) in monopolistic or oligopolistic positions will not wage a price war; instead, they would exploit their position by increasing consumer prices. Third, should the price system bite, will a SOE go bankrupt? It hardly will, as long as the official policy is that there is no unemployment in a socialist country.35 Enterprise autonomy may be a better condition for efficiency than keeping unreconstructed state Kombinats and other production conglomerates under central command ­ but autonomous enterprises must be made to live by market prices. That is, firms will only behave in a market-like way if they are placed under the rule of financial discipline. Reform socialism, however, manipulated the price level and the price system, and consequently, weakened the disciplinary nature of the semi-market instruments that reform-socialist introduced with much fanfares. Students of the reformed regimes had to remind use that "stable non-inflationary prices add to the pressure on enterprises to conduct their activity in as rational a way as possible./.../ This is the domestic side of financial discipline, but financial discipline also has an important international aspect. Here again, CMEA countries have made life difficult for themselves by manipulation exchange rates out of recognition. Distorted exchange rates confuse economic agents and observes so that they no longer know what exactly is happening, but they also confuse the policy makers themselves, so that they no longer know the real state of their own economy."36 Here we have the fundamental contradiction of the reformed, or Socialistmarket, economies: use of prices, banking techniques and other financial forms cannot effectively change the non-competitive nature of the regime as such. Semimarkets and pseudo-banks may be better than no markets and no banks, but they yield, at most, second-best result, and they sometime function as alien bodies within the centrally controlled regime. Is adjustment to artificial prices much better than no adjustment? Is it much better pretending that prices are set freely, when in reality two state-owned, monopolistic firms set producer prices among themselves? Is it efficient if state monopolies set selling prices in a shortage market? Whenever market forces felt themselves, central agencies quickly intervened. The history of the reform-socialist experimentation is also a history of political interventions of stop-go nature, half-backed reforms and regressions. What this period left behind once the regime change took place was not a climate for consistent reforms, rather the feeling of impatience: full liberalization, no state regulation, quick transition to a `real market', and `real owners' for state assets.

35

The Yugoslav model went the farthest in the direction of enterprise autonomy, and the consequences soon appeared in the form of unemployment and regional differentiation within the federal structure of the Socialist Yugoslavia ­ one of the most difficult contradictions of the self-management system of the country. 36 Ljubo Sirc (1994): Why the Communist economies failed. Centre for Research into Communist Economies. Chapter 15. This chapter was written in 1988, and presented in Sopron, Hungary that year. CMEA stands for Council for Mutual Economic Aid (or: COMECON).

32

The reform-socialist period also had left behind a sad legacy of macrofinancial mess. Commercial opening to the West under market reform unavoidably led to foreign trade deficit, and ­ as long as Western banks were willing to finance is ­ growing current account deficits. Entering the IMF helped those reform-minded Communist regimes for a while: having an IMF programme and drawing some official loans from the Fund made is possible for the borrowing governments to keep borrowing also from commercial banks in the international market - and also to pile up more foreign debt; only to realize at the latest by the end of the 1980s that the economy was unable to service such a huge debt. Countries with reform-socialist past had to face an external credit crisis at the very moment they embarked on a hard and risky process of transformation from the pseudo-market to the real market. Domestic financial conditions were also difficult in all ex-socialist countries, whatever variants they formerly belonged to. Orthodox regimes were typically characterized by physical shortages: long lines in the shops, waiting lists for telephones and cars, low quality of (cheap) products and services and other consequences of suppressed inflation. Semi-market reforms did manage to reduce the intensity of suppressed inflation, but resulted in a visible open inflation. Prices in Yugoslavia and Poland grew annually at three digit speed before the final collapse of the regime; consumers in Hungary had already had a decade of inflationary experience before the first free election. Both external imbalances and the inflationary nature of the reformed regimes meant that banks and the nascent capital market players were created and conditioned in a messy period. Pseudo-banks ­ yes. But then also pseudo-bankers and pseudo-brokers during the 1980s ­ this is a legacy that will come dear during the first phase of the change of regime.

Chapter Three: Foreign direct capital and foreign banks in CEE countries 3.1 Early birds in fragile CEE markets
The collapse of the non-democratic regimes opened the way for the nations of the CEE region to return to the family of democratic and constitutional states, and to end the semi-closed conditions forced upon them under the Soviet-type system. In the German case the changes resulted in national unification, while in other cases they fulfilled previous hopes and dreams of national independence, particularly so in the Baltic region or for those living in artificial federations. Expectations were also high concerning the living standards and the life styles, taking prosperous Western countries as models. For the politically active part of the general public, it was rather clear that changes had to involve the upgrading of the obsolete production capacities, and that large investments were needed into services that had been badly neglected during

33

Socialist industrialization. The public was ­ perhaps not fully ­ aware of the fragile conditions of government finances, and expected foreign financial support. Some even remembered the Marshall Plan in the late 1940s in Western Europe, its impressive contribution to the German economy miracle, and laying the ground to the golden period of the French, Italian, Austrian growth in the period from the mid-1950s to the end of the 1960s). Foreign investments were welcome and private funds were expected to enter the CEE markets so needing fresh capital. The high hopes attached to foreign capital inflows did not materialise at first. Admittedly, they were not fully justified at the time of the political changes. Not that the region did not need fresh capital, modern corporate governance and technology that are supposed to go together with foreign funds, particularly with foreign direct investments. Yet, a relative shortage of capital in a particular market is not enough reason for the funds to flow in. What crucially counts is safety in the target market, and low transaction costs; they matter as much as prospective payouts of financial investments. The countries of the region all were of dubious risks at the very start of their historic transformation. The process of the regime change involved much more than a mere change of governments, or even more than a constitutional change. In some of the cases, whole new national entities emerged, and even if the national boundaries were not modified, the geo-political conditions and domestic power relations were radically altered. For potential bankers and investors, all these aspects of the deep going institutional and legal transformation added to the perceived risks. In addition to the above qualitative risks factor, quite sizable quantitative risk components characterized the region: high inflation, current account deficit, evidences of capital flight. It is therefore not surprising that risk-sensitive capital flows were rather reluctant for a while to enter the financial markets of the CEE countries at the very historic moment of the changes. Any market player may have its own risk assessment procedure. Those firms that had previously established long term trade agreements or even joint ventures in a socialist country, could better calibrate the risks they were about to take once political and legal conditions allowed them to enter the market. Foreign banks that had lent funds to socialist governments and central banks could also rely on their records and in-house risk research capabilities. But business contacts had not been widespread, and the transition itself added to the uncertainties of doing business in the CEE area. An important source of information for potential business partners on the risks perceived is the risk assessment made public by rating agencies. They are particular important for the business if it comes to the assessment of the country risks, that is the probability of financial turmoil in any particular state. There are a limited number of major international agencies issuing country (sovereign) ratings. Their verdict at the time of the political changes, and even after that for a long time was that the sovereign risks in most countries of the CEE area fell into the category called speculative grade risk class (see data in Box 1).

34

Box 1 Risky countries A sovereign credit rating is an assessment of a government's capacity and willingness to repay debt according to its terms. Willingness to pay is a qualitative issue distinguishing sovereigns from most other types of debt issuers. A government may decide to default on some of its obligations for political reasons; thus willingness encompasses a range of economic and political factors. Capacity to pay is rated by evaluating key economic factors such as balance of payment, integration into the world economy, total debt service, inflation, the state of the banking sector, economic structure, a history of default, etc. A country turns to the rating agencies if the authorities want to issue a security (a government bond or a central bank bond). The default frequency of sovereign local currency debt differs significantly from foreign currency debt; a government's ability and willingness to service local currency debt is supported by its taxing power and control of the domestic financial system, which gives it potentially unlimited access to local currency supply. This is not the case with foreign currency debts, therefore this rating cannot be higher than the one determined for debts in local currencies. Countries are being rated the first time when they enter the capital market in order to place bonds of other obligations. CEE national acquired their rating at different moments; they are enlisted in Table 1 in the time order as they first entered the international capital market. Hungary was already a party to international bond issues in the 1980s, and rated by Moody's, Standard & Poor's, and the Japanese Credit Rating Agency (JCR), as the country issued sovereign securities through its central bank (Magyar Nemzeti Bank- MNB), and therefore needed rating from international and national rating agencies. Most other countries of the region were either in no need to borrow on these markets at the time of their regime change (the successor countries of the former Czechoslovakia, not indebted during the Communist period), or were not accepted for a time as reasonable country risks due to former default or high perceived risks of such default (Poland, Russia, Yugoslavia).

35

Table 1 Country risk credit rating now and then Ratings by Standard & Poor's Country Hungary Czech Republic Slovak Republic Poland Romania Slovenia Russia Latvia Croatia FC ratings, 2004 ABBB+ BBB+ BB+ AABB+ ABBB+ LC ratings, 2004 A AABBBAA BBBAAFirst rated February 1992, BB+ July 1993, BBB November 1994, BBJune 1995, BB February 1996, BBMay 1996, A October 1996, BBJanuary 1997, BBB January 1997, BBB-

FC: Foreign currency; LC: local currency; - = not rated now Source: Standard & Poor's homepage: www2.standardandpoors.com, ratings as of November 2004; Standard & Poor's CreditWeek February 19, 1997

It is interesting that the Czech Republic received immediately a BBB sovereign rating, that is, one in the `investment grade' class, two notches above the Hungarian level. This initial rating expressed the expectations of the rating agency (and this grade was in line with the grades offered by other rating firms): this particular successor country of Czechoslovakia looked like a good risk for the medium term. With practically no foreign debt inherited during the centrally planned regime, the Czech authorities were free to borrow, and at a rather generous yield level at that, because of the limited risk their securities represented. Compared to that, Hungary still belonged to the `non-investment' or `speculative' grade: not because of the debt service records or the borrowing policies of the authorities, but simply because of the country's heavy debt burdens. Slovakia, on the other hand, did not inherit sizable foreign debt, and at the moment of the peaceful disintegration of the Czechoslovak federation had macroeconomic and macro-financial indicators very similar to those in the Czech Republic ­ yet their initial rating was much lower. Rating agencies obviously entertained certain reservations concerning the Slovak authorities' ability to manage the economy efficiently on the medium term. Poland was a particular case, since the country first had to settle foreign claims under the Paris and London club negotiations. Having successfully achieved this, the country (its central banks and treasury) could again enter the international capital market and tap the capital flows. By the time Poland re-entered the markets, the initial tough transition years have been completed, and the country was on a growth track. This is why rating agencies accepted Poland as an investment grade risk, in spite of the mixed payment history of the country.

36

Chart 3 Country risk rating of three economies 1990 A o ABBB+ BBB BBBBB+ BB BBHungary Slovakia Czech Republic x +
0

1991

1992

1993

1994

1995

1996

1997 o o

1998 o O

1999

2000

o o o x x x X X x x x x x x x + x + o o o + x x + x + x + x o X x + +

o x

o x

+

x +
0 0

Source: based on S & P long term sovereign ratings

Country risk ratings are important for portfolio investors, or for those who are about to enter a particular market in the first time, without any detailed knowledge. Portfolio investors need a relative safe risk profile, an investor-friendly environment, and in addition to all these, they require mature capital markets, an internationally compatible legal system, smooth fund transfer techniques and a set of other important institutional conditions. Yet, international capital flows may take many other forms including equity investments into existing companies, greenfield investments and other types of foreign direct investment (FDI). Statistical classification distinguish direct investments made to acquire a lasting interest in an enterprise operating in an economy other than that of the investor, the investor's purpose being to have an effective voice in the management of the firm, and portfolio investment which covers long-term bonds and corporate equities. Participation in privatisation thus primarily classifies as FDI, since the investor intends not only to make a profitable investment but also to acquire partial or controlling stake in formerly state owned company. On the other hand, privatisation may take the form of purchase of non-controlling ownership stake in a firm and thus could be registered as portfolio investment. From the viewpoint of the countries in transformation direct investment stands out as perhaps the most welcome form of capital inflow. This is because FDI involves

37

a particular mix: not only funds but also the potential of technological, marketing and/or management transfer as well. As discussed elsewhere37, the transfer of Western technology and management as the paramount form of development finance may well apply to many third world countries, but this was not self-evident in the formerly Soviet dominated world. East Germany, Poland, Hungary, Czechoslovakia and the rest of the "Socialist Camp" were not underdeveloped even before the Second World War. The eastern part of Germany had a higher standard of living than the average in the German Reich. Within the Austro-Hungarian Monarchy the Czech and Moravian lands exhibited an industrial culture on a par with any other industrial region in the Continent. Hungary, too at the turn of the century had managed to develop some major firms, competitive on the world market in machinery, electrical engineering, food processing and pharmaceuticals. Companies such as Ganz, Tungsram, Orion, Herz, and Chinoin held strong market positions and relied on highly reputable research and development departments. This is not entirely surprising: relative to the size of the nation, Hungary has produced more Nobel Prize winners than any other country. The initial conditions for the transformation of the CEE region were unique. As distinct from third world countries, the planned economies had built a fairly diversified industry, manned by a relatively well educated, if under-motivated labour force. After decades of high saving and investment rates, there was no general shortage of physical assets. However, as soon as the first democratic governments had removed state subsidies and restrictions to competition, most of these assets quickly proved to be in the wrong place and were typically severely obsolete. Under these conditions, foreign capital did not find it easy to enter the region in 1990 and after. The end of the virtual inaccessibility of the region's economies certainly offered a variety of business opportunities from sales of consumer goods to loans for under-funded state-owned or new private firms; from participating in privatisation to establishing joint ventures or investing in the "greenfield". But investors had to run a risk which was at first not easy to quantify. The risk-mitigating institutions of a fully-fledged market economy, such as financial and legal services, accounting firms, dispute settlement forums, goods and currency exchanges, etc. were still largely non-existent. Not only banks were sensitive to the perceived risks and the lack of a legal and financial framework. Portfolio investors also need reliable capital market institutions, first and foremost a transparent stock exchange. It was therefore important that the Stock Exchanges were re-created in 1990 after four decades; but for any Bourse to gain acceptance and become capable of absorbing serious money takes a while to achieve. Decisions on direct investments are less strongly influenced by country risk or the relative maturity of the domestic capital market. What investors need in the first place is close knowledge of the local firms and factor/product markets. The process through which strategic investors identify sectors and locations of interest is timeconsuming; they usually conduct detailed discussion with central and local authorities before committing themselves.

37

Péter Á. Bod: The social and economic legacies of direct capital inflows: the case of Hungary. In: Jens Bastian (Ed): The Political Economy of Transition in Central and Eastern Europe. Ashgate Publ. Co, Brookfield, 1998

38

There are also difficult considerations from the host country's side. As well as needing fresh capital, countries with high inherited debts (such as Poland, Yugoslavia, Hungary) were hard pressed to find funds to refinance maturing debts. Privatisation offers a foreign-currency earning instrument. However, saleable assets were few in the very first years of transformation, and their sale value was extremely uncertain. Former "star companies" had generally lost their COMECON markets and thus lost value; state monopolies (gas, oil, and electricity) were still functioning under an inadequately defined legal and regulatory framework; undercapitalised state owned firms were not in good enough shape for sale. Economies with no sizeable debs were not under this sort of refinancing pressure (e.g. Czechoslovakia). Whatever their background, when profound transformation began, CEE countries lacked the required capital market institutions and established channels of capital inflows, and all represented a degree of financial and commercial risk which was too great for private sector participants at the time. In short, most former socialist economies were characterised by a limited capacity to absorb capital in the early phase of transition.

3.2 Privatisation methods as powerful policy instruments
Overcoming reluctance and inertia requires policy actions. The three most comparable countries - Poland, Hungary and Czechoslovakia ­ applied various policies, including partly similar, partly different approaches. Similarities characterise their legal regulations: in all these countries 100 per cent foreign ownership, repatriation of profits and dividends, and provision of full current account and near-full capital account currency convertibility were part of the incentives offered after 1990. They also provided generous tax breaks, at least for a limited period of time The main differences in approach to foreign investors manifest themselves in privatisation policy or in the consequences of this policy. All governments applied a set of instruments for transferring state assets into the private sector; thus each individual privatisation practice in the region is a mix of methods, ranging from free transfer of state property to local authorities and the social security fund to sale of assets through competitive tenders. There are, however, marked differences in the composition of that mix. The Czechoslovak government - and later the Czech Republic - favoured the equal-access voucher scheme, while in Poland management buy-outs and sales through investment funds emerged as the main method. Hungary's characteristic approach is through sale to outside owners (see table). In countries where foreigners are offered favourable opportunities to participate in privatisation, the same climate appears conducive to sizeable and steady FDI flows. This policy attitude is the direct link between privatisation and direct investments. As the case of Hungarian privatisation illustrates, the method of market sale tends to favour foreign buyers over domestic buyers, who can hardly compete with them in terms of purchasing power. Thus in the first full year of Hungarian privatisation about 80 per cent of revenues accrued to the Privatisation Agency through the sale of state assets came from foreigners. Hungary also emerged as the only country of the region with significant foreign direct investment in the early 1990s, in spite of output contraction that was as nearly as deep as in other transition countries. The first government, led by Prime Minister József Antall (1990-93) made

39

great efforts to form the appropriate legal and financial conditions for local businesses, and tried to balance the foreign/domestic composition. Yet, in spite of corrective measures, the nature of direct sales gives rise to a predominance of foreign buyers.38 Table 2 Initial methods of privatisation for medium-sized and large enterprises
(Percentages of total)

Country

Sale to Management Equaloutside / employee access owners buyout voucher privatisation 32 5 38 40 3 0 0 7 2 14 22 50 0 0 6

Restitution Other

Still in state hands 10 40 22 42 54

Czech Rep By number By value Hungary By number By value Poland By number

9 2 0 4 0

28 3 33 12 23

Note: Data are as of the end of 1995. 39

Preponderance of foreign strategic investors also lends radical nature to the structural transformation of the economy. In the Hungarian case micro-shocks went mostly unnoticed as they took place within the privatised firms, without much ado. The pattern as demonstrated in the Hungarian privatisation is as follows. First, outside buyers (mostly foreign) quickly transform corporate governance by introducing their own management system, and the new owners radically upgrade the organisations by reducing redundant labour and closing down non-core activities. Reorganisation generally involves further investment into both machinery and facilities and financial restructuring through loans from parent companies. Hungary may be the country where sale to outside owners is most prevalent, but this technique is applied in other countries too, such as the high profile cases in the Czech Republic (SPT Telecom, Volkswagen-Skoda, Philip Morris-Tabak, Continental-Barum). In the case of Poland, sales to foreigners had a slow start, but capital increases in already privatised companies are becoming more frequent. The size of the Polish market in itself is a factor that has increasingly contributed to strong inflows in recent years. The car industry has been the single most important investor in the region: Volkswagen has invested heavily in the Czech Republic and Slovakia; GM-Opel in Poland and Hungary; Fiat and Daewoo in Poland; Suzuki, Ford, and Audi in Hungary. Car manufacturers typically invest into the "greenfield", although not exclusively (as exemplified by the VW-Skoda deal). It is formative to consider the change in composition of the value added by a non EU automotive producer, which had to comply with the EU ruling concerning
38 39

See Bod (1997). Op. cit. World Development Report, World Bank, 1996. Washington DC.

40

local and EU-content for a car to be classified as European. Share of local content also expresses the adaptability and technical standards of the domestic firms (as well as the efforts of the foreign owner to recreate suppliers). Table 3 Local content at foreign owned firms increases with time
Value added at Magyar Suzuki, percent

Oct 1992 1. 2. 3. 4. 5. 6. 7. Magyar Suzuki Hungarian suppliers Local content (1+2) EU suppliers European content (3+4) Japanese suppliers Altogether (5+6) 19 6 25 4 29 71 100

Dec 1994 23 27 50 12 62 38 100

Dec 1996 24 29 53 17 70 30 100

Source: Magyar Suzuki

As this case indicates, it takes time (and effort) to build up a network of subcontractors in the country of operation. Support by financial and technology promotion public institutions may help, since potential local parts suppliers generally need quality upgrading and additional investments. The crucial issue is, of course, the strategy of the main producer. In this particularly case, Suzuki had a vital interest to build a "European" car, and in the process the Japanese car producer contributed to industrial development in the host country.

3.3 Patterns of FDI inflows in CEE countries
Whatever policies the CEE governments had been applied before the changes took place, all former socialist countries suffered colossal output decline as they started to transform their economies in 1990. No country of the region managed to avoid a cumulative loss of about one fifth of GDP in the first years of the 1990s - a fact that revealed the dire legacies of 'really existing socialism'. End of managed trade, fiscal tightening, and rapid elimination of protectionist practices ­ all which meant that established producers were suddenly exposed to competition in 1990 or soon after. Free market entry allowed new market agents to compete for the hitherto protected markets of state-owned companies. But the chances were not equal. Foreign firms have, in reality, enormous advantages over newly created, undercapitalised domestic businesses. The first country to illustrate the shattering effects of "market adoption" was Germany. The GDR represented 48.7 per cent of labour force and 25.2 per cent of industrial production of the - then hypothetical - unified Germany in 1989, but four years later the Eastern Lander's share in German employment accounted for a mere 16 per cent, and in industrial production only 5.1 per cent.40
40

Hall & Ludwig (1995) op.cit.

41

These figures say a lot about the viability of the inherited economic structures, and about the extent of the `creative destruction' that has taken place during the transformation. Part of the picture is inflow of investment from external sources ­ in the case of the former GDR: predominantly from Western Germany -, and another part is the shrinking of the domestic economy. Transition crisis was certainly unavoidable, but the depth of the contraction reveals that domestic economic agents have not been able to compete with the forces of changes and market power of the competitors. Deregulation, trade liberalisation, and privatisation - the core measures along the Washington consensus line in the post-1990 Central-Eastern Europe have been also instrumental in exposing domestic markets to foreigners. The more liberal and open door policies a government was to follow, the more probable it was that the policies would result in rapid growth of foreign economic presence within the country. Germany, due to her sheer size, proximity, and historical links, was destined to assume the dominant role in "globalizing" the region. There was some hope - and also certain fear - of large-scale German capital inflows (or: economic penetration) in Central-Eastern Europe (CEE). This has not taken place. The particular way chosen in 1990 to transform the former GDR, involving enormous initial transfers to the eastern Lander, conflicted with the capital need of the CEE region. But Germany is the single most important economic power of Europe. It was therefore obvious to expect that Germany would become the most important source of FDI-type investment in former socialist countries. Working with FDI data, certain cautiousness is warranted. Apart from the classification problem, there are numerous statistical uncertainties and biases concerning the registration of capital flows41. The Polish authorities initially included in-kind contributions, subordinated loans and even promised top-up investments in their FDI-inflows. The Hungarian statistical system at first recorded only cash transfers, excluding therefore in-kind contributions or loans from owners, which may serve as substitution for formal capital increase, and did not include reinvested profits. Later, after year 2000, this conservative attitude had to be changed, as a significant portion of profits made had been reinvested into existing firms, and neglected them would mislead the analysts. The German Federal Economic Ministry's 'Nettotransferstatistik' have its own distinct methodological specialities, too. This is why statistics of capital import nations and those recorded in the capital exporting countries do not necessarily match. An interesting methodological aspect should be mentioned here: uncertainties in recording the country origin of capital due to the global character of capital flows. Some of the investors are multinational or transnational firms that may invest through a third country entity. Before 1993, for example, General Motors was the biggest single foreign investor in Hungary but it set up and subsequently has been running its investment via Opel, its German subsidiary. This investment is registered in Hungarian statistics as American, but it may be registered as German in Germany. On the other hand, many German companies invest in Hungary through their Austrian subsidiaries like in the case of Mercedes-Benz: these investments appear in national statistics as of Austrian origin. Certain German businesses have formed strategic alliances with partners from other countries like the Dresdner Bank with
41

Klaus E. Meyer (1995): Foreign Direct investment in the early years of economic transition: a survey. Economics of Transition, Vol.3 No.3

42

Banque National de Paris. BNP-Dresdner then invested also in the region in a joint venture - is it now a German or a French investment? The general picture, in spite of methodological weaknesses, is rather clear. In the early years or the transformation, few countries were able to attract significant non-debt creating capital flows. Table 4 Foreign direct investment flows in the early years Flow of FDI, 19891993 1989 1990 1991 1992 1993 Cumulative 1989 - 1993 Hungary Czech Rep. Poland Romania Slovakia Other CEE Total CEE 187 187 311 1459 1471 2339 120 511 983 517 5767 2131 981 171 256 1026 10332 % of total 56 21 9 2 2 10 100

- 117 284 580 77 94 - 100 156 1 116 335 574 432 2203 3250 4260

Computed by using (EBRD, 1996)42

Germany was a major capital exporter to the region already in the early stage of the transformation. The Nettotransferstatistik indicates that, for example, in 1992 the overall German direct investment in the region amounted to DM 1.7 bn (or about $ 1.0 bn), and Hungary was the most popular target country with DM m860. Apart from the Czech Republic (DMm 545), all other countries were lagging much behind: Bulgaria: DM m3; Poland DM m154; Romania DM m11; Slovakia with less than DM m0.5. As for the stock of FDI, Germany became the leader over the US by the end of 1992 with an amount of over 2 bn DM. During the first transition years Germany and the US led the ranking of countries, ahead of Austria, France and Britain. But those years were rather special as the process just started and the statistics could be shaped by a small number of large-scale initial transactions made by multinational firms such as the sale of Tungsram to the General Electric or GM, Ford car assembly investments in 1990.

42

EBRD (1996): Transition report 1996

43

Table 5 Where direct investments went and whence they came Stock of FDI by countries of origin and target
End 1992, mUSD

Origin Germany US Austria France UK Italy Other Total

Total 2203 1783 869 705 348 339 1867 8114

Hungary 540 1000 450 300 110 110 914 3424

Czech Rep. Poland 1000 315 120 150 0 10 15 1610 450 250 100 70 64 66 500 1500

Romania Slovakia 50 59 31 70 67 35 228 540 48 44 53 10 2 13 60 230

Source: Arva (1994)43

The period after 1992 may well be seen as different. Most economies of the region - though not yet in the former Soviet Union and on the Balkans - reached the trough in 1993. Investments started to grow, and new sector were opened up for privatisation (banking, utilities). Net FDI flows to the whole region (CEE, CIS, the Baltics, the Balkans) further increased from $bn 4.2 in 1992 to $bn 6.6, $bn 6.7 and $bn 12.2 in 1993, 1994 and 1995 respectively.44

Árva László (1994): A Közép-Kelet-Európába irányuló közvetlen külföldi beruházások helye és perspektívái a hárompólusú világgazdasági rendszerben [Role and perspectives of FDI into Central-Eastern Europe within a tri-polar world economy order], Közgazdasági Szemle, Vol. 41. No.3.
44

43

EBRD (1996), op. cit.

44

Table 6 Sources of FDI in Hungary Stock of FDI in by Countries of Origin Share of Total in Percentage May 1993 1. USA 2. Germany 3. Austria 4. France 5. Italy 6. Japan *
* **

Dec. 1994 29.0 19.5 13.5 7.0 6.5 4.5 USA Germany Austria France Italy UK * 27.0 24.5 13.4 6.8 5.0 5.0 Germany USA Austria France Italy Netherlands **

Dec. 1995 29.0 24.0 10.5 9.0 4.0 4.0 8.0

without portfolio investments portfolio investments (e.g. EBRD, IFC)

Source: Diczhazi (1996)45

In some countries the eminence of Germany as the biggest single investor has been unquestionable since the early days of the transition period. This is certainly the case with the Czech Republic where Germany's share was above 31 per cent, ahead of the US (28 per cent) and France (13 per cent) as of Jan.1994; Slovakia where Germany's share was 34 per cent followed by Austria (32 per cent) and the US (22 per cent); or Croatia where the league is led by Germany (36 per cent) before Austria (14 per cent) as of January 1995.46 The amounts have been growing throughout the period, particularly in CEE countries close to Germany.

45

Diczházi Bertalan: Külföldi beruházások Magyarországon [Foreign investments in Hungary], Valóság, Budapest, 1996. No. 10. 46 Statistical Information, East-West Investment News,(1996) No.2. Summer

45

Table 7 German FDI into CEE Countries in the early years 19921995 1992 Albania Bulgaria Croatia Czech Republic Hungary Latvia Lithuania Poland Romania Slovakia Slovenia * Czechoslovakia
Source: BMWI (1996)
47

in DM 1993 0 8 45 604 916 3 5 438 7 90 36

1994 0 98 30 1161 741 12 7 545 15 77 16

1995 0 9 70 1213 1822 22 19 778 38 106 32

0 3 25 545 860 3 154 11 2

*

The main recipient of German direct investments was Hungary in these first years. However, there seemed to be no special relationship with Germany in FDI. The inflow of direct investment into Hungary has remained high after the first, exceptional years. 1993 was a strong year, the annual volume of FDI flows topped by the huge privatisation deal between the Hungarian state and the consortium of Deutsche Telekom and Ameritech. There was also strong interest from Dutch, French and Belgian investors. The following year turned to be less robust: an election in the middle of the year after which the privatisation agency practically stopped initiating new transactions. Altogether, Germany's share in overall FDI import of Hungary was about 22 to 28 per cent throughout these years ­ high but not extreme figure. Taken the CEE region as a whole, Hungary's share of the cumulative FDI inflows was still about half - a remarkable achievement for a country of limited market size. It is true that Hungary opened up those sectors for (foreign) investors, fields that are generally not the first on the list of priorities: banking, insurance, power.
47

Bundesministerium für Wirtschaft (1996): Wirtschaftsbeziehungen mit Mittel- und Osteuropa 1995, Bonn, August

46

It may be too early to determine with certainty the balance of the role of foreign capital in the CEE region; as always, there are pluses and minuses. What is certain is FDI has been perhaps the most effective engine of change in industrial structure and corporate governance. Official sources of funds and of influence have taken the back seat during the first one and half decade of the transformation. Preparation for the entry into the EU changed that situation ­ we will have to look at other aspects of the changes in these economies. Yet, foreign ownership in general, and in the banking industry in particular, emerges as perhaps the most important shaper of events.

Chapter Four: Penetration of foreign capital in CEE financial markets ­ a sign of modernity or of weakness? 4.1 Changing size and composition of the banking sector
The functions of a banking sector include, at a simple level, the provision of deposittaking and lending services. As we have seen, the countries in question inherited a rather limited financial sector from their planning past. Even those with some market (or: semi-market) experiences did not start from a much better initial position in 1990. Hence the obvious tasks at the outset of the long transformation process: rebuilding the banking sector, creating a modern capital market, taking determined efforts to recreate or strengthen the legal infrastructure for financial transactions. The opening up of the former planned economies offered opportunities for interested investors in the West. All former socialist economies were obviously in need of more financial institutions. Banks were too few, financial services were delivered at a basic level; such initial conditions should, in principle, prod new players, whether de novo domestic or foreign firms, to enter the emerging markets of the region. The year 1990 conditions in all countries called for capital inflows, for micro, as well as for macro economic reasons. Most of the existing banks in the region were undercapitalised at that time, in need of more shareholders' funds; national savings were not enough to finance the transformation process. Still, bank-to-bank flows were slow to evolve in the very first years. This is noteworthy since some non-bank sectors, such as manufacturing, trade, food processing, construction, and insurance proved quite successful in some CEE countries in absorbing foreign funds. Why not the banks? Under what we have seen in Chapter 3, the reasons why FDI-flows initial avoided most of the CEE financial markets are not difficult to understand. One should add that financial services are sensitive to macroeconomic stability, proper regulation and efficient legal structures ­ not at all available at first in the region. It is thus not surprising that industries such as car manufacturing or components assembly proved faster to absorb direct investment through greenfield or privatisation transactions than banks and financial companies. True, the under-banked CEE economies had been noticed by strategic Western companies already before the 1990s. The earlier cases of entry were recorded in the 1980s in a few countries (Hungary and Yugoslavia). Here again we

47

take note of the `early bird' phenomenon: investors are by nature cautious, but some had been entrepreneurial enough to enter the socialist reform economies before the grand opening in early 1990s ­ and had made huge profits. Still, major players of the international finance took a cautious attitude towards the CEE region not only before the changes but even in the years immediately after 1990. It is hard to define and measure whether an economy is under-banked. Obvious measures of the general banking development are the ratio of bank deposits to GDP or the ratio of domestic credit relative to national income. These two variables strongly correlate with each other at banking industry level, since the amount of total deposits represent the most important items in the asset side and, similarly, the value of total credits represents the liability side in the books of the banks, therefore it is generally enough to take one of these ratios as indicator for the level of financial development. A total sum of bank lending in a country, however, covers the financial activity of all banks, including the central bank ­ a financial institution of non-business character in the domestic market. Yet, it makes sense to exclude the central bank's activity from the data, or at least study the figures without the activity of the national bank. Grand total include loans to the state and to state-owned entities; but providing loans to the public sector is a financial activity that has more to do with government debt finance, rather than ordinary banking business function in the service of the real economy. For this reason, credits issued by commercial banks (excluding the central bank) to the private sector only are the items that present a more precise picture of the real activity of the banking sector.48 Both sets of data on banking activities orient the observers in their assessment of the importance of banking intermediation in the countries discussed here. A low percentage of bank loans to GDP would tell us that the banking sector in case only renders a marginal service to society. A high proportion of deposit-taking or credit provision, on the other hand, may be read as a sign of an active banking sector ­ other things being equal. But can we be really sure that a high proportion of bank loans relative to the size of the GDP is a good sign? Cannot these ratios mislead us? Certainly they can; if, for example, the loan portfolio of the banking sector is high because banks take excessive risks by neglecting careful examination of their clientele - then a high ratio does not allude to advanced financial conditions. Taking too much risk was exactly the case with some former centrally planned economies during the deep-going transformation process: state-owned banks took excessive positions with old and new clients, for different reasons. Long term personal and institutional bonds between state-owned or formerly state-owned banks and industrial clients - dating back to former periods, when both players belonged to the same party-state institutional regime ­ have been found to lead to over-lending. The same banks, but also new private domestic banks with poor capital base may be tempted to take risks above the normal prudent levels to enhance the expected profits, and, through the accumulation of profits, strengthen their capital base. But this is a dangerous strategy. As a consequence of such practices, an outstanding percentage of total loan portfolio to GDP was reported in some CEE countries during the 1990s ­ more of a warning indicator of a looming banking crisis rather than of a vigorous financial life.
48

Rainer Haselmann (2003): The role of financial markets in the growth process of the Eastern European Economies.

48

Over-lending, though, was only one symptom. Production shocks and abrupt changes in ownership patterns may not lead at all to a too high measure of financial activity, but just the opposite of this: a too low financial depth. This is at least what one expects in a formerly socialist planned country, particularly in an economy that had been an orthodox managed economy. As we have seen in Chapter 2, centrally planned economies hardly utilized financial signals, and they, consequently, reached a rather thin financial depth throughout their history prior to the collapse of central planning. The planning past therefore accounts for an inadequate monetization of the given economy compared to other countries of similar level of development and corresponding economic structure. A `normal state' is hard to define, yet efforts have been made to find benchmarks for the countries in transformation. Fries and Taci took a large sample of developing and industrialized market economies for their 1994 and 1999 ratios of domestic credits to GDP, and their level of development (measured by per capita gross national product in international US dollars at purchasing power parity).49 What they found was that most transformation countries (transition economies in the EBRD parlance) had a too small a banking sector in 1994, but there was later in the more developed CEE region a certain (but rather limited) catch-up towards the benchmark, while no convergence to the benchmark took place in other regions. Table 1 Ratio of total domestic credit to GDP in transformation economies measured to market economy benchmark values Country 1994 1999 Ratio total Market Ratio total Market credit to economy credit to economy GDP benchmark GDP benchmark 68.3 70.0 62.6 76.5 12.8 48.7 34.8 59.0 93.1 60.0 52.5 68.4 38.5 54.6 39.2 65.4 79.1 59.7 68.6 70.0 37.4 73.6 48.5 83.4 103.4 51.1 18.6 51.5 11.1 48.1 19.4 49.7 31.7 51.1 32.7 50.3 40.9 46.7 30.1 51.4

Czech Republic Estonia Hungary Poland Slovakia Slovenia Bulgaria Romania Russia Average, all transition region

Source: Fries & Taci, op. cit.

The figures offer a rather mixed picture. Developing (emerging) countries at similar level of economic development had total bank loan portfolios in the range of 40 to 80 per cent of their GDP. Compared to this benchmark, the average of the former socialist countries was slightly lower in 1994 (41 per cent instead of 47); the differences among countries were, however, certainly very wide. A total credit
49

Steven Fries and Anita Taci (2002): Banking reform and development in transition economies. EBRD Working Paper No. 71.

49

portfolio of all banks (including the central bank) exceeding 100 percent of the annual national income in the case of, say, Bulgaria ­ not that one should read it as a sign of impressive financial deepness. Such high figures, as well as the `above-the-norm' data for Hungary and Slovakia, or even the `normal' Czech data, represented either potentially inflated loan portfolios and other bad assets on the book of the banks, or the persistence of direct central bank financing of the budget deficit. It is not surprising that five years later, by 1999, some of the above-the-norm figures of the year 1994 had already been reduced to `normal' level: see the Hungarian or Slovakian data. The above total loan figures contain loans provided by the central bank to government; the loan portfolio should be cleaned of public sector items (loans provided by the central bank) in order to produce an adequate comparison with established market economies. Such a correction immediately reduces the size of bank loans relative to GDP. This is the case with Hungary where meanwhile the government debt assets were removed from the books of the central bank and passed on to the government debt office: this new institution was made responsible for public sector debts under the 1995/1996 reform of public sector debt finance. Such an institutional change reveals the real size of banking activity as measured to the GDP. The Bulgarian figure in 1994 was also very high, but the Bulgarian data looked again outstanding in 1999, for an opposite reason: a total loan figure of less than 20 percent of GDP is certainly much too low for a market economy, and the steep reduction of the relative size of banking intermediation hints at some drastic events in the financial life of the country. This particular 5 year period is too complex but also too short for us to draw conclusions about general tendencies of finance in the formerly planned economies. One reading of the figures is that in some under-banked economies a slow growth of the financial intermediation took place. This is rather obvious: countries of the former Soviet Union, for instance, all inherited from their orthodox communist past a quite simple and undersized banking sector that could not but grow once the market transformation took off. But the growth of financial deepening was doomed to be slow; the first years of the transformation with high inflation, political and business uncertainly, market collapse and various sorts of economic and political risks were not really conducive to creating a healthy banking sector. This was the case, for a while, even in the newly founded independent states with strong determination to build a Western-type modern financial system: countries such as Estonia, Latvia, Lithuania all had in 1994 a relatively low credit indicator (less than one fourth of GDP), and were confronted with the historic task to build up an independent modern banking intermediation in the years to come. Yet, there will be a clear divergence of trends: banking and capital markets in the Baltic countries will develop fast once the necessary legal, regulatory and monetary institutions have been created, while financial intermediation would improve less in Russia and other former Soviet republics. CIS states were also under-banked at the moment of the disintegration of the Soviet Union, and data from later years on will record a below-the-norm financial deepening ­ not a positive sign in itself. On top of that, aggregate official data such as bank credit portfolio ratios to GDP do not adequately describe the situation because of the uncertain quality of the loan portfolio behind the figures. In other, more advanced, countries the mild regression in financial deepening during these five years tell a different story: one of the improvement in the quality and

50

strength of the banking sector, as well as the strengthening of the supervisory structures. The more developed CEE-5 countries (with the surprising exception of the Czechs) introduced early or in the middle of the 1990s a loan portfolio cleaning process, and ­ as we will see later ­ they managed to reduce the relative size of the non-performing bank loans. The process itself led to a reduction of the credit-to-GDP ratio. The overall figure on the bottom line of Table 1 (and later Table 2) thus registers a slow decline but this statistical average is a result of two trends: one is quantity growth in the less developed countries and quality improvement in the more advanced economies in transformation. If total domestic credit ratio is a too wide and a somewhat misleading indicator, the measure of non-governmental sector (NGS) credit as a percentage of GDP is easier to read, as this indicator is free of loans to the government sector. Percentagewise such relative figures should be lower than the overall credit ratios, as they only reflect the services that the banking sector provides for the real economy (firms and households).50 The picture is very much different from the one based on the former (total) credit indicators: the too large figures, that is the above-the-standard indicators, mostly disappear from the table. The data are rather in line with our hypothesis about the region as under-banked at the start of the transformation. The only country above, and significantly above, the corresponding benchmark is the Czech Republic. The distance for the benchmark becomes smaller in most cases during the 5 year period under study: a relative decline in the Czech and the Bulgarian case are probably due to better, more reliable definition of performing loans; while there are increases in the Baltic countries, in Slovenia, and Slovakia. Table 2 Ratio of non-governmental sector (NGS) credit to GDP in transformation economies measured to market economy benchmark values Country 1994 Ratio of Market NGS credit economy to GDP benchmark 76.6 (sic) 58.1 15.4 (sic) 39.5 26.2 49.6 18.6 44.9 43.3 49.4 23.3 61.1 49.3 41.7 19.1 38.9 20.0 41.7 26.4 37.2 1999 Ratio of Market NGS credit economy to GDP benchmark 61.4 63.5 35.8 (sic) 48.7 25.7 56.8 26.8 54.2 56.5 58.1 37.0 69.1 17.9 42.1 10.7 40.4 12.8 40.9 22.2 41.3

Czech Republic Estonia Hungary Poland Slovakia Slovenia Bulgaria Romania Russia Average

Source: Fries & Taci, op. cit.

50

Interestingly enough, the corresponding figures for the Czech or Estonian case are higher than the total figures for the same year ­ a contradiction not discussed in Fries & Taci, op. cit.

51

Regression results for the CEE countries reveal that the loan growth in the 5 years covered by this study was significantly and positively associated with GDP growth (lagged by one year), but the estimated coefficient were in the range of 0.9 to 1.0; which means that lending to non-government customers on average across these countries expanded at about the same rate as output growth - that is, there was no sign of financial deepening in transformation economies. Inflation had a negative effect on real loan growth; the estimated coefficients on the inflation rate variable were negative and significant with a value of -0.2. This result makes sense: inflation is a product and also a factor of macroeconomic instability, and as such it discourages the real expansion of loans (although the size of the effect is small). The authors add that the measurement of bank capital and banks assets is problematic: "some troubled banks may have overstated their capital by not provisioning adequately against their problem loans and then expanded their lending to conceal or to overcome their bad loans".51 These figures square with our earlier statements about financial depth being below norm at the start and, due to path dependency, immediately after the regime change in the CEE region. The data also support our thesis about significant country differences; both initial conditions and policies differ. Large differences in financial depth are explained by a number of reasons: legacies of the previous conditions, different economic policy courses chosen at the time of the regime change, the particular role that foreign direct investments play in transformation. One always should keep in mind that former planned economies had not been fully homogenised during Soviet rule; countries of the CEE certainly differed a lot from Russia, not to mention more eastern parts of the Soviet empire. But even within the region, CEE countries always exhibited heterogeneity in many respects, including their financial sectors. Therefore a comparison to a common `market economy benchmark' is not more than a mere first approximation. This benchmark is about the relative size of bank loans; but banking is but one component of financial life. The other major component of a financial system is the capital market. A better picture, thus, is provided only if the size and activities of the stock markets and other capital market institutions are taken into account.

51

Op. cit. p. 17.

52

Table 3 Relative size of financial markets in CEE and Western Europe
In percentage, app. 2001

Country

Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia Germany UK France

Banking sector Domestic Claims on credit/GDP private sector/GD P 19 13 50 43 40 26 50 31 28 20 15 11 35 24 13 7 59 27 47 22 156 125 135 133 114 91

Stock market Market Total value capitalizatio traded/GD n/GDP P 0.3 9.2 5.4 16.3 2.9 1.7 8.3 2 3.6 5.6 63 348 159 2.3 15.8 32.7 21.4 8.5 11.6 16.3 1.8 2.4 17.4 71 621 156

Source: Haselmann (2003). Year of data is not given; original sources: IMF International Financial Statistics, 2002); World Federation of Exchanges (2003), Emerging Market Database. Stock market figure for France refer to Euronext values, since the Paris stock exchange merged with the Amsterdam, Brussels, and Lisbon exchanges into the Euronext.

The message that the data in Table 3 convey is that a decade or so after the system change the CEE countries are not only somewhat underdeveloped in terms of the depth of banking intermediation, but the existence of the stock markets would not change the general picture much. The so-called Visegrad countries (Czech and Slovak Republics, Poland, Hungary ­ V4 for short) or the CEE-5 (the above four plus Slovenia ­ i.e. the new EU members since May 2004) have developed a larger banking industry that the rest of the transformation countries, but even they lag much behind the developed West European nations in this respect: in this particular year, bank credit to the private sector amounted to 24 to 43 per cent in V4, vis-à-vis to 91 to 133 per cent in their Western counterparts. Among the same CEE sub-group, it is only the Hungarian stock exchange that can be called relatively important for the national economy (16 per cent of GDP market capitalisation of all stocks traded, with serious market liquidity); but even that looks miniscule compared to German and French, and particularly to British relative significance.

4.2 Foreign banks in CEE financial life
The transformation economies, thus, as a whole were still under-banked a decade after the start of the great transformation, but less so than at the start. Meanwhile the

53

bankers' claims had become much safer, and the financial institutions much stronger compared to their conditions a decade before. The changes are partly, and in come countries mostly, due to the fact that foreign financial capital has entered these markets. The penetration of Western banks in the CEE region has certainly been spectacular. But not without precedents: in some emerging economies the increase of the share of foreign financial capital has similarly been fast. The 1990s represented a decade of a surge in financial sector foreign direct investment (FSFDI): cross-border mergers and acquisitions targeting emerging markets rose from $6 billion from 1990-96 to $50 billion in the following four years.52 Such impressive inflows have reshaped the sector composition of the banks in the (limited number of ) countries that have absorbed these funds. The changes have been breathtaking in some countries (see Table 4). Table 4 Ownership structure in the banking sector in selected countries
Per cent

Country Chile Mexico Bulgaria Czech Rep. Estonia Hungary Poland Russia Slovakia Domestic private 62 1 .. 12§ .. 9 17# .. ..

1990 state 19 97 .. 78 .. 81 80 .. ..

Foreign 19 2 0 10 .. 10 3 6 0

Domestic private 46 18 20 14 1 11 10 23 9

2002 state 13 0 13 4 0 27 17 68 5

Foreign 42 82 67 82 99 62 63 9 5

§: 1994 #:1993 Source: CGFS Working Group (2004)

Some semi-peripheral countries in Latin-America had long been discovered and targeted by international banks and other financial businesses; the 1990s saw a fast internationalisation of their financial sector ­ see the surprising figures on Mexico. But this country ­ a victim of recurrent currency attacks ­ might be seen as a very particular case, while the CEE countries as a group offer a sample to analyze trends and tendencies. The trend is a speedy growth of the share of foreign banks at the expense of state ownership in banking. We can see an extreme case (that of Estonia) with 99 per cent foreign property in banking, but even the average foreign penetration has been fast and successful. It is perhaps surprising that countries that opened up their financial markets relatively early (some even before 1990) and had became consequently more internationalised in this respect than other countries ­ that is Yugoslavia, Hungary, Poland versus Czechoslovakia, Bulgaria, Romania ­ did not
52

BIS (2004): CGFS Working Group: Foreign direct investment in the financial sector of emerging market economies.

54

experience above-average foreign shares ten years later. It is also noteworthy that countries with similar general level of development are characterized by similar ownership patterns (see V4 ­ with the exception of Slovakia, temporarily behind the others in selling state-owned banks to foreigners by the year of the above study) ­ in spite of the fact that the attitude to privatisation had been rather different throughout the preceding years.

4.3 Banking sector transformation in CEE countries ­ more than one avenue but similar end-state
Few aspects of life have changed as much as banking and finance in transformation countries in a relatively short period of a decade and a half. As we have seen, the banking industry in these countries was predominantly small, technically substandard, and state-owned at the time of the change of the political regime. By now, at least in the more advanced countries, banks have become dynamic institutions, well integrated into world-wide networks, technologically up-to-date. They are predominantly in private property, or more precisely, in foreign ownership. This similar end-result is noteworthy knowing that these economies not only inherited different financial systems from their planned economy history, but they also embarked on rather different privatisation programmes in general, and on different bank privatization, in particular, during the years immediately after the political changes. Privatizing a bank is different from selling a state-owned textile factory: governments and state agencies in charge of the privatisation transactions were aware of the much larger political stakes, hence their cautious attitude. Banks therefore were not hurried to be placed first on the list of assets to be privatised. When the time was regarded ripe for that, governments followed the same general pattern of their initial national privatisation strategy: in some countries the main avenue to dispose of state-owned assets was trade sale, in other a voucher-type distribution, or placing assets under some semi-public holding forms. Before summarizing the main processes in various countries, a qualifying remark has to be made. Privatisation in strict sense denotes transfer of an asset from public property to (one of the many variations of) private property. But privatisation may also imply the much wider issue of changing the sector composition of the economy: that is, increase of the share of activity or assets of the private sector. When new private players enter the market and/or existing private firms outgrow incumbent public sector firms, the outcome is invariably a growth of the share of the private sector and a corresponding relative contraction of the public sector. A "creeping privatisation" may thus take place when the share of the private sector increases even without the sale or transfer of any single state asset. In this sense, a certain bank privatisation started to evolve in Hungary even before the political changes of 1990 (but after the country joined the IMF), when the authorities allowed three foreign banks in and after 1985 to set up operations on their own or (in two cases) as joint banks with the Magyar Nemzeti Bank (central bank) as co-owner. The participation of a central bank in joint venture commercial banks would today sound surprising as going against the logic of the two-tier banking system and the principle of separating the monetary and the commercial roles (and would not be legal under present laws). Yet, initially, the first international banks to enter a socialist

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country insisted on the central bank's co-ownership as an insurance policy against a variety of risks. Allowing foreign banks to start operations under special charters in a managed economy is still not the same as privatising existing state-owned banks. This latter measure requires adequate legal framework and an established procedure. In Hungary, the first democratically elected government was determined to turn banking into a modern, predominantly privately owned sector; in this spirit, and to upkeep the momentum, the Privatisation Act in 1991 set deadlines for the state to reduce its dominant majority share in banking. Yet, the first attempts died out soon. Failure was mostly due to a problem of general nature, typical of all countries in transformation: banks throughout the region were overburdened with bad claims and other problems in their asset portfolio, and as such they were not ready for market sale. As a result, the first major Hungarian bank privatisation deal could only take place in 1993, much later than originally thought (but sooner than in most of the other CEE countries). Bank privatisation in the broader sense started in all CEE countries immediately after the political changes, and in some countries even before the legal framework had been created. New private banks received rather easily full banking licence; in this respect the growth of the private sector could take off without the sale of existing state-owned entities. Large scale state-owned banks were later privatised via state-sponsored trade sales or through floating on the stock exchange, or any particular way the national authorities devised for disposing of state assets. It is useful to look briefly at some country cases to see that initial efforts so much differed. In the Czech Republic three of the largest four banks were included in the first wave of voucher privatisation in 1992. The same banks, nominally private, but with the state maintaining a large part of the shares, remained rather close to the government for a while after that. Their particular corporate governance structure did not guarantee effective private sector control over banking business decision-making since the non-government portion of shareholding belonged to a large number of private persons, each having a tiny fraction of ownership. The control over management and business policy either still belonged to the state or ­ when the state proved to be a distant owner ­ to none. In contrast, when foreign strategic investors entered the scene as main shareholders, they started to exercise material control over the management ­ and brought to the surface the dire conditions of some former state-owned financial institutions. At first, however, the Czech attitude to banks was the same as to non-financial companies placed on the list of public property to be privatised: distributing a part of the shares under the voucher scheme, and keeping some controlling government stakes in them. The banks, once nominally private, created investment funds that were active in purchasing company shares from the general public that acquired the shares under the voucher scheme. Such banking investment strategy resulted in interlocking ownership with the government retaining indirectly control ­ through partial public ownership of the banks ­ over the voucher-privatized Czech businesses. Such a process was fast, albeit a bit mechanistic, way of re-distributing ownership titles in a post-socialist economy, but led to the emergence of two major problems. First, weak corporate governance: dispersed share ownership does not guarantee effective control of private owners over the management of the voucherprivatized firms. Second: the companies that were privatised in such ways did not receive fresh capital.

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In Poland, the two-tier system was restored rather late, in 1989, under IMF guidance. Like in Hungary, the creation of commercial banks could only be mechanical; in this case 9 regional commercial banks were set up out of the central bank's portfolio, in addition to the exiting 25 national (also state-owned) banks. Privatisation appeared on the agenda after the democratic changes, but the newly created or the formerly founded state-owned banks were not ripe for privatisation. The steep collapse of the output in the Polish economy during 1990-92 led to a deterioration of the banks' portfolio. Their bad debt amounted to one third of total funds disbursed ­ hardly ideal conditions for the authorities to sell banks to private (mostly foreign) owners. 53 Yet, the authorities set a three-year timetable in 1993, with inducement from G7 donor countries and the IMF/WB, for privatising nine smaller state-owned banks that were created in 1989 from the commercial portfolio of the Polish national bank. However, the process proved to be long: by the end of 1994, only two out of nine banks had been privatized, and others on the list remained in public property for a long time.54 What stands out in the Polish case is a rather liberal attitude to licensing de novo banks: in one single year, in 1990, altogether 49 banking licences were issued: 42 to Polish founders, 3 to foreign owners, and 4 as co-operative ventures.55 The number of new institutions can signal at least two trends: one of a pent up demand to provide financial services right after the end of the (badly) planned regime; the other being a soft attitude of the authorities to applicants for license. As time passed, new foreign players entered the market and started to grow, while existing, and some newly created, domestic banks suffered hardship and decline ­ all this shaped the role of foreign capital in Polish banking. Privatisation transactions, however, were few in the first couple of years after the regime change. Was the slowness in disposing state banking assets due to reluctance of the authorities in Poland, or in other countries of the region? Was the slow start a sign of government's clinging to power positions? Or rather, the authorities simply were unable to fulfil their own goals concerning the reduction of the state financial sector? Political conditions in CEE countries differed, and so did concepts concerning privatisation and the attitude to foreign ownership in financial services. Bankgovernment relationship is a complex one during the transformation process; certain aspects will be touched upon later. But what is clear: even if there was willingness to privatise financial institutions, most of the banks to be privatized simply did not meet the definitions of a `going concern' in the early phase of the transformation. A loss making shoe company can be expected to be sold, but a bank that has not got enough regulatory capital is a not an asset a government can easily declare fit for privatisation. Before privatising them, such banks are to be recapitalised.

National Bank of Poland (2001): The Polish Banking Sector in the Nineties. www.nbp.pl/en/publikacje/ine/system_bankowy 54 John P. Bonin, Iftekhar Hasan, Paul Wachtel (2004): Privatization Matters: Bank Efficiency in Transition Countries. William Davidson Institute Working Paper No. 679. April. 55 National Bank of Poland (2001), op. cit

53

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From tough bankruptcy laws to bank rehabilitation ­ the case of Hungary Non-payment or slow payment emerged as an acute problem in practically all former planned economy at the time of the transformation: state-owned firms failed to settle bills with contractors, they were frequently late with paying taxes or social security contributions, and were in arrears with utility bills. Unpaid bills in fact functioned as forced lending: late payers made other firms, the public utility companies and the state provide them with zero interest credit. Besides being unfair, such practice undermined the effectiveness of the monetary policy: a monetary restriction through higher interest rates did not affect the mentioned companies directly, only in the sense that the amount of the unpaid bills increased accordingly. To put an end to that, and to restore financial order and to increase the efficiency of the official monetary policy, the Hungarian government prepared a bill on bankruptcy and liquidation in 1991. The bill entered into force in spring 1992, and was regarded by observers as "path breaking in the region".56 This piece of legislation proved certainly very tough: the law required compulsory filing for liquidation when bills were not paid in time. Until the end of 1994 more than 5 thousand bankruptcy filings and 20 thousand liquidations had been submitted to the courts ­ unfortunately, the gap between the submitted applications and those actually accepted by the courts remained wide. One of the lessons one can draw with the benefit of hindsight is that such a regulatory innovation will only prove successful if adequate support from the legal system is provided. A marked feature of the Hungarian experience has been the apparent passivity of banks in the bankruptcy process: they viewed the liquidation process as costly, and therefore preferred to settle cases out of court with their debtors. Even when banks did get involved in bankruptcy procedures, they simply did not have the necessary managerial skills to deal with clients. Nor were the banks eager to initiate legal actions, instead they called for state support. And they were not mistaken in their expectations of state bail-outs: two public property agencies provided support either through purchase of company debts from the banks, or by providing credit guaranties to banks. Fiscal discipline got eventually strengthened in the corporate sector, but similar discipline was not pursued with similar zeal in the banking sector of Hungary. Under this regime, undercapitalized and loss-making firms could not escape their fate. Initial capital shortage and inefficient functioning in the corporate sector thus surfaced due to the tough regulations. Some firms that had been placed under financial pressure managed to reorganize production and sale through determined measures, others could not avoid the exit. But shake-up in the corporate sector soon spread to the banking sector, too. Growth in bankruptcy among clients led to a fast build-up of non-performing loans in the banking sector. Provisioning for bad debts threatened to reduce the capital/asset ratio of most major (state-owned) banks below zero. The government could not avoid recapitalisation in order to preserve bank solvency: a bank recapitalisation programme was launched in 1993. The process dragged on, and the change of government in 1994 did not help in maintaining pressure on the banks to keep costs down. As a result, bank managements proved

56

OECD (1995): Economic Surveys. Hungary.

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rather successful in passing the losses on to the state, and save their well paying banking jobs in spite of all the losses incurred in Hungarian banking. One of the reasons of the frequent banking crises in the transformation countries was the accumulation of bad debts. The size of the problem assets is hard to estimate and particularly compare among countries as the national definitions and standards differ, and so differ also the quality of the national regulatory agencies. Therefore a simple summary variable such as the share of non-performing loans visà-vis total banking loans does not tell the whole story; yet in any particularly countries the data on the level of bad banking assets and the tendency of changes provide an important piece of information. Reduction of such bad loans requires work-out efforts or other asset cleaning process. Banking sector rehabilitation exercises were mostly accompanied by recapitalisation of the financial institutions ­ all at sizable costs to the national economy and eventually to the tax payers. Table 5 Non-performing loans as a percentage of total loans in EU accession countries Country Bulgaria Czech R. Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia EU-15 1995 12.5 26.6 2.5 Na 19.0 17.3 23.9 37.9 41.3 9.3 Na 1996 15.2 21.8 2.0 Na 20.0 32.2 14.7 48.0 31.8 10.1 Na 1997 13.0 19.9 2.1 6.6 10.0 28.3 11.5 56.5 33.4 10.0 Na 1998 11.8 20.3 4.0 7.9 6.8 12.5 11.8 58.5 44.3 9.5 4.7 1999 17.5 21.5 2.9 4.4 6.8 11.9 14.5 35.4 32.9 9.3 4.5 2000 10.9 19.3 1.3 3.1 5.0 10.8 16.8 3.8 26.2 9.3 4.2 2001 7.9 13.7 1.2 2.9 3.1 7.4 20.1 3.4 24.3 10.1 4.0 2002 10.4 9.4 0.8 4.6 2.1 5.8 24.6 2.3 11.2 na 3.9

Source: Volz (2004)57

Some figures in the table do look suspicious: it is hard to imagine that in a country like Romania where for the most part of the 1990s the banking sector was practically overburdened with bad debts and risky clients, the turn of the decade would immediately put an end to bad loans, and from then on the Romanian banks have a cleaner loan portfolio than the average of the 15 EU countries. Estonia does not look that much suspect; yet such a clean health report may be partly due to terminology and measurement problems. We should only accept such qualitative figures if other data corroborate them. One quality measure, for example, is the spread between lending and deposit rate; a too wide margin signals low efficiency or lack of competition.

57

Ulrich Volz (2004): European financial integration and the financing of local businesses in the new EU member states. EBRD, Working paper No. 89. Oct. 2004. The author used EBRD country database for the countries covered.

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Table 6 Spread between lending and deposit rate, accession countries Country Bulgaria Czech R. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Euro area 1996 1997 1998 1999 2000 2001 2002 2003 na na 10.3 9.6 8.4 8.2 6.6 5.9 5.8 5.5 4.7 4.2 3.7 4.1 4.0 3.9 8.8 5.6 7.0 6.9 3.7 3.8 4.0 3.1 8.7 4.9 4.9 4.4 3.1 3.7 2.8 Na 14.1 9.4 9.0 9.2 7.5 5.9 4.7 2.4 7.6 6.5 6.2 8.2 8.3 6.6 5.1 4.6 6.1 5.6 6.3 5.8 5.8 6.6 5.9 Na 4.6 5.2 4.9 6.7 6.4 4.8 3.6 3.1 7.5 6.8 5.6 5.1 5.7 5.2 4.9 4.8 4.8 4.2 3.5 3.2 3.2 3.2 3.3 Na

Source: Volz (2004)

The trend is clear: in most CEE countries the formerly high gap between the two rates keep shrinking. In some countries competition, mostly for corporate clients, bring about a rather narrow margin between the two rates (Hungary, Estonia, Slovakia, and Czech Republic). To reach that state of affairs was costly. The later the authorities took the steps (and the necessary steps), the more it cost the taxpayers. Figures, again, are hard to compare among countries and jurisdictions. Yet, the financial literature keeps record of the recapitalisation exercises. Table 7 Fiscal Costs of Bank Recapitalization Czech Rep. 1997 8.9 11.8 Hungar y 1994 7.2 6.8 Poland 1996 1.6 1.4 Slovaki a 2000 13.1 13.1 Sloveni a 1997 2.5 1.7

Main part of recapitalization program completed in Fiscal costs up to the year above, in % of GDP in that year Fiscal costs of recapitalization up to 2000 in % of GDP in 2000

Source: Schardax & Reininger (2001)58

There are important differences among countries. Hungary, Poland and Slovenia had succeeded in stabilising their banking systems by 1997 as a result of extensive government rescue and recapitalisation programs, while the Czech Republic and Slovakia still faced continuing problems at the turn of the decade.
58

Franz Schardax and Tomas Reninger (2001): The Financial Sector in Five Central and Eastern European Countries: An Overview. ÖNB. Focus on Transition. No. 1.

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The relative success of such exercise can be measured by (1) fiscal costs, (2) length, and (3) sustainability of recapitalisation efforts. The fact that an exercise is not too expensive for the budget does not tell the whole story. If, for instance, very high inflation eradicates the real value of the banks' liabilities much more than the asset side of the banks, and this is why inadequate bank capital is not much of a problem, then the mere size of the fiscal costs is a poor indicator in itself. Poland's case is partly attributable to the design of the recapitalisation process, but also to the relative small size of the Polish banking sector in relation to GDP, and to the "beneficial" effect of high inflation in 1990 and immediately after. Length is a factor: the shorter the process, the better. Protracted exercises increase the probability of moral hazard, that is appearance of incentives of adding new bad debts to the stock of old such debts in the hope that public agencies will again cover the potential losses. Also, the sooner the banks regain adequate capital ratios, the sooner they can render financial services to the society at large. Finally, and obviously, an exercise is successful if the banking sector will be able to maintain its stability and general health for a long time without repetition of such a public sector intervention. Privatization helps in-as-much banks not in public ownership will have to turn to their private sector owners should any difficulty emerge, while financial institution with significant state ownership will always easier turn to the government for rescue. Some earlier fiscal expenditure can be later recovered ­ this is the case of Hungary (the sale of Postabank to Erste in year 2003) or, to a smaller extent, Slovenia and Poland ­ where the years bearing the bulk of the consolidation costs were followed by a period of partial recovery of the public funds invested into the restoration of the health of the financial sector. The share of foreign capital had increased dynamically in most countries by the year 2000, particularly in those economies where foreign advice and external financing expedited the opening op of the financial services sector to foreigners. The Polish figures indicate an acceleration of the penetration of foreign capital in the second half of the 1990s: the share of foreign actors in the capital of banks is the following: 18.1 % in 1995; 28.1 % in 1996; 39.6 % in 1997; 47.3 % in 1998, 53.1 % in 1999, 53.8 % in 2000, and 57.4 % in 2001.59 In Hungary, the foreign penetration was even more determined: foreign private owners represented 65.4 % of the banks' capital in 1999, and 66.7 % at the end of 2000 ­ reaching thus the two-third mark, a psychological borderline.60 However, what is surprising is not that these figures are relatively high; they only reflect the continuation of a longer tendency. In contrast: some other CEE governments have either followed a U-turn in their policy towards foreign participation in banking (most importantly in the Czech Republic where the original concept was privatisation via the voucher scheme ­ i.e. to domestic players ­ soon to be abandoned after a costly macroeconomic turbulence after the 1998 banking crisis); or have been eager to let foreign banks create a banking system on their own, without any domestic influence or participation (Estonia).

59 60

National Bank of Poland (2001), op. cit. These figures are not fully comparable with those of other sources. Hungarian Financial Services Authority (2003): The Effect of the EU Accession on the Hungarian Financial Sector. See: www.pszaf.hu/english/start.html.

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4.4 And the rise of the domestic Bourses...for how long?
If banks are needed for a mature market economy, then capital markets are not less important for growth and development. Efficient, smoothly functioning capital markets, providing liquidity to market agents, are regarded to be vital for growth and innovation. Banks offer a bond between the financial institution and the client; bonds offer liquidity no bank-client relationship ever can. Some therefore regard the inherent flexibility of a capital market instrument an important plus over the banks. Yet not all students of the subjects are equally convinced about the superiority of the Bourses over banks: Bhide, for example, calls our attention on the drawbacks of too much liquidity, particularly in terms of potentially poorer corporate governance, a less emphasis on monitoring efforts.61 Levine, on the other hands, proposes models in which market liquidity increases economic growth through lower transaction costs.62 Whatever the theoretical background, the historic fact is that in some CEE country the organized capital markets have had a long history. The Warsaw Stock Exchange was opened in 1817, the Budapest Bourse was founded in 1864, and the Prague Stock Exchange was established in 1871. Under socialism, however, all stock markets were closed. With the regime change, bourses reappeared: the first exchanges in the region emerged in Hungary in summer 1990, followed by Poland in 1991 and the Czech and Slovak Republics in 1992. Bulgaria, Romania, Lithuania followed soon after. We have seen that the existence of such exchanges has not basically changed the nature of the financial systems in the countries involved: they are predominantly bank-based. Yet, differences are again count; it is worthwhile to look at the more detailed picture as presented by the year 2000 figures.

A. Bhide (1993): The hidden costs of stock market liquidity. Journal of Financial Economics. Vol. 34. pp. 3151. 62 R. Levine (1991): Stock markets, growth and tax policies. Journal of Finance, Vol. 46. pp. 1445-1465.

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Table 8 Characteristics of selected Stock and Bond Markets, 2000 Country
Stock market capitalisation Billion USD GDP % of Stock market turnover, bn USD Bond market capitalisation Bn USD % of GDP

Czech Rep. Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia Austria Germany Portugal United Kingdom

9.70 1.80 11.90 0.56 1.60 31.4 0.44 3.10

19.2 40.5 26.1 7.9 14.2 18.9 2.3 17.4

6.70 0.31 12.10 0.27 0.20 19.30 0.54 0.92

5.2 0.04 9.2 0.46 0.39 17.9 2.2 1.1

10.1 1.0 20.2 6.5 3.5 10.8 7.0 6.2

29.90 15.5 9.60 114.1 59.1 1270.20 66.6 2119.80 2076.5 108.9 60.70 56.7 90.4 49.0 45.8 2612.20 187.1 4558.70 1423.7 101.9
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Source: Köke & Schröder (2003)

As these figures indicate, the securities exchanges of the CEE countries are relatively small markets. The largest among them in terms of stock capitalisation and liquidity, the Warsaw Stock Exchange, is comparable to the smallest Western exchange (Vienna Stock Exchange), otherwise these markets do not qualify for being important capital market institutions. The Budapest stock exchange is liquid and, compared to the size of the country, significant, but that of Tallinn, Bratislava, or Riga are still in their infancy. When discussing the significance of the exchanges, bonds are not to be forgotten. While in some countries where there has not been sizable domestic public debt (e.g. Estonia), the bond section of the exchange is miniscule, in more indebted countries the bond markets do count (e.g. Hungary). The above figures should be interpreted with caution because bonds are also traded over the counter (OTC), and OTC trade is typically not included in turnover not in capitalization figures. Closer look would reveal that corporate bond markets are particularly underdeveloped in these economies. According to Bank for International Settlements (BIS) statistics, the Czech Republic has the largest domestic debt market relative to GDP, Hungary ranks second and Poland third, and only in Poland in there a significant primary market for international corporate debt securities.64 The limited size of these exchanges raises important policy questions. Will these markets grow in time: Once their tender age is over, will stock exchanges grow in terms of number of companies publicly listed and vigorously traded? Or the days of the national exchanges are numbered under out globalized conditions? It is hard to answer these questions, as the whole European financial landscape may change
Jens Köke and Michael Schröder (2003): The Prospects of Capital Markets in Central and Eastern Europe. Eastern European Economics. Vol. 41. pp. 5-37. 64 Köke & Schröder (2003), op. cit.
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fast. What is certain is that for CEE firms entering the domestic stock exchange to raise capital has not been simple; there have been long periods even years without a single new stock issue in some of the exchanges. Trade is very much concentrated; the CEE markets are dominated by just a few companies. In the Czech market these are the Cesky Telecom, Komercni banka, CEZ; in Estonia the Hansabanka and the Eesti Telecom, in Hungary MATÁV, OTP Bank, Mol and Richter Gedeon, in Poland the Telekommonikacja Polska, Bank Pekao, Bank Handlowy Warszawic, and PKN Orlen, in Slovakia Slovnaft. Some of these companies at the same time are listed in larger Western exchanges, and the values traded abroad are not negligible. According to studies, out of the 70 firms listed in the Budapest Stock Exchange, 52 are cross-listed in New York (all four Hungarian blue chips) or in London, representing about 15 per cent of the value of trade abroad. The value traded abroad vis-à-vis value traded domestically represents over 60 per cent in the Polish case, and over 80 in the Estonian case. Dual listing thus easily can lead to the `migration' of domestic shares.65 If these tendencies persist, and the more important securities migrate to where liquidity can be easier found, then these local exchanges will lose significance in spite of the rally of the years 2003-04.

Chapter Five: Conclusions
Whether one calls the train of events transformation or transition, the social and economic consequences have been drastic in the CEE region after 1990. Hard data reviewed here prove that the depth and width of changes have been tremendous in these countries. In spite of the similarities both in external challenges and the broad agreement on strategic goals, the socio-economic differences among countries have all along been significant, even among the so-called converging countries. At this point in time it would be too much to claim that they uni-linearly converge either to each other or to the reference group of countries, that is, to the European Union, their official role model. Lack of full group convergence should not come as a surprise. Even cursory overview of the initial conditions in the region reveals that the starting positions very much differed 15 years ago and the policies pursued since the start of the transformation process have not been identical. Some of the countries of the region appeared more successful at the very start of the changes, while other took a late start and had a harder road ahead of them after 1990. Still, the fact is that the EU did not admit the more developed applicants (say, the Visegrad 4) as full members around year 2000 - as it was widely, though not universally, expected in the mid1990s. The European Union first postponed the decision on `small group accession', and later decided to accept the application of 8 formerly centrally planned economies under the 2002 "Big Bang" enlargement, and started accession negotiations with further ­ even less developed ­ applicants; this all may be read as a revival of the `block' attitude to the CEE region.

Stijn Claessens, Ruben Lee, Josef Zechner (2003): The Future of Stock Exchanges in European Union Accession Countries. Corporation of London. See also: www1.fee.uva.nl/fm/papers/claessens

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What appears as a region is in fact a set of countries with significant cultural and structural differences. Certainly, the decades spent together under a nondemocratic regime after World War II compressed these nations, and created, at least in the eyes of external viewers, a somewhat similar-looking grouping. The regime change, however, quickly put an end to artificial homogeneity. At first, the initial differences among CEE countries further grew, since the quantitative changes obviously started first to be felt in countries that were the first to break with the planning past. Institutional and real-life changes tend to accumulate and result in qualitative changes. New, market-like economic structures first evolved in countries that had started earlier, or in societies that had proved ready and eager to absorb the new rules. Others, particularly in the Balkan and in the core area of the former Soviet Union have not been able to adopt themselves to the changing conditions so fast. Yet, one would expect that with the passage of time, a certain homogenisation in the major institutional set-up, particularly in financial and banking affairs takes place since most of these countries have become, or will soon become, part of a larger integration. Still, it is early to declare that. Institutions and legal frameworks do look the same, but real life achievements widely differ. In financial affairs, formal structures and public policies do seem to be rather similar across the CEE countries. This is not odd, since at the moment when their transformation was set into motion, all countries had to address the same common issues of historic belatedness and financial backwardness. Advice from influential circles also sounded similar, whatever the local conditions were. Opening up the financial markets and liberalising current account and ­ what should have become a topic for a serious policy debate ­ liberalization of capital account transactions were advised as part of the policy mainstream.

Do it Fast or Do it Your Way? ­ The Case of Capital Account Liberalization It is worthwhile to recall the arguments of Stanley Fisher (then the First Managing Director of the IMF) concerning the reasons why emerging and transition markets should stop applying exchange restrictions and should instead liberalize their capital account regimes. "The first is that it is an inevitable step on the path of development, which cannot be avoided and should be embraced. After all, the most advanced economies all have open capital accounts. The second and more powerful argument for the liberalization is that the potential benefits outweigh the costs. Put abstractly, free capital movements facilitate an efficient global allocation of savings and help channel resources into their most productive uses, thus increasing economic growth and welfare."66 These arguments carry weight even now, after heavy episodes of currency crises. Views like that certainly sounded convincing in the early 1990s. If something is inevitable, such as the cross-border flows of private funds, then it is better to accept the new realities rather than resist them. Reference to the conditions of the advanced economies also strengthened the arguments for liberalisation: `countries in transition' were supposed to become, as soon as possible, something like the rich, advanced Western states.
66

Fisher, Stanley (1998): Capital-Account Liberalization and the Role of the IMF. In: Peter Kenen (Ed): Should the IMF Pursue Capital-Account Convertibility? Essays in International Finance No. 207. Princeton University.

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The second argument ­ positive cost-benefit balance of a quick financial opening ­ carries even more weigh, particularly if economic research provides strong proof for that. The idea that free capital mobility enhances economic welfare in a transition (transformation) economy is an appealing concept for most economists and policy makers; yet, there has been little empirical evidence so far either to support or to refute such a statement. There were even less proof at the time when decision makers in these countries had to take decisions about financial opening and related issues. Berry Eichengreen (2001) noted that the consensus among academic economists favouring liberalization emerged with a surprising degree of certitude quite early, and in the absence of hard evidence.67 Not all economists consented to the mainstream views, though. Dani Rodrik warns of the dangers, referring to the Mexican and Asian currency crises. "Boomand-bust cycles are hardly a sideshow or a minor blemish in international capital flows, they are the main story. From this perspective, embracing as the IMF's next major mission the liberalization of capital-account ­ albeit in an `orderly' fashion and buttressed by enhanced prudential regulation of financial practices ­ seems genuinely odd."68 The reference here to the capital-account debate only serves to remind us that the so-called Washington consensus has perhaps never been fully discussed, let alone agreed upon, in academic circles, yet the mainstream views have all along been predominant in institutions that are, and have been, influential in shaping public policies in most CEE countries. Politicians in countries dependant for a long time on IMF and World Bank funds (particularly those economies that were either financially bankrupt or close to bankruptcy at the time of their great transformation ­ Poland, Hungary, and the countries on the Balkan) could not but follow the advices suggesting a bold opening up of financial markets to foreign capital. Others, less dependent on official capital inflows, like Slovenia or the Czech Republic, could go their own ways, paying less attention to what international financial institutions felt to be the best policies. Banking crisis in the Czech Republic ­ a contrary case compared to those more under IMF tutelage - indicates that you own way may turn out to be a blind alley. Still, another a contrario case - that of Slovenia - offers a rosier conclusion: a high (relatively speaking in CEE context) living standard and an adequate share of domestic owners in their financial and non-financial companies in Slovenia prove that being not too eager to heed all the external advices may be the proper strategy. The policy differences during these past fifteen years have been thus significant, yet they have somewhat lost their explanatory power by now, since most of the CEE countries entered the EU as part of the 8+2 country set. The big bang of 2002 may strengthen the validity of those views which argue away the country specificities in the region. Yet, the fact of the block enlargement cannot, in itself, cancel out the importance of earlier differences in strategies, but may point at a new factor of CEE (institutional and policy) convergence: the factor of the enlargement
67

Eichengreen, Barry (2001): Capital Account Liberalization: What Do Cross-Country Studies Tell Us? The World Bank Economic Review. Vol. 15. No. 3. pp. 341-365. 68 Rodrik, Dani (1998): Who Needs Capital-Account Convertibility? In: Peter Kenen (Ed): Should the IMF Pursue Capital-Account Convertibility? Essays in International Finance No. 207. Princeton University. Pp. 5565.

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itself. The pre-accession adjustment process opened up a new opportunity and offered a new start for those countries that had not been in the vanguard of the transformation. With some luck and a lot of hard work, some countries managed to accelerate their progress in key areas, including banking, finance and capital markets ­ this is the case with the Baltic countries or with Slovakia at the turn of the century. Others lost steam, mostly for domestic politics reasons (Hungary, the Czech Republic). Aside the institutional changes, real economy variables and structures also converged, but the real life exhibit much more variety even in this relatively small set of countries. Utilisation of foreign capital, and most importantly of FDI, has been quite diverse. Some economies have, on the whole, positively benefited from foreign direct inflows (see the case of Hungary or Slovakia), in other economies too few foreign investment have been offered for absorption; while in others too much and sudden FDI inflows have created or are about to create financial tensions (see Romania for the first, and perhaps Estonia for the second case). EU membership will, on the whole, accelerate the process of legal convergence, and the macroeconomic convergence. Real convergence is still another story. Even within the EU 15, inequalities and quantitative differences in national development levels and patterns have not disappeared during the long decades of co-habitation, and there are no sign of instant convergence. Thus, it would be a mistake to take homogenization in CEE countries for granted. The factors that drive the growth of the financial markets (domestic savings, inflow of direct and portfolio capital, agglomeration effects) can easily cause divergence instead of convergence in real life. Success breeds success, above-the-average returns invite further funds and more players. Nations under the EU structure do receive impulses and enjoy incentives to converge to a common model, but the same market forces that deliver progress may strongly distinguish between markets, locations, regions. It is still too early to declare the winners of the accession, but not all economies will benefit the same way out of the new legal-institutional setup. A key area in this competition is the domestic banking sector and capital market. Domestic - the adjective in itself is of questionable relevance; all new member states are characterised by a predominantly foreign-owned financial life. The fast internationalisation of finance in the CEE region was necessary, and probably unavoidable, right after 1990. This speedy process has contributed to improvements in the region's capacity to absorb foreign capital. Yet, the improvements have not been evenly distributed to all segments of society. As research proved, "financial integration and the dominance of foreign banks will make the banking system more unconstrained in their power to create credit, this might largely benefit larger businesses, leaving small and medium enterprises aside."69 If banking is foreign-dominated, so are capital markets in CEE countries. A majority of investors are foreign investment banks and funds in case of most stock exchanges, and the share of non-domestic players is also high in bond markets. But this is only a side story: the main issue is whether security exchanges in CEE countries are serving the economy well enough. Some conclude that the picture is still relatively dark: "stock markets exhibit low market capitalization ­ both in absolute terms and relative to GDP ­ and a low level of liquidity compared to West European
69

Volz (op. cit).p. 30

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exchanges".70 These figures are not simply about some abstract concept of development; they depict the potential sources of corporate and household finance. A semi-developed capital market means that CEE firms mostly finance their investments internally. "Compared to Western countries, only Hungarian firms finance a similarly large share, about 50 percent, of gross fixed capital formation externally, that is, without relying on internally generated funds such as retained earnings. This share is much lower for Poland, 25 percent, the Czech Republic, 11 percent, and Slovakia, 4 percent. Closer analysis of the sources of external finance reveals that the largest part is obtained by taking new credits, and a much smaller part by issuing equity or debt securities."71 Moreover, the very existence of local security exchanges may be soon questioned by the logic of capital market developments, in spite of the spectacular 2004 results of the Polish or Hungarian share prices and bourse indices. These institutions, as we have seen in earlier chapters, are not really sizable, and are in search of alliance partners from a Western exchange, or have been absorbed into one (like the Budapest exchange in 2004). Trading of local blue chips may migrate to more liquid Western markets, while entering an organized exchange may further prove to be too costly for domestic SMEs. A country without a domestic stock exchange sounds odd ­ but so has been the case with national airlines or a national telephone monopoly. We will see how much country size counts, and how the agglomeration principle accelerates the concentration of capital market transactions into a limited number of trading places ­ meaning: not necessarily all exchanges in CEE countries will mature into their second or third decade... The future is not strongly determined by previous path, as we have witnessed in the CEE region in the last two decades, therefore much is left for hard work, adequate policies, and perhaps a bit of a good luck.

70 71

Köke & Schröder: op. cit. P.34. Ibid. P. 34.

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