Czechmate, Or the Pitfalls of Rapid Privatization in Emerging Economies

Published: July 03, 2002 in Knowledge@Emory

A recent BusinessWeek headline for an article about the Czech Republic didn’t mince words: "This Country is a Mess."

The Czech Republic today is struggling with economic difficulties and widespread corruption that has it lagging behind many of its Eastern European neighbors – a humbling fall for a country hailed in the early 1990s as the paragon of post-Communist privatization. In just four years the Czechs privatized 1,800 companies. In 1990 they boasted virtually no inflation, no unemployment, no budget deficit, and no foreign debt. The mass privatization model was going to open the golden door to the Czech free enterprise system even as it inspired some of the policies instituted in post-Communist Russia.

Yet by 1997, the economy was in a state of collapse and the government had to re-take control, a crisis from which the country is still trying to recover. What happened?

"The Czech Republic did hit the numbers for a while," says Wharton management professor Gerald McDermott. "But one big problem was that there was little institutional development. For example, in terms of capital markets issues, it didn’t do much to develop an effective SEC-type body, courts, or a banking regulatory structure."

In his forthcoming book, Embedded Politics: Industrial Networks and Institutional Change in Postcommunism, McDermott offers a new explanation for why the Czech Republic and other emerging markets, which try to eliminate state involvement and undergo rapid mass privatization, may achieve only short-term or illusory economic success. He says his findings about the Czech Republic have relevance for the faltering economy of Argentina and other developing markets in Eastern Europe and Latin America.

McDermott characterizes the predominant attitude after Communism as, "‘Get rid of the state, or clearly demarcate what the state does so that it has no discretion to do anything else.’ It’s an understandable attitude after years of Communism." But according to his research, this is an idealized approach which in reality undermines economic development.

One way in which state involvement is valuable, according to McDermott, is in helping to build public-private institutions. "Transitioning to a capitalist system is not just a question of saying, ‘Be private,’’’ he says. "The U.S., for example, has many public-private institutions," including Chapter 11 for bankruptcy, Fannie Mae for mortgages, and multiple forms of federal and state support for small business development, technological change, research, and education.

"I believe these types of institutions are the saviors of development, because they allow people to learn, invest, and take chances. We have developed these institutions to share risk," McDermott says. He recommends that for growth in emerging market countries, representatives of public and private interests need to work within an uncertain zone for a time, collaborating project-by-project to reorganize assets. Within this experimental, evolutionary process, a role for the state is key.

In his book, McDermott tracks the progress of the Czech Republic, at one point criticizing the country’s decision to leave the reorganization process to banks and industry to work out among themselves. He describes the conundrum facing the newly privatized Czech banks, a phenomenon he says is not uncommon in emerging market economies. On the one hand, they want to clean up their portfolios by closing companies, but on the other, they don’t have that many companies to choose from. "All these big ‘problem’ firms are the banks’ bread and butter. Get rid of the manufacturing firms and you get rid of the whole economy." Yet, says McDermott, the banks also don’t want to take on the enormous risk of leading and financing the restructuring process. "So they stall. They wait for a new partner to help achieve the reorganization."

The industrial sector did not sail effortlessly into privatization, either. What the state failed to recognize, says McDermott, was the existence of powerful, decades-old business and social networks – within and between firms – that had emerged in Communist days. Although virtually everyone welcomed privatization, these entrenched relationships sparked battles among subsidiary managers, plant managers, and headquarters managers over how to proceed with restructuring. The government can be an important mediator of these conflicts.

McDermott compares a successful and a failed joint venture - Skoda-VW and Skoda-Siemens – to illustrate how government involvement during a transition can foster economic progress.

In 1991 a unique joint venture model was successfully used between Skoda (the Czech car manufacturer) and VW. "The whole idea was to put emphasis on investment and link that to ownership change in a gradual way. The government played a key role. It took over bad debt, monitored the activities of the two firms, and worked with foreign investors to develop support industries. Skoda-VW cars became one of the most successful foreign investment stories in Eastern Europe."

The plan that so successfully launched the cars was intended to be replicated in a joint venture between a Czech mechanical engineering association (also called Skoda) and Siemens, the German electrical engineering firm. But around 1991-92, political winds were changing in favor of state non-involvement and rapid privatization. A similar philosophy was being advocated for Argentina and for what was then Yeltsin’s Russia.

The new attitude toward privatization toppled the fledgling Skoda-Siemens venture. "A key part of the Skoda-Siemens negotiation required government commitment to resolve some problems," says McDermott. "The government reneged, and Siemens walked away; Skoda defaulted on its local debts within a few months, and in 1992 it shut down." McDermott recounts how huge amounts of inter-firm debt and bank debts started to accumulate at this time, so that within two years most Czech companies were formally insolvent. The situation was exacerbated by problems in Russia – the Czechs’ main export customer – and the economy foundered.

The 1992 crisis sparked the government to intervene in ways it should have all along, says McDermott. It was forced to enter the fray as a short-term financial partner and a mediator. McDermott asserts that great advances were made in reorganizing companies between 1992 and 1995. "The government started to say things like, ‘We’ll absorb some old debt; we don’t know how to restructure this firm, but we know there has to be transparency and debt restructuring. You have to reorganize operations to create positive cash flow. And representatives of the government and the firm will meet every three months.’ This got people sharing information, control, and resources, and that’s where you start to see success."

Nevertheless, says McDermott, the Czech economy collapsed again around 1997-98. Despite the restructuring work that was accomplished for firms and banks, the government failed to learn from its advancements. It didn’t create the kinds of institutions necessary to support continued growth and stability, he notes. It didn’t empower regional governments or agencies, change the bankruptcy law, or alter the securities and exchanges laws. Finally, in 1998-99, the Czech government had to take control of the major banks and firms and create a special workout vehicle to stabilize the economy. "They have had a fair amount of success, but it’s cost them dearly – about 25% of their GDP," McDermott says.

What’s more, corruption can be one of the unfortunate side effects of trying to privatize overnight, asserts McDermott. "The Czech Republic, by throwing institutional development to the winds, created a great breeding ground for corruption." The country suffers more from this practice, according to corruption indices, than many of its neighbors.

The star performer of Eastern Europe has turned out not to be the Czech Republic but – surprising most analysts - Poland. During the past decade, Poland emerged as one of the two fastest-growing countries (the other was Ireland) with the strongest GDP numbers for Europe. McDermott believes that Poland’s unwillingness to impose mass privatization has contributed greatly to its current prosperity. Poland set up a worker leasing method instead, by which about 67% of firms were privatized. The government gave managers and employees the opportunity to lease the firms, with an option to buy over time. In order to apply for the leasing program, the firm had to have 50% approval of the employees.

McDermott points out that this arrangement both helps discourage corruption (because it does not simply put assets up for grabs) and keeps multiple claimants to a firm – such as plants and facilities – negotiating and working together. "The numbers on these firms are really extraordinary, in terms of their competitiveness, export performance, and productivity gains. And that’s not just in tourism or restaurants but in the manufacturing sector as well."

McDermott sees the Polish approach to reorganizing the banks as particularly effective also. Between 1993 and 1996 Poland implemented its Enterprise Bank Restructuring Program (EBRP). "It got together the major banks and had them focus on 60% of all debt, which in this type of economy is concentrated in only a couple of hundred firms. Then rather than simply saying, ‘We willl take away these bad debts and then you’re on your own,’ it gave the banks the message that they had to start restructuring their operations. And in many cases, such as the Lodz bank, the success of the restructuring department even led to new opportunities in private equity and venture capital. In short, the EBRP not only solved the debt problem but helped both the banks and public agencies build new capabilities."

McDermott also explains how Poland empowered its provinces, which he believes is another clue to its success. The provinces oversaw the worker leasing process: writing contracts, selecting winners, and monitoring the terms. In addition, the provinces were heavily involved with the big commercial banks during the EBRP, supplying them with needed information on firms. That, in turn, built up significant institutional capabilities for Polish regions, which didn’t happen in either the Czech Republic or Russia.

For firms doing business in Eastern Europe, McDermott suggests that his book helps explain "how business networks in Eastern Europe operate, which is vital to grasp, not only in terms of making technical decisions about which assets are connected, but about how you understand negotiations. You may think you are dealing with one firm, but there could be other connected firms in the background, and there are financial liabilities related to that."

The struggles of the Czech Republic, the collapse of Argentina, "huge failures like Russia," unexpected successes like Poland – all these point to one principle for emerging market countries, McDermott says. "It’s not about coming up with an ideal institutional design at the outset, but having a couple of basic goals and principles in mind, and accepting that institution-building will be an ongoing, experimental process. That’s risky, but it’s how things really work."

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