Czech and Slovak Republics: Looking for well-heeled partners

Abstract

The Czech and Slovak Republics, freed from the constraints of a communist command economy and liberated from their troubled union, are looking to foreign investors to provide the necessary capital to finance their program of reform and renewal. The Czech Republic optimistically hopes to attract $10 billion in foreign investment over a 5-year period. For Slovakia, expectations are more modest. Of the nearly $2 billion invested from abroad in Czech and Slovak enterprises since 1990, less than 10% has found its way to Slovakia, and only a handful of deals have involved substantial amounts of capital. More has been invested in Prague than in the entire Slovak Republic. To lure foreign capital, Slovakia has offered tax exemptions and holidays to foreign ventures in certain areas of the economy. Slovak officials have said they intend to cut corporate tax for foreign corporations. The Czech Republic has also tailored specific parts of its economic policy to attract foreign capital. The task confronting Slovak leaders in coming months will be to convince foreigners that their republic is economically and politically stable.

As is often the case following divorce, the two new states emerging from Czechoslovakia's dissolution are actively, even aggressively, searching for new partners. Both republics, freed three years ago from the constraints of a communist command economy and now liberated from their troubled union, are looking to foreign investors to provide the necessary capital to finance their programme of reform and renewal.

The Czech Republic optimistically hopes to attract US$10 billion in foreign investment over the next five years. For Slovakia, expectations are more modest. Of the nearly US$2 billion invested from abroad in Czech and Slovak enterprises since 1990, less than 10% has found its way to Slovakia (home to a third of the former federation's population) and only a handful of deals there have involved substantial amounts of capital. More has been invested in Prague than in the entire Slovak republic.

Contrary to some reports, Slovakia appears committed to redressing this imbalance. To do so, the eastern republic, which has long lived in the shadow of the more prosperous Czech Republic and Prague in particular, will clearly need to create a strong, positive image abroad.

Following the June 1992 federal elections, economic and political forecasts for Slovakia were grim. It was widely believed that following independence, the republic's leaders would slow down or bring to a halt many of the radical reforms implemented by their counterparts in Prague. Such a move would cushion Slovak workers and industries from the new and hostile forces of the market economy. Foreign investors' fears of a return to failed central planning were fuelled by reports that Prime Minister Vladimir Meciar's initial cabinet was stacked with former communists. Uncertainties over politics and the economies of both republics caused many interested foreign investors to sit on the sidelines and wait out the storm.

Eight months later, the peaceful separation has been successfully implemented. As the dust settles, it is clear that many initial fears about Slovakia's course were unfounded. Slovak leaders seem intent on proceeding slowly, but they are nevertheless committed to reform. The two republics have vastly different economies and Slovakia's is undeniably the weaker of the two in most areas. Different industries, Slovaks say, need to be revamped and privatized in different ways. Leaders in Slovakia are hopeful that their careful approach will both provide economic stability during the transition to a market economy and reduce the risk of social unrest. It is important that investors do not interpret Slovakia's caution as regressive or anti-reformist.

CRUNCH IN SLOVAKIA

Before the January 1 1993 split, Slovak leaders were united in their dissatisfaction with what was seen as shock-therapy economic reform coordinated from Prague. Now that they are their own helmsmen, however, Slovak leaders have come increasingly to realize that there are few alternatives. The Slovak government intends to aggressively pursue foreign investment. In a broader sense, leaders there are beginning to share the Czech commitment to macroeconomic stability through budgetary and monetary restraint, although their fiscal policy so far seems expansive. They are learning the hard way of the difficulties involved in overhauling an entire economy. And the lesson gets tougher and tougher as the separation places ever-greater stains on the republic's budget.

The costs of creating an independent army, establishing embassies abroad and maintaining a separate currency are immense. Although the data is confusing, some estimates suggest that with the federation's dissolution, Slovakia lost as much as 10% of its gross national product (Kr15 billion or US$450 million) which came in the form of transfer payments and other subsidies from the Czech lands. Whatever the real financial situation, Meciar's government has acknowledged that by itself, Slovakia lacks the means to revive its ailing economy. And it has already has begun borrowing from the Czech Republic.

To lure foreign capital, Slovakia has offered tax exemptions and holidays to foreign ventures in certain areas of the economy. Although Slovaks are still developing their economic plan, they have said they intend to cut corporate tax for foreign corporations. Some say these incentives are not of sufficient duration to be truly significant. Still, there is growing consensus that the government is flexible in discussing arrangements to make business in its territory simpler and more lucrative. A key change this year is that privatization plans will place more emphasis on public auctions and tenders. This will open the process to foreigners, who have been excluded from the closed and complicated coupon voucher privatization scheme used in both republics.

CZECH SOLUTIONS

The Czech Republic has also tailored specific parts of its economic policy to attract foreign capital. Recently, for example, the government lifted import duties on certain types of automotive production machinery, making it less costly for foreigners to bring in the necessary technology to modernize the factories they have acquired. Also important are recent measures that indemnify joint ventures in the automotive sector against liability for environmental damage caused in the past. Such measures should help to alleviate the concerns of some investors, who have been universally wary of inheriting responsibility for environmental devastation under the old regime. Although the scope of these provisions is narrow, they represent government willingness to create solutions to satisfy the concerns of specific foreign investors.

In general, however, the Czech Republic does not offer special financial incentives to foreign investors. With the tax code imposed on January 1 1993 all tax breaks were phased out so that foreign and Czech firms now operate according to the same laws and tax code. As Czech Prime Minister Vaclav Klaus has repeatedly stressed, the government is fundamentally committed to creating a level economic playing field without government intervention.

Perhaps the greatest challenge for both republics in 1993 will be to initiate insolvency proceedings against many poorly performing companies. Once bank credit guarantees are discontinued, and such enterprises are no longer shielded from previously unfelt market forces, many will be forced to close down. After many delays, implementation of the bankruptcy laws is expected in April in the Czech Republic. It is not yet clear when Slovakia will follow suit. In both republics, these measures should ultimately give a boost to foreign investment.

Throughout eastern Europe, it has been difficult for investors to assess the solvency of companies that have never operated in free markets. Enterprises under the old communist system did not operate according to western business notions of efficiency or profitability, making it difficult to predict their future economic performance. This is particularly true as reliable financial data is scarce. Most available records are not in line with western accounting practices. Bankruptcy laws should ultimately create a better atmosphere for the valuation process in both republics.

Inevitably, they will also lead to much higher unemployment, particularly in Slovakia. Some estimates are that the Slovak jobless rate could rise from the current 12% to nearly 20% by the end of 1993. Already, there are regions where the problem is more acute. In the Slovak town of Martin, where tank production was cut in 1990, some 20% of inhabitants may already be without work. In fact, during 1990 and 1991, significant reductions in armament production helped to galvanize popular support for Meciar's nationalist movement. Slovak leaders argued that tens of thousands of the republics's workers were sacrificed by the Prague leadership in a gesture to demonstrate to the west that Czechoslovakia was serious about reform. In the Czech Republic, unemployment currently stands at about 3% but is expected to double by the end of the year.

EASING THE PAIN

Slovakia is likely to ease the pain of bankruptcy proceedings by maintaining credit guarantees to certain state enterprises and state-owned companies. High unemployment would no doubt undermine support for the government. By propping up its industries, the Slovak government is effectively buying political stability.

What's unclear is whether Slovakia can afford it. The government is hopeful that extensions of credit will give companies time and means to restructure their operations. Some of these firms, it is reasoned, may be viable in open markets after such an overhaul and could then be capitalized effectively. Naturally, Czech and Slovak companies cannot adapt overnight to the new market environment, particularly as many are burdened with a heavy debt load resulting from the loss of former eastern markets. To eliminate government support entirely would simply lead to the demise of many of these firms. Skeptics wonder, though, whether such restructuring can work at all.

The Czechs' markedly different approach is to hurry through the privatization process and let the market determine whether companies sink or swim. As Klaus has said, when you are driving through mud, you speed up rather than slow down. Extending subsidies and other support to industry only postpones the inevitable. The Czechs aim to maintain a truly conservative fiscal and monetary policy and express reluctance to give direct support either to investors or to the firms and companies that need it. In practice, though, they too have bowed to political pressure and have continued credit allocations to a number of heavy industrial plants throughout the republic.

To be sure, both sides are approaching privatization carefully, and are more likely to approve foreign proposals for acquisitions and joint ventures that contain certain social and financial guarantees. Particularly important are commitments to preserve employment and retrain workers, to invest in and modernize equipment and to help develop new export markets. Despite their caution, policymakers in both republics realize that the survival of their economies depends on continued privatization, coupled with a steady infusion of foreign capital.

EMBRYONIC SECURITIES MARKETS

One opportunity this year for foreign investors may be available only in the Czech Republic. This month investors, including those from abroad, should be able to freely buy and sell shares in companies privatized through the coupon voucher scheme, which was closed to foreign participation.

In Slovakia, there has been discussion of placing a two-year moratorium on foreign ownership of shares acquired through vouchers. Investment funds (and there are literally hundreds of them, which together manage some three-fourths of all voucher shares in the country) promised clients extremely high returns on initial voucher investments. Many such funds will be strapped for cash in coming years and may need to unload some of their stock portfolios to raise capital quickly and to generate their own cash flow for standard operations.

Stock markets, though open in both republics, are embryonic. On the trading floor in the Czech capital, as the newspaper Prague Post noted recently, paint-splattered boots still outnumber loafers by about 10-1. But even without established securities markets and effective regulatory systems to monitor them, many investment funds have begun trading voucher shares among themselves.

Initially, Germans were by far the largest foreign investors. In 1991, Czechoslovakia's neighbour to the north and west accounted for some 73% of all foreign investment. Volkswagen AG's acquisition in 1991 of the Czechoslovak auto maker Skoda represented close to half of the year's total.

In 1992, the United States, led by Philip Morris Holland BV's purchase of the state tobacco company Tabak a.s., accounted for 29% of all foreign capital. With the purchase by Air France, the country's national carrier, of a stake in Czechoslovak Airlines, the French had a 23% share of the year's total.

Austria has been the largest investor in Slovakia, accounting for nearly a third of all investment there. This is logical because Vienna is a mere 60 kilometres from the Slovak capital of Bratislava.

Foreign investment statistics are incomplete. The Czech National Bank, formerly the State Bank of Czechoslovakia, calculates the figures based on its balance of payments and includes only capital that has actually come into the country. Money that companies have only pledged to invest (which in the case of Volkswagen amounts to some $5 billion) is not included in current investment totals.

TWO STATES, TWO ECONOMIES

Prior to World War I, some 70% of Austo-Hungarian industry was concentrated in the Czech lands. Slovakia, also under Hapsburg rule at the time, was a rural, agrarian part of northern Hungary. Not until Czechoslovakia's founding in 1918 did these dichotomous nations came together.

By 1937, Slovak industrial production was still just 8% of total output, but under communism, Slovakia underwent a massive build-up of heavy industries such as metallurgy and energy. For many such industries, which in the past were highly dependent on eastern export markets, finding new markets may be difficult.

Foreign investors remain interested principally in consumer goods, production of which is more widespread in the Czech Republic. Partly as a result of this, the Czech per capita gross domestic product appears 20% higher than that of Slovakia, although data on the split economy is still sketchy. In any case, there remain plenty of good investment opportunities in both republics, where labour costs are only a fraction of those in the west.

The majority of investment in the former federation has been in the automotive and transport industries. Other sectors of the economy with considerable foreign involvement are building and construction, food and banking and increasingly, foreign firms are participating in tourism-related businesses. Slovaks will be eager to promote their mountains and castles to vacationing westerners, but sorely lack the necessary service industries to accommodate an inflow of travellers.

Even in Prague, visited by some 60 million tourists in 1992, there remains a shortage of hotel and restaurant space, a situation which has led to Komercni Banka, the nation's largest (and now fully private) commercial bank, recently establishing a mutual fund to invest solely in hotels, which will offer shareholders considerable returns on investment. Tourism-related industries collectively make up perhaps the largest sector of the Czech GNP.

The task confronting Slovak leaders in coming months will be to convince foreigners (and Slovak investors as well) that their republic is economically and politically stable. Vague and often inaccurate international reporting has perpetuated the myth of instability, which is alleged not to exist in the Czech Republic. Such reports are very damaging, particularly in an atmosphere that continues to lack well-developed legal systems. Many decisions in the privatization process are based not on a long history of statutes, codes and precedents, but simply according to agreements reached by the parties involved.

Leaders of both republics are beginning to believe the worst of their economic troubles are over. Inflation in 1992 was down to about 11% from close to 50% in 1991. This year, though, with the imposition on January 1 of a value-added tax, inflation has shot up again. GNP continued to fall in 1992, but modest gains are expected for this year. And while industrial production remains at about 75% of the 1990 level, it has bottomed out and is now on the upswing.

There is no doubt, however, that the future growth of both economies will be slow. For years to come, both republics will continue to pay the large bills associated with their separation. It is important that foreigners realize this and view business in either republic as a long-term investment. Products need to be adapted and effectively marketed; new sales markets need to be pinpointed; management needs restructuring; old technology requires modernization; workers need new skills; and capital markets to finance all of this are still developing. These hurdles, though, are surmountable. The population is well educated, and the industrial tradition is strong. The time is ripe for foreign investment.

Milan Ganik is the Managing Partner of the Prague office, and Robert Jillson is the Managing Partner of the Bratislava office, of Squire, Sanders & Dempsey. Robert Milius is a legal assistant in the Prague office.