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CENTRAL AND EASTERN EUROPE:
FINANCIAL MARKETS AND PRIVATE CAPITAL FLOWS
Dorothy M. Sobol
Federal Reserve Bank of New York
Research Paper No. 9626
August 1996
This paper is being circulated for purposes of discussion and comment only.
The contents should be regarded as preliminary and not for citation or quotation without
permission of the author. The views expressed are those of the author and do not necessarily
reflect those of the Federal Reserve Bank of New York or the Federal Reserve System.
Single copies are available on request to:
Public Information Department
Federal Reserve Bank of New York
New York, NY 10045
CENTRAL AND EASTERN EUROPE:
FINANCIAL MARKETS AND PRIVATE CAPITAL FLOWS
Dorothy Meadow Sobol
Federal Reserve Bank ofNew York
November 1995
Revised: August 1996
Prepared for Study Group on Private Capital Flows
to Developing and Transitional Economies,
Council on Foreign Relations
The author thanks Kate Kisselev for superb research assistance as well as
Warren Moskowitz and Adam Posen for helpful comments. The views expressed are the
author's and do not necessarily reflect those of the Federal Reserve Bank ofNew York or the
Federal Reserve System.
CENTRAL AND EASTERN EUROPE:
FINANCIAL MARKETS AND PRIVATE CAPITAL FLOWS
The resurgence of private capital flows to developing countries beginning in the late 1980s
did not initially benefit the countries of Central and Eastern Europe. With the collapse of
Communist governments throughout the region beginning in 1989, most countries in the region
were absorbed in a political and economic upheaval unimaginable only years earlier as they sought
to undo decades of central planning and transform their economies into ones based more on
market principles. In this environment, it is understandable that private foreign capital was slow
to enter any of these countries. Not until the efforts of these countries to free up their economies
and introduce macroeconomic and structural reforms began to bear fruit did private foreign
investors begin to take significant note of this region in their investment decisions.
Today, while the amount of private capital entering Central and Eastern Europe is still a
very small fraction of that provided to all developing countries, it has nonetheless begun to flow in
(Chart 1, Table 1). Whereas the countries in Central and Eastern Europe as a group were running
capital account deficits in the early 1990s, this situation turned around beginning in 1992, as
reform programs in a number of countries started to take hold (Chart 2). 1
'For the three countries in this study--Hungary, Poland, and the Czech Republic--the combined
capital account swung from near balance in 1990 to surpluses of $2.7 billion in 1991, $4.5 billion
in 1992, $14.3 billion in 1993, before falling off to $10.8 billion in 1994. Poland's surplus
beginning in 1991 stemmed from the exceptional financing it received from its official creditors in
the Paris Club.
CHART 1
DIRECTION AND COMPOSITION OF PRIVATE CAPITAL INFLOWS
PRIVATE FLOWS TO DEVELOPING COUNTRIES
THE CZECH REPUBLIC
USS Billions
us~ :\1illions
Hows to the Czech Republic, Hungary, and Poland
4,000
Bank
Loans
200
2,000
150
International
Bond Issue:-
-2,000
'
50 :'
International
Equity l:-.su •·,
Flows to Other Eastern European Countries
-4,000
Flows to Other Developing Countries
0 .L-----~----__:_-"---~---'
19~0
1991
1992
1993
1994
1995e
1990
1996[
1991
1992
1993
1994
part-1995
Note: 1990. J 992 figures are for Czechoslovakia.
HUNGARY
POLAND
USS Millions
USS Millions
,. ''
International
4,000
Bond Issues · ,-
(12/95)
'
4,000
'
'
'
2,000 '
-. -. -. - ...
... . ... .
,•
0
,,,,
,,
'•,
'
''-'•,
,....
::;:::>'·
International
Equitv. Issues,,
·····-·••.... .,
FD!
' ·(6/95)
2,000
,,
I
(12/9;)
(6/95)
International
Bond Issues
Bank
Loans
-2,000 •
., -
0
-2,000
(12/9;)
I
(6/<J5 J
((1/95)
Bank
Loans
International
Equity Issues
·,(12/95)
-4,000
-4,000
1990
1991
1992
1993
1994 part-1995
1990
1991
1992
1993
1994 part-1995
See Table 1 for the data in the last three charts,
Sotir,·,·s: Balance of Pavments Statistics, International Financial Statistics, Czech National Bank, National Bank of Hungary, National Bank of Poland,
I.\IF 1nl<'rnat1onal Capi;al :\1arket~, The Banker.
TABLE 1
COMPOSITION OF PRIVATE CAPITAL INFLOWS
(Millions of USS)
1990
1991
1992
1993.
1994
955
200
2138
3293
-656
-1395
1061
-990
-652
-1899
-882
-3433
-163
-1234
-891
-2288
1953
1068
-4929
-1908
586
1462
298
2346
1073
1479
3217
564
2339
1697
4600
762
1095
1846
3703
2525
4453
2511
9489
0
91
0
91
0
33
0
33
0
17
I
18
10
214
0
224
32
0
14
46
(6/95)
(6/95)
(6/95)
(6/95)
0
1778
250
2028
(6/95)
(6/95)
(6/95)
(6/95)
1995
BANK LOANS
Czecl- Republic*
Hung ,ry
Polar, I
TOT,,L
1746 (12/95)
411 (12/95)
324(12/951
2481 (12/951
NET ~OREIGI\' DIRECT INYEST,\1ENT
Czech Republic*
Hung:<•1 y
Polarnl
TOTAL
187
354
89
630
665
(12/95)
(12/95)
(12/951**
(12/95)
INTELNATIONAL EQUITY INVESTMENT
Czecl 1-epublic*
Hung 1 y
Polan/,
TOTf~
0
68
0
68
INTI~ATIONAL BOND INVESTMENT
Czecl .~epublic*
Hung,ry
Pola,; I
TOT,'L
375
888
0
1263
277
1186
0
1463
129
1242
0
1371
697
4796
0
5493
396
2250
-624
2022
GRAl\'D TOTAL
5254
2910
1188
7823
4041
* Data ;- e for Czechoslovakia from 1990-1992.
** For, i ,!O Direct Investment figure is gross.
14044 (part vear)
Bank loans in 1993 are also for Czechoslovakia
Source: - Balance of Payments Statistics, Bank for International Settlements Semiannual Data, IMF International Capital Markets, IMF Privatl" MarkC't Financing
for Dt'veloping Countries, Reuter Textline
CHART2
CAPITAL ACCOUNT REVERSAL IN THE l 990s
C 1.PITAL AND FINANCIAL ACCOUNT BALANCES
U: S Billions
f:r----------------------------------6 .
I
4 ,_
I
2 -
0
Czech
... Republic
-4
L---------~---------'---------__J.__________,
1990
1991
1992
1993
I 99·
Note: Figures are according to the 1995 Balance of Payments methodology, and include exceptional financing.
Sources: Balance or Payments Statistics.
2
There are a few caveats, however. For one, the bulk of the private capital flowing into
Central and Eastern Europe in recent years has been concentrated in relatively few countries. Of
these, the most important are Hungary, Poland, and the Czech Republic.2 These countries
therefore form the focus of this paper.
Second, the evidence is as yet only preliminary and the data far from comprehensive.
Nonetheless, the findings to date suggest that these three countries, as well as many others in the
region, should benefit from private capital inflows for many years. Whether they will be able to
do so, however, will be a function of both their ability and their willingness to adhere to marketoriented reforms and carry out often politically difficult restructuring measures. For those able to
hold to such a course--and lucky enough to avoid or overcome the political backlashes likely to
accompany the implementation of their policies--foreign private capital should be forthcoming.
Nevertheless, the competition for capital is fierce. And, in this era of globalized markets, when
investment decisions are often made within minutes, markets will not be slow to respond to those
who are perceived to lag, falter, or fail in their reform and restructuring efforts.
By focusing on the three major recipients of private capital flows to Central and Eastern
Europe thus far, the paper seeks to identify the nature and composition of private capital flowing
into the region in recent years and some of the factors driving these flows. In addition, it explores
some of the problems these inflows have raised, how policymakers are responding, and what the
prospects are for continuing inflows over the coming years. One conclusion seems clear. While
some market participants may continue to view the region as a single entity, many increasingly
2By
some accounts, these three countries accounted for 90 percent of net capital inflows into
Eastern Europe in 1995. United Nations Economic Commission for Europe, Economic Survey of
Europe. 1995.
3
appear to be distinguishing among the countries when making their investment decisions.
COMPOSITION OF PRIVATE CAPITAL FLOWS
In broad terms, private capital flows consist of three basic elements: lending by
commercial banks; foreign direct investment (typically defined as an equity investment of
IO percent or more in a foreign firm); and portfolio investment through bonds and equities.
Portfolio investment through bonds takes place when foreigners invest in the money and capital
markets of another country and when public or private entities, including governments, raise funds
in a foreign market or the international markets. Equity flows are generated when foreigners buy
shares in firms that are listed on another country's stock exchange and when private or publicly
owned firms in one country issue shares in the markets of another country or in the international
markets through the use of depositary receipts.
On a net basis, the flow of private capital from these three sources to Hungary, Poland,
and the Czech Republic rose from an estimated $5.3 billion in 1990 to almost $8 billion in 1993
before dropping off to about $4 billion in 1994 with the collapse in international bond markets and
Poland's agreement with its commercial bank creditors which entailed writeoffs of a portion of its
bank debt.3 Inflows in 1995 are likely to total well over $14 billion, based on partial data for
portfolio investment. As elsewhere in the developing world, bank flows ceased to dominate
private sector financing to the countries of Central and Eastern Europe in the 1990s. Between
1991 and 1995, Hungary and the Czech Republic combined amortized more bank debt than they
took on. In Poland's case, debt was forgiven. Offsetting the declines in bank lending have been
3
As part of its agreement with its commercial bank creditors, Poland was granted a 50 percent
reduction in the net present value of its bank debt. Although not counted here as such, the debt
forgiveness this agreement entailed ought properly to be thought of as a capital inflow.
4
notable increases for all three countries in foreign direct investment and, for Hungary in particular,
portfolio inflows.
Also noteworthy is the extent to which the changes taking place in the composition of
private capital flows to these three countries during the 1990s shifted from those considered to be
debt-creating, such as bank lending and portfolio investment through bonds requiring repayment,
to those considered to be oflonger duration and to entail no direct repayment obligation, such as
foreign direct investment and portfolio investment through equities. Between 1990 and 1995, the
share of bank and bond finance provided to the three countries as a share of their total private
sector inflows fell from 87 percent to 32 percent. No country was more affected by these shifts
than Poland, which on a net basis saw its non-debt-creating flows as a share of total private
inflows fall from 96 percent in 1990 to about 19 percent in 1995, following its 1994 commercial
bank debt-reduction agreement and marked increases in foreign direct investment.
These broad patterns, of course, mask important differences among the three countries.
The following sections discuss some of these similarities and differences.
COMMERCIAL BANK LENDING
Throughout the 1980s and into 1990, commercial banks continued to lend to many
countries in Central and Eastern Europe, including Poland, Hungary and the Czech Republic
(Chart 3). Beginning in the early 1990s, however, bank lending to these countries began to slow
markedly as economic and financial conditions deteriorated following the collapse of Communist
regimes in 1989 and 1990 and amortizations in both Hungary and the Czech Republic began to
offset new inflows on a net basis. The falloff in bank lending was, to be sure, most notable in the
case of Poland, where new lending net of amortizations fell from an inflow of $2.1 billion in 1990
CHART 3
ACCESS TO BANK LENDING IN THE 1980s AND 1990s
BIS BANK CLAIMS IN THE 1980s AND 1990s
US\ Billion~
18
1-----------------------------------,
16
i'
' .._: ~Ba~k Claim~ on Poland
....
........
14
'
12
IO
(- ·
· Bank Clail'.m· on· Hungary ·
4 \-
2
[-------------.-.~Bank.
I
Claims on Czecho.sl.oYalda.
!
0----------------~---'-----~---------------"
.980
1981
1982
1983
198+
1985
1986
1987
1988
1989
1990
1991
1992
1993
199+
1993
Sources: Bank for International Settlements, L\ff International Capital Markeb
5
to an outflow of $900 million in 1993, prior to the country's implementing its commercial bank or
so-called Brady agreement in October I 994.
Beginning in 1994, however, bank lending to both Hungary and the Czech Republic began
to revive and these inflows continued in I 995, including flows to Poland. In the Czech Republic,
net increases in bank flows that started in 1994 have been very pronounced. During 1995, net
claims by BIS-reporting banks on Czech borrowers rose by $1.7 billion (Chart 4). The bulk of
these credits have been short-term in nature. The attraction of these credits to Czech borrowers
has been their lower interest rates and longer maturities than those available from domestic banks.
Among economists, there is some disagreement about the nature of this increased foreign
borrowing by Czech institutions. On the one hand, the increased borrowing may reflect a
substitution of foreign for domestic credit, motivated by inefficiencies in the domestic financial
system--in particular, wide margins between domestic deposit and lending rates. On the other
hand, the increased borrowing may simply reflect a genuine shortage of credit in the economy,
despite the fact that interest rate spreads, particularly with respect to the Deutsche mark, though
still wide, have generally been declining (Chart 5). To one group of IMF economists, the credit
shortage hypothesis is more consistent with the evidence: economic activity has strengthened over
the past several years, increasing the real demand for money.4
To counter some of the effects of these bank inflows, including the upward pressure they
have put on the real exchange rate (Chart 6), as well as to deter those inflows that have been more
speculative in nature, the Czech monetary authorities have adopted a variety of measures over the
Guillermo A Calvo, Ratna Sahay, and Carlos A Vegh, "Capital Flows in Central and Eastern
Europe: Evidence and Policy Options," IMF Working Paper WP/95/57, May I 995, pp. 19-20.
4
CHART4
MATURITY OF BIS BANK CLAIMS
HUNGARY
CZ' ,:HOSLOVAKIA
US:.-; Billiom
1+
c---------------~
14 ~ - - - - - - - - - - - - - - - 12
12
10
Claims on Czech Republic
8
6
Long-Term
4
Long-Term
2
2
0
1991
1992
1993
1994
1995
1990
1991
1992
1994
1995
1993
1994
1995
POLAND
USS Billions
14
12
10
8 -
Long-Term
6
4
2
0
1990
1991
1992
1993
Source: Bank for International Settlements.
CHART 5
DOLLAR AND DEUTSCHE MARK RETURNS ON LOCAL
INVESTMENTS
A~I -IUALIZED DOLLAR RETURNS ON LOCAL INVESTMENTS
Pen ·nt per annum
50·- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~
40 '
30 '.
20
i
U.S.
(3-mo T-Bill)
'
'
'
'
'---...
'
'
-··-·····-··-··-··-··-··-
o'-----\c--+-----\--~---------------------1r+-----w----1
I
-10 ' - - - - - - - - - - - - - - - - - ' - - - - - - - - - - ' - - - ' - - ' - - " - " - ' - - - - - - - - - - ~
1
1/96
1 /95
-~ 93
DE .l.TSCHE MARK RETURr,s ON LOCAL INVESTMENTS
Pen ;•nt per annum
so----------------------------,--------40
Germanv
(12-month T-Bill)
-10 -,_ _ _ _ _ __j__:__-'---'------'---'--_j__j_l-l-J_l-l--'--'----'----'--'---'-'- - ~ - - - - - ' - - - - - - '
,/93
1/94
1/95
1/96
N, ,..: Deutsche mark exchange ratt'~ ,rt' calculated from exchange rates vis•a-vis the dollar and and do not necessarily reOect actual tradmg prices.
'
'
Sources: International Financial Statistics, Bloomber~.
CHART6
REAL EFFECTIVE EXCHANGE RATES
REAL EFFECTIVE EXCHANGE RATES
19')0::: I 00
300 , - - - - - - - - - - - - - - - - - - ~ - - - - - -
251)
Poland
--- ---------
,, ,,
".'.••...•••• ~·················································•················
50
Hungary
.
i . __ _ _ __ ; __ _ __ _ J_ _ _ __ j __ _ _ _..J..__ _ _- - - ' _ ,
1990
1991
1992
1993
1994
1995e
Sources: International Financial Statistics, PlanEcon, J.P. Morgan.
6
past two years. Chief among these, the central bank introduced a more flexible foreign exchange
policy in February 1996, by widening the band within which the koruna is allowed to fluctuate
from ±0. 5 percent to ±7. 5 percent. By bringing a greater measure of risk to the exchange rate,
the authorities have sought to reduce speculative inflows and ease growth of the money supply.'
This decision followed a series of earlier measures the central bank had put in place for similar
reasons.
For example, in April 1995, the central bank announced that it would no longer buy and
sell foreign exchange at uniform rates but instead would charge a fee based on a percentage of the
intermediaries' exchange rate. Further, in August, it limited commercial banks' borrowing abroad
to no more than 30 percent of their short-term assets, or Kc 500 million ($19 million). At the
same time, it unified reserve requirements for sight and time deposits at 8.5 percent (from
12 percent and 3 percent, respectively), raised the discount and Lombard rates, and announced
that short-term borrowing by commercial banks would be slowed through administrative
procedures. 6 In October, the government made the koruna fully convertible for current account
transactions and partly liberalized capital account transactions by allowing Czech residents for the
first time to purchase real estate and make direct investments abroad.
A welcome development for Poland in 1994 was to regain access to the syndicated lending
market after years of protracted arrears and debt-servicing difficulties. Following the country's
Brady-type debt-reduction agreement with banks in October I 994, which, among other things,
reduced the net present value of its bank debt by 50 percent, a state utility company received five-
'"Prague eases exchange controls," Financial Times, February 29, 1996.
6
Girocredit, East European Chronicle, April 1995, p. 41.
7
year term financing of $113 million from a syndicate of European banks. 7
Like the Czech Republic, Poland has also faced mounting inflows of foreign exchange
over the past two years. Market participants believe that the bulk of these foreign exchange
inflows, which are estimated to have reached $5 billion to $6 billion in 1994, represent revenues
from domestic sales of goods and services to foreigners, primarily Russians, Ukrainians, and
Germans, who come to Poland to shop and benefit from comparatively more attractive prices.
Because of Polish balance-of-payments accounting procedures, however, these inflows were not
well captured in the data until January 1996. 8 Although the inflows from this border trade have
led to dramatic increases in Poland's reserves and have contributed to strong output growth, they
have also put upward pressure on the real exchange rate.
In response to these inflows, the Polish authorities opted in mid-May I 995 to float the
zloty by widening the band within which the currency is allowed to fluctuate to 14 percent. The
authorities also chose to continue the monthly devaluation rate of 1.2 percent. In the four weeks
before the central bank's decision, an estimated $1.5 billion flowed into the country in anticipation
of a currency revaluation.' To discourage further inflows of speculative funds, the authorities
lowered interest rates substantially. In addition, on June 1, 1995, the zloty was made fully
convertible for current transactions in line with the IMF's Article VIII guidelines. Nevertheless, in
7
IBRD, World Debt Tables 1994-95, Volume I, pp.11-12.
'Beginning in January 1996, these previously unclassified transactions, notably stemming from
cross-border trade, are no longer counted as short-term capital transactions but instead are
shown on the current account. Creditanstalt, Central European Quarterly. 11/96, p. 33.
9Leon Podkaminer et, al., "Transition Countries: Economic Developments in Early 1995 and
Outlook for 1995 and 1996," Part II, The Vienna Institute for Comparative Economic Studies
(WIIW), July 1995, pp. 32-33.
8
December 1995, the authorities revalued the zloty by 6 percent and in January 1996 they lowered
the monthly devaluation rate to 1 percent. 10
One feature of bank lending that applies particularly in the .case of Hungary has been the
increasing use banks have made of various risk-reducing techniques in their lending decisions,
including co-financing loans with some of the major international financial institutions. In
February 1993, for example, Hungary arranged a $375 million loan facility in connection with a
road transport project that was secured by toll revenues together with the participation of the
EBRD. 11 More recently, in June 1995, MAT AV, the Hungarian telephone company, entered
negotiations to syndicate a $300 million loan that was being arranged by the EBRD and the IFC
together with Deutsche Bank of Germany. 12
Finally, it is interesting to note that the Czech Republic has been offered some of the best
borrowing terms among developing country borrowers. For example, whereas weighted average
spreads for developing country borrowers tended to rise between 1990 and 1994--from an
average of64 basis points over Libor to 100 basis points over Libor13--the Czech Republic has
seen its spreads narrow dramatically over this period. In 1994, two of the country's major banks,
Obchodni and Komercni, were able to raise funds at 65 to 70 basis points over Libor, well below
the average for developing country borrowers. In May 1995, CEZ, the state-owned power utility,
'°Creditanstalt, Central European Quarterly. 1/96, p. 37.
"Commission of the European Communities, European Economy. "Private Capital Flows to
CEECs and NIS," Supplement A, No. 3, March 1994, p. 3.
12
"Matav to syndicate $300 million loan," Financial Times, June 21, 1995.
13
IMF, International Capital Markets, August 1995, p. 41.
9
broke new ground by arranging a $100 million, three-year syndicated credit from Sumitomo Bank
at just 25 basis points over Libor when average spreads to developing countries had risen to about
107 basis points. 14 Obchodni Bank achieved comparable spreads in a $75 million three-year credit
it arranged with Societe Generale. 15 By 1996, most borrowers in the region were witnessing a
downward trend in margins as well as a lengthening in maturities.
FOREIGN DIRECT INVESTMENT
One of the main factors assisting the transformation of the Central and Eastern European
countries has been foreign direct investment. Because it is generally longer term in nature, this
form of investment can help to encourage structural change and modernize obsolete production
facilities while bringing with it such indirect benefits as the transfer of technology, management,
and marketing skills. Practically nil in 1989, foreign direct investment has grown markedly
throughout Central and Eastern Europe, almost doubling between 1994 and 1995 to about
$14 billion for the region as a whole, 16 of which two-thirds went to Poland, Hungary, and the
Czech Republic. Its rapid rise is not surprising given the sudden opening of the economies in the
region and the massive privatization programs initiated by some. A substantial portion of these
investment flows, however, has to date been concentrated in one country--Hungary, which has
accounted for close to 50 percent of the total net flows to the three countries since 1990.
Generally, direct investment inflows to Central and Eastern Europe have not taken place
through "green field" operations, in which new facilities are created from scratch. In fact, the
14
IMF, Private Market Financing for Developing Countries. November 1995, p. 26.
15
The Economist Intelligence Unit, Business Eastern Europe, September 11, 1995, p. 5.
16
"Foreign investment in eastern europe doubles," Financial Times, March 25, 1996.
JO
OECD estimates that investment in this form has accounted for only 20 percent of all such flows
to the region. Instead, most direct investment inflows have entailed either taking over existing
companies or taking holdings in existing companies. Surveys have.shown that investment in the
region thus far has been motivated primarily by the desire for access to the domestic markets.
Low wages have also been cited as an attractive feature drawing capital to the area, 17 as have such
factors as comparative political stability and a skilled labor force. 18
The sectors that have interested foreign investors have varied across countries (Chart 7).
In Hungary, manufacturing has played a major role. In the Czech Republic, investments in
transport, beverages, and construction have been particularly significant. In Poland, foreign direct
investment has flowed largely to the electrical engineering sector, the food industry, and the
financial sector.
By virtually all measures, Hungary has surpassed all other countries in the region in
attracting foreign direct investment since 1990 (Chart 8). Market-based reforms progressively
implemented since 1968 together with its close proximity to Austria have given Hungary an edge
and made it a low-cost production site for exports to Western Europe .. 19 Between 1990 and
1995, the country accumulated $11.2 billion in foreign direct investment, almost double the
$5. 7 billion for the Czech Republic and well over the $7 .1 billion for Poland. As a share of GDP,
these inflows between 1990 and 1995 reached 5.9 percent in Hungary, compared with 2.5 percent
in the Czech Republic and 1.4 percent in Poland. In terms of annual flows on a per capita basis,
17
Jan Stankovsky, Direct Investment in Eastern Europe, Bank of Austria, p. 27.
18
"Piling into Central Europe," Business Week, July 1, 1996, p. 42.
19
"AII Busy on the Western Front," Business Eastern Europe, October 30, 1995, p. 5.
CHART7
FOREIGN DIRECT INVESTMENT BY SECTOR
CUMULATIVE FLOWS TO SELECTED
EASTERN EUROPEAN COUNTRIES
CZECH REPUBLIC
11'.'lernm.
S],414
C. , h R('public
S7. I
Transport
S1,064
Oth('r
Food
Consumer Goods
Hung<ir)
S 11.2
Engmeering
Cumulati\"e flows in USS billions from 1990 to 199S
S351
~+2+
S443
]lJlJ)
\Vholesale/Retail
Financial
S1,347
SI ,279
Construction
S889
S496
S380
5438
Engineering SI ,080
Telecom.
Financlll
I ,Obb
POLAND
Other S456
Transport S204
Cons·1 uction
Tracit'
Cumulative FDI in USS milliom bet\\'een 1990 and
HUNGARY
, .otel /Restaurant
S481
,1,
S290
S1,227
Trade
Agri< idtural
S364
s90
Food Industry
Manufacturing
S6, 165
Cumulatin> FD! in USS millions between 1990 and 1995.
Otht>r Industry
S1,888
Cumulative FOi in USS millions betwel.'n 1990 and 199.)
Breakdown is based on trend between 1990 and 1993.
Sources: Rl!uters, European Economy, Economist lnell1gencr Linn.
CHARTS
FOREIGN DIRECT INVESTMENT BY COUNTRY OF ORIGIN
CZECH REPUBLIC
:UMULATIVE FLOWS FROM MAJOR INVESTORS
Gcrmam
SI. 74ll
u.s
Germany
F ·nc('"
51.9
I: dy
S0.6
SS.3
France
A ;,tri;i
s I .S
S542
:\u~tria
Other
C,:mulat1n• FIJI bt.>twem 1990 and J(J(l::;
is an aggregation
1n
S316
S821
S9.6
LI:-~ b1lliom. This graph
Cumulative 111\'l'.,tnwnt in USS million~ lwt \Wen 199() .ind J')\J;
or the othl'r graphs on this pagt>
POLAND
HUNGA\'Y
GermarnGermany
s3,007
S 574
U.S.
us
s 580
Oth{·r
CIS
S202
France
S574
OthC'r
Italy s 2 50
Switzerland S279
Aus ·ia
s3,153
S372
tlls:
S799
France
5759
Belgium S510
!\etherlands 5533
Cumulative investment in USS millions between 1990 and 1995.
Breakdown is estimated based on trend from 1990-1994.
International
S 1,101
Cumulative foreign direct investment in USS millions between 1990 and 199;.
"International" includes the EBRD, as well as multinational rnrporations.
Sources: Reukrs, National Bank uf Hungan
11
Hungary again outdistanced its neighbors, with inflows averaging $160 a year over the 1992-94
period, compared with $77 for the Czech Republic and $36 for Poland. Both Poland and the
Czech Republic, however, made considerable strides in attracting new direct investment inflows in
1995. Interestingly, the Czech Republic offers no tax concessions to attract foreign direct
investment, whereas both Poland and Hungary do.
Also influencing the levels of direct investment inflows to Hungary, Poland, and the Czech
Republic have been macroeconomic developments in each country over the past several years
(Chart 9). Hungary, whose reform efforts started as early as 1968, has recorded steady, if
sometimes slow, progress in developing a market economy. Despite large fiscal and current
account deficits, which the government has begun to address through the introduction of an
austerity program in March 1995 coupled with a devaluation and an import tax surcharge, the
country has never failed to service all of its external debt (Chart IO). Tight monetary and fiscal
policies pursued by the Czech Republic since reform began in 1989 and low levels of external debt
have contributed to a domestic environment conducive to long-term economic growth, although
significant structural problems remain, for example, in the corporate and financial sectors. After
difficulties in some key areas of its economy in the early 1990s, including a sharp run up in
inflation following price liberalization, Poland has seen its economy recover strongly over the past
three years, fueled by strong export growth and private sector activity as well as by the
normalization of relations with its external creditors.
Integral to these broad macroeconomic and structural reforms have been efforts on the
part of all three countries since 1990 to reduce the share of state holdings in the economy. The
magnitude of the privatization efforts undertaken by each country may be seen by the fact that, as
CHART9
INDICATORS OF MACROECONOMIC PERFORMANCE
REAL GROSS DOMESTIC PRODUCT GROWTH
CONSUMER PRICE INFLATION
Percent change from preYious year
Percent change from preYious year
10 ~ - - - - - - - - - - - - - - - - - ,
5
I
-- - -
70
226%
'
Poland
60
50
0 f-----.J.----,,c....."'---Hungar)·
,. '/oland _
\
I
'
40 -
....
-5
30 - 10
20
Czech
· · Republic
-15
10
Republic
-20
1990
1991
1992
1993
1994
1995
O'---~--'~---------~
1990
1996[
1991
1992
1993
1994
1995
1996[
FISCAL BALANCE AS A PERCENT OF GDP
CURRENT ACCOUNT BALANCES AS A PERCENT OF GDP
Percent of GDP
Percent of GDP
4,--------------------,
10 , - - - - - - - - - - - - - - - - - - - ,
5
\
'
Czech Republic
...\,
-2
-5
-4
\
\
.,,,
' '
Poland
\
Hungarv \
.,
,
....
\.
.............
-6
1991
1992
1993
1994
1995
1996[
-15 - - - - - - - - ~ - - - - - - - - - - - - - ~
1992
1993 1994 1995 1996[
1990 1991
Sour :es: Economist Intelligence Unit/ Data stream (for<:'casts), International Financial Statistics, National Bank of Hungary, Creditanstalt Central
Eun pean Quarterly, Czech National Bank, BIS.
CHART 10
EXTERNAL DEBT
CZI: 2H EXTERNAL DEBT
HUNGARIAN EXTERNAL DEBT
USS ,:illions
USS Billions
60
60 , - - - - - - - - - - - - - - - - -
50
50 -
40
40
30 -
30 -
20
20
Long-Term
JO
Short-Term
JO
Short-Term
Long-1t"rm
0
]99]
1992
1993
1994
J995f
1996[
1990
199]
1992
1993
1994
1995
]996f
POU 1:H EXTERNAL DEBT
EXTERNAL DEBT AS A PERCENT OF EXPORTS
USS Bdions
Percent
60
3SO , - - - - - - - - - - - - - - - - - ~
50
300
- - - ..... '
, Poland
250
40
200
30
!SO
Long-Term
20 -
100
JO
0
J99c.
Sources
so
199]
1992
1993
1994
1995f
1996f
0
--1990
1991
Czech
Republic
1992
1993
1994
199Sf 1996[
World Debt Tables, Czech National Bank, National Bank of Hungary, PlanEcon, Balance of Payments, International Financial Statistics, BIS,
Ernnoml;t Intelligence llnit/Datastream ffoi-r,asts).
12
of 1995, the private sector contributed 60 percent to the GDP of the Czech Republic, 70 percent
to that of Hungary, and 60 percent to that of Poland.
There are clear differences among the countries, however, _in the privatization course each
has chosen and its implications for the participation of foreign finance. Although the World Bank
calculates that foreign participation was most marked in the privatization efforts of countries in
Europe and Central Asia, with an estimated 57 percent of sales revenues stemming from foreign
sources between 1988 and 1993, 20 this finding appears most applicable to Hungary, but
considerably less so to the Czech Republic and Poland.
Hungary
Unlike the programs in Poland and the Czech Republic, the privatization program in
Hungary has been dominated by sales for cash. When Communism collapsed in 1989, the
Hungarian government, which had been introducing many market elements to its economy since
1968, opted for a market privatization program combined with generous tax incentives to attract
foreign investors. It opened up large sectors of the economy and sold them primarily to Western
firms. General Electric, Unilever, and Electrolux all bought out existing companies. Ford and
General Motors built new ones. The drive to sell state assets culminated in late 1993 with the sale
of a 30 percent stake in MAT AV, the state telephone company, to a German-American
consortium for $875 million, the region's second largest privatization to date.
After having spent most of the 1990s aggressively pursuing privatization and attracting
considerable foreign investment inflows in the process, however, the country began to falter in
1994 when it saw its revenue from foreign direct investment fall by more than $1.2 billion from its
20
IBRD, World Debt Tables, "External Finance through Privatization," 1994/5 p. 125.
13
1993 level. In part this decline is misleading in that almost one-third of the 1993 inflows stemmed
from the MAT AV sale. Nonetheless, a change in government in March 1994, together with a
lack of political consensus on the desirability of foreign participation in the disposition of the
government's remaining holdings (valued at roughly $14 billion) stalled the privatization program
considerably in 1994 and much of 1995.
A new privatization Jaw passed in May I 995, however, helped revive activity. The law
merged the two existing privatization agencies into the State Privatization and Holding Company
(APV Rt) and charged the agency with selling most of the remaining state companies by 1997.
Under the new Jaw, the Finance Minister is no longer in control of privatization and parliament is
given final say in privatization decisions considered to be "vital to the nation." At the same time,
the government committed itself to bringing several medium-sized companies to market over the
remainder of 1995, including the oil and gas utility (MOL), five regional gas suppliers, and a
major broadcasting company, despite considerable political opposition. The government's success
in meeting its goals far exceeded expectations. Initially, the government had hoped for
privatization revenues on the order of$1.5 billion for 1995. Instead, by year end, the government
was able to realize a record $3. 5 billion in privatization revenues and a total of $4. 5 billion in
foreign direct investment. 21 The government's successful privatization efforts have continued in
1996.
The Czech Republic
As in Hungary, foreign direct investment flows to the Czech Republic have also been
related to the country's privatization program, although in the Czech Republic the relationship has
21 Creditanstalt,
Central European Quarterly, 11/96, p. 26.
14
been somewhat less direct. The Czech privatization program consisted of two waves. In the first
' wave, which began in 1991, a direct auction method was used for small privatizations. Foreigners
were not allowed to bid, at the initial auction, but could do so--and did--if there were no domestic
buyers to offer bids. In the second wave of privatization, which was completed in early 1995, the
country handed out vouchers to all Czech residents, who could use them to purchase shares either
directly on the stock exchange or in newly fonned investment funds. Again, no foreign
participation was involved in the initial distribution, but foreigners could subsequently purchase
shares from Czech residents.
As a result, the Czech Republic has been extremely successful in attracting foreign direct
investment inflows, even though it offers no specific tax concessions. Although revenues from
foreign direct investment fell rather sharply in 1993, the drop was primarily associated with
uncertainties surrounding the country's split with the Slovak Republic on January I. By 1994, the
flows returned such that, by the end of 1995, the country had attracted a total of almost $6 billion .
in foreign direct investment since 1990, over 40 percent of this in 1995 alone.
As elsewhere in the region, however, the government continues to retain major stakes in
some key sectors of the economy, including the banks, utilities, and oil refineries, but like
Hungary, it too has demonstrated over the course of 1995 its commitment to gradually reducing
its role in many of these sectors. For example, in late June 1995, it sold a 27 percent stake in SPT
Telecom, the telephone company, for which it received $1 .45 billion from a consortium led by a
Dutch finn, making this sale the largest privatization in the region since the $875 million share
offering in Hungary's MAT AV in 1993. 22 In addition, the government has begun to privatize its
22
"Czech telecom stake sold for record $1.5 billion," Financial Times, June 29, 1995.
15
oil refineries. Three Western oil companies--Royal Dutch Shell, Conoco, and Agip ofltaly-agreed in September 1995 to buy 49 percent of the two main refineries for $173 million and to
invest an additional $480 million over the next five years. A new state holding company,
Unipetrol, retains a 51 percent stake in the refineries. 23
One long-term issue that may discourage foreign investment relates to the ownership
structure of Czech enterprises. Although much of the economy is in private hands, a major
portion of these ownership rights is concentrated in a comparatively small number of private
investment funds created as part of the voucher privatization program. Most of these investment
funds, in tum, are owned by the major banks. As a result, ownership of Czech enterprises is not
as widespread as had been envisaged. Moreover, this ownership structure raises the potential for
conflicts of interest on the part of fund managers who, when faced with market pressures, may bt
tempted to maximize earnings at the expense of the long-term development interests of their
funds' portfolios. The comparatively low unemployment rate in the Czech Republic--2.9 percent
in 1995, compared with 10.6 percent in Hungary and 15.1 percent in Poland--suggests that the
necessary restructuring of Czech enterprises has not yet been undertaken in part because of these
ownership arrangements. 24
Poland
In contrast to developments in both Hungary and the Czech Republic, foreign direct
investment was slow to get under way in Poland following the introduction of the country's
shock-therapy program in 1990. As the economy began to stabilize, with the fixing of the
23
"Czech oil refinery deal signed," Financial Times, June 19, 1995.
24
Creditanstalt, Central European Quarterly. 11/95, p. 8.
16
exchange rate in early 1991, foreign investment did flow into Poland. Nevertheless, the amount
was relatively modest given the size of the country's economy, by far the largest of the three
countries. Although foreign investment has grown steadily over the 1990s, the bureaucratic
hassles stemming from the fact that a number of enterprises may report to more than one ministry
tended to discourage investors and precluded more substantial inflows.
In addition, the country's privatization program did little until I 995 to promote the inflow
of foreign direct investment. Prior to 1995, the Polish privatization program was largely
voluntary, relatively slow in implementation, mostly confined to small- and medium-sized
businesses, and considerably delayed by a Jack of a political consensus on its aims and methods.
Of the 8,400 state firms registered in August 1990, only 2,290 small- and medium-sized firms and
135 large firms were privatized by the end of 1994. Of this total, 961 were sold in 1991,
compared with only 294 in 1994. 25
This situation began to change in the middle of 1995. After a three-year delay, the
government agreed in July to launch its long-planned mass privatization program, signing
management contracts with fund management companies to manage fifteen National Investment
Funds (NIFs). The NIFs, which are partly managed by foreign fund managers and
85 percent owned by the adult population, received 60 percent of the shares in over
500 companies privatized. The government reserved 15 percent of the remaining shares for the
employees of the companies; it planned either to hold the balance of the shares or to distribute
them to local authorities and suppliers.
Under the terms of the privatization plan, one fund serves as lead manager for each
25 "Poland:
Set Loose the Dogs," The Banker, May 1995, p. 25.
17
enterprise privatized, receiving one-third of the shares offered in that company. The remaining
shares were then distributed equally among the other funds. Using a lottery system, each fund
was allowed to bid on those companies it wished to lead-manage.. The lottery took place in early
1996. To encourage the investment funds to take a longer term interest in the enterprises whose
shares they hold, the government has allowed them, for a specified time period, to reconfigure
their portfolios if they wish. 26 In addition, beginning in late 1995, the government allowed all
adult Poles, or 29 million people, to purchase at a nominal price of20 zloty each ($8)
participation certificates that can be converted into shares in each of the fifteen funds. These
shares became tradable on an over-the-counter market in early 1996 and were listed on a special
market of the Warsaw Stock Exchange in July 1996. This is preliminary to the listing of the
individual funds on the Warsaw Stock Exchange in 1997. 27
While the mass privatization program may bring little immediate revenue to the country, it
holds the promise of attracting foreign investment in the coming years. At the same time, it also
permits a rapid selloff of state assets in the face of a shortage of capital among the population.
Nonetheless, aspects of the new program continue to be mired in political controversy. For
example, parliament and not the privatization minister has the right to veto all privatization
decisions involving key sectors of the economy, such as banks, oil and gas, and insurance. The
legislation creating the program barely survived the president's veto, which parliament voted to
override in October 1995. While Poland's privatization program is likely to remain highly
politicized, it does open the way to move the restructuring process of Polish enterprises forward.
26
Girocredit. East European Chronicle, July 1995, p. 9.
27
"Fibremaker gives dress rehearsal for privatised Poland," Financial Times, July 18, 1996.
18
Under new government leadership, the privatization program for 1996 appears to be on
track, with the government moving forward in its plans to sell a minority stake in Polska Miedz, a
copper producer expected to be valued at $2 billion, which would make this transaction the
largest privatization in the region to date. 28 In addition, in early 1996, the government announced
plans to privatize over seven years most of the country's electrical generating and distribution
sector. 29 In mid-year, it allowed two foreign banks to take majority control of their respective
Polish partners. 30 At the same time, the government faced some potential conflicts with foreign
investors stemming from the dismissal in May 1996 of two U.S. managers of one of the funds. 31
PORTFOLIO INVESTMENT
Portfolio investment is undeniably the most significant new development in the provision
of private capital to developing countries in the 1990s. Launched by the efforts of pension funds,
insurance companies, mutual funds, and other institutional investors located primarily in the
United States and the United Kingdom to diversify their portfolios in the late 1980s, portfolio
investment has probably grown at a faster rate than any other source of private capital flows to
developing countries. The countries of Central and Eastern Europe, however, have only just
begun to benefit from inflows from this source. Moreover, the activity that has been reported to
date vis-a-vis the region has almost always assumed the form of bond flows and not equity flows,
despite the fact that the bulk of emerging market mutual funds' global portfolio investment takes
2
'"Polish privatization plan survives cabinet changes," Financial Times, February 8, 1996.
29
"Poland plans power sell-off over seven years," Financial Times, March 13, 1996.
30
"Poland allows foreign buyers for some banks," Financial Times, July 1, 1996.
31
"U.S. fund managers furious at Polish sacking," Financial Times, May 3, 1996.
19
place through equity and not bond investment. 32 Of the Central and Eastern European countries,
Hungary continues to dominate activity in these markets.
One caveat to note in considering portfolio investment to t_he region is the relative paucity
of data and the uncertain reliability of the infonnation that is available. To date, there has been no
systematic compilation of statistics on portfolio flows by an international organization. Much of
the data that do exist have been obtained from diverse and often inconsistent sources. 33 In
addition, balance-of-payments statistics in individual countries often do not distinguish portfolio
flows from other capital flows. Moreover, most countries lack systematic methods for recording
secondary market transactions in domestic market bonds and equity. Therefore, recorded foreign
activity in these markets may be significantly understated.
Bonds
To date, over 90 percent of all private capital flowing into Central and Eastern European
in the fonn of portfolio investment has taken place through bonds. As noted earlier, portfolio
investment through bonds occurs in two ways, and both merit discussion. First, public or private
entities can issue securities in the domestic market of a foreign country or in the international
markets. Thus far, most of the activity concerning the countries of Central and Eastern Europe
has taken this fonn. Second, non-residents can invest in the money or capital markets of another
country. This fonn of bond investment is only just beginning in Central and Eastern Europe.
Some data are available for international purchases by these countries in foreign markets, but only
anecdotal evidence is possible in the case of foreign purchases in these countries' domestic
32
33
IMF, International Capital Markets, August 1995, p. 39.
European Economy, p. 6.
20
markets.
Hungarian. Czech. and Polish Bonds Issued in Foreign Markets
Of all the Central and Eastern European countries, Hungary has been the most active
participant in the international capital markets during the first half of the 1990s. On average, it
raised more than $1 billion a year in the Eurobond market until 1993 when, taking advantage of
favorable market conditions, it raised a spectacular $4.8 billion. Mounting fiscal and current
account deficits prompted its need for finance. According to some estimates, Hungary alone
accounted for as much as 83 percent of all international bonds issued by all countries in the region
between 1989 and 1994. 34
In addition, Hungary has also been able to access the Euroyen or Samurai market and, in
1993. for the first time, the U.S. dollar or Yankee bond market. Although Hungary lacks the
investment grade ratings from some of the international credit rating agencies that both Poland
and the Czech Republic enjoy, 35 the fact that the country has long been committed to marketbased reform and has serviced its external debt strictly according to schedule despite some
unfavorable conditions has been important to its generally positive reception in the international
34
lbid., p. 5.
The Czech Republic saw its investment grade ratings upgraded in the fall of 1995 (to Baal in
September by Moody's and to A in November by Standard and Poor's). While Poland has had an
investment grade from Moody's since June 1995 (Baa3), it was rated below investment grade by
Standard and Poor's (BB) until April I 996 when it was upgraded by two notches to investment
grade (BBB-). Hungary is rated below investment grade by both these rating agencies (Ba I by
Moody's and BB+ by Standard and Poor's), but was given investment grade status by two other
rating agencies in 1996, by IBCA in April and by Duff and Phelps in June. "Credit Rating Boost
for Hungary," Financial Times, June 11, 1996.
35
21
markets. 36
Like Hungary, the Czech Republic began to access the international capital markets before
the fall of its Communist government. The amounts the country h!IS raised, however, have been
on a far more modest scale than those raised by Hungary, averaging less than $400 million a year
between 1990 and 1994. Following the dissolution of the former Czechoslovakia on January I,
1993, the Czech National Bank tapped the Eurobond market for the first time in April 1993,
issuing a three-year $375 million Eurobond to help rebuild the reserves depleted by speculation
against the koruna in connection with the breakup of the country. 37 Notwithstanding the Czech
Republic's investment grade ratings, which it received in March 1993, spreads for dollardenominated issues for both the Czech Republic and Hungary were comparable at about 27 5 basis
points over U.S. Treasuries in 1993 (Chart 11).
Poland, by contrast, was able to access the international capital markets only after it had
normalized relations with its commercial bank creditors in 1994. It made its debut offering in the
Eurobond market in June 1995, raising $250 million for five years at a spread of 185 basis points
over comparable U.S. Treasuries--a lower spread than that achieved by other comparably rated
borrowers (Greece and South Africa). 38 The offering followed close on the heels of the country's
having been awarded an investment grade rating by Moody's earlier in the month. With some
$15 billion in reserves, Poland mainly sought to test its standing in the international debt markets.
In July I 996, following its upgrade to investment grade by Standard and Poor' s, the country
36
Creditanstalt. Central European Quarterly. 111/95, p. 17.
37
European Economy, pp. 5-6.
3
s,,Poland's debut meets strong demand," Financial Times, June 28, 1995.
CHART 11
YIELD SPREADS ON SOVEREIGN BORROWING
YIELD SPREAD AT LAUNCH OF SOVEREIGN BOND ISSUES
B~_;is Points for Dollar•DenominatC'd Bonds Only
350 ~ - - - - - - - - - - - - - - - - - - - - - - - - - - ~
I llll
1991
1992
Czech Republic
□
Hungary
1993
D
Poland
I
1994
1995
Sourcc-s:
IMF International Capital 1V1arkeb.
22
further tested the markets by issuing its first Deutsche mark-denominated Eurobond, a five-year
DM 250 million ($165 million) offer at a spread of65 basis points over comparable German
government bonds. This spread was roughly in line with secondary market spreads on its dollardenominated Eurobond, whose price had risen sharply over the year with the yield spread over
U.S. Treasuries falling from 185 basis points to about 70 basis points. 39
Although the vast majority of developing country borrowers in the international capital
markets during the 1990s were non-sovereigns, all of the borrowing by Hungary and most of that
by the Czech Republic between 1990 and 1994 was undertaken by sovereigns. 40 As privatized
companies are restructured, however, and the corporate sector strengthened, some of the major
firms in these countries have begun to access the international capital markets. In March 1996,
for example, Poland's Export Development Bank (Bank Rozwoju Eksportu) issued a $50 million
three-year floating rate note with a spread of about 150 basis points. 41 In April, the Czech
Republic's Komercni Banka raised $250 million with a spread of78 basis points over U.S.
Treasuries. 42 And in May, Poland's Bank Handlowy issued $100 million three-year bonds at
88 basis points over comparable U.S. Treasuries. 43
39
"Investors snap up DM 250 million Polish eurobonds," Financial Times, July 10, 1996.
4
°In November 1994, CEZ, the state-owned power company, became the first corporation in
the region to enter the Eurobond market with a $150 million issue at a spread of 110 basis points.
IMF, Private Market Financing for Developing Countries, November 1995, p. 21.
41
"Polish bank plans $50 million international bond issue," Financial Times, March 28, 1996.
42
"Komercni banka eurobond," Financial Times, April 29, 1996.
43
"Bank Handlowy three-year offer heavily oversubscribed," Financial Times, May 1, 1996.
23
One development of note was that in October 1995 the Czech koruna became the first
post-Communist currency in which borrowers can tap the Eurobond market. General Electric
Credit Corporation was the first borrower to raise funds denominated in koruna with a
Kc 2 billion ($76 million) issue of three-year bonds. A second issuer, the Nordic Investment
Bank, raised Kc 1.5 billion ($58 million) later in the month. Both these issues followed the
decision by the Czech parliament in September to approve the full convertiblity of the koruna for
current account transactions and a significant liberalization of the currency for capital account
transactions. Interest rate differentials enabled these borrowers to fund their operations in the
Czech Republic more cost-effectively in the international markets than they could have in Czech
local markets. 44 In December 1995, the World Bank became the largest issuer ofkorunadenominated bonds, issuing Kc 2.5 billion ($96 million) two-year bonds at a spread of 600 basis
points over domestic German paper. 45 The Bank placed a second issue in May 1996 for
Kc 1.5 billion ($54 million).46 As ofFebruary 1996, borrowers can also tap the Eurobond market
in Polish zloty. 47 The IFC, the EBRD, ING Barings, and British Midland have all issued zlotylinked bonds, in anticipation of the full convertibility of the zloty. 48
44
"Czech koruna broadens eurobond currency base," Financial Times, October 10, 1995.
45
"World Bank launches record Czech koruna issue," Financial Times, December 21, 1995.
46
The Czech National Bank Monthly Bulletin, June 1996.
47
"First zloty eurobond," Financial Times, February 7, 1996.
The Polish authorities eased constraints on direct investment flows in April 1996. They plan
a further dismantling of controls beginning in January 1997 when they will ease curbs on portfolio
investment, allowing Polish citizens to buy stocks on the international markets. "Poland to ease
capital flows," Financial Times, March 28, 1996.
48
24
Foreign Access to Hungarian. Czech. and Polish Money and Capital Markets.
Evidence of private capital inflows to the domestic markets of countries in Central and
Eastern Europe is by necessity anecdotal. Comprehensive data do .not exist. Nonetheless, there
are indications that foreign investors have begun to take note of both the government securities
markets and the corporate bond markets in some of these countries, especially those where
regulations affecting foreign access to these markets and the ability to repatriate investment
income have been liberalized (Table 2). 49
Since I 993, Hungary in particular has been easing restrictions on the ability of foreigners
to participate in its Treasury markets. In view of its substantial fiscal and current account deficits,
it has sought to attract additional funds to help finance these deficits. Foreign participation to
date, however, has been modest. For example, in the first Hungarian Treasury issue made
available to them in May 1994, foreigners took only HUF 104 million ($1.02 million) of the HUF
8.8 billion ($86 million) offered. 50
Corporate bond markets in both Hungary and the Czech Republic have also begun to
attract the interest of foreign investors. The bulk of these investments, however, has been
arranged through private placements with the issuers--either local subsidiaries of multinational
companies or state-owned firms and banks. As a result, there is virtually no secondary market
trading in these bonds. Some market participants estimate that total portfolio investment in
koruna-denominated securities amounted to Kc 28 billion ($10.8 million) at the end of 1994. 51
4
9European Economy. p. 7.
'
0
51
Girocredit, East European Chronicle, January/February 1995, pp. 18-19.
Creditanstalt, Central European Quarterly. II/95, p. 9.
TABLE 2
EXCHANGE REGIME AND CAPITAL ACCOUNT RESTRICTIONS
Czech
Repub.ic
Exchange Regime
Capital Account Restrictions
The koruna is pegged \t' the dcutschc mark (65%)
and the dollar (35%). '."he market \'alue of the
koruna is established in a daily fixing session by the
Czech National Bank an<l domestic interbank foreign
exchange market participants, and is allowed to
fluctuate by plus/minu~ 7. 5°.·o around a central rate
based on international exchange rates. The band was
widened from 0.5% on February 28, 1996.
INFLO\iV: There are no restrictions on equity
participation in the Czech Republic by non-residents. The
authorities allow direct investments bv residents of EU
member countries without a foreign -exchange lice.be, but
require that in.\,estments be reported. Czech companies
may accept credits from non-resident bariks. Foreigners
may buy up to 10% of Czech banks before obtaining a
central bank license. Restrictions remain on purchases of
real estate by non-citizens.
OUTFLOW: Czechs are allowed to purchase real estate
abroad and make direct investments abroad. Remaining
restrictions include a ban on the purchase by Czechs of
foreign stocks, restrictions on proYision of credit to
non-residents (outside of credits from the statl', thosl' ,,·1th
a term of over fiye years, for the purpose of direct
inYestment, or between persons), and restrictions on th.__issue of foreign securities on the Czech market.
Authorities are working toward full convertibility.
The koruna has been fully convertible for current
account transactions under the IMFs Article VIII
guidelines since Octoher 199).
Hungary
The forint is pegged to the ECU (70%, to be
replaced by the deutsche mark in 1997) and the
dollar (30%). As part of an austerity package
introduced in March 1S95, the forint was devalued
by 9 percent and a crawling peg system of
devaluation was introduced, devaluing the forint by a
total of 26 percent in I 995. The forint is allowed to
fluctuate by plus/minus 2.5% around the central
rate.
The forint has been cmwertible for current account
transactions in line with IMF Article Vlll guidelines
since January 1996.
Poland
The zloty is pegged to the dollar (45%), the deutsche
mark (35%), the pound sterling (10%), the French
franc (5%), and the Swiss franc (5%). The central
exchange rate is adiusted under a crawling peg
system, and since May 1995, the zloty has been
allowed to fluctuate by plus/minus 7% around the
central rate. In Decem 1)t'T 1995, the authorities
revalued the zloty by 6 percent.
INFLOW: Hungarian financial institutions must report
foreign short-term borrowing. Foreigners may purchase
Hungarian bonds, but licenses are required for original
maturities under 1 year. Under the foreign exchange code
introduced in January 1996, long-term foreign capital
inflow is unrestricted, and non-residents may pun use
Hungarian real estate with some restrictions.
OUTFLOW: Most credits granted to foreigners are
limited to maturities of under six months. Hungarians
must obtain a license for direct investments abroad.
Foreigners who earn forints from exports of goods or
services to Hungary may freely invest their earnings in
Hungary or convert them to h~rd currency and repatriate
them. Foreigners may repatriate inYestments at any time.
Some OECD companies may issue equity in Hungary with
a Securities and Stock Exchange Commission license.
INFLOW: As of April 1996, no restrictions remain on
foreign direct investment. Foreigners may freely inYcst in
securities with maturities of more than one year, but
restrictions apply on shorter~term instruments.
OUTFLOW: As of April 1996, no restrictions remain on
foreign direct investment.
The zloty has been com·ertible for current account
transactions under the JMF's Article Vlll guidelines
since June 1995.
Sources:
J.i". Morgan, Girocredit, Financial Tim<.>s, Reuters, Czech National Bank, Exchange Arrangements and Exchange Restrictions Annual Report 1995,
25
Were the Czech government to lift its prohibitions against allowing domestic borrowers to issue
short-term debt denominated in hard currency, a greater pool of foreign investors might be
attracted to the local market, prompting the development of a secondary market. 52
Finally, new investment funds geared to attracting foreign investment have been formed in
recent years. One such fund in Hungary, capitalized at HUF 330 million ($2.6 million), was
launched by the Austrian bank Creditanstalt Bankverein. In addition, two local Czech brokers
have also launched similar funds geared to attracting foreign participation. 53 By early 1996, plans
were in place by the Templeton Fund to raise $300 million to invest in Central and Eastern
European government debt instruments."
Equities
Portfolio investment through equities takes place when non-residents purchase shares in
the stock exchange of a foreign country or when private or publicly owned firms issue shares in
the international markets or the domestic market of a single country through the use of global or
American depositary receipts. To date, the bulk of activity in portfolio investment through
equities for the Central and Eastern European countries has taken place through non-resident
direct purchases in the stock exchanges of these countries rather than through the issuance of
shares in the international markets by firms in these countries." As privatization efforts proceed,
however, and firms continue their necessary restructuring, equity investment is likely to grow
52
Business Eastern Europe, September 4, 1995, p. 7.
53
Wall Street Journal Europe, Central European Economic Review, February 1995, p. 32.
54
"Debt fund planned for central and eastern Europe," Financial Times, January 12, 1996.
"European Economy, p. 5.
26
markedly. A stronger corporate profile will not only enhance the attractiveness of these countries'
stock markets to foreign investors but also make firms seeking to issue shares abroad more
"
appealing. Foreign interest in these equity markets has been facilitated by the inclusion
of these
countries in emerging market indices over 1995 and 1996. 56
Foreign Purchases of Shares in Czech, Polish, and Hungarian Markets
The striking growth in emerging market mutual funds, which numbered some 900 by the
end of 1994, has made direct purchases of shares in developing country stock markets an
increasingly important source of portfolio investment over the 1990s. Mutual fund purchases of
developing country equities are estimated to have grown from almost $6.5 billion in 1990 to over
$58 billion in 1994 when despite turbulent market conditions in many developing countries, these
funds continued to grow rapidly. 57 According to market participants, virtually all mutual funds
today hold investments in Central and Eastern Europe, compared with only 68 percent in 1991. 58
As for the countries to which equity funds are directed specifically, the IMF lists only one,
Hungary. By the end of 1994, it reports, there were three closed-end equity funds for Hungary
with a combined net asset value of $200 million. 59 Because many mutual funds combine both
equity and bond holdings and are global or regional in focus, it is impossible to reach a
"Emerging-Nation Markets to Receive Big Lift from New Indexes Created by World Bank
Unit," The Wall Street Journal, June 20, 1996. "Elusive benchmark of emerging markets,"
Financial Times, July 15, 1996.
56
57
IMF, Private Market Financing. November 1995, p. 26.
Joyce Chang, "Looking for Value Outside of Latin America, Salomon Brothers Emerging
Markets Seminar, New York, August 15, 1995, p. 6.
58
9IMF, International Capital Markets, August 1995, pp. 48-51.
5
27
comprehensive estimate of the amount of equity they hold in any given country.
Nonetheless, the booms in the Czech, Polish, and Hungarian equity markets, particularly
from the second half of 1993 until early 1994 and again in 1996, clearly suggest a significant
presence of foreign investors (Chart 12). The Budapest Stock Exchange, for example, estimates
that foreigners, mainly institutional investors, account for between 50 percent to 70 percent of the
exchange's turnover and investments. 60 In the Polish market, foreigners are estimated to account
for about 25 percent of turnover and 20 percent of market capitalization. 61
Some have argued that increased equity investment in the region largely reflects the resale
to foreigners of stocks received by domestic residents during the mass privatization of state
enterprises in 1991 and 1992. 62 This observation appears to be particularly relevant to the Czech
Republic, whose stock exchange opened in April 1993, just prior to the completion of the first
wave of privatization in May 1993. By the fall, local mutual fund managers reportedly began to ·
offer blocks of shares to international fund managers once it became apparent that the holdings
were relatively inexpensive, especially when compared with Polish shares, at a time when
prospects for the Czech economy looked relatively favorable. 63
The performance of stock markets in these countries to date has been anything but
predictable. After registering huge run-ups in 1993, stock markets in Hungary, the Czech
Republic, and Poland pulled back, often unevenly, over the course of 1994 as increases in U.S.
~udapest Stock Exchange, "Five Years of the Budapest Stock Exchange," June 1995, p. 6.
61
European Economy. pp. 6-7.
62
Calvo, "Capital Flows in East and Central Europe, 11 p. 17.
63
CS First Boston, Czech Stock Guide 1994, January 1994, p. 5.
CHART 12
INDICATORS OF STOCK MARKET PERFORMANCE
STOCK MARKET INDICES IN DOLLAR TERMS
9/ 1/93=100
40(1 , - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,
Czech Re rnblic
350
30;
25 I - ·
15IJ
1011
.
50 L - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ~
9/93
1196
1/95
1/94
STOCK MARKET INDICES IN DOLLAR TERMS
9/'7/93=100
40', , - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,
35
>
25':
201'
S&P 500 \
15(,
100
•
,..,,,.
nC>,•
~::..~~~-·-··,.,~~
Nikkei 500
5,L.---------------------------------~
9/93
1 /94
I /95
1 /96
Sources: Datastream, PlanEcon, Bloomberg, Reutrr.~.
28
interest rates beginning in February made returns on these investments relatively less attractive
and domestic demand slackened. From where it stood in February 1994, the Prague stock market
had lost two-thirds of its market value by the fall of 1995, while the Warsaw market also suffered
a major decline. 64 In Budapest, the stock exchange fell to a fifty-two-week low in January 1995
and gradually moved up over the year, but at a considerably reduced level. By early 1996,
however, after two years of strong export-led growth and privatization programs actively under
way in both Hungary and Poland, most of these markets had begun to turn around, with markets
in Poland, Hungary, and the Czech Republic all registering gains ranging from 41 percent to
49 percent in the first quarter of 1996. 65
The resurgence in equity markets in the region led Europe's largest independent fund
manager, Mercury Asset Management, to launch the first equity fund for Central and Eastern
Europe in January 1996. The open-end fund, based in Luxembourg, plans a capitalization of
DM 30 million-40 million ($20 million-$30 million) and to allocate roughly 70 percent of its funds
to Poland, Hungary, and the Czech Republic. 66 In addition, in mid-1996, an affiliate ofDeutsche
Bank, DBG Eastern Europe, launched a private equity fund, capitalized at Kc 900 million
($32.7 million), to provide development capital to companies in the region. The aim of the new
fund is to provide finance for management buy-outs and buy-ins, acquisitions and joint ventures,
64
"Eastern European Stock Markets Start to Attract Notice," New York Times, October 6,
1995.
65
"Market Place," New York Times, April 5, I 996.
66
"Eastern Europe fund from Mercury," Financial Times, January 18, 1996.
CHART 13
INDICATORS OF STOCK MARKET PERFORMANCE
M, !<.KET CAPITALIZATIO:\
DAILY MARKET TURNOVER
USs llillion~
USS Milliom
25 - - - - - - - - - - - - - - - - - - - - - ~
60
20
so
S20 S20
S46
40
IS
s33
30
10
20
~i
-
t
~
0I
s
Czct·h Rcpuhl1c
~
S:
s3
'4
S4·
~
~
Cn·ch Rcpublit
Poland
Hungar:
Hungar:,
Poland
PRICE/EARNINGS RATIOS
2S
20
'
IS
Poland,
10
~
- ....._·-......
·~;;;.;:;:··············~•• •• , •• :.:.··::··~··::.······
1993
1994
1995f
Sourcf's: Creditanstalt Central European Quarterly {data and forecasts), Bloomberg, Reuters
29
and improvements in the quality of earnings and management. 67
In looking at the performance of the equity markets in these countries, it is useful to bear
in mind how very recently they have come into operation and how. very much still needs to be
done to strengthen not only the markets themselves but also the banking and financial systems of
which they are integral parts. 68 The Prague market opened in April 1993, the Warsaw market in
mid-1992, and the Budapest market in June 1990. There is little dispute that these markets lack
breadth and liquidity, making any large-scale trade impossible to execute without significantly
moving the price of the stock. Problems and glitches abound.
Hungary
The Hungarian market listed only forty-eight stocks as of August 1996 and, although in
operation longer than either the Czech or Polish exchange, continues to have a smaller market
capitalization than either of these countries (Chart 13). Because of political differences
surrounding the country's privatization process, only a handful of major privatizations were
effected for a good part of 1995, the first major one being the successful offering of shares in July
1995 in OTP Bank, the national savings and commercial bank. However, the government's
renewed commitment to an active privatization program in the fall of 1995 and its unexpected
success in exceeding its goals led, for example, to a sharp increase in the market capitalization of
its stock exchange. This rose from less than $2.6 billion in October 1995 to $3.3 billion by
67
68
"Fund set up for central Europe," Financial Times, May 17, 1996.
More formal statistical analysis is required to assess the performance of these markets fully.
In broad terms, the IMF has found evidence of volatility spillovers from U.S. markets to emerging
country stock markets and has determined that these spillovers are strongest when portfolio flows
have been most volatile. IMF, International Capital Markets, August 1995, p. 119.
30
February 1996 and $3.8 billion by May. Daily turnover also increased dramatically, averaging
about $5 million by May 1996, over four times the average daily figure for 1995. 69
Over the past two years, the Hungarian government has undertaken some specific steps to
help strengthen the country's stock market. In 1994, it established a fully operational
clearinghouse and share depository that has reduced settlement time on trades. An efficient
settlement system can help to improve surveillance and regulatory control, thereby contributing to
investor confidence and increased cross-border transactions. 70
During March 1995, the government took two additional steps to improve the breadth and
transparency of the Budapest Stock Exchange. First, it opened an unregulated market (UM) that
is able to use the regular stock exchange facilities after official trading hours. The UM market,
which was formed by the agreement of thirty-three stock exchange members, is not official;
listing, disclosure, and trading requirements do not apply to the stocks traded there. Since
opening, eleven stocks have been admitted and trading has been sporadic. Second, the
government allowed trading in certain derivative products to take place on the Budapest
exchange, with a total of five contracts made available. 71
Investor confidence in Hungary has been boosted in 1996 not only by the measures the
government has taken to improve the country's stock exchange but also by the improved
performance of the economy, including renewed growth and declining inflation, the introduction
of currency convertibility in January, the approval of an IMF $387 million standby in March, and
69
Creditanstalt, Central European Quarterly, 11/96, p. 30.
°1MF, Private Market Financing. March 1995, p. 32.
7
71
Creditanstalt, Central European Quarterly. 11/95, p. 19.
31
acceptance as an OECD member at the end of March, the second ex-Soviet bloc country to be
admitted. Continued strengthening of the stock market is likely with the privatization ofTVK, a
chemical producer, which is expected to be the largest equity offedng from the region after MOL,
the Hungarian oil producer, and the decision by Cofinec, a central European packaging company,
to become the first non-Hungarian firm to seek a listing on the Budapest Stock Exchange. Both
of these equity issues promise to attract a wide range of investors, boosting the Hungarian market
even further in 1996. 72
Poland
Like its Hungarian counterpart, the Polish stock exchange has also suffered from
comparative thinness. As in Hungary, this situation has begun to change in 1996, driven by strong
economic growth, the persistent influx of foreign capital, and the implementation of the mass
privatization program in mid-1995. With only forty shares listed in October 1995 and a market .
capitalization of roughly $4.3 billion, the Polish stock exchange had fifty-eight companies listed by
August 1996 and a market capitalization of over $7.0 billion. Still, the size of Poland's stock
exchange is almost three times smaller than that of the Czech exchange while the size of its
economy is almost four times larger. After almost four years of trading, there are few open-end
mutual funds, the main one being the Boston-based Pioneer Group's Pioneer First Polish Trust
Fund, which began operations in July 1992.
Domestic restrictions on fund activities--rather than market concerns--have tended to hold
back the development of funds. Until 1996, Polish residents were prohibited from holding any
investments abroad. This meant that mutual funds could invest only in domestic securities, which
72
"Hungarian share issue well-received," Financial Times, July 9, 1996.
32
until the end of 1995 comprised fewer than fifty stocks and a small array of government debt
issues. Moreover, a regulation requiring trust funds to employ at least two licensed investment
advisers in a country where only twenty-two had been licensed as of early 1995 made new
applications for setting up funds scarce. 73
Further, until the middle of 1995, the Warsaw Stock Exchange tended to be dominated by
retail investors, who began to leave the market after heavy losses in 1994. Domestic institutional
investors, such as banks and insurance companies, were mostly absent, as were foreign investors,
who were largely deterred from entering the market between 1994 and mid-1995, owing in part to
uncertainties stemming from political tensions between the president and the parliament.
With the government's decision to implement its mass privatization program in May 1995,
these factors began to change. By year-end, shares in over 400 companies were added to the
Warsaw Stock Exchange, a development that clearly contributed to improving the market's
liquidity. Driven by strong foreign interest, in part resulting from 7 percent real .growth in 1995 as
well as sharply declining inflation, the Warsaw exchange saw its average daily turnover catapult
from as low as $21 million in late October to over $46 million by May 1996. Moreover, the
National Investment Funds are expected to help stimulate corporate restructuring by deepening
the stake each fund has in the success of the companies in its portfolio. This too should add to
foreign interest in Polish equities. In addition, Poland has the most stringent disclosure
requirements of all countries in the region, obliging companies listed on the exchange to report
not quarterly, as is typical elsewhere, but monthly. A new securities law in 1995, which
73
Wall Street Journal Europe, Central European Economic Review, February 1995,
p. 32.
33
establishes strong penalties for securities offenses, such as the falsifying of information in
prospectuses, has also helped improve investor protection rights. 74
Foreign involvement in the Warsaw Stock Exchange shoulcj deepen further by the decision
of the government in early 1996 to allow foreigners to sell investment fund units, stocks, and
securities with a maturity of more than one year up to an overall total of ECU 200 million
($250 million) after obtaining permission from the Polish Securities Commission. 75 In addition,
domestic residents are expected to be able to widen their portfolios, particularly toward the
manufacturing sector, as soon as their certificates have been exchanged for shares in the fifteen
National Investment Funds in 1997 and traded in an organized market. 76
The Czech Republic
The Czech stock market, by contrast, faces a rather different set of problems as it
struggles to cope with over 1,700 listed stocks as of March 1, 1995, following the completion of
the second wave of voucher privatization in February. With a market capitalization of over
$20 billion by May 1996--the region's largest--and an economy whose performance would suggest
that the stock market should be strong, the Prague Stock Exchange faced notably slack demand
for most of 1995. This was true as well for the market created at the same time for small
investors, called the RM system. In large part, the sluggishness of these markets stemmed from
the absence of a significant foreign presence in an environment characterized by inefficiency,
fragmentation, and a lack of transparency. This situation began to change in 1996, as foreign
74
IMF, Private Market Financing. March 1995, p. 32.
75
"Poland to ease capital flows," Financial Times, March 28, 1996.
76
Creditanstalt, Central European Quarterly. 11/96, p. 37.
34
investors returned to the stock exchange and were mainly responsible for the market's upward·
surge in the first half of 1996. 77
Nonetheless, market activity continues to be dominated by_a handful of regularly traded
companies--CEZ, SPT Telecom, and Komercni Banka--which account for more than
55 percent of the market's turnover (bonds account for 25 percent) and 57 percent of its
capitalization. On average, only 677 issues trade daily, which is no more than 40 percent of the
total 1,700 companies listed. 78 Added to these difficulties is the fact that voucher privatization
basically created a large and fragmented body of shareholders but no active investors. The fifteen
largest investment funds manage an estimated 40 percent of the assets distributed; many of these
funds are owned by the country's major banks, which remain largely state-owned. 79
In addition,• the bulk of share trading, 80 percent by some estimates, takes place outside
the organized exchanges in over-the-counter markets, in part because settlement time is faster and
in part because prices on the official exchanges are not allowed to fluctuate by more than a
specified amount on any trading day. 80 Thus, public prices bear little relation to over-the-counter
trades, leading to a serious lack of transparency that keeps away many domestic as well as foreign
investors.
77
Creditanstalt, Central European Quarterly, 11/96, p. 25.
78
Creditanstalt, Central European Quarterly, 111/95, p. 11.
7!'J>ier Luigi Gilibert and Alfred Steinherr, "Changing Investor Base, New Instrument and the
Adjustment Process in the Emerging Markets Crisis of 1994-95," Conference on Private Capital
Flows to Emerging Markets after Mexico, Institute oflnternational Education and the Oesterreich
National Bank, September 7-9, 1995, p. 7.
°Czech National Bank, The CNB Monthly Bulletin, No. 8, 1995, p. 4.
8
35
These weaknesses have convinced market participants and the authorities of the need for
changes. In a fall 1995 initiative, intended to encourage market transparency, a group of
brokerage firms agreed on a voluntary code committing them to report over-the-counter trades on
a daily basis. In addition, in September 1995, the authorities introduced new measures to limit the
number of stocks that can be listed on the main exchange and to improve disclosure requirements
for all traded stocks. The plans call for a primary and a secondary exchange for listed stocks, plus
a third exchange to function as a free market. Whether a company is listed on one of the main
exchanges depends on the volume and amount of its shares that are traded publicly. Investment
funds, too, are subject to similar requirements. Reporting requirements are far stricter for
companies and funds that trade on the primary exchange, although disclosure requirements are
imposed on all. Any company that fails to fulfill these conditions may be transferred to the free
market. 81
The authorities put in place two additional initiatives in early 1996. The first was the
introduction of continuous trading on the Prague Stock Exchange of the exchange's five most
liquid shares (SPT Telecom, Komercni Banka, CEZ, Ceska Sporitelna, and Komercni Banka
Investincni Fund). This measure, which had been planned for over a year, is intended to facilitate
market liquidity and may be followed by continuous trading in other issues before year end. 82
In addition, planned improvements in investor protection laws, which, among other things,
require disclosure of those holding more than IO percent in any company were also put in place in
81
Creditanstalt, Central and Eastern Europe, Monthly Market Review, July 1995,
pp. 2-3.
82
Creditanstalt, Central European Quarterly. IU96, p. 25.
36
April, when parliament approved an amendment to the country's securities act. Among its other
provisions, the new legislation requires companies listed on the Prague exchange to publicize their
annual results within three months after the end of their fiscal year.at the latest as well as to
provide semi-annual reports. Broadly, the legislation is intended to strengthen foreign confidence
in the Czech markets and boost their transparency, which has lagged that of both the Polish and
Hungarian markets." Still left unaddressed, however, is the fact that most trades on the Prague
Stock Exchange continue to take place outside the official markets, so that prices on the exchange
often vary widely from those investors are paying. 84
In addition to its disclosure and investor protection requirements, the new securities
legislation also provides for the possibility of transforming investment funds into different types of
companies. Investment funds may not hold more than 20 percent of their assets in any one
company. But if these funds elect to become managerial companies, which they may now do with
the consent of three-quarters of their shareholders, they may be permitted to acquire majority
stakes in Czech companies and, for the first time, to manage the assets of pension funds. This
means as well that they are no longer subject to investment fund regulations and oversight by the
ministry of finance. The new legislation took effect July 1."
As early as the fall of 1995, it was clear that foreign investors had begun to take note of
some of these prospective stock market changes. In October, a U.S. investor opted to invest
83
1bid., p. 25.
84
"Czech capital markets performed," Financial Times, April 26, 1996.
"The Czech Republic, The Second Time Around," The Banker, February 1996, p. 43;
"Czechs plan tighter bourse rules," Financial Times, April 9, 1996.
85
37
$140 million through a newly created investment fund, the Stratton Fund, which contributed
importantly to the market's liquidity and was intended to give fresh impetus to corporate
restructuring. 86 Moreover, in December, Bankers Trust, in an arrangement with Ceska
Sporitelna, bought a forty percent stake in two Czech voucher funds, paying Kc 6. 7 billion
($252 million) in notes due in 2000, making this investment the largest single investment in the
region's equity markets. 87 Finally, two principal U.S. investors in the Czech market agreed in July
1996 to create a joint investment vehicle targeted not just at Czech companies, but also at others
in the region. With a net worth of roughly $1.4 billion, the new company, Daventree, plans to
seek stakes of more than fifty percent in companies in the region, before restructuring and selling
them. 88
Issues of Czech, Polish, and Hungary Shares in Foreign Markets
Another source of equity flows, although far more modest than direct purchases by
foreigners, has been the issuance of shares in foreign markets by Hungarian, Polish, and Czech
firms between 1990 and 1994. Available IMF data show that Polish firms raised $1 million in
1993 and Czech firms $10 million in 1994.
Hungarian firms have been far more active. They issued shares abroad totaling over
$400 million between 1990 and 1994, roughly half of which were placed in 1994. The greater
amount of share issuance abroad by Hungarian firms is explained in large part by the fact that
16
"U.S. investor revives Czech stocks," Financial Times, October 23, 1995.
87
"Bankers Trust to sell Czech shares to Western funds," Financial Times, December 18, 1995.
88
"Bermuda businessmen link to fund Eastern European groups," Financial Times, July 9,
1996; and "Investment marriage made in the Bahamas," Financial Times, July 10, 1996.
38
most securities listed on the Budapest exchange also trade in markets outside Hungary, primarily
in Austria, Germany, and the United Kingdom. Of the forty companies listed on the Budapest
Stock Exchange in March 1995, twenty-eight were also listed on foreign exchanges, accounting
for 91 percent of the Budapest exchange's total capitalization at the time. In addition, foreign
ownership accounted for 57 percent of the capital held by these twenty-eight companies, and in
some of these companies it exceeded 90 percent. A few Hungarian shares also trade in the United
States. 89
As for recent activity, the Czech Republic's Komercni Banka offered $32 million in nonvoting depositary receipts to international investors in May 1995, 90 and made available a second
tranche a year later, bringing to $140 million the total of the bank's shares held in global
depositary receipts.9 1 Another Czech bank, Ceska Sporitelna, raised $48.5 million in early June
1996. 92 Two large Polish companies, Optimus and Mostostal Export raised $14 million in the first
halfof1995 by these means, while Bank Gdanski became Poland's first financial institution to
offer shares to foreign investors through global depositary receipts as part of its privatization. 93 In
July 1995, Hungary's OTP Bank completed an international private placement for 20 percent of
its shares.94
89
"Five Years of the Budapest Stock Exchange," June 1995. p. 6.
90
The Czech National Bank Monthly Bulletin, Number 8, 1995. p. 4.
91
"Komercni banka in further GDR issue," Financial Times, May 13, 1996.
92 "
Ceska Sporitelna raises $48.5 million with GDR issue," Financial Times, June 3, 1996.
93
"Polish bank makes its debut in London," Financial Times, December 20, 1995.
94
"Stake Placed in Biggest Hungarian Bank," American Banker, July 10, 1995, p. 16.
39
CONCLUSIONS
It is not surprising that private capital has only recently begun to flow into the countries of
Central and Eastern Europe. After all, 1994 was the first year since 1989 that all three of the
countries examined here--Hungary, the Czech Republic, and Poland--began to see some of their
liberalization and restructuring efforts bear fruit as each registered significant gains in real growth.
Private inflows allowed the three countries to incur a combined current account deficit of
$16 billion over the 1990-95 period and to accumulate $35 billion in reserves (Chart 14). By
enabling these countries to run larger current account deficits than would otherwise have been
possible, the capital inflows contributed to an improvement in the countries' living standards,
"directly through a greater variety (and higher quality) of imports of final goods and indirectly
through imports of high quality capital and intermediate goods. "95
Nevertheless, as has been widely noted in the literature, capital inflows also bring with
them concerns, one of the most important of which is a potential loss in competitiveness in global
markets owing to real exchange rate appreciation. Of course, countries have a variety of policy
options to mitigate the effects of capital inflows on their domestic economies, but none is without
drawbacks, whether sterilizing inflows, reducing fiscal deficits, or imposing temporary capital
controls.
What is of fundamental concern is how the imported capital is ultimately being used. If
the capital goes to finance current consumption, it fails to contribute to the productive capacity of
the economy and therefore cannot promote growth in the long run. But if the capital goes
primarily to finance investment, there are few reasons for concern, assuming the investment is
95
Calvo, "Capital Flows in East and Central Europe," p. 23.
CHART 14
E):TERNAL POSITION OF EASTERN EUROPEAN COUNTRIES
CZK H REPUBLIC
HUNGARY
LISS Li hon~
USS Billion,
•~-------------------~
4
2
Trade Balance . ·
0
.2
Current Account
: rade Balance
.4
.,,
.r,
!990
1991
1992
1993
\9l)4
l 9<J5c
1990
19%f
1992
1991
]993
1994
1995
]9')61
1990an<l ]99] <lata arl' for C1c·lho-.]0Y,1k1a
:'\ot ·
POLAND
LI'-~ Billion,
4
2
0
-2 -
.
Trade Balance
.4
-Current Account -
.!,
1990
1991
1992
1993
1994
1995
1996f
Trade figures exclude cross-border trade. If included, Poland's
1995 trade and current account balances are in surplus.
IN I ERNATIONAL RESERVES
US: Billion~
20,------------------------------------------,
Poland
✓--
IS
10
s
I
I
Hungary
..:..:.:::.--·- ·- ·- ·::·:;:.••·································
'
I
0
')9()
1991
l91J2
-----
--- ...
1994
]99)
19')6!
Sn .rc-e~: Balance of Payments Statistics, Czech National Bank, National Bank of Hungary, National Bank of Poland, Economist lntelligenc,
Un
1/
Datastream (forecasts;.
40
productively used and improves export-earning capacity. By this means, countries are able to
earn the necessary foreign exchange to service their ongoing borrowing.
To date, the evidence on the uses of imported capital by thr: Central and Eastern European
countries is mixed. Saving and investment rates clearly fell in all three countries in the early years
of the post-Communist economic transformation (Chart 15). This is to have been expected, as
households were obliged to draw on savings to maintain consumption levels or avoid seeing too
sharp a falloff in consumption in the face of widespread cutbacks in state subsidies.
There are indications that investment is beginning to increase, although the levels are still
far below those that prevailed before the transformation process got under way, particularly in the
Czech Republic and Poland. While all three countries currently face gaps between saving and
investment levels--the current account deficit that must be financed with foreign funds--the gap
for Hungary is the most pronounced.
What then should countries do if they wish to preserve the benefits of continued private
capital inflows at the same time as they minimize the costs? The basic policy prescriptions are no
less relevant for the countries of Central and Eastern Europe than they are for other developing
countries. Avoidance oflarge external debt positions as well as attention to other aspects of
macroeconomic stability reduces the risks of investing in these countries. To the extent that these
reduced risks result in favorable credit ratings, countries may find their access to private capital
eased and the price they must pay for it lower.
Structural reform remains crucial as well. Only with an infrastructure provided by a wellfunctioning banking and financial system will capital be allocated efficiently and money flow to its
most productive uses. The amount of work that lies ahead for all countries in Central and Eastern
CHART 15
SAVING AND INVESTMENT RATIOS
CZh -IOSLOVAKIA
HUNGARY
Percent of GDP
Percent of GDP
35
35
r-----------------,
30
25
25
,
20 · ·
Sa,ing
'
--
lnvestmeo.t -- - - ..
20 .. ·
-✓
lnYestment' .,,,,. ., .,,,,.
15
15
1991
1993
1992
10 ' - - - - - - - - - - - - - - - - 1990
1991
1992
1993
1994
1994
POLAND
Percent of GDP
35
30
25
20
''
15
1990
1991
,,
,,
,,
Saving
'
_ _ _ _ _ _ !"'
Investment
1992
1993
1994
Sources: European Economy, International Financial Statistics, EBRD Transition Report
41
Europe in these respects will be a challenge for many years. Progress will require, among other
things, modernization of telecommunications facilities, more efficient payment and settlement
systems, recapitalization and privatization of the banking system, clarification of property rights,
improvements in accounting and disclosure standards and investor protection laws, and
development of sound supervisory and oversight institutions. Measures to boost labor mobility
and improve pension systems are also needed. 96 All of these reforms of necessity require time.
What is most significant is that for Hungary, Poland, and the Czech Republic, the initial steps
seem to be well under way.
The fact that private capital has begun to flow into these countries, despite the many
challenges that they yet confront, is a market vote of confidence in the potential these countries
offer. If the countries, in tum, are able to hold firm to their course and not be swayed or felled by
political backlashes, they stand to be the beneficiaries of potentially substantial inflows of private
capital from abroad for many years to come.
96
See World Bank, From Plan to Market, World Bank Development Report 1996, June 1996.
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FEDERAL RESERVE BANK OF NEW YORK
RESEARCH PAPERS
1996
The following papers were written by economists at the Federal Reserve Bank of New
York either alone or in collaboration with outside economists. Single copies of up to six papers
are available upon request from the Public Information Department, Federal Reserve Bank of
New York, 33 Liberty Street, New York, NY 10045-0001 (212) 720-6134.
9601. Bartolini, Leonardo, and Gordon M. Bodnar. "Are Exchange Rates Excessively Volatile? And
What Does 'Excessively Volatile' Mean, Anyway?" January 1996.
9602. Lopez, Jose A. "Exchange Rate Cointegration Across Central Bank Regime Shifts."
January 1996.
9603. Wenninger, John, and Daniel Orlow. "Consumer Payments Over Open Computer Networks."
March 1996.
9604. Groshen, Erica L. "American Employer Salary Surveys and Labor Economics Research:
Issues and Contributions." March 1996.
9605. Uctum, Merih. "European Integration and Asymmetry in the EMS." April 1996.
9606. de Kock, Gabriel S. P., and Tanya E. Ghaleb. "Has the Cost of Fighting Inflation Fallen?"
April 1996.
9607. de Kock, Gabriel S. P., and Tania Nadal-Vicens. "Capacity Utilization-Inflation Linkages:
A Cross-Country Analysis." April 1996.
9608. Cantor, Richard, and Frank Packer. "Determinants and Impacts of Sovereign Credit Ratings."
April 1996.
9609. Estrella, Arturo, and Frederic S. Mishkin. "Predicting U.S. Recessions: Financial Variables
as Leading Indicators." May 1996.
9610. Antzoulatos, Angelos A. "Capital Flows and Current Account Deficits in the 1990s: Why Did
Latin American and East Asian Countries Respond Differently?" May 1996.
9611. Locke, Peter R., Asani Sarkar, and Lifan Wu. "Did the Good Guys Lose? Heterogeneous
Traders and Regulatory Restrictions on Dual Trading." May 1996.
9612. Locke, Peter R., and Asani Sarkar. "Volatility and Liquidity in Futures Markets." May 1996.
9613. Gong, Frank F., and Eli M. Remolona. "Two Factors Along the Yield Curve." June 1996.
9614. Harris, Ethan S., and Clara Vega. "What Do Chain Store Sales Tell Us About Consumer
Spending?" June 1996.
9615. Uctum, Merih, and Michael Wickens. "Debt and Deficit Ceilings, and Sustainability of Fiscal
Policies: An Intertemporal Analysis." June 1996.
9616. Uctum, Merih, and Michael Aglietta. "Europe and the Maastricht Challenge." June 1996.
9617. Laster, David, Paul Bennett, and In Sun Geoum. "Rational Bias in Macroeconomic Forecasts."
July 1996.
9618. Mahoney, James M., Chamu Sundaramurthy, and Joseph T. Mahoney. "The Effects of
Corporate Antitakeover Provisions on Long-Term Investment: Empirical Evidence." July 1996.
9619. Gong, Frank F., and Eli M. Remolona. "A Three-Factor Econometric Model of the U.S. Term
Structure." July 1996.
9620. Nolle, Daniel E., and Rama Seth. "Do Banks Follow Their Customers Abroad?" July 1996.
9621. McCarthy, Jonathan, and Charles Steindel. "The Relative Importance of National and Regional
Factors in the New York Metropolitan Economy." July 1996.
9622. Peristiani, S., P. Bennett, G. Monsen, R. Peach, and J. Raiff. "Effects of Household
Creditworthiness on Mortage Refinancings." August 1996.
9623. Peristiani, Stavros. "Do Mergers Improve the X-Efficiency and Scale Efficiency of U.S.
Banks? Evidence from the 1980s." August 1996.
9624. Ludvigson, Sydney. "Consumption and Credit: A Model of Time-Varying Liquidity
Constraints." August 1996.
9625. Ludvigson, Sydney. "The Channel of Monetary Transmission to Demand: Evidence from the
Market for Automobile Credit." August 1996.
