Chapter 11 Outline

Closing Case The Search for Capital in the Czech Republic

Following the collapse of communism and the shift toward a more market-oriented system, the Czech Republic initially emerged as one of the more vibrant and market-driven economies in Eastern Europe. By early 1998, however, the economic development of the Czech Republic was being held back by a shortage of capital. The problem was rooted in macroeconomic conditions and institutional problems.

On the macroeconomic front, 1997 saw a combination of adverse developments, including a rise in inflation, a growing government deficit, and a speculative attack on the Czech currency that forced the government to abandon its fixed exchange rate policy for a floating exchange rate system. After the shift to a floating exchange rate system, the Czech currency declined by about 10 percent against the German deutsche mark and over 15 percent against the US dollar. Since many internationally traded commodities, such as oil, are traded in dollars, this devaluation added fuel to the Czech Republic's inflation rate fire. The government responded by tightening monetary policy, raising interest rates to around 16 percent.

These macroeconomic problems had a predictably negative effect on the Prague stock market. The PX50, the key index of Czech shares listed on the Prague exchange, declined from around 520 to a low of 430 by June 1998. Much of the decline was due to foreign investment capital leaving the country for more attractive investment opportunities in neighboring Hungary and Poland, where macroeconomic conditions were more favorable and where local stock markets were performing better.

But that wasn't the only problem for the Prague stock market. Many Western investors had been discouraged from investing in Czech stocks by the poor reputation of the Prague stock exchange. That institution is reportedly rife with stock manipulation by insiders, insider trading that would be illegal in more developed markets, a lack of protection for minority stockholders, poor corporate reporting, and fraud. Also, most state-owned enterprises in the Czech Republic were privatized through a voucher scheme that has left the majority of shareholdings in the hands of institutions and groups that are preoccupied with maintaining control over their companies and opposed to any attempt to raise capital through new equity issues. Consequently, the Prague stock market is small and liquidity is very limited.

These factors have combined to increase the cost of capital for individual Czech enterprises. Traditionally, many Czech firms forged tight relationships with banks and borrowed money from them. However, with interest rates at 16 percent and many banks reining in credit to make up for past largesse, it was increasingly expensive for Czech companies to raise capital through borrowings. As for the Czech stock market, its poor reputation and low liquidity made it almost impossible to raise capital by issuing new shares. In mid-1997, one of the Czech Republic's most dynamic and profitable new enterprises, Bonton, a film and music company, attempted to raise $30 to $40 million through an initial public offering on the Prague exchange. This would have been only the second IPO in the history of the Prague exchange, and the only one of any significance.

A successful IPO would have helped to legitimize the market, but Bonton canceled the IPO when the Prague market declined to yearlong lows in the wake of the Asian financial crisis.

Despite all these problems, most agree that the Czech economy has a bright future. However, this future cannot be realized unless Czech companies can raise the capital to invest in the necessary plants and equipment. A number of prominent Czech companies in 1998 announced their intentions to make international equity issues. At the beginning of 1997, only two Czech companies had foreign listings, both of them large banks. However, another five significant companies sought listings on the London stock exchange in 1998. In a sign that this strategy may work, the first to list was Ceske Radiokomunikace, a state-owned radio, television, and telecommunications company that successfully raised $134 million in equity by listing Global Depository Receipts on the London exchange, increasing its equity by 36 percent and decreasing the state holding in the company to around 51 percent.

http://www.henge.com/~vspina/index.shtml

Source: R. Anderson, "Czech Groups Cast Their Net Abroad in Search of Funds," Financial Times, May 26, 1997, p. 27; V. Boland, "The Czech Stockmarket: Looking Beyond Recent Turmoil," Financial Times, December 1, 1997, p. 4; and "Ceske Radiokomunikace Equity Offer Raises $134 million," Financial Times, May 27, 1998, p. 38.

Case Discussion Questions

1. What are the causes and likely consequences of the capital shortage faced by Czech firms? How does the capital shortage affect the cost of capital in the Czech Republic?

2. How will selling equity to foreign investors benefit Czech firms and the Czech economy? What would happen to the Czech economy if Czech firms were prohibited from accessing the global capital market? Can you see any drawbacks with the strategy of selling equity to foreign investors?

3. Why is it easier for Czech firms to execute an IPO in London than in Prague?

4. If Czech firms continue to raise capital through foreign equity issues, ultimately more than 50 percent of the equity of these firms will be owned by investors based outside the Czech republic. If and when this occurs, will these still be Czech firms?