The New Capital Markets in Central and Eastern Europe - European ...

The New Capital Markets in Central and Eastern Europe - European ...

The New Capital Markets in

Central and Eastern Europe

Final Report

Mannheim, January 28, 2000

Head of the Project Team: Dr. Michael Schröder

P.O. Box 10 34 43, D-68034 Mannheim, Germany

Tel.: +49/621/1235-140, Fax: -223,


Centre for European Economic Research /

Zentrum für Europäische Wirtschaftsforschung

(ZEW) GmbH, Mannheim, Germany


It is the aim of this study to assess the effects of the EU enlargement on the capital

markets in the most advanced countries of Central and Eastern Europe (CEE) and

Russia and to analyse the impacts on the interactions between Eastern and

Western capital markets due to the integration process. Therefore, this study

should be particularly useful for financial analysts, institutional investors and

academic researchers who are interested in the economic and institutional

developments of capital markets in CEE countries and are looking for a thorough

and comprehensive analysis of the future perspectives of these capital markets.

Since the collapse of the communist regimes about ten years ago the CEE

countries are in a transition period from a command economy to a marketorientated

economic system. Capital markets and the banking system are the major

intermediaries that allocate savings and investments in market economies. Under

the communist regime capital markets and banking institutions as we know them

in Western economies did not exist. The transition in the field of capital markets

and banks therefore had to start almost from scratch. Although the capital markets

of some of the CEE countries have developed quite positively they are still in an

early stage.

The European Union has opened negotiations for EU membership in early 1998

with five CEE countries, the Czech Republic, Estonia, Hungary, Poland and

Slovenia. In autumn 1999 the group of CEE countries involved in the negotiations

for EU membership has been enlarged by Bulgaria, Latvia, Lithuania, Romania

and Slovakia. The negotiations with some of the CEE countries have already

reached a stage that makes entry into the EU in the next few years very likely. The

joining countries have to adopt the whole acquis communautaire, which represents

the legislative framework common to all EU members. Important parts of the

acquis communautaire e.g. the liberalisation of capital movements, European

Monetary Union, the free provision of bank and non-bank financial services and

new rules for prudential supervision directly and indirectly affect the behaviour of

the financial sector and the functioning of capital markets. As the capital markets

are an important determinant and essential part of the whole transition process it is

of major interest to analyse how the CEE capital markets are affected by the

integration process into the EU.

The CEE countries included throughout this study are the former so called firstwave

candidates: the Czech Republic, Estonia, Hungary, Poland and Slovenia.

These countries are relatively advanced in approaching EU membership and

within the group of CEE countries these countries have the most developed capital

markets. In most chapters we also analyse Slovakia which is the most advanced


country of the formerly second-wave group. In some chapters also other Eastern

European countries are included. In addition, Russia is part of our analysis,

because the economy and the capital markets of Russia as well as the interactions

between Russian and CEE financial markets could be strongly affected by the EU

enlargement process.

The markets analysed in the study are the markets for equity and bond securities.

The markets for bank loans, financial derivatives and currencies are also

considered. As markets for financial derivatives are underdeveloped in CEE

countries, these markets naturally play only a minor role in the analysis.

The study consists of two major parts. In the first part (chapters 1 – 5) we evaluate

the current status of the capital markets. We consider the economic factors that

determine the development of the capital markets and investigate the current status

of market structure and organisation including the regulatory framework. A result

from this analysis is the identification of the most important factors that stimulate

or restrict the current and future development of these capital markets. In addition,

we also quantitatively investigate the efficiency of the stock markets and their

interactions. This gives a clear picture of recent developments and the existing

differences to mature Western capital markets.

In the second part of the study (chapters 6 and 7) we investigate the effects that

result from the adoption of the acquis communautaire on the CEE capital markets

and analyse their future perspectives. This second part resumes the findings of the

first part and gives a detailed analysis of the likely changes of the economic and

regulatory framework of the CEE capital markets. Then the effects on the

financial markets and their expected future development are considered, taking

into account the relationships and competition to Western capital markets.

This extensive work programme could only be carried out by a large project team

that combined experienced researchers for each part of the study. Under the

leadership of the Centre for European Economic Research / Zentrum für

Europäische Wirtschaftsforschung (ZEW), Mannheim, 14 researchers from the

ZEW, the Raiffeisen-Zentralbank Österreich (RZB), the Centre for European

Policy Studies (CEPS), Brussels, the University of Erlangen-Nürnberg and the

University of Strathclyde, Glasgow worked together since the beginning of the

project in January 1999 and prepared the final report. During the project three

internal workshops took place in Mannheim and Vienna, where interim results

have been presented and discussed. We have to thank Peter Brezinschek (RZB)

for supporting the study by helpful suggestions and hosting one of our workshops

in Vienna.

Especially we have to thank the European Capital Markets Institute (ECMI) for

the financial support of this study.

Mannheim, January 2000 Dr. Michael Schröder (Head of the project team)


Table of Contents


Table of Contents.............................................................................................................VII

Executive Summary .......................................................................................................... IX

List of Abbreviations..................................................................................................XVIII

1. Economic Background...............................................................................................1

1.1. Macroeconomic Developments and Public Finances................................. 2

(Michael Schröder)

1.2. Success of Privatisation in CEE Countries.................................................21

(Claudia Stirböck)

1.3. Monetary Policy and Banking Systems........................................................39

(Thomas Reininger)

1.4. Exchange Rate Arrangements in Transitional Economies.......................67

(Ronald MacDonald)

2. The Emerging Regulatory Framework for Banking and Securities Markets in

the CEECs ..................................................................................................................85

(Karel Lannoo and Tanja Salem)

3. Market Structures and Developments................................................................. 123

3.1. Main Features of the Markets.....................................................................124

(Anne Benoit, Walter Demel and Thomas Reininger)

3.2. The Role of Institutional Investors in Equity and Bond Markets..........208

(Jens Köke)

4. The Information Efficiency of the Stock Markets in Central and Eastern

Europe ...................................................................................................................... 230

(Jürgen Kähler)

5. Transformation of External Shocks and Capital Market Integration ............ 265

(Ronald MacDonald)

6. Integration in the European Capital Markets..................................................... 279

6.1. The Central and Eastern European Countries on their Way to EU-


(Karel Lannoo and Claudia Stirböck)

6.2. Effects of the Capital Account Liberalisation in Central and Eastern

European Countries........................................................................................286

(Claudia Stirböck)


6.3. Effects of new Exchange Rate Arrangements on CEE Capital Markets.....

(Michael Schröder and Claudia Stirböck) .................................................308

6.4. Public Finance in CEE Countries..............................................................331

(Michael Schröder)

6.5. Future adjustments in the banking systems...............................................342

(Thomas Reininger)

6.6. Effects of the Integration Process on the Capital Markets in Russia...370

(Tereza Tykvová)

7. Outlook and Perspectives: The Future Role of CEE Capital Markets in the

European Capital Markets ......................................................................................... 392

7.1. The Future Role of Capital Markets in Central and Eastern Europe for

the Domestic Economy ...................................................................................396

(Jens Köke, Thomas Reininger and Ronald Schneider)

7.2. Investments in CEE Capital Markets: Benefits from Diversification and

Optimal Portfolios...........................................................................................465

(Michael Schröder)

7.3. Competition between Western and Eastern European Equity Markets......


(Anne Benoit, Christoph Schantl and Johannes Weyringer)

8. Country Summaries ............................................................................................... 500

List of Authors ................................................................................................................ 514


Executive Summary

This summary gives an overview on the main results of the study. More detailed

conclusions can be found at the end of each chapter. At the end of this volume the

country summaries present the major findings separately for each country

analysed in this study.

The study covers the following countries: the Czech Republic, Estonia,

Hungary, Poland, Slovenia and Russia. In most chapters additional CEE

countries, particularly Slovakia, are analysed.

The capital markets covered are equity and bond markets. As the exchange

rate regime has an important influence on the functioning of capital markets,

the currency markets are also analysed. We also include markets for loans and

financial derivatives into our study.

The study consists of two major parts. In the first part (chapters 1 – 5) the aim is to

assess the current situation and major characteristics of the CEE capital markets

(incl. Russia). After the analysis of major macroeconomic developments related to

the capital markets (chapter 1) the analysis continues with the following topics:

the regulatory framework and its future development, the market structures and

the situation for institutional investors, the efficiency of the stock markets as well

as the statistical long- and short-term relationships between Eastern and Western

European stock prices.

In part two (chapters 6 and 7) the focus is on the integration of CEE countries into

the EU and the resulting consequences for CEE capital markets. The major topics

of these two chapters are: future changes in capital account liberalisation and

exchange rate arrangements and their consequences for capital flows, future

developments in the banking system of CEE countries and in the equity and bond

markets, effects on corporate and public finance from the expected entry into the

EU, and the relationships between Eastern and Western securities exchanges.

Part I: Assessment of the Current Situation and the Major Characteristics of

the Capital Markets in CEE Countries and Russia

1. Economic Background

After the strong decrease in GDP in the first half of the nineties most CEE

countries show a remarkably strong growth since the mid-nineties. The

privatisation of small-scale enterprises is mostly completed in all countries while

Poland, Russia as well as Slovenia are less advanced in the privatisation of largescale

enterprises in comparison to the others. The privatisation of the banking

sector is lagging behind in Slovakia, Slovenia and Russia. Foreign investors

usually engaging in direct sales like in Hungary and Estonia seem to have played

an important role in an efficient privatisation.


The CEE countries have chosen different exchange rate arrangements and in most

cases these arrangements allow adjustment of nominal exchange rates with respect

to changes in economic fundamentals. As the CEE countries are still in transition

flexible exchange rate regimes have helped to absorb real economic changes as

well as the effects of the still considerable inflation differentials, particularly

compared to the EU countries. But in the last years the CEE countries successfully

lowered disinflation by a monetary policy which supported their antiinflationary

exchange rate policy targets.

The concept of Purchasing Power Parity (PPP) does not seem to be a suitable

approach for analysing real exchange rates and other approaches of

fundamentally-based equilibrium exchange rates are probably unstable over time

as well. Although such approaches could be successfully used to evaluate the real

value of CEE currencies they have to be updated over time.

It is important for the success of the integration into the EU that most of the CEE

economies show a high level of openness, especially towards the European Union.

The CEE countries, especially Estonia, Hungary, Poland and the Czech Republic

profit considerably from capital inflows of international investors. The high net

liabilities of most CEE countries to foreigners make these countries vulnerable to

sudden outflows of foreign capital, but it also shows the high confidence

foreigners have concerning the positive future economic development.

Nevertheless it should be kept in mind that an unfavourable outcome of the

negotiations e.g. a postponement of the expected EU entry or even a failure could

induce larger capital outflows with the consequence of turbulences on CEE capital

and currency markets.

2. The Emerging Regulatory Framework for Banking and Securities Markets

in the CEE Countries

Ten years after the collapse of communism, enormous progress has been realised

in the Central and Eastern-European countries in putting in place the necessary

regulatory framework for financial markets. The development of the regulatory

set-up for financial markets in CEECs was influenced by the method of enterprise

privatisation chosen and the approach followed in the creation of financial

markets. These varied considerably across countries, and are one cause of the

differences in the regulatory policy priorities of the CEE countries. The prospect

of EU accession has worked as an important trigger for a rapid adjustment of the

regulatory framework. It has helped these countries to successfully withstand the

negative influences from the Russian economic crisis. However, the EU regulatory

framework is designed for a developed market economy. The question emerges

whether the acquis communautaire will not stifle development of financial

markets, and will be too much for the local administrations to absorb. The EU will

very probably not accept significant exceptions in the adoption of the acquis

communautaire because it would create dangerous precedents in the accession

negotiations. Therefore, to make the adoption of the acquis less burdensome to the


joining CEE countries we propose a longer transition period. The outcome of the

accession negotiations and the implications of EU membership for further

development of financial markets is therefore difficult to predict.

3. Market Structures and Developments

The empirical analysis of the performance of CEE equity markets shows that these

markets have been vulnerable to shifts in foreign investors´ opinion on emerging

markets in general, because foreign investors are particularly important

participants in the CEE equity markets. The performance of CEE equity markets

in the period 1996-1999 was superior to that of other regions´ emerging equity

markets. Also the CEE domestic bond markets outperformed other emerging

markets. We find that the fixed-income markets are dominated by government

securities, whereas the corporate bond markets are still very underdeveloped. But

in the future they could play a much more important role as additional source of

corporate finance. Longer-term fixed-income securities are more important than

short-term ones, highlighting the success of monetary stabilisation. As equity and

debt securities markets are dominated by foreign investors and residential banks, it

is a major challenge to the authorities to favour the creation of domestically based

institutional investors and to promote the sale of government securities to nonbanks.

In Western countries investment by institutional investors (e.g. banks, pension

funds and insurance companies) has been growing considerably over the past two

decades. Institutional investors are also active market participants due to their

increasing engagement in corporate governance. Therefore, they might play an

important role in the transition process of the CEE economies. Institutional

investment is still low in the CEE capital markets compared to developed Western

markets but the size of assets under their management is growing rapidly. The

corporate ownership structures indicate that foreigners are mainly engaged

through foreign direct investment. A survey conducted among Western

institutional investors gives some important insights into the determinants and

current obstacles of foreign direct and portfolio investment. Fund managers report

that stability of the legal and financial system, management competency and

market liquidity are the most important criteria for portfolio investment. At the

same time, low managerial qualification, low productivity and low stock market

liquidity still limit their CEE investment. Particularly problematic are also some

country-specific institutional regulations, e.g. weak protection of minority

shareholders and unfair treatment of domestic and foreign investors. Overall,

problems seem to be the smallest in Hungary and Poland, but the largest in Russia.

Among the EU candidates the Czech Republic is plagued by the largest obstacles

to foreign portfolio investment.


4. The Informational Efficiency of the Stock Markets in Central and Eastern


In this chapter the informational efficiency of the stock markets of the CEE

countries and Russia is focussed. The analysis is based on the returns of the

market indices and uses time-series approaches to model the mean process

(ARIMA, Markov-switching models) and the process of stochastic volatility. We

explore the time-series properties of seven CEE stock-market indices: BUX

(Hungary), PX50 (Czech Republic), RTS (Russia), SAX (Slovakia), SBI

(Slovenia) 1 , TALSE (Estonia) and WIG (Poland). The volatility is measured with

an EGARCH model and cyclical patterns are captured by a Markov-switching

model. An ARIMA model is applied to short-run price dynamics and the varianceratio

quantifies the tendencies towards mean reversion. To gauge the extent of

potential market inefficiency, the price dynamics of the CEE stock markets are

compared with those on the London stock market as represented by the FTSE100.

We have found that the volatility of CEE stock markets is very high and varies

systematically over time. In London, volatility is higher in bear markets than in

bull markets and the same can be found for most CEE countries. A notable

exception is Bratislava. The SAX shows higher volatility in market upswings. The

larger volatility of CEE markets is mainly due to the fact that during turbulent

periods volatility increases more dramatically on these markets than in London.

We have also found that at least the stock markets of Poland and Hungary seem to

reward higher risk with higher return.

Another important set of findings relates to the adjustment to news. The randomwalk

model implies that this adjustment is instantaneous and complete. Instead we

have found strong and highly significant first-order and also higher-order

autocorrelation in the CEE index returns. This means that positive return shocks

tend to be followed by positive ones and vice versa. Therefore, there is significant

scope for technical analysis of CEE indices. On the basis of the time-series

properties it appears that there is a lack of informational efficiency. But this

inefficiency could be used by investors to forecast future returns applying methods

of technical analysis and time-series modelling.

5. Transformation of External Shocks and Capital Market Integration

In this chapter the long-run interdependencies and correlations between the

Eastern European stock markets and major Western stock markets are quantified.

The analysis uses a cointegration approach to quantify the relationships between

these markets and to assess how shocks from one market affect the other markets.

The purpose of this chapter is to examine the interactions amongst the stock

markets of the transitional countries and their interaction with key stock markets

1 The SBI is also called SSEI.


in continental Europe and the United States. This objective is achieved using a

vector error correction representation of the stock price indices of six CEE

countries and the stock indices of three mature economies. Amongst our findings

are: 1. the German DAX stock price index has a crucial role in the determination

of the CEE indices, probably due to the close current and capital account

connections between Germany and most CEE economies and 2. the Russian stock

market is shown not to be an important driving variable in any of the systems but

rather passively reacts to developments in other markets. This indicates that

contagion effects from the Russian stock market to CEE stock markets are

unlikely to be pronounced.

Part II: Adoption of the Acquis Communautaire and the Effects on CEE

Capital Markets

6. The Process of Integration in the European Capital Markets

This chapter concentrates on four macroeconomic topics that determine the

functioning of CEE capital markets: the effects of capital account liberalisation,

the effects of new exchange rate arrangements, adjustments in public finance and

changes in the banking sector. Here we resume the major findings of the first part

of the study and evaluate the consequences of the adoption of the acquis

communautaire. In addition, chapter 6 investigates the effects of the EU

enlargement on the economy and the capital markets of Russia.

The Czech Republic and Estonia are very advanced in the liberalisation of capital

movements, whereas Russia and Slovenia, in contrast, have re-implemented some

stronger regulations in a first reaction to the Russian financial crisis. The highest

degree of capital inflows can be found in Hungary, Estonia as well as in the Czech

Republic. Usually, direct investments are higher than portfolio investments,

capital inflows much higher than outflows. However, Russia is marked by a strong

capital flight. Overall, a positive sign is that – as a general development in CEE

countries - loans to the public sector and trade credits, at the beginning of the

transition process the largest part of inflows, as well as the part of public in total

capital inflows are decreasing.

The fluctuations of the exchange rates of the CEE currencies against the euro are

still relatively high, much higher than those of EMU members in the two years

prior to EMU. There is a trend towards nominal devaluation and real appreciation

in most CEE currencies, which is an indication for the still existing need to use the

exchange rate as a shock absorber. As inflation rates are still higher than in the

EU, even though they have approached significantly, flexibility of the nominal

exchange rate is still needed to absorb permanent inflation rate differences and to

identify a fundamental stable exchange rate for the introduction of the euro. For

international investors the currency risk is only of minor importance (with the only

exception of Russia): the total risk of an investment in CEE stock markets is

dominated by the risk of the local stock market and in some countries the currency


fluctuations even reduce total risk due to a negative correlation between currency

and local stock market returns.

For the future exchange rate arrangements in CEE countries we do not recommend

to join EMU quickly. A transition period should be used to achieve monetary and

real convergence and to build up confidence in future exchange rate stability. In

the period before the official EU membership a system similar to ERM II should

be constructed and adopted by most of the CEE countries. Then, after joining the

EU we recommend a membership in the ERM II. The perspective of a future

EMU membership in addition to a monetary policy orientated towards monetary

stability can have very beneficial effects on the transition process.

Most of the CEE countries are relatively advanced in adopting the EU directives

concerning public finance. After joining the EU the CEE countries will have to

stick to the rules of the stability and growth pact which commits them to submit an

annual convergence programme to the EU Council. This will help to increase

macroeconomic convergence but does not restrict national economic policy very

much. Currently all CEE countries are able to meet the public debt criterion of the

Maastricht treaty. And most of them also have budget deficit ratios below the 3%limit.

The only exceptions are Hungary and Slovakia. The Czech Republic,

Hungary, Slovakia and of course Russia have a relatively large external debt.

These countries are therefore vulnerable to a depreciation of their currency. In the

Czech Republic; Hungary, Poland and Russia also a large amount of public debt is

financed abroad. But in all CEE countries, except Slovakia, the actual public debt

seems to be sustainable in the long run. For most CEE countries the availability of

timely and high-quality data on public debt, public sector deficit and especially the

primary surplus is not guaranteed. Therefore, every assessment of the situation of

public debt has to be interpreted with some caution. We strongly recommend to

improve the quality and availability of data on public finance.

Concerning the future development of the banking sector an important influence is

that the central bank’s lending to the public sector will probably decrease strongly

in the near future, whereas the domestic lending to the private sector will further

increase. Moreover, several forces strengthen the expectation that foreign

ownership of capital in the banking sector will even surpass the relatively high

level of Hungary (60%) in the medium term. A further strong rise in the mediumand

long-term cross-border lending to the banking and the corporate sector

(mainly syndicated loans) can be expected in the next years. In the long run, short

term capital inflows will probably substitute part of these cross-border loans to the

banking sector. However, it is strongly recommendable to strengthen the domestic

banking sector (e.g. via the entrance of foreign direct investment), before opening

it completely to short-term capital. The banking systems as a whole (i.e. including

the central banks) do not seem to have been out of balance regarding exchange

rate risk in the CEE countries at the end of 1998. A decline in the non-bank

interest rate margin in the longer-term in particular in Poland, the Czech Republic

and in Estonia due to stronger competition in the banking sector can be expected.


Furthermore, the profitability rates in the CEE banking sectors are likely to

stabilise at a level slightly above 10% in the longer-term.

The EU enlargement process could have negative consequences for the Russian

economy and the capital markets insofar as most of the CEE countries are

speeding up in improving economic and political conditions, whereas Russia

suffers from a deep financial crisis. The CEE countries could serve as a model for

a successful transformation process. The experiences of these countries could help

Russia to reform economic structures and institutions. The main goal of the

reforms in Russia should be the establishment of credibility which was badly hurt

by the 1998 crisis. However, there are influential groups in Russia that are

interested in the conservation of the status quo or even in changes towards more

regulation. IMF loans must be used more efficiently as a means of putting pressure

on the Russian government to enforce the necessary reforms. On the other hand,

Russia cannot overcome the consequences of the crisis completely on its own.

European countries should open their markets for Russia, particularly for finished

products. A customs union with the EU could stimulate trade and a better business

climate, promote the integration of Russia into Western markets and boost


7. Outlook and Perspectives: The Future Role of CEE Capital Markets in

the European Capital Markets

This chapter analyses the future role of the CEE capital markets amongst the

international and European capital markets. We first analyse the CEE capital

markets from the perspective of their functions for the domestic economy,

especially corporate and public finance. Then, the focus is on changes concerning

the international integration of CEE financial markets and the future interactions

between Western European and CEE capital markets and securities exchanges.

To evaluate the overall benefits from investment in CEE stock markets from the

point of view of international investors we analysed the performance of CEE stock

markets in the recent past (Aug. 1994 – Dec. 1998). The results show that the

inclusion of these markets in a well diversified world portfolio did not improve the

risk-adjusted return (measured by the Sharpe ratio). This result is true for the

analysed U.S., British and German investors and refers to a simple buy-and-hold

strategy. But particularly the Slovakian, Slovenian and the Czech stock markets

offer high benefits from diversification due to low or even negative correlations

with international stock markets.

The expected entry of CEE countries into the EU could significantly change the

expectations on future returns of CEE stock markets and also on their future

volatilities and correlations with international markets. To assess changes in

expectations on portfolio holdings the following scenarios have been simulated in

the context of portfolio optimisation: 1. increase in expected excess returns, 2.

decrease in expected volatility and 3. rise in expected correlations. Although the

simulations lead to different results for each CEE stock market, international


investors will clearly increase their holdings of CEE equities due to the expected

entry in the EU.

Currently, internal financing (incl. asset divestiture) is the most important source

of CEE corporate finance. Among debt financing, domestic and foreign lending as

well as inter-company loans are significant. Debt is predominantly short-term and

debt levels are still low compared to Western companies, particularly in non-listed

CEE firms. Volumes raised by the issue of international and domestic bonds are

the smallest component of corporate debt financing. Relatively high growth

perspectives can be concluded from the currently low level of new equity issues

and the underdeveloped corporate bond markets in comparison with most OECD


Regarding demand for equity and corporate bond securities in CEE capital

markets, the amount of capital managed by international and domestic institutional

investors will increase significantly. Regarding the supply of these securities we

expect that growth of profit-based internal financing could be dampened by

stronger competition on the product markets. But credit limits established by

commercial banks will probably lead larger companies to increasingly turn to the

capital markets. Equity financing will be also stimulated by the expected growth

in foreign direct investment.

Debt financing via corporate bond issues will grow, as many owners of companies

will aim to maintain corporate control by preferring bond issues to equity issues

and to enhance their Return on Equity by a higher leverage. The issue of corporate

bonds denominated in local currency will benefit from 1. the increasing financial

stability of the CEE economies, 2. the modification of the legal framework to EU

standards, and 3. lower issuance costs. We also expect an increasing demand for

corporate and public bonds because foreign investors will benefit from further real

appreciating CEE currencies and domestic investors gain from the continuing high

real interest rates.

By now, one of the most important contributions of the CEE equity markets to the

economic development has consisted in providing a channel through which the

government could sell stakes held in companies. In Poland, in particular, further

important contributions to financing the public sector can be expected from the

equity market. The publicly issued domestic debt securities have considerably

gained in importance, as they were the main or exclusive source of financing the

budget deficits. We expect a further increase in the market capitalisation of

government bonds.

The demand side will be determined by: 1. pension reforms, 2. a more important

role of private households, and 3. an increasing share of foreign investors. Net

issue of domestic government debt securities will rise primarily due to the need to

finance increasing spendings for public investments.


Uncertainties about the economic situation or a negative outcome of the

negotiations with the EU might lead to a sudden outflow of a part of the foreignheld

portfolio stock which was accumulated over time. This can put pressure on

the currency. In most CEE countries, the foreign portfolio holdings in equities

amount to between 18% and 37% of official FX-reserves. Thus, they constitute a

higher risk to the financial stability than the foreign portfolio holdings in domestic

debt securities which were only between 8% and 14% of official FX-reserves at

the end of 1998. Overall, we can summarise that the currency risk involved by the

foreign portfolio holdings was still at a controllable level at the end of 1998. In

addition, most CEE governments will buy back an increasing share of their own

debt securities denominated in foreign currencies and thereby limiting the external


In the CEECs, the pay-as-you-go (PAYG) system of the public pension scheme

was negatively affected by the sharp increase in the unemployment rate due to the

whole process of transformational restructuring. In addition, demographic

projections show that the economic burden on the part of the population in the age

of economic activity (15-64) will increase in the period 2010-2030, due to the

increasing share of the population aged 65 and over. The recent experience and the

long-term demographic outlook stimulated the tackling of institutional reforms of

the pension systems in Poland, Hungary and the Czech Republic. Hungary and

Poland included a mandatory form of capital-funded system, while in the Czech

Republic it is exclusively voluntary. Regarding the investment rules for pension

funds, the maximum percentage of total investments into equities in Hungary

(50%) is higher than in the Czech Republic (25%). In contrast, the Polish

regulation on the eligible instruments is the least restrictive in regional


As a response to not yet fully developed CEE stock exchanges and, above all, to

investors’ demands, CEE companies have initiated a process of

internationalisation via the additional listing of Depositary Receipts and ordinary

shares on foreign stock exchanges. By increasing market fragmentation and

weakening the liquidity in the home market, this process threatens the future

growth of CEE stock exchanges. Moreover, we expect this process to become

even more dynamic with the realisation of the centralised Eastern European stock

exchange jointly planned by Deutsche Börse (Frankfurt/Main) and Wiener Börse

(Vienna). To avoid disadvantages the CEE stock exchanges have to significantly

enhance their market liquidity. We see two main complementary strategies to

achieve this goal. Firstly, the importance of governmental policy to favour the

creation of a stronger and more active domestic base of institutional portfolio

investors. Secondly, the CEE stock exchanges would be well advised to try to

establish a direct connection to the planned pan-European trading system of

Western European stock exchanges as soon as possible. Efforts would have to be

continued by the CEE stock exchanges to modernise their trading systems to the

Western standards.


List of Abbreviations

ADR American Depository Receipt

ARCO Agency for the Restructuring of Credit Organisations (Russia)

BIS Bank for International Settlements

BMWi German Ministry of Economic Affairs

BSE Budapest Stock Exchange

BUX Budapest Stock Exchange Index

CAC40 Paris Stock Exchange Index

CAD Capital Adequacy Directive

CB Central Bank

CBR Central Bank of Russia

CBX Czech Republic Bond Index

CDAX Composite DAX

CECE Central Eastern Countries Europe (Stock Exchange Index)

CEE Central and Eastern Europe

CEECs Central and Eastern Europe Countries

CESI Central European Stock Index

CHF Swiss Franc

CIS Commonwealth of Independent States

CPI Consumer Price Index

CTX Czech Traded Index

CZK Czech Crown

DAX German Stock Index

DI Direct Investment

DR Depository Receipt

EA Europe Agreement

EAEUR Eastern Europe Index (of ING Barings)

EBIT Earnings Before Interest and Taxes

EBO Employee-buy-out

EBRD European Bank for Reconstruction and Development

ECB European Central Bank

EDR European Depository Receipt

EEK Estonian Crown

EFFAS European Federation of Financial Analysts

EIB European Investment Bank

ELMI Emerging Local Markets Index (10 countries)

ELMI+ Emerging Local Markets Index (24 countries)

EMU European Monetary Union

ERM II Exchange Rate Mechanism II

EUR Euro

FDI Foreign Direct Investment

FIBV International Federation of Stock Exchanges

FIG Financial Industrial Group


FOI Foreign Other Investment

FPI Foreign Portfolio Investment

FRF French Franc

FTSE Financial Times Security Index

FX Foreign Exchange

GBP British Pound Sterling

GDP Gross Domestic Product

GDR Global Depository Receipt

GEEI Greater Eastern Europe Index (of ING Barings)

GFCF Gross Fixed Capital Formation

GFI Gross Fixed Investment

GKO Russian Government Securities in Local Currency

GNP Gross National Product

HBX Hungary Bond Index

HCPI Harmonised Consumer Price Index of the EU

HTX Hungarian Traded Index

HUF Hungarian Forint

IBCA European International Credit Rating Agency

IFC International Finance Corporation

IFCG International Finance Corporation Global Index

IMF International Monetary Fund

IOSCO International Organisation of Securities Commissions

IPF Investment Privatisation Fund

IPO Initial Public Offering

IRTS Index Russian Trading System

ISD Investment Services Directive

LCY Local Currency

LSE London Stock Exchange

MBO Management-buy-out

MCF Market Cap Factor

MFN Most Favoured Nation

MICEX Moscow Interbank Currency Exchange

MMTS Multi-Market Trading System

MoF Ministry of Finance

MSCI Morgan Stanley Capital International

MSCIEMG Morgan Stanley Capital International Emerging Markets Index

NASDAQ National Association of Securities Dealers Automated

NCB National Central Bank

NFA Net Foreign Assets

NRI Nomura Research Institute

NYSE New York Stock Exchange

OFZ Russian Government Securities in Local Currency

OTC Over the counter

PBX Poland bond index


PCA Partnership and Cooperation Agreements

PI Portfolio Investment

PPP Purchasing Power Parity

PSE Prague Stock Exchange

PTX Polish Trading Index

PX50 Prague Stock Exchange Index

PZL Polish Zloty

RDX Russian Depository Receipts Index

RF Russian Federation

RFSEC Russian Federation Commission for Securities and the Capital Markets

ROA Return on Assets

ROE Return on Equity

ROS Return on Sales

RSIGEN Russian Stock Index General

RTS Russian Trading System

RTX Russian Traded Index

RUR Russian Rouble

SAX Slovakian Stock Exchange Index

SBI Slovene Stock Exchange Index

SBS State Banking Supervisor

SIT Slovanian Tolar

SPAD Market-Maker Based System on the PSE

SPO Secondary Public Offering

STX Slovak Traded Index

TALSE Tallinn Stock Exchange

TBILLS Treasury Bills

TBONDS Treasury Bonds

TSE Tallinn Stock Exchange Index

UCITS Undertakings for collective investment in transferable securities

UNCTAD United Nations Conference on Trade and Development

U.S.GAAP U.S. Generally Accepted Accounting Principles

U.S.SEC U.S. Security Exchange Commission

US$ US Dollar

USSR Union of Soviet Socialist Republics

WIG Warsaw Index General

WIIW The Vienna Institute for International Economic Studies

WSE Warsaw Stock Exchange

WTO World Trade Organisation


1. Economic Background

This chapter gives an overview of major economic developments that are

particularly important for the assessment of the status quo and the future of CEE

capital markets. Major topics to be described and analysed are the importance of

foreign capital for the economies of the CEE countries, the privatisation process

and the current status of privatisation, the banking systems in CEE economies and

the developments of the exchange rate systems. This chapter aims to give an

understanding for the monetary and capital market developments of the recent past

of CEE countries. Important topics, namely public finance, the banking system

and the exchange rate regimes will be resumed in chapter 6 when the ongoing

process of the integration of CEE capital markets in the European capital markets

is analysed.

Chapter 1.1. describes and analyses the economic performance of the CEE

countries Czech Republic, Estonia, Hungary, Poland, Slovakia, Slovenia and of

Russia. The results show that the CEE countries are already well advanced in

transition and convergence to Western European countries although the distance in

real income is still very large. Very important for the future integration is the

considerable openness to the European and the world economy. The high net

capital inflows particularly of medium and long term capital show the already

existing confidence of international investors in the positive prospects for the

future economic development of the CEE countries.

Chapter 1.2. describes the methods of privatisation which have been used in the

CEE countries and Russia and analyses the current status of the privatisation

process. An important finding is that the best results both on the company level

and for the whole economy have been gained when outside investors and

particularly foreign investors played a substantial role in the privatisation process.

A detailed investigation of the banking systems of the CEE countries can be found

in chapter 1.3. The starting point of the analysis is the change which the monetary

and the banking system experienced during the transition process. Then the effects

of the new systems on the credit activities of banks in the CEE countries are


The analysis of the economic background is finished by an analysis of the

exchange rate experiences of the CEE countries (chapter 1.4). In addition, the

concept of equilibrium exchange rates, particularly purchasing power parity, is

applied to CEE currencies.


1.1. Macroeconomic Developments and Public Finances

1.1.1. Introduction

Macroeconomic variables such as economic growth, savings, productivity,

inflation and public deficits are important factors of the development and the

performance of national capital markets. They determine the domestic demand

and supply of capital and influence the import of capital from abroad. It is the aim

of this chapter to analyse the behaviour of major macroeconomic factors in the

recent past that are relevant for national capital markets in the CEE countries and

Russia. The analysis gives background information for the further investigation of

the capital markets in the following chapters of this study. 2

This chapter is divided into four parts. The first part compares the development of

national income and the major growth factors for the last years. The aim is to get

an idea of the different economic potential of the countries under consideration.

Part two analyses the savings of the CEE countries and the monetary stability

including inflation, monetary policy as well as public debt and public deficits. As

stable monetary conditions are an important prerequisite for confidence in the

stability of capital markets it has a major impact on capital inflows from abroad.

International trade and the capital account and its structure are investigated in part

three. Part four summarises the importance of the macroeconomic factors for the

capital markets. Important parts of this chapter especially public finance and

foreign capital inflows are again discussed in chapter 6 but then with an emphasis

on the future process of integration of CEE countries into the Western European


1.1.2. Comparison of Economic Performance

Figures 1a and 1b show the development of the gross domestic product (GDP)

from 1990 until 1998 in real terms. The countries shown in figure 1a exhibit the

same shape of GDP: a sharp downturn at the beginning of the transition period in

the early 1990´s and then a significant and strong recovery in economic growth.

2 In the last years several articles and books have been published which describe and

analyse the macroeconomic environment of Eastern European countries and Russia.

Particularly interesting are the country reports of the IMF and the OECD as well as

the transition reports of the EBRD. These publications give a general overview on the

economic developments of Central and Eastern European countries. In contrast to

these studies this chapter focusses on those topics of the macroeconomy that are of

special interest for the analysis of the capital markets in the CEE countries and Russia.


Figure 1a: Real GDP Growth (1990 = 100)















Figure 1b: Real GDP Growth (1990 = 100)
























Czech Rep.


EU15 Average




EU15 Average

Notes: All GDP figures are in national currency and deflated by the GDP deflator. Source

for figures 1a and 1b: EBRD (1999), own calculations. The figures for 1998 are

expectations of the EBRD.

Most noticeable is the very strong GDP growth in Poland from 1991 on. Even

over the whole period 1990–1998 growth in Poland was much higher than in the

EU-15. In the Czech Republic, Slovenia and Slovakia the recovery did not start

before 1992/93, but then GDP growth was much stronger than in the EU-15 as

well. These four CEE countries succeeded in decreasing the gap relative to

Western European countries, at least in terms of real GDP growth.

In Estonia, Hungary and especially in Russia the development of real GDP was

significantly worse than in the other CEE countries. As can be seen from figure 1b

the recovery in Hungary and Estonia started relatively late and both countries did

not succeed in catching up with the growth in the EU-15 in that period. In Russia

the economic slump has not even come to an end.

Table 1: Real GDP Growth and Growth Components








Gross Fixed





Total GDP


Czech Rep. 8.26% 0% 10.85% -7.44% 11.67%

Estonia na na Na na 20.7%

Hungary -5.2% -1.7% 9.4% 4.9% 7.4%

Poland 11.6% 2.4% 17.9% -10.6% 21.3%

Russia 1.2% -2% -4% -1.9% -6.7%

Slovakia 8.8% 5.2% 18.6% -11.2% 21.4%

Slovenia 6.3% 2.5% 6.3% -3.7% 11.4%

EU-15 3.69% 0.54% 1.75% 1.1% 7.08%

Notes: The growth components are calculated as 100*{X(t) – X(t-1)} / GDP(t-1), where X

is e.g. private consumption, t is equal to 1997 and t-1 refers to the year 1994. The growth

components add up to the total growth of GDP (in %) for the period 1994-1997. For the

Czech Republic, Hungary, Poland and Slovakia the correct deflators are used for each

expenditure category of the GDP. Due to the lack of data the real figures of the expenditure

categories of Russia and Slovenia have been calculated using the GDP deflator. Source:

OECD: National Accounts, vol. II, OECD: Main Economic Indicators, IMF: International

Financial Statistics, EBRD (1998), OECD (1999a), own calculations.

Table 1 shows a breakdown of real economic growth into the main expenditure

categories of the GDP. The real performance of each expenditure category shows,

how much this category contributed to total GDP growth in the period 1994 until

1997. The sum of the growth rates of all four expenditure categories is equal to

real GDP growth. 3 As can be seen, the major growth factor in all CEE countries,

3 Unfortunately, the true deflators for the real expenditure categories are not available for

Slovenia, Estonia and Russia. For these countries the calculations have been done

with the exception of Russia, was gross fixed investment. In the Czech Republic,

Poland, Hungary, Slovakia and Slovenia gross fixed investment therefore was the

dominant driving force of economic growth.

The second important factor of growth in the Czech Republic, Poland, Slovakia

and Slovenia was private consumption and thus the increase in real private

income. Due to the relatively high growth of consumption the imports also show a

significant increase which has led to a deficit in the trade balance. In Hungary the

decrease in consumption induced a slow growth in imports and thus Hungary had

a positive trade balance. It is interesting to see that, with the exception of

Slovakia, public consumption plays only a minor role for GDP growth. In the

Czech Republic and Hungary public consumption remained unchanged or even

decreased over the period from 1994 to 1997. Compared to the EU-15 the CEE

countries not only show a much higher economic growth but the dominance of

gross fixed investment also emphasises that the building of capacities for

production is still the major driving force of the economic development in CEECs.

The situation of Russia was quite different. In the whole period from 1994 to 1998

real GDP was decreasing even though the rate of decline was diminishing. As

figure 1b might suggest, Russia could be now close to the deepest point of the

economic slump. But projections e.g. of the EBRD are still pessimistic at least for

growth in 1999. In any case, the economic development of Russia is many years

behind that of the CEE countries analysed in this study.

Table 2 shows another interesting feature of the economic development of CEECs.

In all countries, except Russia, both overall productivity and productivity in

manufacturing has risen extremely.4 Especially in manufacturing the increase was

many times greater than in the EU-15. Table 2 also shows that overall productivity

has grown in most CEE countries at a much slower pace than productivity in

manufacturing. This means that especially in administration and in the service

sector a further improvement in productivity can be expected in the future when

these sector are catching up with manufacturing. The negative consequence of the

rise in productivity in the short term could be a strong increase in unemployment.

In most CEE countries the official unemployment is now well above 10%. But the

high GDP growth limits the future rise in the number of unemployed people and

has already led to an improvement of the situation of the labour market in some

countries e.g. in Poland, where the rate of unemployment has declined from 16%

in 1994 to about 10% in 1998.

under the assumption that all expenditure deflators are equal to the GDP deflator. This

leads to an underestimation (overestimation) of the real growth of the expenditure

category if the true but unknown deflator has increased less (more) than the GDP

deflator. The data for these countries should therefore be interpreted with some


4 Overall productivity measures the relation between real GDP and total employment while

productivity in manufacturing concentrates on the development in the manufacturing



Table 2: Labour Productivity

Period: Real GDP /

Industrial Production /

1994-1997 Total Employment Employment in Manufacturing

Czech Republic +8.9% +35.2%

Estonia +29.2% +22.6%

Hungary +7.8% +38.9%

Poland +17.8% +33.9%

Russia -4.1% +12.1%

Slovakia +18.8% +11.7%

Slovenia +11.7% +20.2%

EU-15 +5.1% +5.5%

Source: EBRD (1998), IMF: International Financial Statistics, own calculations.

This shows that the CEECs are catching up quickly. But the process of catching

up with the EU-15 is, of course, still at an early stage in all CEE countries. If GNP

per capita (in US$, based on PPP) is used as an indicator of development, then the

gap between the CEEC and the EMU-area is between 42% and 78%. The highest

ranking of all CEE countries in terms of GNP per capita has Slovenia. Its per

capita income (11.880 US$) is only slightly below that of Greece (12.500 US$)

and Portugal (13.650 US$). But Table 3 shows clearly that the CEE countries and

especially Russia are far behind even those EU member countries with the lowest

income levels.

Table 3: GNP per Capita (PPP based, in US$), 1997

1997 Change to in % of in % of Greece

1996 (in %) EMU-area (12.500 US$)

Czech Republic 10,380 0.8 51.3 83.0

Estonia 5,090 8.3 25.2 40.7

Hungary 6,970 4.7 34.5 55.8

Poland 6,510 6.4 32.2 52.1

Russia 4,280 0.2 21.2 34.2

Slovakia 7,860 4.9 38.9 62.9

Slovenia 11,880 3.5 58.7 95.0

EMU-area 20,230 2.0 100 161.8

Source: World Bank (1999).

But all in all, the improved productivity shows that the CEE countries are on a

good way of restructuring their economies towards more efficient production.

Together with the strong economic growth this demonstrates not only the high


speed of economic development in most CEE countries but also the decisive

nature of the restructuring process. The only exception is Russia where the process

of restructuring the economy towards the standards of the G-10 countries is still at

its beginning.

1.1.3. Savings, Money and Public Finance 5

Table 4 gives insights into the national income account. The fundamental identity

in the national income account is that investment has to be equal to savings expost.

Table 4: Breakdown of National Savings and its Uses (Bill. US-Dollar, Average per Year)



Gross Fixed



(Government) 1




Trade) 2

Savings (Private

Households and

Companies) 3

Czech Rep. +16.8 0 +2.5 +14.3





+0.9 0 +0.36 +0.54

+10.6 -2.4 +1.4 +11.6

Poland +23.4 -2.9 +2.4 +23.9

Russia +86.2 -23.8 -13.15 +123.15

Slovakia +5.6 -0.3 +0.65 +5.25

Slovenia +3.9 0 -0.1 +4.0

1 Savings (government) = revenues ./. expenditures = budget deficit, 2 Savings (foreign

trade) = (-1)*trade deficit = net capital imports, 3 Savings (private households and

companies) = gross fixed investment ./. savings (government) ./. savings (foreign trade).

The sum of all three savings categories is equal to gross fixed investment. The figures for

gross fixed investment and savings (foreign trade) are from the national account statistics

(IMF). The savings of government are taken from the government finance statistics of the

IMF. A positive sign for savings of foreign trade means a trade deficit and consequently a

net capital import, while a negative sign means a net capital export. A negative sign of

savings of government is equal to a budget deficit. Source: IMF: International Financial

Statistics, own calculations.

In Table 4 the savings are divided into three major categories: savings of the

government, savings in the field of foreign trade and savings of private households

and companies. The sum of the three savings categories is equal to gross fixed

5 This chapter gives only an overview on the development of the public finances in CEE

countries and Russia. A deeper analyis can be found in chapter 6.4. of this study.

investment. Therefore the figures tell to what extent the different sources of

savings contribute to the financing of gross fixed investment.

For Poland, gross fixed investment is financed mainly by the savings of private

households and enterprises. The net capital inflow from abroad is just sufficient to

finance the budget deficit of the government. This situation is very similar to

Hungary and Slovakia. In the Czech Republic and Estonia net capital inflows

instead helped to finance gross fixed investment by a remarkable amount. This is

derived from the fact that in these two countries the budget deficit was not

significant in the corresponding period 1994 to 1997. Russia was again in a totally

different and much worse situation. Nearly 20% of private savings have been

needed to finance the public budget deficit. About 10% of private savings were

invested abroad. Therefore, gross fixed investment amounted to only 70% of

private savings of the Russian economy. If capital outflows could be reduced

significantly in the future, there would be much more potential for the financing of

domestic investments.

Overall it can be stated that savings of domestic households and companies are by

far the most important sources of financing gross fixed investment and economic

growth. From the results of 1.2.4. below it can be seen that foreign capital inflows

contribute significantly to the financing of public and private investments. But

nevertheless this is only in addition to internal savings which are the dominant

factor of growth in CEE countries.

One major factor that determines the degree of confidence in the long run

performance of the economy on international capital markets is the stability of

monetary conditions. Low and stable inflation rates are a precondition for stable

exchange rates and capital inflows from abroad as well as for confidence of

private households and companies in the future development of the economy.

Therefore stable monetary conditions help to raise domestic and foreign sources of


At the beginning of the transition process all CEE countries and Russia exhibited

very high inflation rates due to an enormous monetary overhang in all of these

countries. The figures of Table 5 show clearly in which year the price regulations

have been abolished or at least significantly reduced. In this respective year

consumer prices rose to sometimes even three- and four-digit inflation rates e.g. to

585.8% in Poland (1990), 550% in Slovenia (1990), 1076% in Estonia (1992) and

1526% in Russia (1992). After two or three years a large amount of the monetary

overhang had been inflated away and a relatively moderate monetary policy in the

following years led to a significant drop in the inflation rate. In 1997 and 1998 the

CEE countries approached the 10%-inflation level and some of them even

exhibited inflation rates below 10%.


Table 5: Development of Consumer Price Inflation (Annual Average)

Year-to-Year Changes in %



Estonia Hungary Poland Russia Slovakia Slovenia

1990 10.8 23 28.9 585.8 5.6 10.8 550

1991 56.6 211 35 70.3 92.7 61.2 117.7

1992 11.1 1,076 23 43 1,526 10.1 207.3

1993 20.8 90 22.5 35.3 875 23.2 32.9

1994 10 48 18.8 32.2 311.4 13.4 21

1995 9.1 29 28.2 27.8 197.7 9.9 13.5

1996 8.8 23 23.6 19.9 47.8 5.8 9.9

1997 8.4 11.2 18.3 14.9 14.7 6.1 8.4

1998 10.7 8.2 14.3 11.7 27.7 6.7 8.0

1999 (p) 2.5 3.3 9.0 7.0 87.0 10.6 7.5

Notes: Figures for 1999 are projections of the EBRD. Source: EBRD (1999), IMF:

International Financial Statistics.

In Russia the inflation rates still are relatively high compared to its neighbouring

countries in Central and Eastern Europe. In 1998 the downward sloping inflation

trend was interrupted by the Russian currency crisis. The huge devaluation of the

Rouble has consequently led to a strong increase in consumer prices. 6 Another

source of inflation in Russia is the need to finance the governmental budget. After

the Rouble devaluation the government has nearly no access to domestic or

international capital markets. Therefore, one of the major sources for financing the

expenditures seems to be the printing press. As a consequence, the inflation rates

will remain relatively high as long as the budget deficit cannot be funded by

increasing tax revenues or by bond emissions on international capital markets. 7

The tighter monetary policy in CEE countries led to a reduction in consumer price

inflation. As a consequence, the interest rates also declined on average in the CEE

countries. But the ex-post real interest rates 8 moved upwards from in some cases

even negative values in the first half of the nineties to between 4 % (Czech

Republic) and nearly 12% (Estonia) at the end of 1998. Most of the CEE countries

have real interest rates well above 6%. This is mainly due to the strong economic

growth in these countries and should not be seen as an obstacle for future

performance. Instead, the relatively high real interest rates help to increase

domestic savings and therefore stimulate future growth.

Another important indicator for the stability of the monetary economic

environment is the financial behaviour of the government. With the exception of

Russia the budget deficit of the general government is relatively low and should

6 See also Russian Economic Trends (1998b), pp. 11-12.

7 Westin (1998), pp. 20-21.

8 Nominal lending rate / consumer price inflation.


not cause inflationary pressure (see Table 6). In Estonia, Slovenia, the Czech

Republic and Poland the budget deficit ratio in 1998 will stay probably below the

3%-limit of the Maastricht treaty. But in some CEE countries the budget deficit

expanded slightly in the last years. Particularly Hungary and Slovakia have

problems to meet the budget deficit criterion. An example of remarkably tight

budgetary discipline is Estonia, where the deficit ratio was on average almost zero

in the last years.

Whereas the government finances seem to be sound in most of the CEE countries,

the external debt of CEE countries reaches levels that give rise to serious concerns

about future risks. The external debt measures the private and public debt of the

economy that is raised abroad and funded in foreign currencies. The external debt

ratio (relative to GDP) therefore can be used as a measure of the vulnerability of

an economy concerning changes of the external value of its currency.

Table 6: Public Deficits and External Debt

General Government

Balance as % of

GDP, 1994-1998 (e)

General Government

Balance as % of

GDP, 1998 (e)


External Debt as

% of GDP

1998 (e)

Russia -7.3 -5.4 55.1

Hungary -5.1 -4.6 55.9

Poland -3.1 -3.0 29.9

Slovakia -3.0 -5.8 58.5

Czech Rep. -1.9 -2.6 41.7

Slovenia -0.3 -1.4 25.4

Estonia -0.4 -0.3 26.9

Source: EBRD (1999), OECD (1999c) for data on the external debt of Estonia. (e) means

expectations of the EBRD, all figures are yearly averages.

As can be seen from Table 6 Russia, Slovakia and Hungary have external debt

levels higher than 50% of GDP. A depreciation of the currency could therefore

have very unfavourable effects on the debt service these countries have to bear. A

postponement of EU entry or a serious delay in the negotiations with the EU could

trigger off a weakness of some CEE currencies and thereby cause a debt crisis.

Currently it seems to be very improbable that the negotiations about the EU entry

could fail, but it should be born in mind that the remarkably high external

indebtedness of some CEE countries is a real risk to these CEE economies itself

and to foreign investors.

1.1.4. International Trade and Capital Flows

The economic development of most CEE countries depends heavily on foreign

trade. In the Czech Republic, Estonia, Slovakia and Slovenia the ratio of trade to

GDP 9 is above 50%, in Estonia it even approaches 73%. This means that the CEE

countries exhibit a very high degree of openness of their economy. The only clear

exceptions are Poland and Russia, where trade is relatively unimportant.

Openness is an important indicator for the assessment of a monetary union. The

more open an economy is, the more it is vulnerable to changes in exchange rates

and vice versa. A monetary union has the benefit of stable exchange rates and

therefore, a high degree of openness can be interpreted as a positive precondition

for a future monetary union with the EU, because the future benefits of stable

exchange rates increase with the degree of openness as is the case for most CEE

countries. This result is supported by the high share of trade with the European


Table 7: Openness of the Economy and Trade with EU-15 (1997)


in % of GDP

Share of Trade

with EU-15

(in %)


Share of GDP depending

on Exports to EU-15

(in %)

Czech Republic 60.3 60.6 34.4

Estonia 72.6 57.0 45.4

EU-15 33.7 61.0 21.3

Hungary 44.6 66.7 27.8

Poland 27.8 63.9 16.2

Russia 21.8 36.0 7.8

Slovakia 60.0 51.8 30.0

Slovenia 57.7 57.5 36.3

Notes: Trade is measured as the average of the absolute values of exports and imports.

Share of trade with EU-15 is in percent of total trade. Share of GDP depending on exports

to EU-15 is the ratio of exports to EU-15 relative to GDP. Source: OECD: Monthly

Statistics of Foreign Trade, EBRD (1998), IMF: International Financial Statistics, own


Table 7 also shows that for nearly all CEE countries the share of trade with the

EU-15 is as high as the ratio for the European Union itself. Only for Russia the

trade with the EU-15 is less important. Another figure concerning the importance

of trade with Europe is the share of domestic GDP that depends on exports to the

EU-15 countries. From the fourth column of Table 7 it can be seen that the

9 Trade is defined as the average of the absolute values of exports and imports.

economic development of the CEE countries is strongly linked to exports to the

European Union. For example in Estonia about 45% of the GDP depends via

exports on the economic situation in the EU-15. With the only exception of Poland

between 27% and 36% of the GDP of the other CEE countries is produced by

exports to the European Union. In strong contrast, the dependence of Russia on

the exports to EU-15 is fully unimportant.

The economic growth in most CEE countries depends therefore to a large amount

on the growth in the European Union. Changes in the business cycle of the EU-15

countries have an immediate and strong influence on the CEE economies. The

CEE countries are also vulnerable to exchange rate changes vis-à-vis the euro.

While a depreciation could help to increase exports and GDP it would boost

inflation and interest rates. CEE countries should therefore have a strong interest

in a stable exchange rate against the euro. From this point of view, a further

monetary integration of CEE countries into the EU is a logical continuation of the

integration via trade of goods and services of the last years.

Table 8: Financial Account (in mn. US-Dollar)


1994 1995 1996 1997 1998 Sum



Sum in

% of




4,504.0 8,225.0 4,317.0 1,122.0 2,684.0 20,856.0 8.0

Estonia 167.2 233.4 540.9 802.8 508.1 2,252.4 11.3

Hungary 3,370.0 6,577.0 -1,575.0 388.0 2,814.0 11,574.0 5.2

Poland -9,065.0 9,260.0 6,486.0 7,957.0 13,053.0 27,691.0 4.2

Russia -29,882.0 -8,047.0 -20,729.0 -1,995.0 -13,621.0 -74,274.0 -4.2

Slovakia 71.0 1,211.0 2,268.0 1,780.0 1,922.0 7,252.0 8.1

Slovenia 130.6 424.9 547.9 1,189.7 -4.8 2,288.3 2.5

Source: IMF: International Financial Statistics, EBRD (1999). A surplus of the financial

account means a net capital inflow.

The international capital flows between CEE countries and foreign countries are

of special interest for the understanding of the capital markets in these countries.

Although domestic savings are by far the dominant source of finance, foreign

capital contributes significantly in the financial markets of CEE countries and

helps to finance equity capital and budget deficits. The financial account balance

(Table 8) measures the net effects of financial investment flows between the

country under consideration and foreign countries. Table 8 shows that all CEE

countries experienced net capital inflows and therefore a surplus of the financial

account balance in the years 1994 until 1998. The financial account balance shows

remarkably high values between 2.5% and 11.3% of GDP. Only Russia shows a

net capital outflow in each year of the period from 1994 to 1998. The net capital

outflows amount to more than 4% relative to GDP.

For international investors emerging capital markets are of special interest because

they do not only promise high returns but also an improvement in risk

diversification. 10 In combination with a trustworthy legal framework, an economic

policy that concentrated on monetary stability and a sufficient interest rate

differential that compensated investors for exchange rate risk a huge amount of

foreign capital could be attracted in some CEE countries.

Table 9: Structure of the Financial Account (in Mio. US-Dollar)



Net Direct


Net Portfolio



Net Other


Assets 1

Total =



Czech Rep. 8,537.0 4,971.0 7,318.0 20,856.0

Estonia 1,224.9 361.9 665.2 2,252.4

Hungary 10,661.0 4,745.0 -3,833.0 11,574.0

Poland 20,820.0 4,649.0 2,222.0 27,691.0

Russia 8,717.0 31,984.0 -113,628 -74,274.0

Slovakia 1,292.0 337.0 5,623.0 7,252.0

Slovenia 929.0 916.5 442.9 2,288.3

1 Other Investment Assets = Investments of monetary authorities, general government,

banks, and other sectors, e.g. transactions in currency and deposits, loans, and trade credits.

The sum of the three investment categories may differ from the total financial account due

to errors and omissions, which are not reported in this table. Source: IMF: International

Financial Statistics.

Further insights in the composition of foreign capital flows can be gained from

looking at the structure of the financial account. Table 9 shows net direct and net

portfolio investments. Direct investments are investments into companies. In

particular, they include equity capital, intercompany transactions between

affiliated companies and reinvested earnings. Direct investments therefore

represent foreign capital that is invested for a medium- or long-term period,

10 It is a well-documented result of empirical research concerning emerging stock markets,

that the inclusion of these markets improves portfolio efficiency by increasing

expected returns and diminishing portfolio risk. For an overview on the literature see

e.g. Bekaert/Urias (1999). In our chapters 5. and 7.3. we have found relatively low

correlations of CEE stock index returns with matrure international stock markets. This

indicates benefits from diversification for international investors engaged in CEE

stock markets. For this purpose investments in the stock markets of Slovenia,

Slovakia and the Czech Republic seem to be particularly useful.

ecause a disinvestment would cause relatively large transaction costs. Portfolio

investments summarise investments in the capital and credit markets. Although

this kind of foreign capital could also be invested with a long run perspective, the

transaction costs for reallocating these investment to other countries are relatively

small. Therefore, portfolio investments can easily flow out of the country again

when expectations about future returns worsen.

In all CEE countries listed in Table 9 the direct investments significantly dominate

net portfolio investments. This means that the CEE countries especially attract

medium and long term investments that are of importance for the financing of the

private sector.

Russia shows just the opposite relationship between direct and portfolio

investments. The majority of foreign investments in Russia are portfolio

investments and especially investments in government debt. Another interesting

feature of the financial account of Russia is the extreme importance of “other

investment assets”. This category includes transactions in currency and deposits as

well as loans and trade credits. It represents therefore an investment category that

could be characterised, at least partially, as “hot money”. In the period 1994 –

1998 Russia experienced an enormous outflow of “other investment assets” that

caused a major deficit in the financial account. From additional sources it can be

seen that this deficit mainly comes from unrepatriated trade revenues and foreign

cash holdings of the private sector. 11 In contrast to the CEE countries, there is a

strong distrust in the economic and political stability of Russia. Therefore, Russia

attracted especially short-term money that offered a high interest rate as

compensation for risk.

The capital inflows and their structure can be seen in more detail from Table 10.

In most of the CEE countries the inflows of direct investments are much more

important than the investments in equity and debt securities. Especially Estonia

and Hungary benefit from direct investments. The value of medium and long term

foreign investments amount to remarkable 5 - 7 % of GDP. The importance of this

capital inflow is further stressed by the high ratios of FDI relative to gross fixed

capital formation (GFCF) in some countries. In Estonia (26.4%), Hungary

(25.2%), Poland (16.6%) and the Czech Republic (11.2%) a huge amount of

investment is financed by direct investments of foreigners. 12

11 See Russian Economic Trends (1998a) p. 63.

12 It has to be noted that FDI is not part of GFCF. Whereas GFCF consists of domestic

(private and public) investments, the figures on FDI show the capital inflows of

foreigners invested in domestic companies.


Table 10: Capital Inflows as Direct and Portfolio Investments (in Mio. US-Dollar)








Investments 1



FDI in %

of GDP

FDI in

% of


Czech Rep. 3,807.0 1,843.0 5,650.0 8,822.0 3.3 11.2

Estonia 344.1 302.1 646.2 1,412.8 7.1 26.4 5

Hungary 1,784.0 3,004.0 4,788.0 11,660.0 5.2 25.2 5

Poland 3,301.0 1,004.0 4,305.0 21,305.0 3.2 15.5

Russia 4,224.0 28,590.0 32,814.0 13,574.0 0.8 3.9

Slovakia 190.0 165.0 355.0 1,593.0 1.8 4.0

Slovenia 58.9 944.6 1,003.5 975.6 1.1 4.9

1 Capital inflows from portfolio investments are the sum of equity and debt securities

(columns 2 and 3 of this table), 2 FDI = Inflows of direct investments from abroad. 3 GFCF

= Gross Fixed Capital Formation. 5 Data for 1997 and 1998 could only be approximated.

Source: IMF: International Financial Statistics, EBRD (1999).

In Slovakia, Slovenia and Russia direct investments were only of minor

importance but still comparable to most Western industrialised countries: in Spain

5.1% of gross fixed investment came from FDI in 1997, in the U.S. this ratio was

7.8% and in Germany there was no inflow of FDI at all in this year.

While the financial account shows the flows of international capital, Table 11

summarises the stocks of international investments. The figures are calculated as

the difference between assets held abroad and liabilities to foreigners. Therefore, a

negative value means that foreigners have a positive net investment position in the


The figures clearly show that all countries under consideration have net liabilities

to foreigners. The high degree of indebtedness can be seen from the ratio of net

liabilities to GDP. In Hungary, the foreign net liabilities sum up to remarkable

81% of GDP. Although nearly half of this amount are direct investments, the

Hungarian economy is obviously vulnerable to the investment behaviour of

foreigners. The same is true for Estonia, where net liabilities amount to more than

50% of GDP and to a lower extent also for Poland, Slovakia and the Czech

Republic. The positive interpretation, of course, is that foreign investors have

strong confidence in the economic and political stability and the long-term

economic performance of these countries. But nevertheless a drop in confidence

would considerably hurt these economies by a sudden outflow of portfolio

investments. As already mentioned with regard to the high external indebtedness

of most CEE countries, a postponement of EU entry or – in the worst case - the

failure of negotiations between the EU and a CEE country could cause large

capital outflows with the consequence of a crisis not only of currency and capital

markets but also of the whole economy.

Table 11: International Investment Position 1998

(Net Position = Assets–Liabilities), in Mio. US-Dollar

Net Direct





Net Debt



Net Portfolio

Investments 1

Net Other

Investment 2

Sum 3 in

% of


Czech Rep. -12,732.0 -3,272.0 -1,013.0 -4,287.0 +347.0 -30.3

Estonia -1,623.3 -269.7 -222.0 -491.7 -879.9 -57.5

Hungary -16,969.0 -2,230.0 -12,013.0 -14,245.0 -7,523.0 -81.0

Poland -21,314.0 -4,960.0 -7,605.0 -12,565.0 -34,394.0 -45.4

Russia -22.0 -22.0 +829.0 +807.0 -20,301.0 -7.1

Slovakia -2,150.0 -71.0 -14.0 -85.0 -5,137.0 -36.1

Slovenia -856.8.2 -92.6 -1,346.1 -1,461.6 -823.9 -16.0

Notes: The international investment position is equal to the stock of foreign investments,

whereas the financial account statistics (see Tables 8-10) show the flow of transactions with

foreign countries. The figures of this table show the difference between assets abroad and

liabilities of the domestic country. 1 Net portfolio investments = sum of net equity and net

debt securities. 2 Net Other Investment = Investments of monetary authorities, general

government, banks, and other sectors, e.g. transactions in currency and deposits, loans, and

trade credits. 3 Sum is equal to (net direct investment + net portfolio investment + net other

investment).Source: IMF: International Financial Statistics, EBRD (1999).

On the other hand, the low ratio for Russia and the fact that almost the total net

liability position consists of “other investment”, namely trade credits, loans and

deposits, is a signal of the unattractiveness of the Russian economy for foreign

medium- and long-term investments.

1.1.5. The Capital Markets from a Macroeconomic Point of View

Recent articles find significant positive relationships between the development of

the stock market country and the economic development of a country. 13

Atje/Jovanovic (1993) and Levine/Zervos (1996) for example estimate significant

positive correlations between long run economic growth and the development of

the stock market using cross-sectional models. They measure the stock market

development using market capitalisation and the market turnover relative to GDP

13 See Atje/Jovanovic (1993), Levine/Zervos (1996) and World Bank (1998), chapter 3.

The development of the stock market in most studies is usually measured by market

capitalisation compared to GDP, market turnover as a proxy for liqudity and some

additional factors concerning the degree of international integration.

as the two most important characteristics. Their results show a clear bi-directional

relationship between economy and stock market: a well functioning stock market

supports the development of the economy and that an improvement in economic

growth stimulates the development of the stock market. This indicates the

importance of the stock market for corporate finance and risk allocation and

emphasise that the economy and the domestic stock market should develop


Table 12: Importance of the Stock Market for the Economy (End 1998)

Stock Market


(Bill. US$)

Stock Market


(% of GDP)


Stock Market


(Bill. US$)

Market Liquidity

(Turnover in % of


Czech Rep. 13.9 25.3 5.3 38.1

Estonia 0.81 15.6 1.2 148.0

Hungary 14.0 29.5 16.1 115.1

Poland 20.7 13.1 8.9 43.0

Slovakia 0.65 3.1 1.0 153.8

Slovenia 3.5 18.0 0.87 24.9

Russia 11.0 4.1 9.2 83.6

London 2,372.7 175 2,888.0 121.7

Frankfurt 1,094.0 51.3 1,491.8 136.4

Madrid 402.2 72.7 640.3 159.2

Notes: Stock market capitalisation and turnover refer to domestic companies only. Source:

National stock exchanges and RZB. In case of Slovakia, London, Frankfurt and Madrid:

Fédération Internationale des Bourses de Valeurs (FIBV; The figures for

Russia do not include the capitalisation and turnover of Gazprom.

Table 12 compares the importance of stock markets in CEE countries to major

Western European stock markets. The capitalisation of CEE stock markets is

relatively low compared to mature Western stock markets, both in absolute terms

and relative to GDP. These figures indicate an early stage of development of these

stock markets. Nevertheless, in Estonia, Hungary and Slovakia, the market

liquidity - measured by the ratio of market turnover relative to capitalisation – is

relatively high and shows active trading in these three stock markets. In contrast,

the stock markets of the Czech Republic, Slovenia and Poland do not only exhibit

a low capitalisation but also low liquidity which indicates that trade actually takes

place only in a small fraction of stocks listed at these stock exchanges. The results

of the aforementioned two articles by Atje/Jovanovic and Levine/Zervos give rise

to the expectation that the further development of the CEE economies should also

improve the functioning of the stock markets via an increase both in capitalisation

and in turnover.

The ratings of major international rating agencies can be used to summarise the

macroeconomic findings for the CEE countries and Russia and to give an

evaluation of the ability to service outstanding debt to foreigners (see Table 13).

These ratings evaluate the default risk for governmental debt denominated in

foreign currency. Thereby, they assess the sustainability of debt, the ability to earn

foreign currencies and the political will to pay the outstanding debt. The ratings of

the three rating agencies Standard & Poor´s, Moody´s and Fitch IBCA give almost

identical rankings for the CEE countries. At the top of the ranking is Slovenia

which has the same rating as Hong Kong and is higher ranked as e.g. Greece


Table 13: Sovereign Long-Term Credit Ratings (Foreign Currency), November 1999

Standard & Poor´s Moody´s Fitch IBCA

Slovenia A A3 A-

Czech Republic A- Baa1 BBB+

Estonia BBB+ Baa1 BBB

Hungary BBB Baa1 BBB+

Poland BBB Baa1 BBB+

Slovakia BB+ Ba1 BB+

Russia SD B3 CCC

Source: Standard & Poor´s, Moody´s, Fitch IBCA.

The Czech Republic, Estonia, Hungary and Poland have very similar ratings.

Their rating is comparable to most countries in South-East Asia and the Middle

East. Of course, Russia has the worst rating and shows a very high probability of

default. Currently only Pakistan, Indonesia and the Ukraine have comp arable bad

ratings. This shows that with the exception of Russia, the other countries have

already reached a relatively high level of confidence in international capital

markets. The future integration into the European Union and the improvement in

economic development should further increase the ratings for this group of

countries. 14

1.1.6. Conclusion

After the strong decrease in GDP in the first half of the nineties most CEE

countries show a remarkable strong growth. The most important growth factor has

been gross fixed investment. Since the beginning of the economic upswing, also

productivity has significantly improved. But measured in terms of GNP per capita

the distance to the Western European countries is still very high. The consumer

14 Since the beginning of 1999 the ratings of Hungary and Poland have already been

slightly upgraded.


price inflation in all CEE countries strongly decreased since the beginning of the

transition process. Also, interest rates declined but real interest rates increased to

relatively high levels during the process of disinflation.

Most of the CEE economies show a high level of openness, especially towards the

European Union. A large amount (ca. 20 – 45%) of their GDP depends on exports

to the EU. The CEE countries, especially Estonia, Hungary, Poland and the Czech

Republic profit from capital inflows of international investors. Between 11% and

26% of gross fixed capital formation of these four countries is financed by foreign

direct investment. The high net liabilities of CEE countries to foreigners make

these countries vulnerable to sudden outflows of foreign capital, but they also

prove the high confidence foreigners have concerning the positive future

economic development. Nevertheless, the high external debt and the huge net

investment position of foreigners mark a potential risk for CEE economies and

capital markets if expectations on the future economic performance worsen e.g.

due to a postponement of EU entry.

The stock markets of Eastern European countries are still very underdeveloped in

terms of capitalisation and turnover. But the empirically found positive correlation

between the development of the economy and the stock market show that an

improvement in economic performance should also stimulate the development of

the stock market, and vice versa. The overall assessment of the economic situation

in CEE countries measured by international credit rankings shows that these

countries already have internationally - at least - a medium position.

For Russia the situation is almost always just the opposite of the CEE countries.

Russia is still in a recession or even depression, has a very low GNP per capita

level and extremly high inflation. The distrust in the economy is proved both by

huge net capital outflows and the worst possible credit rating.



Atje, R. and B. Jovanovic (1993): Stock Markets and Development, European Economic

Review, vol. 37, pp. 632-640.

EBRD (1998): Transition Report 1998.

EBRD (1999): Transition Report 1999.

Levine, R. and S. Zervos (1996): Stock Market Development and Long-Run Growth, The

World Bank Economic Review, vol. 10, No. 2, pp. 323-339.

OECD (1999a): Slovak Republic (OECD Economic Surveys).

OECD (1999b):Hungary (OECD Economic Surveys).

OECD (1999c): Joint BIS-IMF-OECD-World Bank Statistics on External Debt, (updated quarterly).

OECD (1998a): Czech Republic (OECD Economic Surveys).

OECD (1998b): Poland (OECD Economic Surveys).

Russian Economic Trends (1998a): vol.7, No. 3.

Russian Economic Trends (1998b): vol.7, No. 4.

Westin, Peter (1998): Threats and Consequences of Inflation, in: Russian Economic Trends,

vol. 7, No. 4, pp. 13-21.

World Bank (1997): Private Capital Flows to Developing Countries, Oxford University

Press, New York.

World Bank (1999): World Development Indicators.


1.2. Success of Privatisation in CEE Countries

1.2.1. Introduction

Privatisation is regarded as a necessary condition for the efficient functioning of

markets because without privatisation in combination with the allocation of

property rights, efficient microeconomic allocation through prices cannot be

obtained. While this is important for sustainable private sector growth and

efficient capital markets, the functioning of financial markets and a positive

stabilised and liberalised macroeconomic climate are also necessary for the

success of the privatisation procedure. Although, it is not the sufficient condition

and it is not the only condition.

The earlier successes of privatisation and liberalisation are now discontinued by

the as of now incomplete next phase of transition which addresses the more

difficult structural and institutional restructuring (EBRD, 1998). In addition to

this, CEE governments complain about the fact that their predecessors have

wasted the best times for the privatisation of hard to sell state-owned firms several

years ago when investors were more attracted by emerging markets than they are

today. Before summarising in 1.2.3. the extent of privatisation reached today,

1.2.2. first gives a short overview of the main methods of privatisation. 1.2.4.

shows that the process and the success of privatisation as well as the involvement

of foreign investors have had major impacts on the economic development as well

as on the emerging regulatory framework for financial markets (see chapter 2) and

on the development of market structures (see chapter 3).

1.2.2. Methods of Privatisation

There is a wide range of different methods of privatisation. Their economic effect

differs according to the degree of actual transfer of capital and property rights to

private owners. Only the more than formal privatisation (i.e. a privatisation that

goes beyond pure conversion of state-owned companies in stock corporations kept

by the state) as well as exposure to financial constraints and implementation of an

efficient bankruptcy mechanism can put the necessary competitive pressure on


Private owners are not always easily found. The evaluation of former public firms

is rather difficult, foreign investors are regarded with scepticism, and domestic

investors are often marked by a lack of savings. The small privatisations, i.e. the

privatisation of small firms which can adapt and be restructured more easily, were

completed relatively fast due to simple privatisation procedures and included

successful sales to private investors. The large privatisations, i.e. the privatisation

of large enterprises mostly from the industrial sector, were more difficult and are

still incomplete. Especially for the latter, new methods of transferring capital to


private owners had to be developed as sales to private investors were not always

feasible. However, such an alternative transfer did not always include an actual

privatisation 15 or the end of governmental interference.

Four main ways of “privatising” can be differentiated: sale to private investors,

internal buy-out by managers or employees, privatisation by vouchers as well as

the restitution of formerly expropriated firms. In practice, though at the beginning

of the privatisation process the countries mostly referred to one predominant

method, several methods have usually been adopted simultaneously. Each method

has its advantages and disadvantages which are summarised in the following.

Sale to Private Investors

The sale of state-owned companies to private investors is the common and

widespread method of privatising in market economies. At the beginning of the

transition period, the former socialist countries were eager to refer to this method

as well. Such a sale of a state firm to private hands can be a sale to individual

investors by a formal procedure like a public offer as well as by an informal

procedure, the latter often being more flexible and faster than the former, but

without making use of market mechanisms. However, only Estonia and Hungary

were capable of privatising a larger part of their state-owned companies by direct

sales to external investors (World Bank, 1996). Further, state companies can be

sold to anonymous investors in the process of privatising, e.g. by a capitalisation

on the stock market. However, financial markets as well as the stock exchange

have not well functioned in the past in many CEE countries.

The first and strong advantage of this kind of privatisation method is the

generation of revenues for the state by the sale to investors. Another advantage is

that the companies are handed over to outsiders who are interested in profitability

and efficient management while they can also afford the often necessary

restructuring of the formerly state-owned, and often inefficiently producing

enterprises. However, it is difficult to find willing investors for unprofitable

enterprises. In addition to this problem, domestic investors often do not have the

necessary financial resources and transition economies are generally rather

reluctant in the admission of foreign investors.

15 It is important to note that in the very narrow sense, only sales to private investors can be

regarded as privatisations. In a less narrow definition, already the transfer of capital to

private actors is called privatisation though sometimes it is the state who remains the

owner of the “privatised” stock corporations. According to Goldstein and Gultekin

(1998) privatisation is in fact a process that changes production as well as pricing

totally while transfering control over both from public to private hands.


Management- or Employee-Buy-Out (MBO, EBO)

This method is very fast and leads to company owners who are familiar with the

companies’ internal structures and business-related knowledge. Large straight

insider sales took place in Poland and Slovenia. The problem with this method is

that an internal buy-out is often equivalent to a free distribution of company shares

to employees or managers. In most cases they are rather reluctant to engage in the

necessary restructuring that is usually linked to staff reduction. Further, employees

often cannot afford to invest in the company. However, the internal buy-out seems

to have been a successful and adequate method for smaller companies relying

strongly on human capital.

Voucher Privatisation

The privatisation through vouchers - a variety of different procedures existed - can

be a fast and equitable kind of distributing the state’s property to private citizens.

Governments using this method of mass privatisation therefore usually achieve an

immediate political benefit. In form of auctions, i.e. referring to market processes,

parts of companies are handed over to new owners.

The Czech Republic was the pioneering country making use of this method with a

seemingly great success of 75 % privatised firms in 5 years by this method.

However, the final result of such a voucher privatisation can be, which has been

the general case in the Czech Republic, the concentration of property rights in

investment funds controlled by state-owned banks. Ellerman (1998) points at the

bias that voucher funds introduce in the economy as they create a “financial

sector” that has little, if any positive financial role but is well-protected by friendly



By this way of privatising, companies are given back to formerly expropriated

owners. Though, property rights cannot always be allocated directly to their

former owners. Due to the long time period of expropriation, companies have been

transformed and their value has changed, former owners have moved away, or the

legal heirs have to be found. As the restitution implies no sale, there are no

revenues resulting from this method of privatisation.

As can be seen in Table 1, the restitution of enterprises did not represent one of

the more important methods of privatising. The principal privatisation methods

have been voucher privatisation programmes in the Czech Republic and the

Russian Federation 16 , the sale to outside owners in Hungary and Estonia as well as

internal buy-outs in Poland and Slovenia. While the Czech Republic and the

16 The Russian Federation's voucher program in fact was mostly combined with an insider

privatisation, often also characterised as an internal buy-out.


Russian Federation already started their mass privatisation through vouchers in

1992, Poland finally made use of this method in 1995.

Table 1: Privatisation methods ( medium/large sized firms, number or value of privatised

firms in %) as of end 1995










Others Still


Number 32 0 22 9 28 10

Value 5 0 50 2 3 40

Estonia Number 64 30 0 0 2 4

Value 60 12 3 10 0 15

Hungary Number 38 7 0 0 33 22

Value 40 2 0 4 12 42

Poland Number 3 14 6 0 23 54



Number 0 55 11 0 0 34

Notes: The category "privatisation through vouchers" in this table only refers to voucher

programmes including outsiders. Source: World Bank, World Development Report 1996.

1.2.3. Development of Privatisation

The extent of privatisation varies among CEE countries. According to the data

indicated in the EBRD Transition Report 1998, Poland has the lowest degree of

privatisation (only 36 % of medium and large enterprises turned out to be

privatised by 1997) while Estonia has succeeded very well in privatising. The

EBRD index of small-scale privatisation (EBRD, 1999) for 1998 ranges from 4

(Russia) to 4.3 (all others) and does therefore not differ much in the CEE countries

regarded here. Only with regard to the large enterprises, the EBRD index gives a

more differentiated picture: Poland, Russia as well as Slovenia are less advanced

(index of 3.3) while the other four are a bit more advanced in privatising (index of

4). Simultaneously, the banking sector is state-owned to a large extent in Poland,

Slovakia, Slovenia as well as Russia, but mostly privatised in the other countries.

Although some countries are still exposed to large difficulties in the privatisation

of larger enterprises, the official figures in Tables 2 to 8 indicate that besides

Slovenia (only 50 % in 1997) all countries have, from the mid-1990s on, reached a

relatively high degree of private sector production (65 to 75 %). 17

Private ownership is already widespread in the Czech Republic. Table 2 shows

how from 1992 to 1994 the private sector developed increasingly and that since

1994, the majority of the Czech GDP is produced by the private sector. However,

a quarter of the medium or large firms still belonged to the public sector in 1997.

These figures neglect that the Czech voucher privatisation led to close

relationships of banks and industrial companies (directly through equity holdings

as well as indirectly through investment funds under the control of often stateowned


Table 2: Key data of privatisation success in the Czech Republic

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 30 45 65 70 75 75 75

Share of medium/large firms privatised 57.9 66.7 71.6 74.2

Privatisation revenues (cumulative,

% of GDP)

1.6 2.6 2.8 3.3 NA

Number of banks

45 55 55 53 50 45

(of which foreign-owned)

(12) (12) (12) (13) (14) (13)

Asset share of state-owned banks 20.6 20.1 19.5 18 18.1 18.8

Source: EBRD Transition Report 1998, 1999.

According to the European Commission’s Progress Report 1998, only in some

sectors companies are still mainly state-owned, such as energy, chemical

companies, mining and steel mills. The banking sector is privatised by more than

80 %. In March 1998, the sale of the first of the remaining four large state-owned

banks IPB (to the Japanese investment bank Nomura) was completed. In May

1999, the KBC group (Kredietbank) of Belgium took over holdings in the second

bank CSOB. By 2000, the other two banks shall be privatised by June 2000. This

is important as a large part of the structural economic problems seems to lay in the

banking sector. The highest proportion of bank loans in the CEECs can be found

in the Czech Republic (at the end of 1998, 63% of GDP). In this context, the

stability of the financial sector is endangered as a burden of important bad loans

(about 30% of all credits) prevents the financial sector from creating an efficient

and market economic environment (European Commission, 1998).

17 Here, it is important to note that the private sector consists not only of privatised firms

but also of new founded firms.


However, the Progress Report (European Commission, 1999: 21) states that “in

July 1998 loan classification and provisioning rules were tightened, and the Czech

National Bank has since been pressing banks to be assertive towards debtors, and

to write-off more bad loans. These measures are crucial to improve the

transparency and the long-term financial health of the sector, but in the short term

they have induced more cautious lending practices on the part of the large stateowned

banks, thus worsening access to finance for most Czech enterprises and

aggravating the current recession.”

The EBRD data in Table 3 indicates the nearly complete privatisation of all

Estonian firms as well as banks. However, according to this data only 70 % of the

Estonian GDP is produced by the private sector – a low share compared to the

Czech Republic and Hungary, which by far do not reach the official privatisation

level of Estonia. According to the EU Commission’s Progress Report

privatisation, however, is not completely fulfilled, though it is advancing. With the

sale of Liviko distillery throughout 1999, industrial company privatisation was

largely completed (EBRD, 1999). The privatisation of Eesti Telekom, the most

important telephone operator, was completed in February 1999. Land privatisation

is also accelerating, but is still incomplete.

Table 3: Key data of privatisation success in Estonia

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 25 40 55 65 70 70 70

Share of small firms privatised 50.3 69.1 78.9 88.1 94.7 99.6

Shareofmedium/large firm privatised 57.1 86.5 95.4 99.0

Privatisation revenues (cumulative,

% of GDP)

2.2 6.9 9.4 10.6 12.9 13.7

Number of banks

21 22 18 15 12 6

(of which foreign-owned)

(1) (1) (4) (3) (3) (2)

Asset share of state-owned banks 25.7 28.1 9.7 6.6 0.0 7.8

Source: EBRD Transition Report 1998, 1999.

The financial sector has been marked positively by strong growth and increased

engagement of foreign investors. Very important in this context is the successful

launch of the Tallinn Stock Exchange. Nevertheless, ineffective control

mechanisms as well as speculations led the Estonian stock market to a sharp

decline at the end of 1997. After this crisis, the four largest financial institutions

have merged to form the two largest institutions in the consolidation process of the

commercial banking system and the state again obtained assets in the banking

sector. In any case, it is a good sign that foreign investors continued their


engagement in the Estonian banking system with e.g. the take-over of two large

banks by Swedish banks in 1998.

Table 4: Key data of privatisation success in Hungary

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 40 50 55 60 70 75 85

Share of small firms privatised 10.6 40.4 57.8 66.0 77.2 87.7 Na

Privatisation revenues (cumulative,

% of GDP)

1.2 1.8 2.7 5.9 9.6 12.6 13

Number of banks

35 40 43 42 41 41 40

(of which foreign-owned) (12) (15) (17) (21) (25) (30) (27)

Asset share of state-owned banks 74.4 74.9 62.8 52.0 16.3 10.8 11.8

Source: EBRD Transition Report 1998, 1999.

Mass privatisation in Hungary was officially completed in 1997. Though, it has to

be stressed that the introduction of market-orientated elements had been started in

the 1970s. Therefore, a number of privatisations had already taken place in the

1980s and the banking reform had started.

Besides, the renationalisation of Postabanka due to its problematic development,

the privatisation of the financial sector is far reaching, only 12 % of bank assets

were state-owned in 1998. Hereby, only minority participations are exerted by the

state which for example limits its influence to a single golden share in the largest

commercial bank OTP. Remarkably, the largest share of banks – 27 out of 40 - is

owned and controlled by foreign investors, i.e. 61% of assets at the end of 1998.

As several large state-owned banks are in foreign or at least joint ownership, their

influence is strong. This results in the starting international acceptance of the

Hungarian financial sector while, however, the degree of governmental

involvement in the capital market development as well as the low level of

customer-orientation of the commercial bank branches is still criticised.

In addition to the banking sector non-financial companies are mostly privatised as

well. 18 Hence, most sectors are now exposed to market forces and should function

efficiently – what has already been underlined by the Progress Report 1998. Most

revenues from privatisation, half of it were paid in foreign currency, have been

used to reduce public foreign debt. The government plans to hold “golden stakes”

in a number of private enterprises comprising some agricultural companies which

in fact includes an influence on changes in product lines as well as ownership

18 As a consequence, FDI in Hungary are decelerating and are now mostly restricted to



structures. In 1999 the privatisation of the telecommunications company MATAV

Rt was completed.

Table 5: Key data of privatisation success in Poland

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 45 50 55 60 60 65 65

Share of medium/large firms privatised 21.8 27.0 34.1 35.7

Privatisation revenues (cumulative,

% of GDP)

0.6 1.1 1.9 2.8 3.8 5.3 6.7

Number of banks

NA 87 82 81 81 83 83

(of which foreign-owned)

(10) (11) (18) (25) (29) (31)

Asset share of state-owned banks NA 86.2 80.4 71.7 69.8 51.6 48

Source: EBRD Transition Report 1998, 1999.

Compared to the other CEE countries, private sector production in Poland was not

as small as in Slovenia in 1997, but its share is lagging behind the other countries’

levels.In comparison to the other CEE countries, Poland has the lowest share of

privatised medium-sized and large firms of only 36 % in 1997 and of privateowned

banks of 52 % in 1998. The process of privatisation seems to increase

slowly, though steadily. At the end of 1999 the privatisation of the banking sector

in Poland seemed to be nearly completed. 34 of 80 banks are owned by foreign

capital owners, i.e. 52% of assets in tbe banking sector, having played an active

role in their restructuring.

The Polish government plans to have completed privatisation of most of the

remaining state assets before 2002. Privatisation over the period until 2001 should

cover more than 70% of the assets currently held by the State Treasury, and raise

more than euro 35 billion. 3000 enterprises were still state-owned in 1998, the 420

large companies represent the largest part (90 %) of these state assets. Around half

of these 3000 enterprises remain to be privatised under the direct sales method –

with only 156 direct sales made in 1998 (European Commission, 1999).

The privatisation plan for the coming years includes 1800 firms and envisages that

only 44 enterprises will remain in public ownership. In 1998 several of the largest

Polish companies were still completely state-owned 19 , a number of them were

subject to privatisation plans (TPSA, BPH, Group Pekao).

19 These include the two steel mills Huta Katowice and Huta Sendzimira, state telecoms

TPSA, the second largest fuel refinery, the national airline LOT, the insurance

company PZU, the railways, the savings bank PKO BP as well as the group of cooperative

agricultural banks BGZ.


Russia started mass privatisation in 1992 using a voucher program. However, the

Russian programme preferred the transfer of property rights to insiders –

employees and managers - and therefore actually ended in a more or less

unchanged and non-competitive environment. 20 The process of cash privatisation

in 1995 and 1996 was very slow. Additionally, the OECD points at the

institutional and legal problems in the Russian economy that continue to hinder

the successful restructuring and market creation. However, according to the EBRD

data 70 % of the Russian GDP in 1998 are produced by the private sector which is

about the same as in the more rapidly privatising transition economies.

Table 6: Key data of privatisation success in Russia

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 25 40 50 55 60 70 70

Number of firms privatised 23,000 8,414 3,675 1,546

Privatisation revenues

(cumulative, % GDP)

0.8 1.1 1.3 1.5 1.7 1.7 2.3

Number of banks

2,295 2,029 1,697 1476

(of which foreign-owned)

(19) (23) (26) (29)

Asset share of state-owned banks 40.9 42.2

Source: EBRD Transition Report 1998, 1999.

In mid-1997 the government finally intended to introduce a new case-by-case

privatisation program. However, only eight large-scale privatisations which in

addition did not include the sale of controlling stakes, were carried out in 1997

and 1998 (IMF, 1999e: 126). In addition, the privatisation programme aiming at

medium-sized and large enterprises is advancing very slowly (3500 firms in 1997

and 2500 in 1998). The 1998 financial crises even worsened the situation and the

financial attractiveness of investment engagements.

While in the banking sector privatisation has led to about 1600 commercial banks

in 1997 which were to a large extent private-owned 21 , the 1998 crisis in Russia has

restricted liquidity. Many banks reached their limit of solvency. As a consequence,

the Russian banking sector could not be prevented from a wave of bankruptcies,

mergers and renationalisations (increasing asset share of state-owned banks in

20 The most problematic result of the Russian mass privatisation was the frequent

dominance and increased influence of managers. This prevented a signalling of

successful privatisation and restructuring to the market as well as an opening of firms

for external financing and control.

21 However, these banks were often founded by large enterprises (as part of FIGs). For

further details see chapter 6.6.


1998) so that on Nov., 30 1999 the number of existing banks has gone down to


The privatisation process was started early, at that time when Slovakia still was

part of former Czechoslovakia with the first, common round of voucher

privatisation. Private sector share in production as well as the share of medium

and large firms privatised in the Slovak Republic has reached about the same

extent as in the Czech Republic.

Table 7: Key data of privatisation success in Slovakia

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 55 60 70 75 75

Share of small firms privatised 94 96.5 98 98.3 98.3 98.5

Share of medium/large firms privatised 59.6 66.9 71.3 79.4

Share of assets privatised 32.3 43.3 52.0 62.0

Privatisation revenues (cumulative, %

of GDP)

3.7 4.8 6.9 9.4 11.4 11.9 12.3

Number of banks

18 19 25 24 25 24

(of which foreign-owned)

(3) (4) (9)


(9) (8)

Asset share of state-owned banks 70.7 66.9 61.2 54.2 48.7 50

Source: EBRD Transition Report 1998, 1999.

However, in 1998 the banking sector is still state-owned with 50% to a large

extent. The sale of the IRB, directly administrated by the National Bank of

Slovakia, should be finalised by the end of 1999. In preparation of further

privatisation procedures, some top managers have been replaced and bad loans are

either avoided or actively tried to be recuperated (European Commission, 1999:


The government still exerts a remarkable influence in the Slovak economy and a

group of economically important firms in the machinery sectors,

telecommunications, pharmaceuticals as well as agro-industry has been excluded

from the privatisation programmes. In addition to this strong governmental

involvement, the Progress Report criticises the low degree of FDI in Slovakia.

Furthermore, the Transition Report 1998 points at the lack of transparency in the

process of privatisation. As a consequence, the legality of a number of nontransparent

and unfair privatisation deals from the past are now being checked

which could lead to some new, but transparent and open procedures (European

Commission, 1999: 23). A new law on large-scale privatisation from June 1999

allows the sale of strategic enterprises.


Slovenia is marked by a very low private sector share in GDP of only 50 % in

1998. Enterprise restructuring has only been enforced very slowly so far, but now

seems to proceed which is demonstrated by the sharp increase in the share of

privatised firms from 7 % in 1994 to 72 % in 1997. Since the bankruptcy

mechanism has started to work, the most unprofitable enterprises (and many

enterprises were particularly characterised by losses) went bankrupt. 44% of total

Slovenian assets belong to non-privatised or state-owned companies where losses

are concentrated (European Commission, 1998).

Table 8: Key data of privatisation success in Slovenia

1992 1993 1994 1995 1996 1997 1998

Private sector share in GDP 20 25 30 45 45 50 50

Share of firms privatised 7.0 26.0 62.0 72.0

Privatisation revenues (cumulative,

% of GDP)

0.00 0.4 0.8 1.3 1.8

Number of banks

45 45 44 41 36 34 34

(of which foreign-owned)

(2) (5) (6) (6) (4) (4) (3)

Asset share of state-owned banks 47.8 39.8 41.7 40.7 40.1 41.3

Source: EBRD Transition Report 1998, 1999.

In the privatisation of the so-called “socially-owned” (i.e. employee managed)

enterprises only few foreign investors have been involved. Instead, many of these

small and medium size companies have been taken over by their employees

(internal buy-out) who probably are financially restricted. However, the bigger

ones were sold to private, but mostly domestic, investors.

Besides sectors like insurance, steel and mining (only in May 1999, the first steel

company has been privatised), the state is still predominant in the banking sector –

41 % of assets were state-owned in 1998. Particularly problematic is the fact, that

the financial sector is not exposed to any important competitive pressure. This

situation might change due to the introduction of a new Banking Act in 1998

which increased the openness of the financial sector to foreign investors.


Figure 1: Average Government Participation in CEE Companies in 1997 and

1998 22








Czech Republic


3.78 4.34









1997 1998


Slovenia (5) Slovakia (5)

Note: Average fraction of shares held by the government in the firms listed in the highest

market segments. Number of companies given in brackets for each year (1997;1998).

Source: Budapest Business Journal (1998, 1999), own calculations.

Figure 1 gives the average extent of state-ownership in the CEE companies listed

in the highest market segment in 1997 and 1998. 23 Average government

involvement is extremely high in the Czech companies - alarming if one notes that

this represents the involvement in some of the best-perfoming companies and that

this averge involvement increased strongly between 1997 and 1998. 24 In Poland,

Slovakia and Slovenia governments’ influence is rather moderate while it is very

low in Hungary. 25

22 For further details on the ownership structure of these firms see Table 3 in chapter 3.2.

23 Here, a direct comparison is somewhat biased due to the fact that companies listed in the

highest market segment in some cases (especially in the Czech Republic) have

changed between 1997 and 1998.

24 If one regards the distribution of governmental involvement among these companies, it

can be seen that in 1997 the Czech state owned more than 50% of assets in 8 out of

the 34 considered companies while state ownership was less than 10% in not less than

20 companies. However, governmental involvement increased from 1997 to 1998 as

in 1998 11 out of the 20 companies considered in that year were state-owned to more

than 50% and only the remaining 9 of the 20 firms were state-owned to less than 10%

with 5 companies totally private-owned.

25 If the statistics were calculated with a weight for each firm equal to market capitalisation

the results would not differ much. However, the weighted average government

participation was 38.03% (instead of 22.34%) in 1997 and 48.16% (instead of

33.87%) in 1998 in the Czech Republic as well as 44.03% (instead of 12.06) in 1998

in Poland. This indicates that in these countries, the government involvement was

higher in larger enterprises in the given years.

1.2.4. Success of Privatisation

The results of several studies have shown that privatised firms as well as new

private sector enterprises develop in a better way than state enterprises (EBRD,

1997: 77-78) However, such results might be biased as the more efficient firms are

the first to be sold to (often strategic) investors. Nevertheless, the introduction of

clear property rights as well as of an efficient corporate governance influences

firms’ outcomes. 26

Some general developments concerning privatisation and the effect on enterprises

are differentiated by the EBRD (1997). It was the rapid privatisation by sales to

strategic investors as in Estonia and Hungary that led to the best company results.

The Czech Republic made use of a voucher program without privileging insiders

and therefore was also marked by rapid successes in privatisation. 27 But even

internal buy-outs as in Poland have been superior to the management in stateowned

enterprises. This is in line with the findings of Havrylyshyn and

McGettigan (1999) who compare a variety of existing and recent studies on

privatisation experiences in CEE countries. De novo or greenfield enterprises

seem to be the best performing enterprises, while privatised outsider-dominated

firms are more efficient than privatised, but insider-dominated ones. However, the

economic performance is better for privatised firms regardless of the privatisation

procedure than for state-owned enterprises.

Simultaneously, the way and success of privatising has enormously affected the

development of security markets in the CEE countries (Blommestein, 1998: 15-

18). 28 The mass privatisation by use of the voucher method in countries such as

the Czech Republic and Russia was implemented without the existence of

functioning financial markets. Only with increasing demand by market investors

to improve financial services and supervision on the capital markets, the emerging

financial markets have been regulated ex-post. 29 In other countries, e.g. Poland,

the financial markets as well as the private sector were supposed to be created

simultaneously. However, because of the slow privatisation process in Poland, the

financial markets did not develop rapidly.


For further details on the issue of corporate governance, finance and performance in

CEECs see 7.1.1.


Though the overall success of Czech privatisation is rather mixed as explained earlier on.


Chapter 2 presents the influence the process of privatisation of enterprises as well as of

the banking sector had on the emerging regulatory framework for banking and

securities markets.


By its nature, privatisation by a voucher scheme includes the creation of mutual fonds.

As long as the legal framework does not guarantee the execution of the law and legal

forms as well as of bankruptcy proceedings, the financial intermediares bear no or

only few risk and may not always exercise the adequate or needed monitoring or



According to Blommestein (1998), countries like the Czech Republic that

privatised early while relying on mass privatisation methods in general obtained a

high capitalisation level, though a lack in liquidity. In contrast to this situation,

those countries that were more reluctant to privatise had a lower level of offered

shares and were therefore marked by a higher liquidity. Poland, for example,

though trade here was active, was characterised by a low degree of capitalisation

that has only increased since 1997. Hungary followed an intermediate way with,

though low at the beginning, steadily increasing capitalisation and liquidity. Since

1996 a trend to convergence of the capitalisation levels and liquidity levels in the

CEE countries can be found, i.e. their development seems to become more

independent from the former way of privatisation.

Closely related to the success of the privatisation process and of the development

of a sound financial sector is a market-orientated privatised banking sector. 30

Traditionally, the CEE countries were characterised by the presence of a

government-directed banking sector without independent financial institutions.

This often monopolistic sector had to be transformed into a two-level banking

system by establishing private-owned commercial banks in addition to an

independently acting Central Bank. Although the privatisation process has begun

at the end of the 1980s in Poland, Hungary, and the Czech Republic and the

recapitalisation process at the beginning of the 1990s, both are still incomplete

(Bonin and Wachtel, 1998). The famous Hungarian Postabank scandal took place

in 1997 and is an example of the still not fully restructured banking sectors in

most transition countries - not even in Hungary which seemed to be the most

developed. As a consequence, the banking sectors do not exert their private sector

control by inducing a hard budget constraint to a sufficient degree. While in

functioning market economies banks have a strong position in private finance and

control of enterprises, banks in transition economies generally lack experience in

management, restructuring and even in assessing the credit-worthiness of their


In spite of the political fears and the higher sensitivity in case of financial or

economic crises and capital outflows, foreign investors play a substantial role in

the transition of former socialist economies. 31 In fact, it is the inflow of foreign

capital that can provide the transition economy with some of the capital needed for

restructuring both the banking sector as well as the industrial sector. Foreign

(strategic) investors also possess market knowledge and management skills so that

positive knowledge spill-overs to the managers and workers, often inexperienced

with market economic conditions or even untrained, can take place. In addition,


The development of the banking sectors in the different transition economies is discussed

in detail in chapter 1.3.


According to Hunya (1998b) about 50% of the FDI in the CEE countries was used for

privatising companies. The selected privatisation methods have reinforced FDI in

Hungary and discouraged it in the Czech Republic, Slovenia and Slovakia.


foreign direct and institutional investors instantly introduce stronger financial

discipline. Simultaneously, economic openness as well as the introduction of

world price levels is reinforced. As a consequence, an increase in competition and,

in the best case, the de-monopolisation of some markets will take place.

Regarding (as in Figure 1) the ownership structure of the CEE companies listed in

the highest market segment, it can be seen in Figure 2 that the foreign ownership

in these few, but well performing companies on average amounts to about 49% in

Hungary (which has had a very low government participation), 21% in the Czech

Republic and Slovakia as well as 27% in Poland and nearly 9% in Slovenia in

1998. Simultaneously to the strong increase in the average government

participation in these firms in the Czech Republic, the average share of foreign

investors sharply declined between 1997 and 1998 – to some extent certainly due

to the Russian financial crises in 1998. In Hungary, foreign investor engagement

also slightly decreased while it slightly increased in Poland.

Figure 2: Foreign ownership of CEE companies










Czech Republic












1997 1998


Slovenia (5) Slovakia (5)

Note: Average fraction of shares held by foreign investors in the firms listed in the highest

market segments. Number of companies given in brackets for each year (1997;1998).

Source: Budapest Business Journal (1998, 1999), own calculations.

Foreign portfolio assets in the stock market relative to market capitalisation is

highest in Estonia with more than 50 %, still high in the Czech Republic, Poland

and Hungary and very low in Slovenia. 32 However, the structure of foreign

liabilities shows that in 1997 the stock of FDI was much higher in its amount in

each CEE country than the stock of foreign portfolio investment. 33

FDI flown into Central and Eastern Europe amounted to an annual average of

nearly $ 6 billion during 1992-1994 and to more than twice that amount during

1995-1996 (UNCTAD, 1997: 96-105). Focussing on the regional allocation of

absolute FDI flows, a concentration of capital can again be detected in those

countries that proved to show the highest average degree of foreign ownership in

the companies listed in the highest market segment in Figure 2. 68% of 1996 FDI

inflows measured by the UNCTAD went to the Czech Republic, Hungary and

Poland while the same countries accounted for 73% of the FDI inward stock.

Originally, Hungary received most of FDI inflows, while now Poland seems to

attract the most foreign investors in CEE countries.

However, for a relative comparison, FDI inflows have to be regarded in terms of

GDP or gross fixed investment (GFI) and not in absolute terms. Table 10 in

chapter 1.1 shows that from 1994 to 1998 Estonia and Hungary, the best

performers in privatisation, are marked by the highest level of FDI flows in terms

of GDP of 7.1% and 5.2% as well as in terms of GFI (26.4% and 25.2%), the

Czech Republic (3.3 or 11.2%) and Poland (3.2 or 15.5%) by a rather intermediate

level while Slovenia (1.1 or 4.9%), Slovakia (1.8 or 4.0%) and Russia (0.8 or

3.9%) show the lowest level of FDI flows in terms of GDP or GFI. 34 The

increasing trend of capital inflows to CEE countries, however, stopped in 1996

(UNCTAD, 1997). 35 This, to some extent, was due to appearing or persistent

macroeconomic difficulties. Additionally, the big or mass privatisation

programmes were more or less either completed or stopped.

1.2.5. Conclusion

Summarising the process and the effects of privatisation in the CEE countries, it

can be shown that the sale to private investors, a management- or employee-buyout

as well as the voucher mass privatisation have been used as the main methods

of privatisation in the CEE countries regarded.

However, the extent of privatisation varies among countries: In 1998, Poland

shows the lowest, Estonia the highest degree of privatisation. The banking sector

is mostly privatised in Hungary as well as Estonia. The Czech Republic referring

32 See Figure 2 in chapter 3.2.

33 See Figure 1 in chapter 3.2.

34 If one notes that the world average for FDI inflows to GFI has been about 5% in 1995

(Hunya, 1998b), the foreign investment shares of many of these CEE countries are


35 Further details on the development and problems of international capital flows can be

found in chapter 6.1. dealing with capital account liberalisation as well as in 1.1.4.


to a large voucher program suceeded in having fast privatisation, but is now

confronted with inherent structual problems.

The rapid privatisation by direct sales (often to strategic and foreign investors) in

Estonia and Hungary led to the best company results. Even better results,

however, were reached by „de novo“ or greenfield enterprises. In any case,

privatised outsider-dominated firms show a better performance than privatised, but

insider-dominated firms.

In addition, foreign investors have played a substantial role in the success of

transition and privatisation. This is underlined by the fact that the best performing

countries, Hungary and Estonia, are marked by the highest FDI inflows in terms of



Blommestein, Eva T. (1998): The Development of Securities Markets in Transition

Economies – Policy Issues and Country Experience, in: OECD proceedings: Capital

Market Development in Transition Economies, Country Experiences and Policies for

the Future, 13-34.

Bonin, John and Paul Wachtel (1998): Bank Privatization in Poland, Hungary and the

Czech Republic, mimeo.

Budapest Business Journal (1998, 1999), Equity Central Europe (1998) 1999, Budapest:

New World Publisher.

Ellerman, David (1998): Voucher privatization with Investment Funds: An Institutional

Analysis, World Bank Working Paper Series No. 1924, May 1998.

European Bank for Reconstruction and Development (1995, 1997, 1998): Transition


European Commission (1998): Regular Report from the Commission on Progress towards

accession. Different country reports.

European Commission (1999): Regular Report from the Commission on Progress towards

accession. Different country reports.

Goldstein, M.A. and N.B. Gultekin (1998): Privatization in post-communist economies in

Doukas et al: Financial Sector Reform and Privatization in Transition Economies, 283-


Havrylyshyn, Oleh and Donal McGettigan (1999): Privatization in Transition Countries: A

Sampling of the Literature, IMF Working Paper 99/6.

Hunya, Gábor (1998a): Direktinvestitionen in Mittel- und Osteuropa, Central European

Quarterly I/98, 86-90.

Hunya, Gábor (1998b): Recent Developments of FDI and Privatization, The Vienna

Institute Monthly Report 1998/5, 2-7.


IMF (1999a): Hungary: Selected Issues – IMF Staff Country Report No. 99/27.

IMF (1999b): Republic of Poland: Selected Issues – IMF Staff Country Report No. 99/32.

IMF (1999c): Republic of Estonia: Selected Issues and Statistical Appendix – IMF Staff

Country Report No. 99/74.

IMF (1999d): Czech Republic: Selected Issues – IMF Staff Country Report No. 99/90.

IMF (1999e): Russian Federation: Recent Economic Developments – IMF Staff Country

Report No. 99/100.

IMF (1999f): Slovak Republic: Selected Issues and Statistical Appendix – IMF Staff

Country Report No. 99/112.

UNCTAD (1997): World Investment Report 1997: Transnational Corporations, Market

Structure and Competition Policy.

World Bank (1996): World Development Report – From Plan to market, Washington.


1.3. Monetary Policy and Banking Systems

1.3.1. Introduction

In this chapter, we analyse the historic development and the present situation of

the monetary policy and the banking system in those five CEE countries which

belong to the first group that has entered the negotiations to join the European

Union. In addition, we also take a closer look to the situation in Russia.

Forming part of chapter 1 which aims to present the macroeconomic background

for the development of capital markets in those countries, our present analysis of

the banking system takes an exclusively macroeconomic viewpoint. The banking

system in those countries is decisively affected by the general macroeconomic

development and by the macroeconomic policies pursued in the different areas.

Within the following analisis, the term banking system comprises both the central

bank and the commercial banking sector. It follows that the monetary

development and the monetary policy has particularly to be taken into account

when considering the banking system including the central bank.

The macroeconomic policies prevailing in any country as well as the situation of

the banking system condition the origin and development of the capital markets,

both the equity market and the market of debt securities in that country. Policies

towards financial stabilisation have an impact on both the commercial banking

sector and the capital markets. The strength of the banking sector is not only

significant for the macroeconomic stability, but also relevant to the capital

markets. On the one hand, commercial banks´ deposit taking and lending activities

constitute a channel of financial intermediation competing with other channels, for

instance the equity market (see the synopsis of funding sources of the corporate

sector in chapter 7.1.2). On the other hand, commercial banks are one important

group of domestic investors in the framework of capital markets, in particular

within the market of government debt securities denominated in local currency

(see chapter 3.1.2).

The present chapter starts with a brief description of the status-quo ante, the

situation of the banking system before the transformation, and of the main

systemic changes introduced in the course of transformation, including the recapitalisation

programmes by the government. After discussion of the

development of the ratio of the money supply to the gross domestic product during

the first years of transition, the main monetary policy steps of the central banks are

sketched. It follows the description and analytical explanation of the monetary

developments during the more recent period of 1995-1998. Here we focus not

only on the general money velocity, but also on the main components of money

supply, the net foreign assets and the domestic credit. In addition, we analysed the

importance of the FX-denominated part of domestic assets and liabilities of the

banking system. Emphasis is put on the development in Russia during that period,


the ambitious stabilisation effort and the failure to survive the global effects of the

Asian financial crisis.

In order to get more insight into the role of the banking system within the whole

economy, we performed a comparative-static analysis of the sub-aggregates of the

domestic credit, separating the credit to the government extended by the central

bank and by the commercial banking sector as well as the credit to the corporate

sector and to the households. Based on this analysis, we assessed the importance

of the domestic lending to the corporate sector for the financing of the gross fixedcapital

formation. In the last section of this chapter, we consider the development

of lending and deposit rates to non-banks and, in particular, the corresponding

interest rate margins.

Finally, we would like to hint to the chapter 6.5. where the focus rests with the

future adjustments to be expected in the banking system during the process of

approaching and integrating into the European Union. In that context, among other

things, further information on the status quo of the banking sector is given, also

from a microeconomic viewpoint.

1.3.2. Systemic Changes during the Transformation

In the framework of centrally planned economies the banking systems in the CEEcountries

(including Russia) had the following characteristics: 36

• Banking as a state monopoly

• Single-tier banking system: monolithic central bank, plus a limited number of

specialized banks (e.g. for foreign trade, agriculture, etc)

• Banks were not run as profit-maximizing business units, but were vital

elements of the centralized allocation system; hence, loans were granted on

the basis of criteria not related to market performance

The transformation policy regarding the banking systems consisted in the

following main measures:

• Introduction of a two-tier banking system: First, departments of the central

bank that had administered deposit or credit accounts were separated from the

central banks and converted into independent (but initially still state-owned)

commercial banks. Second, tasks and functions typical for central banks in

market economies were ascribed to the central banks: safeguarding their

respective currency´s internal and external stability, participation in prudential

supervision and participation in the management of the government debt.

• Lifting of sectoral restrictions on specialized banks.

36 See Müller and Würz, 1998.


• Admission of privately owned banks.

• Granting access to foreign banks and joint ventures.

• Allowing all the banks to freely conduct retail and corporate business and

liberalizing interest rates. However, for some activities, especially FXactivities,

a license had to be acquired.

• Development of legal framework and supervisory system.

The newly founded state-owned commercial banks inherited a huge burden of bad

loans against which their initial capital base was insufficient. Even more so as the

development of the legal framework took into account the relevant BIS-rules. In

addition to the inherited burden, new bad loans were incurred in the first years of

the transition, as criteria of economic soundness and risk were not applied, losses

were automatically covered, and either there were no bankruptcy laws or they

were simply ignored. 37

In the years 1993-96 bail-out programes were run for these banks by which the

government (often in the form of some specialised state-banks or state-agency)

took over a huge part of the non-performing loans, while replenishing the banks´

capital base. These recapitalisation programes were designed also to improve the

pre-conditions for future privatisations of the banking sector. Selling government

stakes at higher prices to domestic or (mostly) foreign investors should then partly

compensate for the additional debt burden incurred by the government.

The recapitalisation was often done by issuing special state securities and handing

them over to the commercial banks. These privately placed treasury securities

were mostly non-negotiable, at least initially. We tried to compare the size of the

bank rehabilitation programes in the different CEE-countries by focussing on the

outstanding face value of these issues. The following figure indicates that the

Hungarian program seems to have been by far more substantial.

In Hungary, the size of the banks´ recapitalisation laid the ground for the huge

sell-off of state stakes in banks in 1995-96. While these bond issues had

previously increased the public domestic debt significantly, the ensuing

privatisation of banks allowed to get significant parts of this support repaid.

Also in Slovenia, the bank rehabilitation programme was huge in size. The bank

rehabilitation agency had issued non-negotiable securities guaranteed by the

central government since 1993. Their total volume amounted to 6.6% of GDP at

the end of 1995, when the central government became the direct obligor of these

bonds. At the end of 1998, their face value reached 4.2%. In addition, in October

1997, a further bond was issued for bank rehabilitation, worth 1.6% of GDP at

year-end 1998.

37 See Müller and Würz, 1998.


Figure 1: Size of recapitalisation of banks (end of period, in % of GDP)

via privately placed government bonds











1993 1994 1995 1996 1997 1998

Poland Hungary

Source: Polish Ministry of Finance, Hungarian State Treasury.

The development in the banking sector in those countries highlights the

importance of timely and transparent policy of active government intervention. In

contrast, there has been a protracted bad-loan problem in the Czech banking sector

which can partly be linked to the lack of a sizeable and timely, systematic and

transparent recapitalisation effort. (In addition, this problem is due to the method

of privatisation that led to a difficult double role of banks as lenders and - via

funds - as owners of companies and to the lack of balance cleaning and fresh

capital for the corporate sector - see chapter 1.2.)

1.3.3. Monetary Developments during the Transformation The Starting Point: Monetary Overhang and its Erosion

Already before the start of the transformation, the level of money supply

(including FX-deposits) relative to nominal Gross Domestic Product (GDP) was

quite different between the CEE-countries. At the end of 1989, it amounted to

43% in Hungary, while it was 63% in Poland and 74% in the Czech Republic. In

Slovenia, it was 35% at the end of 1991. In Russia, the money supply (excluding

FX-deposits) reached a level as high as 66% at the end of 1990 and 1991.

However, due to the scarcity of goods relative to demand a large part of this

created money was considered to be a monetary overhang, leading to inflation in

case of a switch to a market economy.

Three factors led to the quick erosion of that monetary overhang:


• Soaring inflation: The initial wave of inflation was caused by several factors.

The liberalisation itself of prices and foreign trade was the single most

important factor. In Poland, the main liberalisations were introduced at the

beginning of 1990, in the Czech Republic (then forming part of

Czechoslovakia) at the start of 1991 and in Russia on 1 January 1992. In

Hungary and in Slovenia the liberalisations were more stretched from 1990-

91 and 1990-92, respectively. In addition, the national currency had been

devalued in all the countries before the main part of the trade and price

liberalisations took place. On the one hand, this fuelled the following

inflation, on the other hand, it prevented the trade balance from collapsing in

the wake of excessive real appreciation. The loss of confidence into the

national currency and the awakening of inflationary expectations certainly

increased the money velocity and, hence, inflation. While the structure of the

process was similar in all the countries, the size of the resulting inflation was

quite different, reaching from roughly 50% in the Czech Republic and 500%

in Poland to 1000% in Estonia and 1500% in Russia.

• Restrictive monetary policy: In most countries the initial monetary policy was

restrictive due to the phasing-out of automatic central bank financing of the

previous credit departments which had been converted into state banks.

Quantitative credit limits were obviously not (fully) inflation-linked.

However, one might argue that a less restrictive monetary policy would have

led to higher inflation, not substantially altering the final outcome of the size

of the erosion of the monetary overhang.

• Restrictive exchange rate policy: In most countries, the national currency was

held relatively stable after the initial devaluation. Already in the short-term

this was important in relation to the FX-part of the money supply. It helped to

correct the statistical money-increasing effect of the previous devaluation.

The notable exception was Russia, where the efforts to stabilize the currency

were rather limited. This has also to be seen in the context of the then-existing

ruble-zone which Russia had together with successor countries of the former

Soviet Union. On the other hand, Estonia even introduced a currency board

on 20 June 1992 with a peg of EEK 8 = 1 DEM.

In the one year of the main liberalisations, the yearly average money supply

relative to nominal Gross Domestic Product (GDP) had sunk from 36% (1989) to

24% (1990) in Poland, and from 48% (1991) to 19% (1992) (in both years

excluding FX-deposits) in Russia. In Slovenia it was down to 19% in 1992 as

well. This is all the more remarkable as the decline in real GDP was 9%-15% in

these countries in the same year, mainly due to the breakdown of the old structures

of the central planning and the COMECON and due to the loss of market shares

domestically and abroad. Moreover, this stands in sharp contrast to Hungary and

the Czech Republic where this ratio decreased relatively small compared to the

high initial ratio (Czech Republic), or else even increased (Hungary) (Figure 2).


Figure 2: Money supply including FX-deposits (yearly average, in % of GDP)










1990 1991 1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia Russia

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

Among the factors influencing this ratio, the main difference between Poland and

the Czech Republic or else Hungary was the size of the initial inflation which was

remarkably lower in the latter two countries. One explanation for the lower

inflation could be that the monetary overhang was simply smaller there, despite

the much higher average ratio in the Czech Republic before the liberalisations.

Furthermore, it is possible to argue regarding Hungary that the structures had

already been more liberal at the outset, reducing the need of adjustments in the

price structure and hence dampening inflation. However, the most striking fact is

that both countries applied a much lower initial nominal devaluation. This is true

also for Hungary, although the initial undervaluation relative to PPP (purchasing

power parity) was less pronounced in Hungary (-50%) than in the Czech Republic

and Poland (-62%). 38 In Poland, the higher initial devaluation had to do with the

strong black market activities in foreign currency before the liberalisation: the

(overshooting) US$-value on the black market was taken as the guiding mark for

setting the new exchange rate. In Russia, the huge initial devaluation was driven

also by the fact that the initial undervaluation relative to PPP (purchasing power

parity) was very small (only about 10%) in 1991.

38 see WIIW, 1998.

44 Monetary Policy in Transition 1990-1998

In Poland, Hungary and the Czech Republic the monetary conditions were rather

restrictive in the first years after the transition (1990-1993), although the real

refinancing rate was negative. First, the significance of the refinancing rate was

rather limited at that time, as quantitative limits on refinancing credit were in

place. Second, the most important instrument to manage both liquidity on the

interbank market and growth of credit to non-banks were not the refinancing rate,

but the minimum reserve requirements. In 1991-92, the level of the reserve

requirement ratios on primary deposits in local currency were above 20% in

Poland and 16% in Hungary. Third, the monetary conditions were restricted by the

strong real appreciation in Hungary (since 1990), Poland (since 1991) and the

Czech Republic (since 1992).

In 1992-93, inflation was sharply decreasing and real GDP was still declining. The

real increase in the money supply did not prevent inflation from falling, while in

turn it was enhanced by disinflation. The money velocity obviously declined. This

has to be attributed to the moderation of inflationary expectations, which has

probably been fostered by the antiinflationary exchange rate policy.

Figure 3: Reserve requirement ratio on LCY-deposits (weighted average in %)















Poland Hungary Czech


7.0 6.7


1994-95 1997-98






Slovenia Estonia Russia

Source: Bank of Estonia, Bank of Slovenia, Czech National Bank, National Bank of

Hungary, National Bank of Poland, The Central Bank of the Russian Federation, Raiffeisen

Zentralbank Österreich AG, Russian-European Center for Economic Policy.

Since 1993 (Hungary), 1994 (Poland) and 1995 (Czech Republic, Slovenia) the

central banks have developed open market operations as their main form of

liquidity management, based on short-term government securities (T-bills) 39 .

Hence, repo and reverse repo rates became the key monetary policy rates

(included in Figure 4). In addition, central banks´ liquidity bills were issued. In

Poland and Hungary, the reserve requirement ratio were lowered to 13.4% and

14.2%, respectively (see Figure 3). This was both a reflection of the previous

disinflation and part of a shift in the policy instruments towards the interest rates.

This shift had become all the more necessary as foreign portfolio capital started to

pour into these countries´ fixed-income securities denominated in local currency.

However, the reserve requirements continued to play an important role to dampen

domestic credit growth.

Figure 4: Real key monetary policy rate (CPI-deflated) (in % p.a.)


















1990 1991 1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia Russia

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

It is important to note that the nominal interest rates on the required reserves have

been zero in Poland and in the Czech Republic all the time. In Slovenia, this rate

has been 1%, and in Estonia it has been equal to the discount rate of the

Bundesbank or else ECB, in conformity with the currency board. Only in

Hungary, the interest rate on required reserves has been brought a bit closer to the

reverse repo rate during recent years, without yielding positive real rates, however.

39 In Slovenia, FX-denominated bills of the Bank of Slovenia (central bank) have been


In all these countries, the resulting huge negative real interest rate on quite a

significant part of their deposits has been denting competitiveness of domestic

commercial banks vis-a-vis foreign-owned banks which do not depend so much

on primary deposits as funding source.

While Hungary, the Czech Republic and Estonia have had the same reserve

requirement ratios for both LCY-deposits and FX-deposits, Poland and Slovenia

have followed other ways. In Poland, the ratio on FX-deposits has been markedly

lower than the ratio on LCY-deposits for several years which has implied to

favour the interest rates offered to non-banks on FX-deposits and to weaken the

value of the local currency. Quite at the contrary, Slovenia has maintained very

high reserve requirement ratios on FX-deposits. Indeed, the weighted average ratio

was even increased from 47% in 1992 to 58% in 1998. This was part of a decisive

policy to foster holding of investments in LCY without too high a level of real

interest rates for the LCY.

Higher real key rates in 1998 were due to nominal rates not lowered quickly

enough to follow the disinflation, which was enhanced by the low oil prices.

Taking into account all the monetary policy instruments, one can clearly state that

from 1994-95 to 1997-98 the monetary policies of the National Bank of Poland

and of the Czech National Bank have become more restrictive. In Hungary, there

was an easing of monetary policy from 1994 to 1997, followed by a tightening in

1998. The Bank of Slovenia seems to have been conducting not only a rather

stable monetary policy, but also the least restrictive or else most pragmatic

monetary policy of these five countries (including Estonia) (see Figure 3 & 4).

In Russia, both the monetary policy and the exchange rate policy was loose in

1992-94. These policies slowed the dis-inflation, with annual average inflation

amounting to 310% still in 1994. Despite huge nominal increases in the money

supply and further big nominal devaluations of the ruble, the resulting high

inflation led to a sharp decline in the real money supply and to a strong real

appreciation of the ruble. The yearly average money supply relative to nominal

Gross Domestic Product (GDP) sank to only 10% (excluding FX-deposits) in

1993. That increase in the money velocity was probably due to these policies

failing to inspire confidence among the market participants which stimulated high

inflationary expectations. In 1994, the money supply to GDP ratio remained

nearly stable. Sharply higher domestic credit to finance an expenditure-driven

increase in the budget deficit from 4.4% to 9.1% of GDP was compensated by a

dramatic decline in the net foreign assets. Following a further sharp devaluation of

the ruble in October 1994, a change of course was designed under a new (interim)

head of the central bank in close cooperation with the IMF. After the loose

policies of previous years, a strong effort towards stabilisation was started.

47 Main Monetary Developments 1995-1998

In Poland, the combination of real growth in the money supply and disinflation

which we had witnessed already in 1991-93 continued from 1994 to 1998.

Certainly, the acceleration of real GDP growth had increased the money demand.

However, despite the growth in real GDP, also the ratio of money supply to GDP

continued to rise (see Figure 2). The implied slowdown of the money velocity has

to be seen in the context of further real appreciation which stabilized expectations,

in addition to its favourable cost-effects on the inflation. Both domestic

households and foreign institutional investors were increasingly confident into the

domestic currency, which was finally reflected by a declining share of FXdeposits

in total money supply (see Figure 5) and by rising net foreign assets

(NFA) (see Figure 6). 40 Hence, money velocity excluding FX-deposits declined

particularly strong. In contrast, domestic credit remained rather stable (see Figure

7), while the expectation of further long-term real appreciation led more

enterprises to refinance themselves in foreign currency also domestically (see

Figure 8). The declining share of FX-deposits had an increasing effect on the

money supply in local currency also in the way that the domestic interest rates

(applied on LCY-deposits) were higher than the nominal appreciation of foreign


In Hungary, the development was rather similar to the Polish one, after the

balance-of-payment crisis of 1994 had been overcome. This balance of payment

crisis was caused by: (1) the fact that Hungary (contrary to Poland) continued to

carry the total burden of the external debt inherited from the old system, (2) an

excessively quick real appreciation combined with a relatively low level of initial

undervaluation, (3) an overly hard bankruptcy law damaging important exporters,

(4) the decline in external demand due to the slowdown of growth in the EU, and

(5) the excessive domestic demand due to the public sector. Money velocity

started to rise already in 1994, reflecting fading confidence into the local currency.

40 We would like to point out that the mere valuation effect of real appreciation would lead

to a declining ratio of money supply to GDP, ceteris paribus (in particular, with

constant NFA in FX-terms). However, the increased confidence triggered by real

appreciation and the expectations of future stability or even further appreciation in

real terms resulted in rising NFA in FX-terms and a rising ratio of NFA (in LCYterms)

to GDP. Hence, the confidence-driven flow effect overcompensated the

valuation effect of real appreciation.


Figure 5: Foreign exchange deposits of residential non-banks

(end of period, in % of money supply including FX-deposits)








1991 1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia

Source: Bank of Slovenia, Czech National Bank, National Bank of Hungary, National Bank

of Poland, Raiffeisen Zentralbank Österreich AG.

In March 1995, a policy package was announced which comprised a correcting

nominal devaluation of 8%, the installation of a more predictable exchange rate

policy (crawling peg system), the introduction of an import surcharge (which was

important both for the current account and the budget) and some (minor) fiscal

measures. In addition, decisive steps to further privatisations (e.g. in the banking

sector) were taken. These measures reestablished the confidence into the domestic

currency in 1996, as it is shown by the declining share of FX-deposits (Figure 5),

the rising net foreign assets (Figure 6) and the increasing domestic refinancing of

enterprises in foreign currency (Figure 8). The ratio of total money supply to GDP

stabilized again (see Figure 2). However, it has not yet increased, as the domestic

credit has been sharply reduced (Figure 7). The privatisation revenues supported

both the increase in NFA and the reduction of domestic credit.

In the Czech Republic, after having experienced a development similar to the

Polish one in 1991-1994, a quick and comprehensive liberalisation of the flows on

the financial account was introduced in October 1995. This fuelled further real

appreciation despite the worsening of the current account balance. The stock of

foreign investment into the local currency in the form of portfolio and other

investment further increased after interest rates were hiked in the mid of 1996. Net

foreign assets remained relatively stable in 1996, as the losses due to the current

account deficit were compensated by the capital inflow. The fight to defend the

exchange rate regime caused the net foreign assets to decline. After that fight was

finally lost in May 1997, the current account and the net foreign assets improved,


implying a rather stable year-average ratio in 1997 and a higher ratio in 1998 (see

Figure 6). As total domestic credit showed small changes into the opposite

directions in 1997-98 (see Figure 7), the money supply to GDP ratio was rather

stable (see Figure 2). However, the disappointment with the domestic currency led

the households to hold a higher share of FX-deposits, albeit still below the levels

in other countries (see Figure 8). Concerning the high level of the ratio of

domestic credit to GDP, we would like to refer to our analysis in the sub-chapters and 1.3.4.

Figure 6: Net foreign assets of the banking system (average, in % of GDP)









1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia

Source: Bank of Slovenia, Czech National Bank, National Bank of Hungary, National Bank

of Poland, Polish Central Statistical Office, Raiffeisen Zentralbank Österreich AG, WIIW.

The efforts of the Bank of Slovenia to cut back the FX-holdings of households

have proven to be successful. The pursued policy of moderate real appreciation

against the German Mark or else the euro was supported by the minimum reserve

requirements in its effect on the declining share of FX-deposits (see Figure 5). The

stable increase in net foreign assets and in the domestic credit parallel to moderate

disinflation implied a decrease in money velocity (see Figure 2, 6, 7). Declining

FX-funding due to severe reserve requirements on FX-deposits both of households

and of non-residentials seemed to have played the crucial role in the roll-back of

FX-credit to companies despite the process of real appreciation (see Figure 8).


Figure 7: Domestic credit (including FX-credit) of the banking system (average, in % of

GDP) 41









1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia

Source: Bank of Slovenia, Czech National Bank, National Bank of Hungary, National Bank

of Poland, Polish Central Statistical Office, Raiffeisen Zentralbank Österreich AG, WIIW.

Regarding the monetary development in Estonia, one has to stress that the only

monetary instrument available to the central bank have been the reserve

requirements which have not changed since the introduction of the currency board

arrangement in 1992. The increase in domestic credit (from 8% of GDP in 1994 to

28% in 1998) outpaced the decline in net foreign assets (from 22% of GDP in

1994 to 8% in 1998). The decline in NFA resulted from the strong deterioration in

the current account balance. However, it is important to note that 72% of the total

domestic credit was FX-denominated in 1998, while only 16% of the total money

supply was held as FX-deposits. The free switch between the EEK and the DEM

or else the euro which is guaranteed by the currency board seems to be very much

relied upon on the level of households and enterprises. Simultaneously, enterprises

tend to prefer FX-credits as their interest rates are still lower than those of EEKcredits.

41 In Hungary, foreign credit to the public sector was channelled through the central bank.

In order to get levels approximatively comparable to those of other countries, the

central bank´s credit to the government which stems from the increase in the HUFequivalent

of that debt resulting from devaluation had therefore to be excluded (yearaverage

1994: 31%, 1998: 23% of GDP).


Figure 8: Foreign exchange credit to residential non-banks (average, in % of GDP)










1992 1993 1994 1995 1996 1997 1998

Poland Hungary Czech Rep Slovenia

Source: Bank of Slovenia, Czech National Bank, National Bank of Hungary, National Bank

of Poland, Polish Central Statistical Office, Raiffeisen Zentralbank Österreich AG, WIIW.

In Russia, the new effort toward stabilisation comprised the monetary policy, the

exchange rate policy and the fiscal policy. The main monetary policy instrument

was the minimum reserve requirement ratio which was hiked to 20% as of 1

February 1995. In addition, also the refinancing rate was sharply raised, giving an

annual average rate of 23% in real terms. This led the exchange rate to quickly

stabilize, including several months of even nominal appreciation. The general

government expenditures were slashed by 6.5%-points of GDP. However, the

simultaneous squeeze, which implied a decrease of total domestic lending from

32% of GDP at end-94 to 23.5% of GDP at end-95, led to a fall in budget

revenues by 3.5% of GDP, leaving only 3%-points as improvement in the budget

deficit from 9% of GDP in 1994 to 6% of GDP in 1995.

The strong policies inspired confidence into the ruble and lowered inflationary

expectations, which helped to bring about a sharp dis-inflation. With parallel real

increase in the money supply this was linked to a strong decline in money

velocity. The share of FX-deposits in total money supply decreased considerably.

We would like to stress that the decline in budget revenues resulted from the

aggravation of the non-payment circle within the whole economy by the

introduced restrictive policies. The origins of the non-payment circle in the

economy certainly go back to elements of the old command-structure combined

with the period of high inflation from 1992-94, when the real use of money

collapsed caused by too loose a monetary and exchange rate policy. Barter-trade

agreements were established to substitute the use of money. Ironically, this nonpayment

structures were then reinforced by too restrictive policies. The


commercial banks drastically further reduced their lending to the non-financial

public enterprises and to the private sector (enterprises and households), which

already before had been rather low in terms of GDP. This led to the surge of

money surrogates like overdue inter-enterprise arrears and so-called veksels.

Overdue gross payables of enterprises increased from 15% of GDP at the end of

1994 to 25% of GDP at mid-1996, and overdue net payables of enterprises jumped

from 1.5% to 7.5% of GDP in the same period of time. 42 Also the federal budget

got involved into that non-payment circle. In 1996, the budget revenues fell even

further by 1%-point, despite a lot of efforts to tax enforcement. In 1995, the

decrease in central bank´s lending to the government as well as part of the decline

in budget revenues were substituted by an increase in commercial banks´ lending

to finance the deficit, at very high real interest rates. Already in 1996, the

budgetary expenditures had to cover also the surging interest payments on

domestic debt.

Stabilisation and growth of the real economy were necessary, among other things

also to overcome the non-payment problem and achieve a long-term fiscal

consolidation. A cautious easing of the restrictive monetary conditions was

indispensable to achieve this aim. The need for foreign cash to support a

controlled correction of overly restrictive policies arose. With no other foreign

funds available 43 , the authorities (advised by the IMF) started to open the market

of LCY-denominated Treasury securities to foreign portfolio capital. On the one

hand, this strategy started to be successful in the first three-quarters of 1997. Real

interest rates moderated, the non-payment problems in the economy began to ease,

budget revenues rose and real GDP grew for the first time since the start of the

transformation. On the other hand, this strategy was risky, in particular as the

danger of a sudden outflow of foreign portfolio capital had been incurred. Despite

the sharp lowering of real interest rates in 1997, the interest-payments (stemming

partly from the extremly high rates in 1996) constituted still a huge burden for the

current account balance and for the budget, while non-interest expenditures had to

be cut severely in order to stabilize total expenditures. Unfortunately for Russia

(and the IMF), global conditions worsened in the fall of 1997, so that the incurred

risk really materialized by a quick outflow of foreign portfolio capital. In addition,

sharply falling oil prices pressured the balance of payments and the budget. The

authorities turned monetary and fiscal policies again more restrictive, but without

success. In particular, also domestic investors started to loose confidence into the

42 See European Commission and Russian-European Centre for Economic Policy, 1998;

own calculations.

43 In particular, up to now there has been the lack of a comprehensive and sizeable longterm

program by public lenders which would focus on real fixed-capital investment to

support the historic transformation in the CIS, e.g. similar to the European Recovery

Program (Marshall-plan) by the USA after the 2 nd World War (see Schulmeister,



sustainability of the pursued restrictive monetary conditions, given the changed

international environment.

Sufficient support for a controlled easing of monetary conditions out of reach, an

uncontrolled easing evolved by letting the ruble float in August 1998. This made

unavoidable a de-facto default on the part of the external debt which the Russian

Federation had taken over from the Soviet Union. Later on, this has been followed

by formal negotiations with the Paris and London Club on restructuring and

partial cancellation of that part of external debt. The burden of interest payments

on LCY-denominated debt was alleviated both by the inflation resulting from

devaluation and by formal restructuring of that debt. This dampened the budgetary

expenditures in 1999. Import competition collapsed, due to the breakdown of

financial ties between Russian and western commercial banks and due to the

strong real depreciation. This boosted the revenue position of domestic

enterprises. In addition, the oil prices started to recover at the end of the first

quarter of 1999. Both factors as well as the uprising inflation supported the

budgetary revenues. The uncontrolled easing of the monetary conditions via the

exchange rate was counterbalanced by a cautious monetary policy, despite the

change of the head of the central bank. This helped to limit the jump in inflation

rates. The default of most Russian banks on their obligations to foreign partners,

in particular on their off-balance sheet obligations linked to the foreign

investments into the market of LCY-denominated Treasury securities, stimulated

the restructuring of the Russian banking sector.

1.3.4. The Structure of Domestic Credit by the Banking System

In Poland and Hungary, an important factor behind the development of total

domestic credit to the economy was the significant cut-back of the net credit to the

general government extended by the central banks (see Figure 9). 44

In the Czech Republic, central bank credit to the general government has been

zero since 1996, cut down from around 4% of GDP in 1993. In Slovenia and

Estonia, it has been roughly zero since 1992. The efforts to cut-back central

bank´s lending were clearly aimed at supporting disinflation and preparing for the

European Union.

44 In Hungary, foreign credit to the public sector was channelled through the central bank.

In order to get levels approximatively comparable to those of Polish and Russian

ones, the central bank´s credit to the government which stems from the increase in the

HUF-equivalent of that debt resulting from devaluation had therefore to be excluded

(year-average 1994: 31%, 1998: 23% of GDP).


Figure 9: Net credit to the general government by the central bank
















1998 1994






1998 1994



6.3 5.9 7.1




1995 1997 1998

average, in % of GDP in % of net credit to public sector by total banking system

Source: Bank of Slovenia, International Monetary Fund, National Bank of Hungary,

National Bank of Poland, Polish Central Statistical Office, The Central Bank of the Russian

Federation, Raiffeisen Zentralbank Österreich AG, Russian-European Center for Economic

Policy, WIIW.

In Poland, the decrease of central bank´s lending to government caused an

increase of the share of commercial banks´ lending to the government in their total

lending from 23.6% in 1992 (6.0% of GDP) to 37.0% (9.4% of GDP) in 1995.

However, by 1998 this share has fallen back to 26.8% (8.2% of GDP) (see Figure

10), although also central bank´s lending to the government was further reduced.

From 1995 onwards, not only the share of commercial banks´ lending to

corporates increased again, but also its size in % of GDP. This was facilitated by

well-balanced budget deficits and linked to relatively high real GDP growth.

However, with 18.1% in 1998 it was still lower than in 1992 (18.4%). In contrast,

the lending to households has picked-up to nearly 4% of GDP (from 1% in 1992),

amounting to a share of 12.5% in total commercial banks´ lending (see Figure 10).

In Hungary, commercial banks´ lending to the government decreased parallel to

the reduction of central bank´s lending to the government. This was made possible

by the fiscal consolidation and the revenues from privatisations starting in 1995.

Similar to Poland, lending to the corporate sector was simultaneously increased to

18% of GDP in 1998, from 16.7% in 1994 or else the minimum at 15.2% in 1995.

As in Poland, the 1998-level was lower than the levels in 1990-92 when they were

23-26% of GDP. It is remarkable, that the lending to households showed a

continuous decline from a level of 17% of GDP in 1990 to 4% in 1998. While the

development had been opposite to that in Poland, the 1998-level was nearly the

same, both as a ratio to GDP and as a share in total domestic credit of commercial


The Czech Republic, Slovenia and Estonia showed slightly higher levels of

lending to households with 6-8.5% of GDP in 1998. As a share of total domestic

credit, lending to households was particularly high in Slovenia (24%). The size of

lending to corporates (20% and 19% of GDP, respectively) was marginally higher

in Slovenia and Estonia than in Poland and Hungary in 1998. In both countries, it

showed also an increase comparable to that in Poland and Hungary during recent

years. In contrast, the level of corporate lending was much higher in the Czech

Republic with 55% of GDP in 1998, and it had decreased by 3%-points from

1997, conducive to the decline in real GDP. This was linked to both the tightening

in monetary policy and the structural problem of a huge burden of non-performing

loans. The yearly average amount of classified loans was about 15.1% of GDP in

1998, as against 4.4% in Hungary and 2.8% in Poland. If we take into account the

then existing specific loan provisions, the remaining net volume of qualified loans

was 9.1% of GDP in the Czech Republic and 3.5% in Hungary.

These qualified loans include as the worst category the so-called bad loans (or loss

loans), which amounted to 8.1% in the Czech Republic, 0.6% in Hungary and

1.0% in Poland. Among the explanations for this huge difference in the structural

situation of the banking system are the chosen method of privatisation and the

relatively weak bank recapitalisation efforts, as pointed out in sub-chapter 1.3.2. If

we take the total volume of classified loans into account, the difference in the

level of banks´ corporate lending between the Czech Republic and the other CEE

countries diminishes considerably. However, it continues to be significant,

suggesting the need for further explanation as given, for instance, in the subchapter


Figure 10: Structure of domestic credit (including FX-credit) by commercial banks (yearly average, in %)














59,1 43,6






1998 1994


11,7 9,6 11,3










0,4 1,4

1998 1998 1993

Czech Slovenia



18,5 17,2 1,5 15,1




1998 1994










39,1 38,1

1995 1997 1998

Credit to households (Russia: non-financial private sector (enterprises & households))

Credit to corporate sector (Russia: non-financial public enterprises)

Credit to non-bank financial institutions

Net credit to public sector

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National Bank of Hungary, National Bank of Poland, Polish Central

Statistical Office, The Central Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European Center for Economic

Policy, WIIW.


1.3.5. Banking Sector and Gross Fixed-Capital Formation

Looking at the size of the change in lending to the corporate sector by the banking

system relative to the amount of nominal gross fixed-capital formation, a striking

feature in all countries is the decline of the relative importance of domestic bank

lending (see Figure 11).

Figure 11: Credit to the corporate sector by the banking system

(change, in % of gross fixed-capital investment)
















1996-98 1990-91




1996-98 1993-94






1996-98 1992-94




1996-98 1996-98


change, in % of gross fixed-capital investment






1995 1998

Source: Bank of Estonia, Bank of Slovenia, Czech National Bank, International

Monetary Fund, National Bank of Hungary, National Bank of Poland, Polish

Central Statistical Office, The Central Bank of the Russian Federation, Raiffeisen

Zentralbank Österreich AG, Russian-European Center for Economic Policy,


This might be attributed to the following factors:

• Improved self-financing capacity of the companies due to several reasons: (1)

the government programs to bail-out bad debts in 1993-96, (2) higher real

GDP growth, (3) growing share of the private sector (genuine private

companies or privatized former state-owned enterprises), leading to more

efficient use of capital, (4) growing share of foreign-owned companies,

implying loans by the parent company as part of FDIs, and (5) capital

increasing issuance of shares (of minor importance).

• High real lending rates have led to lower demand from the companies, in

particular as competitive foreign cross-border lending has been available

• Improved lending control by domestic banks has led to more selective

lending, while sizeable new bad loans were accumulated in 1990-93.

• Failure of the domestic banks to increase their lending capacity in accordance

with the growing investment needs of an economy striving to catch-up with

the European Union.

Regarding Russia, one has to note that on the one hand, the change in year-end

levels overestimates the effective lending available during 1994, as there was an

inflating effect on credits towards the end of the year after the ruble crash in

October 1994. On the other hand, it is clear that commercial banks´ financing of

companies´ investments declined sharply in 1995. It fell to a level as low as 8% in

1996, before starting to recover again.

1.3.6. Lending and Deposit Rates to Non-banks: Development of Interest


In all countries, the real lending rates have been clearly positive since 1994, with

Poland showing some longer-term upward trend and Slovenia exhibiting a

downward movement, however, starting from a very high level. More recently,

real lending rates increased not only in Poland, but also in Hungary and the Czech

Republic which has to be attributed to the restrictive turn in the monetary policies

(see Figure 12).

Figure 12: Lending rate to non-banks (CPI-deflated) (yearly average, in % p.a.)













1992 1993 1994 1995 1996 1997 1998


Poland Hungary Czech Rep Slovenia Russia

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

It should be noted that the figure shows only CPI-deflated lending rates. Not least

due to the real appreciation and related import competition, industrial producer

price inflation was lower in all these countries throughout these years. Hence, if

the PPI were used to deflate the rates, the real credit cost to the companies would

result, being really high especially in Poland (12% in 1997 and 17% in 1998).

In Poland, the difference between the CPI-deflated lending rates and the PPIdeflated

lending rates helps to explain why the lending to households showed a

significantly higher growth rate than the lending to corporates from 1995 to 1998.

In addition, the very low initial level of credits to households certainly has played

a role as well. A catching-up attitude of households has to be seen in particular in

the context of western consumer models being advertised throughout the country.

Figure 13: Deposit rate to non-banks (CPI-deflated) (yearly average, in % p.a.)











1992 1993 1994 1995 1996 1997 1998


Poland Hungary Czech Rep Slovenia Russia

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

In contrast to the lending rates, real deposit rates have been clearly positive only in

Slovenia and in Poland since 1995. Only in 1998, real deposit rates turned positive

also in Hungary and (to a level just above zero) in the Czech Republic (see Figure

13). The generally rather low real deposit rates might be explained by the

following factors:

The use of reserve requirements (with low or zero interest rates on required

reserves) as an important tool of monetary policy

• Still rather low competition in retail business, into which many new (foreign)

banks have not yet really entered

• Retail customers have perhaps not yet been very demanding

However, all these factors do not really explain the difference between the low

levels in particular in the Czech Republic and the higher ones in Poland. It is

noteworthy that the Czech Republic showed negative real deposit rates in most

years, despite a rather restrictive interest rate policy. This indicates that the

efficiency of the banking sector in the Czech Republic is rather low which

probably reflects the structural problems. In particular, the huge burden of nonperforming

loans creates the necessity to cover the increase of loan provisions (see

sub-chapter 1.3.4).

Figure14: Lending rate minus Deposit rate to non-banks

(difference in %-points of the yearly average of rates in % p.a.)
















1994-95 1997-98 1994-95 1997-98 1994-95 1997-98 1994-95 1997-98 1994-95 1997-98 1995













difference (in %-points) of the year-average of rates in %





1997 1998

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

In Slovenia, the remarkable high and stable declining real lending and deposit

rates have to be seen in the context of the economy-wide practice of indexation of

LCY-denominated assets and liabilities to the inflation rate or else to the

depreciation rate. The mark-up to the inflation rate, constituting the real

component of the economy-wide used indexation clause (TOM-clause), has been

stepwise diminished by the Bank of Slovenia.

The margins between the lending and the deposit rate decreased in all the

countries in terms of percentage points from 1994-95 to 1997-98 (see Figure 14).

However, this is partly also the result of the dis-inflation. Therefore, it is also

interesting to look at the interest margins in relative terms. Figure 15 shows the

interest margin in percent of the deposit rate. Still we see a clear decline of the

margins in Poland, Hungary and the Czech Republic. However, in Estonia that

relative margin was stable and very high, while in Slovenia it has considerably


Figure 15: Lending rate versus Deposit rate to non-banks

(difference in % of deposit rate of the yearly average of rates in % p.a.)













1994-95 1997-98 1994-95 1997-98 1994-95

Poland Hungary










1997-98 1994-95 1997-98 1994-95 1997-98 1995

Slovenia Estonia


difference (in % of deposit rate) of the year-average of rates in % p.a.



1997 1998

Source: Bank of Slovenia, Czech National Bank, International Monetary Fund, National

Bank of Hungary, National Bank of Poland, Polish Central Statistical Office, The Central

Bank of the Russian Federation, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, WIIW.

The decline in the margins might be attributed to the following factors:

• General restructuring and organisational rationalisations within domestic

commercial banks, enhanced by the takeover of (stakes in) state banks by

foreign strategic investors

• Increased competition by the market entrance of new privately owned

domestic banks and of new foreign owned banks

• Increased competition by foreign cross-border lending, in particular as the

real appreciation of the currencies has made FX-credits an attractive

refinancing alternative to companies

As all these factors are not very developed in Slovenia, they also might (at least

partly) explain the increase in relative margins there.

1.3.7. Conclusion

Initially, the banking sector suffered from a huge bad loan problem which was

partly a heritage of the past and partly caused by unexperienced lending during the

first years of transition. In 1993-96 these problems were overcome with the help

of recapitalisation programes by the state in Poland, Hungary and Slovenia. In

Hungary, the substantial size of that programe laid the foundation for the

following comprehensive privatisation of banks. The development in the banking

sector in those countries highlights the importance of timely and transparent

policy of active government intervention. In contrast, there has been a protracted

bad-loan problem in the Czech banking sector which can partly be linked to the

lack of a systematic and transparent recapitalisation effort. (In addition, this

problem is due to the method of privatisation that resulted in a difficult double role

of banks as lenders and - via funds - as owners of companies - see chapter 1.2.).

The initial monetary overhang in the economies was slashed down mainly by the

high inflation following the initial devaluation and the ensuing price liberalisation.

The fact that the initial devaluation was relatively moderate in the Czech Republic

helps to explain why that country preserved quite high a level of money supply in

terms of GDP.

Being small and open economies, emphasis was laid on the exchange rate policy

in order to foster disinflation in all the five CEE countries of the first group which

started EU-negotiations. To a large extent, monetary policy became a function of

the exchange rate policy. In the most extreme version, Estonia has largely given

up an independent monetary policy by introducing a currency board in June 1992.

Exchange rate considerations have been playing a significant role in any monetary

policy decision even where the currency was (partly) floating, as in Slovenia, the

Czech Republic (after the switch in the currency regime and the introduction of

the inflation target in May 97) and in Poland (within the currency band which has

been stepwise widened to +/-15%-points). During all the years, monetary policy

has been relying on minimum reserve requirements as an important instrument in

all countries. Since the end of 1993, open market operations have become a tool of

monetary policy in Hungary, which was followed by Poland in 1994 and the

Czech Republic in 1995. Low or zero interest rates on required reserves have been

constituting a huge disadvantage for domestically owned commercial banks.


Successful disinflation went largely parallel to real increases in the money supply,

and money velocity declined. The increase in the money supply was mainly due to

the sub-position of net foreign assets, in fact resulting from the domination of the

antiinflationary exchange rate policy. From our point of view, one important

driving factor behind disinflation and declining money velocity was the real

appreciation of the currency. Also the tendency of a declining share of FXdeposits

of residents in total money supply and a rising share of FX-credit in total

domestic credit has been linked to this. All in all, designing the monetary policy

instrumental to the exchange rate target has hence proven to be successfull in

achieving the goal of disinflation. The risk to that policy approach has been on the

side of the current account which led to modifications or switches in the exchange

rate regimes.

Russia suffered from stop-and-go monetary and exchange rate policy. Too loose a

policy in 1992-94 was followed by an overly restrictive approach in 1995-1996

when the monetary policy supported the implementation of an ambitious exchange

rate policy to achieve disinflation. In order to get the real economy started, to

overcome the non-payment circle in the economy and to facilitate long-term fiscal

consolidation, a controlled and stepwise easing of monetary conditions proved

necessary. It was tried in 1997, with the help of liberalizing the inflow of foreign

short-term portfolio capital, as Russia faced the lack of a comprehensive and

sizeable long-term program by public lenders which would focus on real fixedcapital

investment to support the historic transformation in the CIS, e.g. similar to

the European Recovery Program (Marshall-plan) by the USA after the 2 nd World

War. In the midst of the attempted easing of conditions based on short-term

portfolio capital, the risk implied by this strategy really materialized, when global

conditions worsened in the fall of 1997, foreign portfolio capital left the country

and oil prices slumped. After a desperate battle to defend the painfully achieved

financial stability, the ruble crashed in August 1998. However, the monetary

authorities held the balance in face of the uncontrolled easing of monetary

conditions from the exchange rate side.

The change in the structure of domestic credit has been characterized by a strong

cut-back of central bank´s lending to the government in Poland and Hungary. In

the Czech Republic, central bank credit to the general government has been zero

since 1996, cut down from around 4% of GDP in 1993. In Slovenia and Estonia, it

has been roughly zero since 1992. Commercial banks´ lending to government

declined as well in Poland and Hungary from 1995 onwards, due to cautious fiscal

policies and due to the growing role of direct financial intermediation between

(foreign) non-banks and the government (see Chapter 3.1). From 1995 to 1998,

this supported the increase in bank lending to the corporate sector in Poland and

Hungary to a level of about 18% of GDP, which, however, was still less than in

1992. In Slovenia and Estonia, it increased to roughly the same level (18-20% of

GDP), while it declined in the Czech Republic in 1998. This decline was caused

by the structural bad-loan problem and by the even more restrictive turn in


monetary policy in 1997-1998. It led to the recession in 1998 which in turn

reinforced the decline in lending. Comparing the lending to households between

those countries renders a quite diverging pattern.

The ratio of commercial banks´ lending to the corporate sector to total gross fixedcapital

investment has fallen since the early nineties. This is probably attributable

to an improved self-financing capacity of the companies, to high real-lending rates

and to an improved lending control and risk-assessment by the domestic banks.

However, it also seems that the commercial banks´ lending capacity does not have

been in pace with the growing investment needs of an economy striving to catchup

with the European Union.

Real lending rates have been rather high, in particular as measured against the

industrial producer price inflation. Moreover, they have increased in 1998, due to

the restrictive turn in monetary policies which was partly a reaction to the global

financial crisis in emerging markets. CPI-deflated deposit rates have been rather

low. This seems to have been mainly the consequence of the use of minimum

reserve requirements as an important tool of monetary policy and of the rather

weak competition between banks in the retail business. The fact that the deposit

rates are particularly low in the Czech Republic is probably due to the lack of

efficiency in the banking sector, in particular the burden of bad-loans. The relative

margin between lending and deposit rates (in % of deposit rates) declined from

1994-95 to 1997-98. This can be attributed to foreign strategic takeovers of (stakes

in) domestic banks and to the intensified competition due to market entrances and

foreign cross-border lending.


Bank of Estonia: Statistical information on

Banka Slovenije / Bank of Slovenia: Monthly Bulletin (1999): vol 8, no 6-9, Ljubljana.

Czech National Bank (1995 – 1999): Annual report, 1994-1998, Prague.

Czech National Bank (1999): Banking Supervision 1998, Prague.

Eichengreen and Rühl (1998): Financial institutions and markets in transition economies,

in: European Bank for Reconstruction and Development: Transition report 1998, pp 92-

104, London.

Hungarian State Treasury, Government Debt Management Agency (1999): Government

Securities Market 1998, Budapest.

International Monetary Fund (1999): International Financial Statistics, Washington D.C.

Müller, W. and Würz, M. (1998): Prudential supervision in Central and Eastern Europe: A

Status Report on the Czech Republic, Hungary, Poland and Slovenia, in: Focus on

transition 2/1998, Vienna.


National Bank of Hungary (1999): Analytical accounts of the NBH, banking survey and

developments in the monetary aggregates, May 1999, Budapest.

National Bank of Hungary (1995-1999): Annual report, 1994-1998, Budapest.

National Bank of Hungary (1999): Monthly report 5-1999, Budapest.

National Bank of Hungary (1999): The Hungarian Banking Sector - Developments in 1998,


National Bank of Poland (1998 and 1999): General Inspectorate of Banking Supervision:

Summary evaluation of the financial situation of Polish banks (annually), 1997 and

1998, Warsaw.

National Bank of Poland: Information Bulletin (1993 – 1999), 1992-1998, Monthly Issues,


Polish Central Statistical Office (1995 – 1999): Statistical Bulletin (monthly), 1995-1998,


Polish Ministry of Finance, Public Debt Department (1997): Poland´s Treasury Securities

Characteristics, 1997, Warsaw.

Polish Ministry of Finance, Public Debt Department (1996 – 1999): Public Debt Quarterly

Review, 1995-1998, Warsaw.

Republic of Slovenia (1999): Ministry of Finance: Euro 2009 Offering Circular, March 11,

1999, Ljubljana.

Republic of Slovenia, Ministry of Finance (1999): Fax on Outstanding Treasury securities,

August and October 1999, Ljubljana.

Raiffeisen Zentralbank Österreich AG – RZB (1999), Group Research Database, Vienna.

Reuters News Service, London.

Russian-European Center for Economic Policy (1996 – 1998): Russian Economic Trends,

Various Issues (monthly and quarterly), Brussels.

Schulmeister, St. (1998): Das "Economic Recovery Program for Eastern Europe" der

Europäischen Union: Ein Gewinn für beide Regionen Europas (unpublished), Austrian

Institute of Economic Research, Vienna.

The Central bank of the Russian Federation (1997 – 1999): Bulletin of Banking Statistics,

Various Issues (monthly), Moscow.

WIIW - Vienna Institute for International Economic Comparisons (1998): Countries in

Transition 1997, Vienna.


1.4. Exchange Rate Arrangements in Transitional Economies

1.4.1. Introduction

The choice of an exchange rate regime is important for any country, but it perhaps

has particular importance for a transitional economy. There are a number of

reasons for this. First, in moving from a planned regime to a market-based one, a

key desire of the transitional country is to establish credibility. This is usually

achieved by fixing the exchange rate at a hard (i.e. overvalued level) and

maintaining this rate in the face of both internal and external macro shocks. Of

course, credibility is not the only issue in the choice of an exchange rate regime.

Since the exchange rate is often seen as ‘the’ macroeconomic price which can act

as a shock absorber, credibility may have to be traded off for a competitiveness

goal. Indeed, credibility itself will be undermined if uncompetitive movements in

the real exchange rate are allowed to cumulate.

One important stylised fact for the behaviour of transitional CPI-based real

exchange rates has been noted by Halpern and Wyplosz (1997), and others, and it

is that the actual real exchange rate initially depreciates and overshoots its

equilibrium path so that initially there is a sizable undervaluation. This

undervaluation is fairly rapidly corrected and the real exchange rate then enters a

phase of sustained appreciation. It is noteworthy that this pattern appears to occur

independently of the choice of the exchange rate regime. There are a number of

factors which may be cited as explaining the initial undervaluation: a large pentup

demand for foreign assets, which are in limited supply; substitution from the

domestic currency as the monetary overhang from the planning period generates a

rapid burst of inflation; in the absence of knowledge of where the equilibrium rate

is, convertibility forces the monetary authorities to allow the currency to become


The appreciation of the real rate from its original overshoot, occurs both because

of a self-correction to the initial undervaluation and also because the

transformation process itself imparts a real appreciation. A number of factors can

be cited in support of the latter phenomenon. First, productivity effects are seen as

crucially important, both because of a Balassa-Samuelson effect and also due to a

demand side effect - the rising income in the transitional process increases the

demand for non-traded goods which generates a real appreciation. Second, nontraded

prices are set too low prior to the transition. When they are freed they rise

to match production costs, thereby appreciating the real exchange rate. Third, on

the tradable side, goods were, in general, of poor quality and badly marketed prior

to the transition; after the transition these factors improve and this is reflected in

an improvement in the terms of trade. Finally, since potential returns on capital are


high in transitional countries, this leads to a net long-term capital inflow which

also appreciates the real rate.

Another important stylised fact to emerge from the actual behaviour of transitional

real exchange rates is the extremely low correlation between real and nominal

exchange rates. This is in marked contrast to the recent experience in developed

industrialised countries where there has been a remarkably close correlation

between real and nominal exchange rates. Although the cause of this correlation is

by no means uncontroversial for developed countries, there does seem to be a

growing consensus that it is driven by nominal, rather than real, disturbances (i.e.

liquidity effects in the presence of sticky prices, rather than real effects).

Intuitively, it would seem, therefore, that the opposite kind of correlation found in

transitional economies must imply the importance of real factors in driving real

exchange rates.

The above discussion has raised a number of important issues with respect to

exchange rates in the transitional process and the purpose of this essay is to

overview some of these issues. First, as we have seen there is the general issue of

defining an exchange rate regime: should it be fixed or flexible, or some half-way

house as represented by a crawling peg? In section 1.4.2. we seek to shed some

light on this issue by having a general discussion of the kinds of issues which are

important here. In Section 1.4.3. we then go on to present a brief description of the

actual experience followed by our group of transitional countries. Another issue

which the above discussion has raised is the concept of an equilibrium rate, which

of course will be particularly important for a country wishing to peg its exchange

rate. This topic is discussed in Section 1.4.4. And section 1.4.5. concludes.

In chapter 6.3. of this volume the costs and benefits of different possible exchange

rate regimes in CEE countries are analysed again but then the emphasis is on how

to manage the transition to European Monetary Union.

1.4.2. The Choice of Exchange Rate Regime

The key to the choice of an appropriate exchange rate regime for an ET is the

trade-off between achieving stability by fixity at a ‘hard’ exchange rate against

maintaining competitiveness. The nominal anchor approach, advocated by the

IMF, was seen as especially beneficial for transitional economies because of the

extreme inflationary pressure – both accumulated and as a result of the transition

process itself - they had to cope with on being liberalised. A fixed exchange rate

was thought to anchor both current flows and also expectations and was therefore

viewed as a major instrument of macroeconomic policy. As is well known,

floating rates are known to be highly volatile and this was seen as especially

damaging for a transitional economy as it could distort the nascent price signals

and expectations (i.e. floating rates could prevent a country importing rational,

market-based price ratios). Exchange rate volatility was seen as especially

problematic for transitional countries because of non-existent or thin currency


markets, underdeveloped institutions, all of which would exacerbate the volatility.

In sum, fixed exchange rates were seen as disciplining economic agents

(particularly the government and trade unions) and have a beneficial affect on

behaviour patterns.

To set against the arguments in favour of fixity, there were a number of important

reasons why a transitional economy may instead have preferred a floating rate

regime. First, the considerable uncertainty about what the appropriate equilibrium

exchange rate was, suggested that the market should be left to decide (although

this is perhaps an argument for having some short-run flexibility rather than

permanent flexibility). Second, the liberalisation associated with the transitional

process implied a higher level of inflation for the domestic country compared to

its trading partners. With a fixed exchange rate this implies an appreciation of the

real exchange rate and so perhaps it is desirable to let the currency depreciate to

avoid this and maintain competitiveness. Third, exchange rate flexibility avoids

the problem of having a balance of payments constraint, which may be especially

important in the presence of only limited foreign exchange reserves.

A fourth reason to favour flexibility is the problem of the incompatible trinity –

fixed exchange rate, relatively open capital markets and an ‘independent’

monetary policy. This may not have been a problem for currencies at the early

stages of the transitional process, but it is clearly an important point for countries

at a mature stage of development – take the third stage of Czech republic as an

example. Finally, since financial markets are often very poorly developed, and

thin, they cannot cope with financing payments imbalances and therefore it is best

to let the currency float.

In actuality, transitional countries have not gone for one or other extreme form of

exchange rate regime, but rather some kind of hybrid situation (i.e. not irrevocably

fixed or purely freely floating). Further, as Hrncir and Matousek (1996) argue, the

relative costs and benefits of a given exchange rate arrangement vary not only

across individual transition economies, but also in individual transition stages.

1.4.3. The Exchange Rate Experience of Six Transitional Economies

In this section we present a brief overview of the exchange rate experiences of six

transitional countries, namely the Czech Republic, Estonia, Hungary, Poland,

Slovenia and Russia. In Figures 1 to 6 (see appendix) we present nominal and

CPI-based real exchange rates for each of these countries. These Figures

essentially confirm the stylised fact referred to in the introduction. On average,

over the component of the transition period considered here, all of the currencies,

with the exception of the Hungarian Forint, show a real appreciation. This holds

true irrespective of the numeriare chosen – DM or US$. In contrast, the nominal

bilateral (US$ and DM) values of the Hungarian Forint, Polish zloty and Russian

rouble show a clear depreciating trend over the period. The remaining currencies

present a more mixed picture. The nominal value of the Czech Crown against the


DM and US$ shows a ‘sideways’ movement over the full sample period, although

there are sub- periods in which it is depreciating and sub-periods when it

appreciating. Although the Slovenian currency is generally depreciating over the

period, there are sub-samples at the beginning and end of our full sample in which

it too exhibits nominal appreciation. The Estonian currency although rigidly fixed

throughout the period, due to its currency board arrangement, nevertheless shows

some sideways movement against the US$ and DM due to the flexibility of these

currencies. We now turn to a more detailed discussion of the kinds of exchange

rate regimes that produce the pattern of nominal and real exchange rate

movements exhibited in Figures 1 to 6 in the appendix. The Czech and Slovak Republics

From the outset of the transition process in January 1990, the former

Czechoslovak Republic resorted to a fixed exchange rate regime, pegging the

Koruna to a basket of currencies with a +/-0.5% margin on either side. The

purpose of choosing a fixed rate peg was in order to provide a nominal anchor for

the stabilisation process; that is, to provide credibility. However, prior to the

comprehensive reform package of January 1991, the Koruna was devalued by

35% in October 1990 and it was further devalued by 15% as part of the 1991

reform package. This underscores the point (made forcably by Hrncir and

Matousek (1996)) that although the fixed rate was used for the maintenance of

credibility, no binding commitment to maintain the fixed exchange rate regime,

either indefinitely or for a pre-announced period, was actually given by the Czech

authorities. After the break up of the former Czechoslovakia, the authorities of the

Czech Republic changed the basket to 65% of the DM and 35% of the US$ in

May 1993 and maintained a very narrow band of +/- 0.5% around the central

parity. This regime of almost complete fixity was maintained for 62 consecutive

months, up to the end of February 1996, when the bands had to be widened to +/-

7.5% as a result of the dramatic real appreciation of the Koruna. Since May 1997

the exchange rate regime for the Czech currency has been characterised by a

managed float.

The Slovak Republic used a pegged exchange rate for the Koruna after the demise

of the former Czechoslovak Republic (using the seam weights as in the original

Koruna). The Slovak Koruna was then devalued by 10 per cent in July 1993 and a

year later the basket was rearranged into 60 per cent DM and 40 per cent US

dollar. In contrast to the Czech Republic, the Slovak Republic maintained very

limited currency convertibility on the capital account. Despite this the

combination of a 7 per cent inflation rate and a pegged exchange rate produced a

real currency appreciation for much of the period. Poland

As part of the Balcerowicz plan, Poland started the transition process in 1990 with

a pre-commitment, for a specified period, to a fixed exchange rate for the zloty-


US$ rate. The rate set was PZL9,500 to one US$ and this represented a 30%

devaluation of the old rate. However, the consequence of this devaluation, and

also the liberalisation of prices, was a relatively high inflation rate and a real

overvaluation of the currency. To restore competitivness, therefore, the zloty was

devalued by 15% in April 1991 and a new rate of exchange was set in relation to

a basket of currencies in October 1991 (the composition of the basket was: 45%

US$, 35% DM, 10% GBP, 5% FRF and 5% CHF). This new exchange rate was of

a crawling peg; that is fixed but adjustable (i.e. an adjustable peg), with the zloty

being devalued by 1.8% per month. The peg was then devalued in February 1992

by 12% and the increments of the crawl lowered to 1.6% per month. The central

rate was then further devalued in October 1993 by 8%, and due to foreign

exchange reserve losses the increment of the monthly crawl was decreased again

to 1.5%.

In May 1995 the Polish exchange rate mechanism was changed again and the

zloty moved to a so-called crawling band. This system allowed the zloty to move

freely on the domestic interbank market within a band of divergence of +/-7%

from a mid-rate which is now labeled the ‘central reference rate’. This rate is set

each morning and at the end of the business day the central bank sets a closing rate

referred to as the ‘fixing rate’. Hungary

Hungary also pursued a policy of fixing its exchange rate against a basket,

although it was subject to occasional (irregular) discrete changes (devaluations).

The aims of this policy changed over time. Sometimes the exchange rate change

simply compensated for inflation (competitiveness) while at other times it

generated a real appreciation (credibility effect). Additionally, a sharp devaluation

of 15% occurred in January 1991. The composition of the basket of currencies to

which the HUF has been pegged has changed over time. For example, since

August 1993 the HUF has been pegged to a basket composed of 50% of the DM

and 50% of the US$. This was then changed in May 1994 when the composition

comprised 70% of the ECU and 30% of the US$. In March 1995, as a result of the

‘Bokros plan’ the HUF was devalued by 9 per cent and Hungary followed Poland

in moved to a crawling peg system. The bands of this system were originally

defined as +/- 4.5%, with an initial devaluation rate of 1.9% which was eventually

adjusted to 1.3% in June 1995 and then to 1.2% in January 1996. Estonia

In contrast to the other currencies considered in this project, Estonia opted for a

currency board system, thereby relinquishing control over both domestic monetary

and exchange rate policies. This arrangement entailed the Estonian authorities

announcing they would supply unlimited amounts of foreign currency into

domestic currency at the rate of 8 Kroons to one DM. Such a system is credible

since the foreign currency reserves are equal in value to the sum of all of the


liabilities of the monetary authorities - high-powered money (cash and deposits of

the banks). The monetary authority also announced that it would only create extra

currency against foreign currency receipts, and thus variations in the domestic

money supply are exclusively caused by net in- or outflows of foreign exchange.

As a result of adopting a currency board price stabilisaton was achieved in Estonia

within one year. Slovenia

In contrast to the relative fixity of the exchange rates of the other countries,

Slovenia has pursued a policy of a managed float combined with fairly extensive

capital controls since October 1991. As we have seen this resulted in a clear

depreciation of the Slovenian currency against the dollar over the period (see

Figure 6 in the appendix), but a more complicated picture against the DM, with

the original sharp depreciation being followed by a sideways movement, an

appreciation and then a further depreciation. As we have also noted the Slovenian

real exchange rate showed an unambiguous real appreciation over the full period.

1.4.4. The Choice of an Equilibrium Exchange Rate

Given that most transitional experiences have been characterised by numerous real

(and nominal) disturbances, a construct like purchasing power parity (PPP) is

unlikely to be well-suited for an analysis of equilibrium in such situations. A fullblown

Fundamental Equilibrium Exchange Rate (FEER) approach, which

explicitly recognises the importance of net foreign asset accumulation and

government fiscal imbalances, is likely to be especially relevant here; however,

since data limitations are even more severe in transitional economies than they

are, say, in developing countries some sort of compromise approach is needed.

Two such compromises have been used in the literature. Halpern and Wyplosz

(1997) use a reduced form approach which focusses on productivity effects and

measures of economic effectiveness, while MacDonald (1995) uses a variant of

the capital account approach referred to earlier.

Rather than present a formal model, Halpern and Wyplosz use three different

measures of the real exchange rate to bring out the driving forces of real exchange

rates in transitional economies. The three REERS are the cpi-based real rate, q, the

US dollar wage real exchange rate, ω and the relative price of non-traded to traded

goods prices. In practice they focus on q and ω. Halpern and Wyplosz posit the

following model for q:


q = k+ γ( a − a ) + γ( ρ − ρ ) + γθ


where q is defined as the foreign currency price of domestic currency, k denotes

the terms of trade (or more directly a quality of traded goods measure), the second

term is a Balassa-Samuelson effect. The ρ j term represents the excess of (sectoral)


eal wages over (sectoral) productivity which is initially assumed positive in the

traded sector and negative in the non-traded sector. The correction of this

imbalance over time imparts an appreciation into the real exchange rate. The final

term, θ, represents the relative wage between the non-traded and traded sectors.

Initially, the wages in the nontraded sector are assumed to be below those in the

traded sector but over time the gap should close, thereby imparting an appreciation

into the real exchange rate. The reduced form for the US dollar wage is:

* *

ω = ( ρ − ρ ) + ( a − a ) + q (2)

where a represents aggregate marginal productivity of labour, ρ is the aggregate

excess of wages over labour productivity, and an asterisk denotes a foreign

magnitude. The key element in this relationship is seen to be the influence of

aggregate productivity, instead of sectoral productivity, on the real exchange rate.

The empirical model is estimated for ω rather than q, but both (1) and (2) are used

to motivate the kind of explanatory variables entering the dollar wage equation. In

particular, they focus on: a number of indicators of economic effectiveness (the k

term), such as human capital (proxied by education), the size of government and

the size of the agricultural sector; average productivity (a) is measured by GDP

per worker; data on differences in productivity and effectiveness across sectors

(a T -a N and ρ T -ρ N ) are not available for most countries and are therefore not


The empirical tests were undertaken on a large panel data set for the following

country groupings: OECD, Africa, Southeast Asia, Latin America and transition

economies (in total they have 80 countries in their panel). Halpern and Wyplosz

are able to distinguish between these different groupings using fixed and random

effects estimators. Their measure of aggregate average productivity (GDP per

worker) produces a large and significant coefficient which is shown to be

sensitive to the inclusion of regional and country dummies - it declines quite

dramatically as such dummies are added in. Conversely the coefficient on

investment in human capital (proxied using secondary school enrolment) rises as

the regional and country dummies are introduced. They also find that a 10%

decline in the size of agriculture relative to industry increases the dollar wage by

between 1 and 2 per cent. A 10 per cent increase in the size of the government

raises wages by 3 to 6 per cent. This effect is interpreted as measuring the effect

of public services and infrastructure on aggregate productivity.

These panel estimates are then used to back out measures of the equilibrium

exchange rate for the transitional economies. The estimates are derived with and

without a planned economy dummy. The measure of equilibrium without the

dummy is seen as an upper bound, to be reached once the market economy

institutions are in place and functioning smoothly. The rate with the dummy gives

the lower bound and hence the ‘true’ measure of equilibrium lies somewhere in

between. With the exceptions of Slovenia and Hungary, all countries started the


transition process with significantly undervalued exchange rates. At the time of

writing, countries which aggressively pursued market reform policies (namely, the

Czech Republic and Poland) have real rates which are not very far from

equilibrium (the lower bound); the same appears to be true of Croatia, Slovenia

and possibly Hungary. The remaining transitional countries studied (Bulgaria,

Romania and the Slovak Republic) all have real rates which are undervalued

Perhaps not surprisingly, the basic upshot of the work of Halpern and Wyplosz is

that PPP is not a suitable vehicle for analysing transitional real rates. Also the

need for real appreciation during the transition period has important implications

for the choice of exchange rate policies and regime. For example, if a transitional

economy decides to peg its exchange rate to a Western country then during the

transitional period the real exchange rate appreciation will require a higher

inflation rate at home relative to overseas (if the authorities have a low inflation

target then the nominal exchange rate should be allowed to float freely). Finally,

given the need for a real exchange rate appreciation during the transition period,

trying to resist it would only produce destablising capital inflows.

MacDonald (1995) used a version of the capital account model, advocated by

MacDonald and Marsh (1997), to analyse the equilibrium exchange rates of

Poland and the Czech Republic (some theoretical justification for the use of this

kind of structure for a transitional economy is given in Hallwood and MacDonald

(1997)). The sample periods are January 1981 to December 1993 for Poland, and

January 1990 to December 1994 for the Czech Republic. The Polish exchange rate

studied is the zloty-US dollar (PZ-US$). For the period prior to March 1989 the

parallel market rate was used, while for the post-March 1989 period the free

market rate was chosen. For the Czech Republic, the Czech Crown against both

the US dollar and the German mark were analysed. Following the work of

Chawluk and Cross (1997) a variable proxying aggregate shortages was used in

the Polish study.

For the Czech Crown against the US dollar (CK-US$) a single significant

cointegrating vector was reported (the methods of Johansen (1995) were used to

test for cointegration and to implement any restrictions tests). However, the kind

of restrictions implied by the capital account model could not be imposed on this

cointegrating relationship and, additionally, the adjustment speed was wrongly

signed. The CK-US$ rate was therefore not pursued further. In contrast, the CK-

DM rate produced a single significant cointegrating relationship and it was

possible to impose the so-called Casselian restrictions on this model. The

estimated long-run relationship is:

* *

ck − dm = p − p − 017 . i + 017 . i


t t t t t

which indicates that homogeneity can be imposed on relative prices (CPIs) as long

as interest rate yields enter the long-run relationship (pribor and fibor rates were


used). The interest rates appear constrained as a differential and with signs which

are consistent with a capital flow interpretation.

For the Polish zloty - US dollar rate one statistically significant cointegrating

vector was reported. The same type of Casselian restrictions as were imposed on

the CK-DM rate could also be imposed for this currency and the final equation is

reported here:

* *

pz − usd = p − p − 0. 46i + 046 . i + rota


t t t t t t

where rotat represents the shortage variable. Potentially (3) and (4) offer a highly

tractable way of assessing transitional economies currencies. However, the rapid

pace of change in transitional economies probably means that these relationships

are likely to be unstable over time (particularly with respect to the interest

differential) and would need to be updated over time (although this criticism could

equally apply to other measures of equilibrium).

1.4.5. Conclusion

In this chapter we have analysed a number of different aspects of exchange rate

arrangements for transitional economies. First we emphasised the fact that the

choice of an exchange rate regime for a transitional economy involves a trade-off

between achieving stability by fixity or maintaining competitiveness by having

flexibility. The advantages of these alternative regimes were enumerated. We then

presented an overview of the actual exchange rate regimes that have been adopted

by the CEE countries studied in this project. Finally, the issue of the appropriate

measure of an equilibrium exchange rate was considered. Reliance on PPP by a

CEE country is likely to be unsuccessful given the important real shocks that such

countries encounter in the transitional process. However, the alternative FEER

based approach is also likely to be unattractive for such countries due to its

intractability. Hence alternative approaches were proposed, such as the panel

model of Halpern and Wyplosz (1997) or the single equation capital account

approach of MacDonald and Marsh (1997).



Chawluk, A. and R. Cross (1997): Measures of Shortage and Monetary Overhang in

Poland. Review of Economics and Statistics. February.

Hallwood, P. and R. MacDonald (1997): International Money and Finance. Second Edition.

Oxford: Blackwell.

Halpern, L. and C. Wyplosz (1997): Equilibrium Exchange Rates in Transition Economies.

IMF Staff Papers, Washington DC.

Hrncir, M and R. Matousek (1996): The Exchange Rate Regime and Stages of Transition

(Czech Experience), mimeo.

Johansen, S (1995): Likelihood-based Inference in Cointegrated Vector Autoregressive

Models. Oxford: Oxford University Press.

MacDonald, R. (1995): An Application of the Casselian Capital Account Approach to the

Visegrad Exchange Rates. Report prepared for ACE-Phare Project.

MacDonald, R. and I.W Marsh (1997): On Fundamentals and Exchange Rates: A Casselian

Perspective. Review of Economics and Statistics November, 655-664.



Figure 1: Nominal exchange rate Czech Crown – DM





















91 92 93 94 95 96 97 98 99

Real exchange rate Czech Crown – DM

91 92 93 94 95 96 97 98 99

Nominal exchange rate Czech Crown – US$


91 92 93 94 95 96 97 98 99


3 6

3 4

3 2

3 0

2 8

2 6

2 4

Real exhange rate Czech Crown – US$

2 2

9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9

Figure 2: Nominal exchange rate Estonian Kroon – DM














91 92 93 94 95 96 97 98 99

Real exchange rate Estonian Kroon – DM


91 92 93 94 95 96 97 98 99






Nominal exchange rate Estonian Kroon – US$


9 1 9 2 9 3 9 4 9 5 96 97 9 8 9 9






Real exchange rate Estonian Kroon – US$


91 92 93 94 9 5 96 9 7 9 8 9 9

Figure 3: Nominal exchange rate Hungarian Forint – DM







91 92 93 94 95 96 97 98 99










2 5 0

2 0 0

1 5 0

1 0 0

Real exchange rate Hungarian Forint – DM

91 92 93 94 95 96 97 98 99

Nominal exchange rate Hungarian Forint – US$

5 0

9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9





Real exchange rate Hungarian Forint – US$


9 1 92 93 94 95 96 9 7 9 8 9 9


Figure 4: Nominal exchange rate Polish Zloty – DM







9 1 9 2 9 3 94 95 96 97 9 8 9 9





Real exchange rate Polish Zloty – DM


9 1 9 2 93 94 95 96 9 7 9 8 9 9








Nominal exchange rate Polish Zloty – US$


9 1 92 93 9 4 9 5 9 6 97 98 9 9







Real exchange rate Polish Zloty – US$


9 1 9 2 93 9 4 9 5 96 9 7 98 9 9

Figure 5: Nominal exchange rate Russian Rouble – DM

1 4

1 2

1 0






9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9





Real exchange rate Russian Rouble – DM


9 1 9 2 9 3 9 4 95 96 9 7 9 8 9 9







Nominal exchange rate Russian Rouble – US$


9 1 92 9 3 9 4 95 9 6 9 7 9 8 9 9







Real exchange rate Russian Rouble – US$


91 9 2 9 3 9 4 95 9 6 9 7 98 99

Figure 6: Nominal exchange rate Slovenian Tolar – DM

1 2 0

1 0 0

8 0

6 0

4 0

2 0

9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9








2 0 0

1 8 0

1 6 0

1 4 0

1 2 0

1 0 0

8 0

6 0

Real exchange rate Slovenian Tolar – DM

91 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9

Nominal exchange rate Slovenian Tolar – US$

4 0

9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9

1 6 0

1 5 0

1 4 0

1 3 0

1 2 0

1 1 0

Real exchange rate Slovenian Tolar – US$

91 9 2 93 9 4 9 5 96 9 7 98 9 9

Source: IMF; WIIW.


2. The Emerging Regulatory Framework for Banking

and Securities Markets in the CEECs

2.1. Introduction

A decade has lapsed since the command economy was abandoned in Central and

Eastern Europe and market economies were progressively put in place. 45 The

progress and the current development of these new market economies has been

analysed from a macroeconomic point of view in the preceding chapters 1.1. to

1.4. This chapter now focuses on the regulatory framework for banking and

securities markets in these countries.

Free and open capital markets, one of the key features of market economies, did

not exist under communist rule, hence experience with market regulation and

supervision was absent. Considering the complexity and gravity of the transition

to a market economy, ten years to put in place a regulatory framework and

competence for capital markets is a short period. Other policy priorities preceded,

or other elements had to be considered first, such as the complete overhaul and

restructuring of the banking system, the key intermediaries in capital markets,

before a well functioning capital market could emerge. This analysis will thus not

only focus on the regulation and supervision of markets, but also, and more

importantly, on the institutions active on these markets, primarily banks.

The intention of most of the countries of Central and Eastern Europe to join the

EU has given an additional weight to the transition process, but has also increased

the pressure to adjust rapidly. As part of the preparation for EU membership, these

countries are required to adjust their legislative framework to the standards

applicable in the EU. 46 The EU framework therefore functions as a transition

benchmark, to which CEECs have to adapt. The degree of adjustment to the EU

regulatory framework, also for financial services, determines when accession can

take place. The transition process and the preparation for membership can, for

most of the countries discussed here, hardly be disentangled.

Before discussing the regulatory framework for financial markets and institutions

in 2.5., this chapter starts in 2.2. and 2.3. with a retrospective on the function of

45 Central and Eastern Europe is in this paper defined in the geographic sense, which

comprises the ten CEEC that have applied for EU membership (the Visegard

countries, the Balkan and Baltic states, and Slovenia), the four countries of the

European part of the CIS (Bielorussia, Moldova, Russia and Ukraine), Albania and

the countries of the former Yugoslavia. The two latter will, with the exception of

Slovenia, in general not be included in the comparisons, since hardly any data are

available, and their economic significance is very limited.

46 The status quo of EU-integration as well as the likely effects on the further integration of

capital markets are analysed in chapter 6.


the financial sector in a planned economy and the approaches followed in the

transition to a market economy. The former is necessary to understand the

fundamental difference between banks under a market economy and a planned

economy and the enormous change of minds that had to take place. Chapter 2.4.

explains the divergences in the transition process, as it can be observed today.

The next part describes the regulatory framework for financial institutions, as of

today, and looks back at the progress made in the approximation to EU legislation.

In 2.5. an overview will be given of the approximation process in the areas of

banking and securities markets. The overview will subdivide the candidate

countries in two groups. As further to the decision by the Luxembourg European

Council (December 1997), accession negotiations started initially with a first

group of 5 CEEC countries. The Helsinki European Council (December 1999)

decided to start accession negotiations with the other 5 candidates as well. Chapter

2.6. concludes with some recommendations for policy.

2.2. The Status ex-ante

The function of the financial sector in planned economies used to be

fundamentally different as compared to market economies. Already only this

insight should allow one to realise that creating a sound financial system takes

time. Banks in planned economies acted as instruments in the planning process,

allocating funds to households and industry, rather than as financial

intermediaries. Securities markets were absent, since the authorities created no

marketable financial instruments, and firms were not in need of funds from the

market. Hence the skills to run and supervise financial markets, as they are known

in market economies, were not existent.

In a planned economy, state enterprises were given production targets that needed

to be met, and prices and costs were fixed by the state. Cash flows were not

market-based and profits were pre-determined. Firms had the right to accumulate

reserves for well-defined goals, but excesses had to be given back to the state.

Western-style efficiency and financial controls were not in place, accounting

standards were non-existent. The financial needs of the state were fulfilled by the

central bank, or, for imports, by banks of market economies. The state had

unlimited access to the central bank.

A two-tier banking system, as is in place in a market economy, did not exist. The

functions of the central bank and the commercial banks were not separated, and no

independent financial institutions existed. Even though, formally, several

specialised banks were in place, they were regulated by and organisationally

dependent upon the central bank. Both, the central bank, as well as the specialised

banks were owned and directed by the authorities. Each one of the specialised

banks was concerned only with its particular clientele: national savings banks

collected private deposits and lent to households, foreign trade banks handled


international transactions, and investment banks dealt with enterprise loans. There

was no link between households’ and enterprises’ financial flows. The investment

banks were in charge of attributing credits to state-owned enterprises and the state

in fulfilment of the plan. Transactions with the general public were limited to

collecting savings (this is excess cash) and giving credit for the purpose of

building a house or in some cases for the purchase of consumer goods.

Basic principles as return and risk did not exist in the banking sector. Appraisal

and valuation of investment projects were not developed. In case a borrower was

unable to serve his loan, the bank could not enforce payment by threatening with

bankruptcy and liquidation. Bankruptcy law did not exist. A huge excess capacity

or unproductive economy was thus in place.

Elements of reform towards a more market-based system were undertaken before

the systems “officially” broke down, but they contributed at the same time to an

accelerated collapse of the planned economies. In Russia, for example, a law of

1987 gave enterprises the right to make profits, but the system continued to pump

funds in “loss-making” firms. In Hungary a two-tier banking system was already

established in 1987, and the tasks of the central bank were reduced to the classical

central banking functions (Welfens, 1997: 416). Also, restrictions on retail and

corporate finance were reduced in Hungary between 1987-89.

2.3. The Transition

The collapse of the planned economies led to a broad debate on the approaches to

be followed in the transition to a market economy. The debate centred on the

speed of the changeover from a centrally planned to a market-led economy

(gradual vs. big bang 47 ), and the way of privatising industry. Seen from the

perspective of 10 years after the start of the transition, this debate was largely

academic, and effectively, only a gradual and mixed approach was feasible.

Putting in place a market economy requires a drastic overhaul, in which many

elements of society are involved. The central element, the administrative

competences to legislate, implement and enforce the regulatory set-up of a market

economy takes years to become effective. The structuring of the changeover and

its pace was thereby largely determined by political factors (see e.g. Marincin and

Van Wijnbergen, 1997; Bocko et al., 1996). On certain principles of a market

economy, however, such as price competition, property rights, monetary policy,

the changeover can only be immediate, since long transitions give the wrong

signals to the market and increase the fragility of the system.

47 The best known big bang plan was the “100-days-plan” of the Russian politician



A country’s approach to privatisation has direct implications for the development

of its financial sector. 48 Privatisation through vouchers and investment funds

stimulates securities markets. Privatisation in management buy-outs reinforces the

role of the banking sector as the main creditor of industry. This also has specific

implications for financial regulation. Depending on the way followed, the

regulatory system will have to be adapted in this or another way. Privatisation

through investment funds means that strict legislation must be in place to ensure

adequate control of and governance by funds, which has often been neglected, and

was one of the reasons for the debacles of Czech economy. Large foreign

ownership may have implications for financial stability, since a deterioration of

the economy can lead to a massive withdrawal of funds by the foreign owners.

So far, only Hungary has made an almost complete and successful changeover to a

market economy, basically by massively opening its market to foreign

ownership 49 , while the quick privatisation in the Czech Republic through

investment funds did not work out as expected as a result of insufficient regulation

and control, and insufficient foreign competition. In the other countries, state

ownership has remained important, and privatisation is still underway.

Privatisation methods in transition economies can, generally speaking, be

classified in three groups:

1. The sale of the firm to the employees or the managers (employee and

management buy-outs);

2. Large scale sale of state assets to the public by auction, negotiated sale, or

other means. This may or may not (or only partially) be open to foreigners;

3. Free of charge transfers to the public, to give the citizens specific claims on

the assets that they previously owned collectively. Vouchers, these are

certificates of ownership of a part of the assets, may thereby be used.

Vouchers can be tradable or not, they can be bundled in investment funds.

The three privatisation methods were applied to different degrees in the countries

of CEE. They must be seen in connection with the moment at which firms were

earmarked for privatisation. In some countries, enterprises were restructured

financially before privatisation, others left this task to the new owners. The rapid

sale of the firms to the management was common in the Czech and Slovak

Republic, while employee take over has been applied most extensively in Poland.

Voucher privatisation was a prominent feature of the Czech and Russian

privatisation programmes, but was also applied to a certain extent in Poland, and

48 A more detailed presentation of the methods, the development as well as the success of

privatisation in selected CEE countries is given in chapter 1.2.

49 Estonia – marked by large foreign investor engagement - succeeded quite well in

privatisation as well. However, its banking system as well as the financial sector still

need some restructuring.


initially, in the Slovak Republic. Hungary is the country where sale to foreign

owners has been introduced on a large scale, but only after firms were restructured

in a state agency. However, the privatisation programmes are not yet completed,

and have often been held up by government out of strategic and industrial policy

considerations. Shifts have already occurred in the holdings by households (as a

result of voucher privatisation) to investment funds and banks.

The importance of a well-administered transition is of even greater importance for

the financial sector, because of its role as financial intermediaries and as

transmitters of monetary policy. The problem of restructuring the banking sector

could have been overcome by building immediately a more capital market-based

system. This was, however, only seen as a theoretical possibility (EBRD, 1998).

The banking sector played a crucial role in the development of virtually all market

economies, contributing only at a later stage to the emergence of securities

markets. A market-based system requires also a very developed system of

regulations, strict observance by the private sector, as well as strict enforcement. It

encompasses rules on listing and public offerings, price discovery and market

integrity, disclosure and reporting standards, issues that may be difficult to

implement rapidly in a transition economy.

The picture of financial sector privatisation that emerges ten years after the

transition is diverse. The two smallest Baltic states, have almost completely

privatised their banking sector. Of the Visegrad countries, Hungary is most

advanced, with an asset share of 12 % for state-owned banks (by the end of 1998),

followed by the Czech Republic, with 19%. However, Hungary renationalised and

recapitalised Postabanka in 1998, Hungary’s second largest bank, which was

nearing bankruptcy. In the other countries, state ownership has remained very

important, with half of the banking sector still in state hands. In Poland, about

50% of the banking sector are in state hands, and foreign control was limited to

16% (in 1997). The Slovak banking market is dominated by three banks, of which

one is completely state owned, and in the other two the state holds 51% and 35%

of the stakes (OECD, 1999a: 76). Those three banks hold 47% of total banking

assets. In Slovenia, the two largest banks are state-owned and dominate the

market. Privatisation is the least advanced in the two Eastern Balkan states,

Bulgaria and Romania (see Table 1).

The large number of banks in the former Soviet Union is a special phenomenon.

Banks were one of the first activities to be liberalised and reformed under the

Perestroika. Joint ventures and semi-private cooperative banks were allowed to be

formed as early as 1987. As a result, many former USSR states found themselves

after independence with a unusually large number of banks. This continued to

grow during the first years of the transition. At the end of 1997, Russia had almost

1700 banks. However, many of them are founded by large firms (being part of

financial industrial groups (FIGs)) as a means to facilitate the transfer of foreign


currency abroad and to tap the pool of CBR credits more easily. 50 Due to the

Russian crisis in 1998 a wave of bankruptcies, mergers and re-nationalisations

took place. At the end of September 1999, the number of banks had declined to


Foreign ownership of the banking sector is most developed in Latvia, with more

than 70% of total bank assets in the hands of majority foreign-owned banks at the

end of 1997. Hungary follows with 62%, or 27 out of the 40 banks being foreignowned.

These two countries are, however, in a rather exceptional situation, and

most countries have preferred to keep banks in the hands of locals. On average,

foreign ownership is below 20%. The reasons for the low level is that

governments have made foreign bank entry and ownership unattractive. Several

governments have often tried to remain shareholder in privatised banks, which

makes foreign investors hesitate to invest.

Table 1: Privatisation in the Banking Sector (1998)

1998 Asset share of


banks (%)

Asset share of


banks (%)*


Number of


Of which


foreign- owned

Belarus 59.5 2 37 3

Bulgaria* 66 15 28 7

Croatia 37.5 4 60 11

Czech Rep. 18.8 13 45 13

Estonia 7.8 28 6 2

Hungary 11.8 62 40 27

Latvia 8.5 71 27 15

Lithuania 45.3 41 10 5

Moldavia 0 14 23 7

Poland 48 16 83 31

Romania 74.6 6 36 16

Russia 42.2 7 1476 29

Slovak Rep. 50 19 24 8

Slovenia 41.3 6 34 3

Ukraine na na 227 12

Germany 52 2.4 3392

France 31 570

Italy 36 5.3 911

Source: EBRD (1999), ECB (1999), CEPS; data marked with (*) and for the asset share of

foreign-owned banks are 1997.

50 On this topic see also chapter

Privatisation and foreign ownership in the banking sector is not only an issue in

Eastern-Europe, but also in the West. In Germany, about half of the bank assets

are still in the hands of the state, in France and Italy, it is about one third.

Moreover, market interpenetration was little developed at the start of EMU. In the

larger EU countries, the asset share of foreign-owned banks stood below 5%

(ECB, 1999)! The continuing sensitiveness to foreign ownership was exemplified

in major take-overs in France, Italy and Portugal in the course of 1999.

2.4. Progress in the Transition to a Market Economy

Ten years after the start of the transition, the development of financial markets in

transition economies is still limited. As compared to developed economies,

banking and securities markets are still in early stages of development, and many

further steps will have to be taken before arriving at levels of mature markets. This

implies, however, that the system of regulation should not yet be as developed as

in mature economies. The task is rather to make sure that regulation follows the

degree of market development, and does not hinder it. As in Western-Europe, the

financial system is strongly bank-based. But the markets are highly concentrated,

which poses a competition policy problem.

Underdevelopment of financial intermediation has the positive side effect that

these markets are less vulnerable to disruption and turbulence in financial markets.

According to the EBRD (1998), the banking crisis in Russia had a less damaging

effect on its real economy than the crises in East Asia, since markets were fairly

underdeveloped and external finance for firms more limited. As markets deepen,

the effects of banking crisis may become more severe, implying that supervision

will need to be adapted in line with market development.

One way to assess the depth and breath of financial markets and the degree of

transition to market economies is the ratio of domestic credit, defined as credit to

the households and private enterprises, to GDP. In developed economies, it stands

at about 120% of GDP, but the comparable figure in transition economies falls far

below this figure. One country’s stands far above the others, the Czech Republic,

followed by Croatia. In a second group of countries, the figure stands around 20%:

Estonia, Hungary, Poland, the Slovak Republic and Slovenia. In the other

countries, domestic credit to the private sector is hardly developed and thus, there

is probably not much banking or financial market either.

Related to credit are savings, which are still low in most CEEC and CIS countries.

This is partly due to the low or negative real deposit rates in most CEEC and CIS

countries during the transition period as a result of macroeconomic instability and

high inflation. This was, for example, the case in Bulgaria and Romania, where

declining bank deposits as a share of GDP were noticed during 1990-95, which

restricts the availability of credit to the private sector (Steinherr, 1997: 118).


Table 2: Credit to the private sector as % of GDP

1991 1992 1993 1994 1995 1996 1997 1998

Belarus 17.6 6.2 6.7 8.5 17.1

Bulgaria 7.2 5.8 3.7 3.8 21.1 35.6 12.6 14.2

Croatia 47.3 28.6 30.8 28.9 36.4 40.1

Czech Rep. 50.8 59.5 59.4 57.4 66.4 60.1

Estonia 18.0 7.5 10.9 13.8 14.8 18.0 25.5 25.3

Hungary 38.8 33.2 28.2 26.2 22.3 21.7 23.4 22.8

Latvia 17.3 16.4 7.8 7.2 10.7 14.1

Lithuania 13.8 17.6 15.2 10.7 9.6 9.5

Moldavia 5.9 5.9 4.1 3.0 5.8 6.8 6.2 13.9

Poland 11.1 11.4 12.2 12.0 12.8 15.9 18.1 20.6

Romania 11.5 8.5 12.8

Russian Fed. 11.8 12.1 8.2 7.0 8.7 12.7

Slovak Rep. 26.9 20.7 24.9 n.a. n.a.

Slovenia 22.1 23.0 27.4 28.7 28.6 32.5

Ukraine 2.6 1.4 4.6 1.5 1.4 2.4 7.6

Germany 132.7 130.1 134.4 131.8 136.0 141.4 152.9 136.1

France 92.8 93.1 91.3 86.2 85.1 80.8 79.9 84.4

UK 105.4 104.2 101.6 99.8 102.8 105.5 106.7 107.1

USA 127.1 123.6 122.0 121.9 124.9 126.2 127.7 133.1

Source: EBRD (1999); IMF, International Financial Statistics (1998); Central Banks.

Even in countries with higher saving rates (such as the Slovak Republic with

around 38% of GDP in 1997, Hungary and Poland), domestic credit as a

percentage of GDP is low. This could be due to the fact that large enterprise

restructuring is using sources from abroad, or that savings produced by the

economy are not intermediated, but largely directed towards own-investment by

the households and enterprises which generate these funds (OECD, 1999a: 109).

Another indicator is the interest rate spreads. In the CIS countries and Bulgaria,

high spreads are indicators of higher risk premia (also due to macroeconomic

instability and high inflation), bad efficiency, and low competition in the banking

sector. In Russia they have been as high as 90%, for the other CIS countries and

Bulgaria, they varied between 10% and 50%. The lowest spreads are found in the

Slovak Republic, the Czech Republic, Poland, Estonia, Lithuania and Slovenia,

where they vary between 5% and 10% (data for 1996; EBRD, 1998: 93).

Looking more closely at the banking sector, the situation is starting to stabilise,

although the overall environment is still very fragile in many CEEC, as could be

noticed in the autumn of 1998. The Russian crisis hit banks in the Baltic countries

more than the other CEECs, particularly those that were heavily engaged in rouble

transactions or trade finance. Also, Ukraine and Moldova were seriously affected.

In the Visegrad countries, the situation is stabilising, whereas much remains to be


done in the Balkan countries. Severe turbulence in the banking sector was

experienced in several countries: in Estonia in 1992, in Latvia and Lithuania in

1995, in Bulgaria and in the Czech Republic in 1996 (where the latter was less

extensive that in the other cases).

The strength of the banking sector can be looked at from several angles. Two

indicators will briefly be discussed: financial performance and soundness. The

latter is important in a regulatory perspective, since it is used by regulators to

assess the stability of banks. Bank performance data, to the extent that they are

available, should be considered with caution. Return on assets, this is the net

income before taxes to total assets of banks, fall in a range between 1 to 3 percent

(EBRD, 1998), compared to an average of 0.5% for the EU countries and 1.7% for

the US (OECD, 1998). Also, net interest income data, this is the difference

between interest revenues and interest expenses, are high in comparison to the

benchmark in developed economies. Net interest income declined from 7% in

1993 to 5% in 1997, as compared to 2.5% in the EU and 5.9% in the US.

Explanatory factors for these high gross income and profitability ratios are the

very low levels of intermediation by the financial sector, as the figures on

domestic credit indicate, and - in some countries and periods - the high-inflation

macroeconomic environment. The total asset base is low, but high profits can be

generated from speculation in money and bond trading. Banks, certainly in the

Eastern part, are thus not the banks as we know them in Western-Europe, but

rather money and bondbrokers. In Ukraine, for example, return on assets stood at

about 9.5% (!) on average over the period 1993-1997 (EBRD, 1998: 120),

whereas the level of domestic credit is the lowest of all CEECs. The same can be

said for Bulgaria and Romania.

The high profitability ratios can also point to a lack of competition in the banking

sector in the CEECs, meaning that the old mono-bank structure has not yet been

overcome, and that certain old plan economy type institutions still dominate the

market. Another reason can be a high moral hazard, which stimulates banks to

take high risks, often fuelled by the expectance of being bailed out when worse

comes to worse.

Performance indicators as return on assets do not give an indication on the

soundness and stability of banking systems in those countries. The Basle

Committee developed ratios, which measure capital, defined as core and second

tier capital, as a percentage of risk weighted assets (this rule is implemented for

the EU in the solvency ratios and own funds directive, see below). To be sound, a

bank needs to have a capital ratio of at least 8%. The EU average stands at about

12%, but most CEECs have ratios well below. Only the Czech Republic and

Poland have ratios around 12% (OECD, 1998; Gros and Steinherr, 1999).

The other intermediaries active on capital markets, institutional investors such as

insurance companies, investment funds and pension funds, are in even earlier

phases of development. Overall, insurance companies make up the largest part of


the market. Investment and pension funds are only of marginal importance. In

some countries, investment funds were used in the privatisation process as holders

of vouchers, such as the Czech Republic. Pension funds were instituted in the

Czech Republic, Hungary, Poland and the Russian Federation.

What about the markets? The data confirm that transition economies have

preferred to develop strong intermediaries first, before emphasising the

development of markets. They also confirm that an immediate step towards a

market-based system is hardly possible. Stock market capitalisation as a % of

GDP, which indicates to what extent the market is used as a means to finance

investment, stands at very low levels. The highest levels of market capitalisation

in 1998 were noted in Hungary (30%), Lithuania (28%) and the Czech Republic

(23%). The Russian crisis only had a pronounced effect in some of these markets.

The relatively high levels of turnover of stock in several countries should not be

seen as an indication for the contrary. Rather they are an indication of the limited

size of the different stock markets. 51

Example: The Czech Transition and Privatisation Experience

The Czech Republic went for a rapid transition. Two state agencies, the

Consolidation Bank and the National Property Fund, were entrusted with the task

of privatisation. Almost 60% of all privatised enterprises were privatised through

vouchers, which took place in two waves in 1992 and 1994. In each case, all

citizens over 18 years of age could purchase a booklet of vouchers, which could

then be used to bid on firms to be privatised, and exchanged for shares in

investment privatisation funds (IPF). Those funds were established to avoid an

excessively dispersed ownership structure, to diversify the risk and to keep control

in local hands. About three-quarters of the vouchers were invested in IPF’s, which

are controlled by the major Czech banks.

Although the Czech example was initially hailed as being very successful, with

rapid changeover and high growth rates, a period of financial instability spread

from 1996 on. The current account deficit grew, industrial restructuring and

economic growth slowed, banking problems mounted, and the Czech Crone was

devalued in the spring of 1997. On the financial side, the Czech crisis emphasised

the importance of the regulatory framework and the need for tight supervision. It

illustrates an often typical problem for rapid transitions: the mismatch between

economic and regulatory development. Since experience with regulation in market

economies is little developed, the establishment cannot keep pace with business

development, problems spread and hit the economy like a boomerang.

51 Data on turnover should be handled with caution, as different methods for calculating

exist, and the data are not always trustworthy, even for the West European exchanges.


The Czech case revealed two problems specific to financial markets in transition

economies: the lack of financial regulation, and of supervision of the “voucher”

investment funds in particular, and insufficient incentives for adequate corporate

governance. It also indicated the difficulties of moving rapidly to a more marketbased

system, which requires a greater awareness of rights and obligations of the

public at large, not only of the supervising authorities. The main problems

encountered in the Czech Republic are the conflict of interest that arose in several

cases where banks were actually the managers of IPF’s and the creditors to the

firms, thus insulating the management of the companies from external control.

Insufficient bankruptcy regulation made it easy to roll over bad debts from one

year to the next, aggravating the problem for the shareholders, which lacked

transparency and disclosure.

2.5. The Emergence of a Regulatory and Supervisory


Transition economies thus went for a financial system that is strongly centred on

the banking sector, rather than securities markets. A bank-based system requires a

different form of supervision than a market-based system. It may be easier to

establish, but requires tight regulation and control. It can support the much-needed

stability in these markets, whereas a market-based system would emphasise the

volatility. Regulation will thus have to ensure that confidence in the system can be

maintained, by avoiding bank runs through deposit insurance and solvency

control. On the other hand, the financial system is not as sophisticated as in

developed economies, implying that the systemic effects of the failure of one bank

will be more limited. Limited development of interbank and securities markets

allows to insulate bank crises more rapidly. Hence financial regulation need not be

as sophisticated as in mature economies. It must keep pace with the market, and

allow the financial system to develop. It should support transformation of the

former state banks into an active entrepreneurial financial sector, and encourage

‘de novo’ banks with low initial capital requirements.

The financial structure that has emerged is thus fairly close to that of the

continental Western-European countries. Banks are typically of the universal type,

with debt and equity stakes in non-financial enterprises, which should play a

strong role in the restructuring of industry. There was probably no choice, in the

absence of a developed equity market, but to go for the universal-type banks.

According to Gros and Steinherr (1999), this was unavoidable because it is

difficult to see how the overhang could have been solved without involving the

banks themselves through equity swaps and increased participation in the

governance of firms. A US type segmented banking system, with Chinese walls

between investment and commercial banking, would have been impossible, since

it requires a well functioning capital market. Another possibility, which has

however not been studied, was a multi-tier banking system split-up on the basis of


the quality of assets and risk exposure. Tier one licence would be for the top range

of banks as measured by their risk-weighted capital ratio and satisfaction of creditexposure

norms. Tier two licensed banks would fall in a lower echelon of quality,

and have to pay higher deposit insurance. Banks falling further below the tier two

criteria would have no deposit insurance and no lender-of last resort facilities. But

such a model pre-supposes that depositors are well informed, which is definitely

not obvious in transition economies.

Measuring the degree of progress in laying the foundations of sound regulatory

framework is a complex task. Objective criteria can only be set to a certain extent,

since it is not only a matter of legislation, but also implementation and

enforcement by the relevant administrations, which will be more difficult to

gauge. The EBRD made an assessment of the effectiveness of legal rules for

banking and securities activities, based on a survey with experts and practitioners

in CEECs, and found a considerable difference between the countries that have

indicated to be candidates for EU membership, and those of the CIS. Ratings on

the extensiveness and effectiveness of rules for banking and securities markets, as

compared to international minimum standards are in each case lower in the CIS

countries than in the candidate EU countries. EU membership is thus a clear

driving element in the transition process.

The conditions for the accession of the CEECs to the EU were laid down by the

Copenhagen European Council (June 1993). It stipulated:

Membership requires that the candidate country has achieved stability of

institutions guaranteeing democracy, the rule of law, human rights and respect for

and protection of minorities, the existence of a functioning market economy as

well as the capacity to withstand competitive pressures and market forces within

the Union. Membership presupposes the candidate’s ability to take on obligations

of membership, including adherence to the aims of political, economic and

monetary union.

For the financial sector, a functioning market economy and the capacity to

withstand competitive pressures from within the Union implies macroeconomic

stability (a stability-oriented monetary policy and sustainability of public

finances), a sufficient degree of development of the financial sector to channel

savings toward investments, and the absence of market barriers (entry and exit of

firms). It requires appropriate government policy in the fields of finance, trade and

competition policy, the appropriate institutions to implement these policies, and a

certain degree of trade integration before enlargement (European Commission,

1997a: 43).


A first step towards accession was laid down in the Europe Agreements,

concluded with all the candidate EU members. 52 The Europe agreements aim at

further integration of CEECs into the EU by lowering barriers to trade,

establishing a framework for political dialogue, harmonising legislation and

providing technical cooperation. They have been concluded with all candidate

countries. The most important aspect of the agreements is the establishment of

free trade in industrial goods over 10 years in an asymmetric way, with the EC

reducing protectionist measures first. All the Europe Agreements contain a chapter

that requires the progressive liberalisation of the supply of services (Chapter III),

and the free movement of persons involved. This chapter is further focused on

transport services, and does not mention financial services at all. Implementation

is monitored by Association Councils, joint meetings of the EU Council of

Ministers and their counterparts of the CEECs. With the European CIS countries,

the EU concluded Partnership and Cooperation Agreements (PCAs), which

basically guarantee “most favoured nation” (MFN) access to each others’ markets.

The 1995 White Book of the European Commission gives detailed criteria for

membership of the Associated States of the EU. The Whitepaper is the key

reference document in the approximation of law processes, specifying the

measures that underpin the EU’s common market (the acquis communautaire) and

need to be adopted by the candidate states if they want to join the EU. It functions

as a benchmark to allow the Commission to make its judgement on the readiness

for membership of the applicant countries. Since this regards minimum rules to

allow free movement of goods, services, capital and labour, as set forward in the

EU Treaty, this corresponds with the basic rules for an open market economy in

the different sectors.

A discussion is ongoing how flexible and lenient the EU can be on the

implementation of the acquis, whether many exceptions can be tolerated in favour

of the CEECs because of the huge delay that has to be overcome and the need for

a political signal. The EU Commission is in general very strict on this subject,

referring to the danger of creating precedents, loosening the Community and

undermining its own powers. Proponents argue that momentum towards accession

needs to be maintained, which risk to run out of steam by insisting too much on

details, and may aggravate political instability in the end. Reference is thereby

made to the flexibility employed in the case of Greek accession, and the change it

has brought about, or to the danger of proliferation of Balkan scenarios.

For all sectors, the pre-accession strategy has been subdivided in two stages,

whereby stage one measures comprise the fundamental rules, stage two the more

specific measures. According to the Commission, the stage one measures needed

to be implemented as soon as possible, since they require time to be effective.

52 Initially, the Europe Agreements were intended as an alternative to accession, but they

gradually evolved as the main vehicle to prepare for accession.


Stage two measures should be implemented before accession, although delays in

this domain will be the subject of the accession negotiations.

Measures of importance for banking and capital markets relate to 1) the free

movement of capital, 2) the free provision of financial services, and 3) the creation

of institutions capable of ensuring stability of prices and financial markets. In the

area of free movement of capital, the stage one measures of the White Paper relate

to the freedom of medium- and long-term capital movements, stage two to the

short-term. They are discussed in chapter 6.2. In financial services, stage one

concerns freedom of establishment and the basic directives for prudential

supervision, stage two the free branching and provision of services with a single

licence. We will first discuss progress in setting up the institutions creating the

necessary environment for financial markets, the central bank and supervisory

authorities, and then discuss progress with the implementation of the White Paper

for banking and securities markets.

2.5.1. Central Banking

Central banks (CB) in market economies play a crucial role in steering the money

markets, supervising payment and settlement systems and in monitoring the

stability of financial markets. In several countries, they are also in charge of

supervising financial institutions. Although it is unlikely that applicant countries

will be able to join EMU immediately upon accession, EU accession implies

compliance with the acquis communautaire, also in this domain. This comprises,

even without immediate EMU accession, independence of the central bank, or

progress towards this objective, prohibition of the financing of public sector

deficits by the central bank and interdiction of privileged access of public

authorities to financial institutions (Art. 101 (ex-Art. 104) and Art. 102 (ex-Art.

104a) of the EU Treaty).

In the CEECs, the establishment of the two-tier banking system often went hand

in hand with the establishment of an independent central bank. However, in some

countries this happened only recently, by ways of amending the framework given

after the first years of transition. Recent changes in this direction have taken place

in Hungary (December 1996), Bulgaria and Bosnia-Herzegovina and Poland

(1997) and finally in Albania and Romania in 1998 (Temprano-Arroyo and

Feldman, 1998: 33).

Strict rules need to be adhered to government financing by the central bank. Any

form of direct central bank financing of government deficits is prohibited. This

includes overdraft facilities, advances and the purchase of government securities.

Only indirect credit through the purchase of government securities from a third

party, as in open market operations (in monetary policy procedures), or for the

refinancing of banks (as lender-of-last-resort) taking government securities as a

collateral, are allowed. Overdrafts and short-term advances are allowed only to

bridge gaps in the operation of the payment system for no longer than one day


(intraday-credits). Privileged access by public authorities to financial institutions

is also prohibited. It comprises, for example, the placement among banks of public

debt below market rates.

In all of the CEEC except Romania, the CB is formally independent from the

government. This needs, however, to be examined in its practical formulation. In

some countries, such as Bulgaria, Estonia and Lithuania, currency board

arrangements were introduced, with a peg to the DM or to the US$ (which were

transformed into euro or euro/dollar pegs). These arrangements constrain the CB

in some cases in the formulation of exchange rate policy, but should not curb the

independence of its monetary policy. If a currency board is in place, CB

independence refers to the freedom in defending the currency board. In the case of

Hungary, exchange rate policy is approved by the government in agreement with

the CB, and the government is represented at the CB board by a minister. Also in

Poland exchange rate policy is defined by the government in agreement with the


Rules on government financing are less clear. Direct financing by the Central

Bank of the government is clearly forbidden (in line with EU regulations) in

Bosnia-Herzegovina, Bulgaria, Estonia, Hungary, Lithuania, and in Poland (after

17/10/98). In all other countries direct financing is allowed under certain defined

conditions, such as the maturity of the loan, market interest rates, and must be

below a certain percentage of the government budget or revenues, such as in

Albania. However, in many countries those conditions do not include the lending

at market rates, such as in the Czech and Slovak Republic. Even more lax

regulations are found in Croatia and Slovenia. However, in both countries direct

purchases of government securities by the CB have never actually taken place

during the years of transition.

2.5.2. The Institutional Structure of Supervision

For obvious reasons, central banks in the CEECs combine the tasks of price and

financial stability with supervision of the banking system. The arguments against

combining the task of central bank and banking supervisor lack weight in

transition economies. On the contrary, the scarcity of resources in transition

economies and the need for clarity almost makes it a conditio-sine-qua-non. The

danger of a conflict of interest in the performance of both functions and a too

powerful central bank are no immediate concerns in transition economies.

Because of the fragility of the financial system, the institution in charge of

providing lender-of-last-resort is better in charge of financial supervision as well.

Hungary and Poland are exceptions to this rule, although the central bank remains

in both cases closely involved. In Hungary, prudential supervision of banks is

shared between the State Banking Supervisor (SBS) and the National Bank of

Hungary. In Poland, the Commission of Banking Supervision is the supreme

authority since January 1998. The Commission is chaired by the President of the


National Bank of Poland, and delegates execution to the General Inspectorate for

Banking Supervision, an organisationally autonomous institution from the CB.

This shows that a certain evolution is already under way in the countries where the

financial sector is stabilising.

CEECs have not yet felt the need for a single financial supervisor, as is the case in

several EU countries. 53 Today, less than half of the central banks in the EU have

the responsibility to supervise the banking sector, and at least 4 EU member states

have single supervisory authorities. The reasons for this trend are the increasing

complexity of financial supervision and growing conglomeration trend in the

financial sector. In the CEECs, a segmentation of the financial market control has

been preferred so far. To build up the necessary confidence and reputation in

transition economies, a specialist supervisor seems to be a better solution. 54 Other

important arguments against a single authority in transition economies are the

need to reduce moral hazard, as a single authority would give the wrong signals to

the market, and the danger of systemic distrust in the financial system, if all

supervision is carried out by a single authority.

The need for the rapid creation of supervisory structures was addressed by

different bodies involved in the transition. From EU-side, the 1995 White Paper

requires accession countries to have appropriate supervisory structures as part of

the stage I measures. At the international level, the Basle Committee, at the

invitation of the G-7 and in response to the emerging market crisis, reiterated in its

“Core principles of Banking supervision” the need for a supervisory agency

possessing operational independence and adequate resources. They must have

adequate supervisory measures at their disposal to bring about timely corrective

action when banks fail to meet prudential requirements.

Supervision of securities markets and the insurance sector is in general performed

by a separate agency, respectively, a specialist regulator accountable to the

ministry of finance. Only Hungary has an integrated banking and capital market

supervisor since 1997, made up of formerly separate bodies (see Table 3).

53 Estonia is considering to create a single supervisory authority.

54 As said Jaroslaw Kozlowski, Deputy Chairman of the Polish Securities and Exchange

Commission, at the European Borrowers Network seminar in Prague, 24-25 June



Table 3: The institutional structure of financial market supervision

Bulgaria Banking Supervision

Department of the CB

Banking Securities Markets Insurance

Commission on Securities

and Stock Exchanges,

appointed by government

Croatia CB Croatian Securities and

Exchange Commission

(independent government




Specialised department

within CB

Securities and Exchange

Commission (administrative

authority, with no rule

making powers)


National Insurance

Council and Insurance

Supervision Department

in MoF

MoF in charge of

supervision of insurance

and investment

Estonia CB


Securities Inspectorate (under MoF

surveillance of MoF)

Hungary Banking and Capital Market Supervision Agency (since State Insurance

1997), made up of formerly separate bodies for each sub- Supervisory Authority,


reporting to the MoF.

Latvia CB Securities and Exchange Insurance Supervision

Commission, appointed and Inspectorate, reporting to

accountable to parliament,

may impose disciplinary


the MoF.

Lithuania CB Lithuanian Securities

Commission, appointed and

accountable to parliament,

may impose disciplinary



Poland Commission of Banking Securities and Exchange State Office for

Supervision, as of 1998 Commission

Insurance Supervision

(autonomous body within

and State Office for the


Supervision of Pension


Romania CB National Securities

Commission, reporting to



Russia CB Independent Securities Specialist insurance

Commission since 1993 regulator



CB Control Office within MoF

Slovenia CB Securities Market Agency

(fully independent)

Note: CB= Central Bank, MoF= Ministry of Finance.

Insurance Supervisory

Authority within MoF

2.5.3. The Regulatory Approximation

Progress towards the adoption of the acquis is measured in relation to the White

Paper for capital movements and financial services, each time for the three subsectors.

55 Free movement of capital implies the removal of barriers to foreign

direct investment (FDI) inflows and outflows, free repatriation of both profits and

capital, investment in real estate, stocks and bonds. Since these issues are only of

relevance to the countries which have indicated to be interested in EU

membership, we will limit ourselves in what follows to these 10 countries. This

means that the European CIS countries, Albania and the countries of the former

Yugoslavia are in general not covered.

Table 4 gives a general overview of the state of implementation of the White

Paper in the 10 candidate countries by mid-1999. The overall view which emerges

from this table is that Hungary is most advanced on the way to membership,

followed by Estonia, Poland and Slovenia. The Czech Republic remains somewhat

behind of the first wave countries. It appears from the Commission’s progress

reports that the two other Baltic countries, Bulgaria and the Slovak Republic have

recently progressed significantly. Romania remains most behind.

A status report on implementation does however not yet mean that the regulatory

framework is functioning. Table 4 has therefore been completed with the EBRD’s

ratings on the extensiveness and effectiveness of rules governing banking and

financial markets. These ratings are based on surveys with academics and experts.

The benchmark is thus not strictu sensu the acquis. The EBRD notes for all

countries a persistent gap between extensiveness and effectiveness, but the

effectiveness of securities laws lags behind that of banking laws, because of the

more recent creation of securities commissions. Hungary and Poland receive the

highest effectiveness scores, followed by Estonia, Slovenia and the Slovak

Republic. But the latter country gets much lower marks from the European

Commission. Overall, the Commission’s evaluation and the EBRD’s ratings seem

to have become more convergent, as compared to earlier versions of the Transition


55 In the appendix, a general overview is given of Stage I and Stage II measures of the

Whitebook on legal approximation.


Table 4: Progress in adopting the White Paper and EBRD rating

Mid-1999 Capital Movements Banking Securities


Bulgaria Stage I largely


national treatment



High degree of

capital market


Estonia Restrictions on real

estate investment

remain for nonresidents

Hungary Stage I fully done,

progress on short

term capital


restrictions on real

estate acquisition

Latvia Stage I largely


national treatment

Lithuania High debree of

capital market


Poland Stage I fully done,

progress on short

term capital


restrictions on real

estate investments

Romania Stage I largely


national treatment



Stage I fully done,

progress on short

term capital


restrictions on real

estate investments

Stage I done,

close to


stage II

Some gaps

remain in Stage

I, Stage II


Stage I and II


Stage I: yes;

stage II almost

completed, with

the exception

for FPS

Stage I fully,

close to


stage II

Stage I fully,

close to


stage II

Stage I fully,

progress with

stage II


Stage I done,

stage II only


Stage I done,

stage II only



Market access

for firms and

listings not

yet regulated

Stage I


stage II: close,

but not


Stage I and II



no remote

access yet.

Stage I: yes;

stage II



with the

exception of


Stage I fully,

progress on

stage II


Stage I and II



no remote

access yet.

Stage I done,

elements of

stage II



Progress was

achieved but


criteria are


Close to stage



Stage I fully,

elements of

Stage II

Stage I: yes;

stage II



with the

exception of


Stage I fully,

elements of

Stage II

Stage I and II

not yet fully


Serious gaps

remain in

stage I


Stage I done Serious gaps

remain in

stage I


EBRD rating on





- ness

3 2+

3+ 2+

4 3+

4 4

3 2

3- 2

4 4

3 3-

4 3+

Mid-1999 Capital Movements Banking Securities


Slovenia Most restrictions

have been removed

Stage I is done,

some elements

of Stage II

remain to be



Stage I to be



by end-1999


Stage I to be


in 2000

EBRD rating on



Extensi- Effective

veness - ness

3+ 3+

Source: European Commission (1999), EBRD (1999). The EBRD ratings refer to the

appreciations of experts of the extensiveness and effectiveness of legal rules governing

banking and financial markets, with 4+ as the highest mark.

2.5.4. Banking

What should banking regulation in transition economies primarily be about? The

core issues should be strict rules for a banks entry and exit, criteria encompassing

minimum initial (but not too high) capital, the range of permissible activities, the

maximum level of equity holdings, the ownership structure and criteria on

management. Second, obligatory deposit insurance, with some proportionality in

the pay-out and a maximum ceiling; third, limitation of single exposures; fourth

rules on accounts of banks and consolidation, and finally, measures against fraud

and money laundering. The EU’s banking directives address these issues, but they

are spread over the first and the second stage measures in the White Paper, and

there is more to implement. The enumeration corresponds grosso modo with

directives listed below, with the exception of the parts of the second banking

directive, the capital adequacy and netting directive. The stages of the

approximation process could thus have been structured differently, and account

could have been taken of the differences in market development, but this would

reopen a discussion on the acquis.

In the banking sector, the White Paper measures 56 are:

Stage I measures:

First Banking Directive (77/780/EEC)

Own Funds Directive (89/299/EEC)

Solvency Ratio Directive (89/647/EEC)

Deposit Guarantee Directive (94/19/EC)

Stage II measures include:

Second Banking Directive (89/646/EEC)

Annual and Consolidated Accounts Directive (86/635/EEC)

56 See also the general overview of White Paper measures in the Appendix.

Capital Adequacy Directive (CAD I) (93/6/EEC) and amendment (CAD II)


Large Exposures Directive (92/121/EEC)

Consolidated Supervision Directive (92/30/EEC)

Money Laundering Directive (91/308/EEC)

Further directives adopted after the White Paper:

BCCI follow-up Directive (95/26/EC)

Netting Directive (96/10/EC)

An overview of the status of implementation of these directives in the CEEC-10 is

given in Table 5. According to our information, stage I is largely fulfilled in all

candidate members. The biggest difficulty is the deposit guarantee directive and

the amount up to which a deposit needs to be protected. Current levels fall well

below the threshold set in EU law, which is 20,000 euro. Only Slovenia has

ensured that the directive will be fully implemented by 2001, with a transitional

period, in the other countries they reach lows going to 800 euro in Latvia. The

authorities argue that lower average incomes justify lower ceilings, but in most

cases they have already phased in a transitional period to come to the EU level.

Much remains to be done for stage II, but this is normal, since many parts of the

freedoms that need to be put into practice will only come in play under full

accession. The second banking directive institutes the free provision of services

under the same control of the home country, which can only be done once the

country becomes member of the EU. Politically, it is strategically better for these

countries to wait with some of the second phase measures, since it could function

as a means in the accession negotiations to get transitional arrangements. More

generally, the question emerges whether the candidate countries already need the

same level of regulation as the developed EU economies. This can certainly be

argued for with the level of the deposit guarantee, the capital adequacy and netting

directive, which, by no coincidence, are the least implemented in the CEEC-10.

Specific problems remain in the definition of the banks which fall under the scope

of the first banking directive, as special rules apply for small co-operative banks in

the Czech Republic, Hungary, Poland and Slovenia. In the Czech Republic, these

co-operative banks were founded in order to allow small farmers to avoid the high

interest rates in the banking market. These co-operative banks are not required to

fulfil many of the regulations applying to commercial banks, and benefit from

lower initial capital requirements.

The annual and consolidated accounts directive aims at the harmonisation of

provisions banks having to adhere in publishing their accounts in order to protect

shareholders’ and third parties’ interests. Amongst other provisions, the directive

specifies the items of annual accounts and the valuation rules (hidden reserves are

authorised under certain circumstances). By and large, this directive seems to be

implemented in all countries. However, the Czech Republic still needs to adopt the


directive, which it has announced for 1999. Implementation of the directive on the

exercise of consolidated supervision is less advanced, but on its way.

The implementation of the Capital Adequacy Directive (CAD) is not very far

advanced. This very complex directive sets minimum capital requirements to

cover market risk in securities firms and in trading departments of banks, and was

amended in 1997 to allow banks to define their own capital requirement through

value-at-risk models. Given the low degree of trading book transactions in CEEC

banks, there has been limited need to implement the directive. In Hungary the

directive has not been implemented, but several rules on credit risk and offbalance

sheet business bridge this gap somehow. Also, regulations on securities

trading, as amended in 1999, contains some elements of CAD. In the Czech

Republic the government has announced plans for implementation in 2000; in

Slovenia, the CAD has only been partially implemented so far, and the same holds

for Poland. The only country where the CAD was implemented is Estonia.

A sensitive issue in many CEECs is money laundering. This directive requires

banks to identify all clients depositing over 10,000 euro and to transmit suspected

cases to the authorities. The EU has on many occasions insisted on rapid action

against the use of the financial system in the CEEC for money laundering.

However, it appears that only Estonia and Slovenia have taken the measures

required. In Poland, for example, bank accounts can stay anonymous up to an

amount superior to the one required by the money laundering directive.

The BCCI directive and the netting directive have only been very partially

implemented in all of the countries, except for Estonia, where it was fully

implemented. Both directives are not part of the stage II. The BCCI directive is

targeted at the efficiency of banking supervision, the cooperation between the

different entities involved in supervision, and the transparency of the legal

structures of banks. The netting directive aims at encouraging a wider recognition

of bilateral netting as risk reducing technique.

At the time of writing, Estonia was most advanced in the implementation of the

directives. Most delays remain within stage II measures. But the legislative and

institutional changes are occurring very rapidly, which makes it difficult to keep

track. The legal approximation process advances rapidly in many of the CEECs,

not only in the first group of candidates, but also in the five other candidate

members. The accession partnerships thereby play an important role in

channelling the know-how on the implementation, while at the same time

pressing for a realisation on time. The reforms in the CEEC and (to a lower

extent) the CIS are thus not only molded by the European example, but also

speeded up considerably through these cooperation structures.


Table 5: Implementation of banking directives in CEECs (as at mid-1999)

As at mid-1999 Czech


Estonia Hungary Poland Slovenia Lithuania Latvia Bulgaria Romania Slovakia

First Banking Directive Partially Fully Fully Fully Fully Fully Fully Fully Almost



Own Funds Directive Largely Fully Fully Fully

(except on 1

Solvency Ratio Directive Largely Fully, SR is


Deposit Guarantee


Second Banking Directive Lower


capital for


Ann. and Cons. Accounts


Consolidated Supervision




Fully Fully Fully Fully Almost


Fully Fully Fully Fully Fully Fully Almost


Partially, Transitional Min 4000 Almost Fully by Fully. Min Present Present Present Partially

min. 14000 period to euro, fully 2001 15,000 euro level is 800 level is level is

euro, only reach EU transition

by 2001, euro. 3000 euro. 2300 euro.

local level. will be

20,000 by Transitional Transition Fully by



2005. period to will be 2005

reach EU



Fully Lower Fully. Fully. Fully Fully Fully Partially Partially

initial Transi-tion Transi-tion

capital for period for period for

credit cooperative cooperative


cooperatives banks banks

Partially Fully Almost Fully Almost Fully Fully Fully Partially Partially




exp. 2002

Fully Partially Very


Fully by


Fully Fully Not yet Partially, by





As at mid-1999 Czech


Estonia Hungary Poland Slovenia Lithuania Latvia Bulgaria Romania Slovakia

Large Exposures Directive Fully Fully Almost Fully Fully Almost Fully Fully Fully Partially



Capital Adequacy

Directive (CAD I and CAD

Fully (by




Not yet,


Partially, by




from mid

Partially Partially Partially Not. By


Not. By




Money Laundering Partially Fully Partially Partially Fully Fully Fully Fully Fully Partially



(anonymous (anonymous



accounts) accounts)


BCCI Directive Partially Fully Partially Partially Fully Partially Partially Almost No Partially. By



Netting Directive No By end


Source: European Commission.

No No, by


Possibly No Ni No Partially. By


2.5.5. Securities Markets

Two factors have influenced the growth of securities markets in the CEECs: the

early development of a government debt market, and the method of privatisation

chosen. Stock markets are generally more developed in countries where

privatisation has been organised through the use of vouchers, such as the Czech

and Slovak Republics, and Russia. In the latter countries market infrastructure and

regulation has been put in place after a rudimentary securities market had already

developed (ex-post), in response to the needs of market participants. In other

countries, such as Poland and Romania, the opposite was the case: privatisation

occurred more gradually and through initial public offerings, after the necessary

regulation had been put in place. In this ex-ante approach, with an emphasis on

high fiduciary and disclosure standards, capital markets developed more gradually

(Thiel Blommestein,1998: 15).

However, not only privatisation played a crucial role. Also, the development of

secondary markets in government securities was important, even if the primary

purpose for policy makers has been the satisfaction of the government’s

borrowing needs. Secondary public debt markets provide liquidity to investors,

incentives for financial market development and support interest rate

liberalisation. In Hungary, for example, the existence of a liquid government

securities market has contributed significantly to the growth of a wider securities

market, and is considered as an important achievement in Hungarian financial

sector reform.

But Hungary is a special case, as capital markets have started to develop with

corporate bond issues already in the second half of the eighties (Csajbok and

Nemenyi, 1998: 58). The first Treasury bills were issued in 1990, and government

securities’ part in the total turnover at the Budapest Stock Exchange (BSE) grew

from 2.97% in 1991 to 81.44% the following year. In 1997, the share of

government securities in the total turnover of the BSE stood at 56.1%. The

strength of the Hungarian public debt market is based upon a clear regulatory

framework and the existence of a good infrastructure for clearing and settlement.

It also contributed to the “education” of investors, through the introduction of new

marketable instruments and the diversification of portfolios (Csaibok and

Neményi, 1998: 65). In addition, also private investors started to get involved: the

share of government securities in the value of household portfolios was around

11% in 1997.

Also, Poland has an advanced public debt market, with a (declining) 51% share of

Treasury bills in the total outstanding value of money market instruments. The

authorities played a major role in the establishment of a domestic securities

market. They established the main place of trade (Warsaw Stock Exchange), the

agency responsible for clearing and settlement, the National Depository for

Securities, and the regulatory body. Similar to Hungary, the public debt market

contributed to the development of securities markets.

In Russia, the market is quite developed as well, however, the problems

encountered by investors are of a broader macroeconomic nature, and related to


insufficient transparency and regulation of the entire securities market, that are not

unified yet (Russian Central Bank, 1998: 51-56).

In Hungary and Poland, the development of government securities markets thus

contributed importantly to the creation of a capital market with high fiduciary

standards. This is of special importance in Poland, where a large part of

privatisation was carried out through vouchers (which accounted for 25% of

industrial output). In the latter country, and later on in Romania, a capital market

infrastructure was in place before voucher privatisation started, with initial public

offerings and an emphasis on very ambitious disclosure and fiduciary standards.

However, market activity in the latter country was initially dominated by shortterm

speculation, also because the privatisation programme started very late

(1992, coupons to the public were only distributed in 1995-96) and still is very

incomplete (Earle, 1998: 3-6).

Compared to these countries, the Czech market is highly developed in terms of

total capitalisation, but weaker in terms of fiduciary standards. This can be

attributed to the fact that there was no financial market prior to mass privatisation,

and that no market for government securities was established to pave the way for

other types of market instruments. A comparable legacy can be noticed in the

Slovak Republic, for evident reasons. The legal environment is still being shaped.

Access for households to government securities markets, for example, still needs

to be provided (Janosik, 1998: 85-87). Moreover, the Slovak public debt market is

not yet liquid and diversified enough to provide a strong basis for securities


International organisations such as the World Bank, the IMF and the OECD agree

on the need for of a step-by-step development of the government securities market

in transition economies (Kalderén et al., 1998: 38). First priorities are of a

macroeconomic nature, i.e. a tight monetary policy, strict public finance and a

stabilisation policy. In the next phase, the development of a medium-and-long

term bond market should be implemented, in order to provide stable funding base

for the public sector, as well as to open up investment opportunities for the

financial sector. Any government’s structural debt management policies influence

the structure of the domestic financial market in general, and the structure of

financial instruments available on the market.

Tables 6 and 7 give an overview of market regulation and market structure in most

CEEC countries and in Russia. All of the countries covered have allowed their

banking institutions to become fully involved in capital market activities. This

means that the so-called universal banking system was followed by all countries

including Hungary, which initially had opted for non-involvement of banks in

securities markets. 57 On the one hand, this reflects a deliberate choice by many

policy makers, on the other hand, it is also a consequence of the status ex-ante in

these countries. As discussed above, the creation of a financial system from

scratch is a difficult task, and the rudimentary financial system present in the

CEEC before transition was based on banks. Also, the development of a more

57 Hungary initially had a prohibition for commercial banks to engage in brokerage

activities. This was lifted in 1996 (Csajbok and Nemenyi, 1998: 58).


market-based system as in the UK and the US requires a higher degree of

information disclosure, dissemination and legal protection than can be

implemented in a very short period of transition.

The Community acquis in the area of securities markets is composed of 1)

measures regarding operations on markets, 2) rules governing the markets

themselves and the intermediaries active on these markets, and 3) unit trusts. The

former comprises harmonised rules for the admission on the stock exchange and

rules covering prospectuses for issues. The second category comprises the main

piece of EU legislation in this domain, the Investment Services Directive (ISD).

The capital adequacy directive, referred to above, defines capital requirements for

market intermediaries, but is also applicable to the trading book of universal

banks. The liberalisation of the sale of unit trusts in the EU was the subject of one

of the oldest free provision of services directives, the UCITS directive. It must be

added that this regulatory framework is currently subject to far reaching review, as

agreed by the Council of EU finance ministers on 25 May 1999. In adopting the

Financial Services Action Plan, Ministers agreed that the regulations were not

adapted to the needs of a single Euro capital market, and that existing directives

will need to be simplified or amended, and new measures will be drafted.

Stage 1 measures include:

Prospectus for public offerings of securities: Council Directive 89/298

coordinating the requirements for the drawing-up, scrutiny and distribution for the

prospectus to be published when securities are offered to the public, OJ L 124 of


Stock exchange admission: Council Directive of 79/279/EEC coordinating the

conditions for the admission of securities to official stock exchange listing, OJ L

66 of 16.3.1979

Publication of information on major holdings: Council Directive 88/627 on the

information to be published when a major holding in a listed company is acquired

or disposed of, OJ L 348 of 17.12.1988

Regulation of insider trading: Council Directive 89/592 coordinating regulations

on insider trading, OJ L 334 of 18.11.1989

Collective investment undertakings (Ucits): Council Directive 85/611 on the

coordination of laws relating to undertakings for collective investment in

transferable securities, OJ L 375 of 31.12.1985

Stage 2 measures include:

Investment services (ISD): Council Directive 93/6 of 10 May 1993 on investment

services in the securities field, OJ L 141 of 11 June 1993

Capital adequacy (CAD): Council Directive 93/22 of 15 March 1993 on the

capital adequacy of investment firms and credit institutions, OJ L 141 of 11 June


Value at Risk amendments (CAD II): Directive 98/31/EC, Official Journal L 204 ,


Another directive was adopted in the meantime. It concerns:


Investor compensation schemes: Directive 97/7/EC of the Council and the

European Parliament on investor compensation schemes, OJ L 84 of 26.3.1997

In designing the structure, CEECs also received help from the IOSCO

(International Organisation of Securities Commissions) principles on securities

market regulation. IOSCO adopted basic Objectives and Principles of Securities

Regulation in September 1998.

The view that emerges from table 6 is that most CEECs are well advanced in the

stage I of the approximation process, which requires an adequate level of

disclosure and the prohibition of insider trading. Two countries seem to have some

delay: Romania and the Slovak Republic. Stage II measures are another pair of

issues: both the investment services directive (ISD) and the capital adequacy

directive (CAD) are not well implemented. This should not provoke major

problems for the time being: Also within the EU, there were serious delays in

implementation (Spain implemented the ISD only in 1998, 2 years after the

official date) and both directives are still undergoing change. The investment

services directive will be reviewed to solve the problem of the application of the

conduct of business rules for cross-border trades, the CAD was recently amended

to take into account internal models in risk management of trading portfolios.

Insider trading is by now prohibited in all of the countries covered. Investor

compensation schemes are granted in most countries covered, but the same

problems will be encountered with the deposit guarantee schemes directive, in

terms of the level of protection. Enforcement is problematic in the Czech and

Slovak Republics, Romania and Russia. The Czech Republic is however the most

advanced of the three, with the problem being mainly that the supervisory body

has no rule making authority.


Table 6: Securities market regulation in selected CEECs

Market Regulation

Insider Laws and Investor Protection Disclosure and Compliance





Bulgaria Yes, in Securities and Stock Exchanges and

Investment Companies Act



Contained in new securities law recently

approved by parliament.


Draft Public Offerings of

Securities Act contains better

on disclosure and enforcement

Enhancement of standards and

strengthening of enforcement


Estonia Yes, in Securities Markets Act. Standards implemented.

Hungary Legal provisions and regulation converging

towards IOSCO standards.

Standards well developed.

Latvia Yes, by recent amendments to the Law on


Standards implemented.

Lithuania Yes, Law on Public Trading in Securities. Standards implemented.

Poland Legal provisions and regulation converging

towards IOSCO standards.

Romania Certain provisions exist in 1994 Securities

Law, but enhancement being undertaken in

line with market development.



Standards well developed.

Regulations developed by

National Securities

Commission and SRO's, but

enforcement procedures not in


New securities law setting standards on investor protection and disclosure

came into force in 1999.

Slovenia Provisions exist in new Law on Securities

Market, in force since 1999, brings

legislation in line with EU, except for

investor protection.

Standards developed and

enforcement capabilities being


Source: Thiel Blommestein (1998); Questionnaires filled in by stock exchanges in

respective countries.

Table 7: Securities market infrastructure, Source: Table form Thiel-Blommenstein (1998) and survey



Organisation of Trading Clearing and Settlement

Bonds Equities Bonds Equities Derivative Trading

Bulgaria Yes Since 1998 public companies shares should be traded on

a stock exchange or on organised OTC market only.

Government bonds are traded on the OTC market. The



trade of corporate bonds on both is about to begin.

Clearing and settlement is performed by the

Central Depository. The Settlement cycle is T+3.

The Central Depository holds the shareholder

books of all public companies.

Yes Stock Exchange Central market handles only 3% of all UNIVYC (100% owned by stock exchange)

trade. The bulk is handled by the unofficial OTC market settles most trades on OTC market and all trades

(90%), the remainder by the RM system (now mainly on central stock exchange. TDK System run by

retail). Bonds are listed on the Prague Stock Exchange Czech National Bank provides DVP for T-bills.

central market.

The Securities Centre is a central

depository/registry for all securities including Tbills.

Hungary Initially no, but 25% of total government

banks have been securities trade on Budapest

allowed to engage Stock Exchange. Bulk of

in securities OTC trade electronically

market activities (Reuters).

since 1997.

86% of trade in listed

shares takes place on

Budapest Stock


Poland Yes Bonds and equities trade on the Warsaw Stock

Exchange. Since 1997, equities also traded on the

official OTC market.

KELER Ltd. performs all clearing and settlement

for BSE trades, and only government securities

failed on OTC market.

National depository for securities performs all

depository and clearing functions.


Not yet traded on the

OTC or stock exchange.

Options and futures

contracts traded on OTC


Well developed both on

Budapest Stock

Exchange and Budapest

Commodity Exchange.

In both cases settlement

via KELER.

Index futures traded on

Warsaw stock exchange.



Organisation of Trading Clearing and Settlement

Bonds Equities Bonds Equities Derivative Trading

Romania No, but proposal Bukarest Stock Exchange; mkt. RASDAQ for Central SRO, national Company for Clearing and None, except

for allowing banks privatisation shares (3700 companies listed). No bonds Settlement.

Commodity Exchange.

to engage in


activities pending

in Parliament.

traded yet.

Russia Yes Govt.securities (GKOs, Russian Trading System Preparation for central depository under way. Currency futures (25%)

OFZs) traded on MICEX* (RTS); Moscow Stock Settlement and clearing services provided by GKO and OFZ futures

plus 8 regional exchanges. Exchange since May 97, several separate institutions.

(80%) unregulated

and regional exchanges.

clearing and settlement.



Yes, with some

restrictions on

banks' proprietary

trading of


Secondary bond mkt.

provided via Bratislava Stock

Exchange and the RM-system

Slovakia. State bonds traded

mainly on BSE.

All equities trading on

BSE-listed, registered

and free markets.

Slovenia Yes Ljubljana Stock Exchange (A&B for listed securities

and C for unlisted securities). Both markets work under

the same management and with the same trading


SCP provides registry and clearing (securities

centre) services for all securities including Tbonds.

Cash settlement via Banking Clearing

Centre for Slovak Republic.

Central Securities Clearing Corporation (KDD),

licensed and supervised by securities agency.

T+2 settlement.


Official mkt. In

preparation by Stock


Forex and equity futures

previously traded on the

Ljubljana Commodity

Exchange. Exchange

closed due to insolvency

end 1997.

An issue of importance is that in many CEEC non-organised over-the-counter

(OTC) trading is typical, with a relatively small proportion of trades being

conducted via the stock-markets. This is especially true for the Czech Republic,

where around 60% of all trades are made over the counter. The reason for this

practice are the less stringent rules of disclosure and registering in OTC-trades.

Also, in Hungary part of the trading is OTC, but only for a much smaller

proportion (around 20%) (OECD, 1998b/1998c).

The dominance of OTC trading in the Czech Republic has led to a lack of

transparency in ownership structures. It is only compulsory to register a trade at

the Securities Centre of the MOF if more than 10% of a given company changes

hands (OECD, 1998(b): 62). Due to the lack of minority shareholder protection,

this can lead to “tunnelling” of funds, whereby the new shareholders can elect new

bodies acting entirely for their benefit and the property can be embezzled by such

a fund within a few days. The Czech Ministry of Finance is however looking into

this issue and suggested the introduction of new legislation to protect minority


2.5.6. Tax Issues of Relevance to Financial Markets

Overall, taxation is not a big issue for capital market operators in the CEECs. The

primary issue in taxation is a public finance matter, this is how to design and

implement an efficient tax system in transition economies. The problems in

enforcement are huge, and tax evasion is widespread. But it has lead to interesting

experiments, such as in Estonia, which applies a zero rate of corporate taxation.

Issues of interest to capital market operators are withholding taxes on interest and

dividend income. A survey of rates applicable in the CEECs shows a diversity of

rates applicable, with most remarkably the widespread non taxation of residents.

This compares starkly to the EU, where all countries except Luxembourg tax

interest income of residents, and only a few apply zero rate taxation of dividend

income. In their effort to attract foreign direct investment, CEECs want to create

an interesting environment for corporations and financial markets. For nonresidents,

and repatriation of profits, important tax disincentives are in place. This

shows again, as with financial market regulation, that priorities between the EU

and the CEECs differ.

The prospect of EU entry will not immediately change this situation. There is

almost no acquis communautaire in the area of direct taxation. The matter is

subject to unanimity voting in the EU Council of Ministers, which has seriously

constrained the possibility to act so far. The only domain where legislation has

been passed concerns the reduction of double taxation of corporations. Recently

the European Commission changed track in the area of tax harmonisation and

announced a programme to combat harmful tax competition. Tax competition

between member states is seen as harmful since it erodes the tax base and

increases the tax burden on the employed. As part of this effort, the various special

tax regimes of the member states and their offshore territories are screened to see

whether they are permissible in an EU context. A related initiative concerns the

harmonisation of withholding taxes. A proposal is on the table of the EU Council

to set a minimum withholding tax rate of 20% to be levied on interest income


obtained by EU citizens in other member states, to avoid tax evasion within the

EU. Although there are still some political problems to be overcome, the proposal

will most likely be adopted. But since it does not harmonise resident withholding

tax rates, the situation in the CEECs will not be affected.

Table 8: Withholding tax rates in the CEECs

Residents Non-residents

Interest income Dividends Interest income Dividends

Bulgaria 15 0 15 15

Czech Republic 25 25 25 25

Estonia 10 0 10 0

Hungary 0 0 15 10

Latvia 0 0 10 10

Lithuania 0 0 0 0

Poland 20 20 20 20

Romania 0 10 0 10

Slovenia 0 25 0 25

Slovak Republic 15 25 15 25

Notes: Numbers are what is the rule but they may be lower under double tax treaties.

Source: Price Waterhouse, Corporate Taxes, A Worldwide Summary, 1997.

2.5.7. Openness of the Financial System

The openness of the CEECs to foreign investment (which is analysed in detail in

chapter 6.2. as well as in 1.1.4.) has been quite high from the beginning, because

of the need for a speedy privatisation. Foreign Direct Investment (FDI) flows as

participations in domestic companies have been important from the beginning of

the transition process. In banking, the licensing policy was fairly liberal in the

beginning, both for foreign and domestic banks. However, with the initial

liberalisation drive slowing down and new problems emerging such as renewed

capitalisations stemming from bad loans incurred after the start of transition,

central banks have been tightening their licensing policy. Foreign banks started to

find it hard or even impossible to obtain a license (Varga, 1997: 428).

In all of the countries with a more advanced financial system, such as the Czech

Republic, Poland, Hungary, a banking license can in practice only be obtained by

acquiring one of the small banks. In terms of the acquis communautaire, in

banking all of the three countries have practically implemented the stage I

measures. Freedom of establishment and free provision of services are, however,

still subject to the constraints implied by the need for separate licensing of foreign

companies by the domestic authorities, which means that the home-country

control principle is not yet established. The central banks’ competition policy in

many CEEC has become highly selective. Especially foreign banks or their

subsidiaries mainly promote blue-chip enterprises in CEECs. Undertakings with

less than first-class ratings, on the other hand, find it rather difficult to raise the

funds they need (Varga, 1997: 428).


In securities markets, the same holds as for banking. In insurance, the

liberalisation of the market towards foreign providers is not as far, yet. However,

in some countries, such as in Poland, the provision of insurance by foreign

companies is quite advanced through participations of foreign companies in or cooperation

agreements with local providers (e.g. 5% of the insurance market share

is held by the Dutch conglomerate ING, and there are several partnerships

between domestic and foreign providers).

2.6. Conclusion

10 years is a short period to put in place a well-functioning regulatory framework

of a market economy financial system in countries where everything was centrally

planned before. Not only had institutions for the supervision financial markets to

be created, also a radical change of minds needed to be pursued. It is no

coincidence that the countries which are most advanced today, Hungary and

Poland, were already the most “liberal” at the start.

The development of and regulatory set-up for financial markets in CEECs was

influenced by the method of enterprise privatisation chosen and the approach

followed in the creation of financial markets. These varied considerably across

countries, and can be explained by cross-country differences in social and

economic traditions and in policy orientations. It has resulted in a complex picture

of the state of the financial markets today, and still explains differences in the

regulatory policy agenda’s in the CEECs.

Gradual and well-structured transitions have proved to be more successful than

big bangs. Governments carry an important task in the management of this

process. Sovereign debt securities have played a vital role in creating a stable and

liquid capital market. They formed a stable institutional and legal framework for

other securities markets to emerge and for the development of local financial

markets, and contributed to the education of investors. Wide availability of stocks

and vouchers, as in the Czech Republic and Russia, formed a more volatile

environment for a stable capital market to develop.

Financial markets are, however, still in very early phases of development, and will

need a considerable time to attain Western-European standards. So why should the

latter markets’ standards immediately be taken over in financial regulation? A

tailor made regulatory package seems to have better suited to these countries. If

everything will be in place as requested by the EU-Commission already from the

beginning on, markets may end up to be over-regulated, certainly as compared to

their levels of development. This is evident from discussion around the minimum

level of the deposit protection, which is very high for countries where the average

income is far below the EU’s. From the point of view of the EU, of course, farreaching

exceptions to the acquis can create dangerous precedents in the accession

negotiations, and cannot be accepted. Therefore, the only way out is to demand

long transition periods to the CEECs to improve the “creative” development of

their capital markets.

The ambiguity of the regulatory package becomes clear in the differences in

judgement on progress in the transition between the EBRD and the European


Commission. The latter clearly has its single market benchmark, whereas the

former follows more general transition indicators. But both institutions agree that

the “accession candidates” are more advanced in their transition and in the

regulatory framework than the European CIS countries. The perspective of

European Union membership and the pre-accession instruments have clearly

speeded up the reform process and contributed to a massive transfer of know-how.

In this context, the well-balanced (and not over-regulated) establishment of EU-

Directives can improve the Western integration of these capital markets. The

rewards of this investment were already clear during the Autumn 1998 turmoil,

which only had a limited impact on the more Western-oriented accession



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first empirical study, SITE (Stockholm Institute of Transition Economics and East

European Economies, No.122.

Emerging Stock Markets Database (EMDB, 1998): Emerging Stock Markets Factbook

1998, Washington, D.C., International Finance Corporation.

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1999 (and preceding issues), London, EBRD.

European Central Bank (1999): Possible Effects of EMU on the EU Banking System in the

Medium to Long Term, February.

European Commission (1995): Whitebook on the preparation of the Associated States of

Central and Eastern Europe for their integration in single market of the Union,


European Commission (1997): Agenda 2000: for a stronger and wider Union, in: Bulletin

of the European Union, Supplement 5/97.

European Commission (1999): Financial Services Action Plan, May.

Gros, Daniel and Alfred Steinherr (1995): Winds of Change. Economic Transition in

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Weisbrod (1998): Financial Regulation. Why, how and where now?, London,


Heiss, Peter and Gerhard Fink (1997): Seven years of financial reform in Central Europe,

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Janosik, Jurai (1998): The present situation and current problems in the state securities

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Kalderén, Lars (1998): The role of the government in the development of the securities

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Lannoo, K. (1999): EMU and financial supervision, Zentrum fur Europaische Integrationsforschung,

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Li, W. (1999): A tale of two reforms, in: RAND Journal of Economics, 30/1, Spring, 120-


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Appendix: The European Commissions Whitebook on Legal


Capital Movements:

Stage One Measures:

Liberalisation of long and medium term capital movements, as defined in

directives of 11 May 1960, 63.21/CEE and 86/566/CEE.


Freedom of establishment (minimum national treatment for institutions from other

EU countries), coupled with basic requirements for the licensing and supervision

of credit institutions, and a system for cooperation amongst supervisory authorities

(first banking directive); the fundamental rules regarding own funds and minimum

solvency ratios (own-funds and solvency-ratio directives); a minimum level of

deposit insurance is obligatory (deposit guarantee directive).

Securities markets:

Two groups of measures, one concerning the conditions governing securities listed

on the stock exchange (admission and listing rules for securities, the necessary

disclosure of major holdings and prohibition of insider trading), a second on the

free provision of unit trusts.

The coordination of the freedom of establishment of investment houses is not

defined in a specific directive, but governed directly by Treaty provisions.

No further rules on stock exchanges: they have to be governed by clear and

transparent rules, and supervised by a competent authority.

Money laundering

Of equal importance for both banking and securities markets is the directive to

prevent the use of the financial system for money laundering purposes.


Directives on the freedom of establishment for life and non-life insurance

companies (first generation insurance directives). Harmonised rules for the annual

and consolidated accounts of insurance companies.


Capital Movements:

Stage Two Measures:

Short term capital movements, as defined in directives 88/361/CEE, replaced by

articles 56-60 (ex-Art. 73b-h) of the EU Treaty.


Free cross-border branching and provision of services (second banking directive)

with a single licence under the sole control of the home country. Limitation of

exposures to a single client (large exposures directive). Other directives are

concerned with the publication of annual accounts and the means of consolidating.


Free provision of non-bank financial services in the EU for brokers and securities

markets (investment services directive), minimum capital requirements for

investment firms and for the trading books of banks (capital adequacy directive).


Free provision of life and non-life insurance with a single licence under the sole

control of the home country (third generation insurance directives). Harmonisation

of asset allocation and prohibition of location requirements for investments.

Source: European Commission (1995).


3. Market Structures and Developments

This chapter provides an in-depth descriptive analysis of CEE capital markets. It

addresses the current structure and the development over the past years of

transition. Whereas chapter 2 draws a picture of the legislative and regulatory

environment, the aim of this chapter is to depict how markets have evolved within

this framework. This chapter serves as a prerequisite for a profound

understanding of conduct in the CEE capital markets. Therefore it also acts as a

reference point for the analyses of information efficiency (chapter 4) and

transformation of external shocks and market integration (chapter 5) of the CEE

capital markets.

In the first part of this chapter (3.1.) we analyse the organisation of equity and

bond markets in the Czech Republic, Estonia, Hungary, Poland, Slovenia and

Russia in detail. For each of the CEE countries covered in this study we describe

the history and regulation of the stock exchanges, give an overview of the

different market categories and listing requirements and of the types of trade. But

trading in CEE equities not only takes place on the local stock exchanges. We

document the relevance of listings on foreign exchanges and the importance of

trading in so-called depository receipts. We proceed to report regulation and

practice of clearing and settlement on the exchanges, analyse the composition of

the main indices and the derivatives markets (chapters through

After presenting the details of the capital markets for each CEE country separately

we summarise the results on the individual countries in a broad synopsis. In

particular, we compare CEE equity and bond markets in terms of size and market

structures. We also examine the extent to which CEE companies set up depository

receipt programs and how far the market for publicly issued debt securities

denominated in local currencies are developed (chapters through

We then proceed to compare the national capital markets in detail regarding

market capitalisation, market turnover and market liquidity. For example, we

control for size of the economy and calculate the freely-traded volume of shares.

Furthermore, we identify the type of market participants (chapter 3.1.2.). To round

up our descriptive analysis we report historic performance and volatility of the

CEE equity markets (chapter 3.1.3.). A broad comparison of all CEE countries

covered in this study can also be found in the Appendix. 58

In the second part of this chapter (3.2.) we focus on a particular type of investor in

the CEE capital markets which is – at least in Western capital markets – becoming

more and more important: the institutional investor. Usually financial

intermediaries like investment funds, pension funds and insurance companies but

not banks are subsumed under this name. We follow this definition and document

past and current investment behaviour of domestic institutions which manage

people’s funds. We show that up to now they play only a minor role in CEE

capital markets. In addition, we extend the analysis to institutional investors from

Western countries since their portfolio investments in CEE countries is starting to

58 See “Country Summaries” in the Appendix.


play a significant role in CEE capital markets. Making use of an in-depth survey

among Western investment funds we examine which criteria they use for portfolio

investment. Drawing on the knowledge of these active market participants we

show which factors currently prevent higher portfolio investment in the CEE

capital markets.

3.1. Main Features of the Markets

3.1.1. Introduction

This chapter attempts to give an overview of the main characteristics of equity and

bond markets in the Czech Republic, Poland, Hungary, Estonia, Slovenia and


In a first part (chapter 3.1.2.) we give a broad comparison of CEE equity and bond

markets. Thereby, we look at size, turnover and liquidity of these markets. Since it

is also of importance who participates in trading in these markets we also analyse

the structure of market participants—both in the equity and the bond markets. To

round up the picture of CEE capital markets we finally summarise their main

characteristics (e.g. number of shares listed in the equity markets, types of

instruments in the primary and secondary bond markets) and describe important

details of the regulatory framework (e.g. listing requirements). Since the

derivative markets are underdeveloped in all countries covered we do not provide

a comprehensive summary on these markets but rather include them in the

Appendix to this chapter.

For the interested reader the Appendix also contains a range of other details on the

markets covered in this study. It comprises information on the history of each

country's stock exchange and/or OTC markets, the market segments, the types of

trade, the main local equity indices.

In a second and third part (chapters 3.1.3. and 3.1.4.) we provide a thorough

analysis of cross-country indices currently available for the equity and bond

markets of the CEE countries, respectively. This is important information since

these indices (which are calculated by financial institutions) are often used as

benchmark by market participants in the CEE capital markets. We evaluate in how

far they are capable of fulfilling this benchmarking role.

In the third and last part of this chapter (3.1.5.) we analyse the historical

performance and volatility of the countries' equity and bond markets. The

performance and volatility characteristics of CEE equity markets represented by

regional indices (CECE and MSCI Eastern Europe) are compared with both other

emerging markets "competitors" and developed markets. The relative performance

of each CEE market and of the Russian market is also analysed. Moreover, the

performance of fixed-income instruments denominated in local currency (LCY) is

presented both in US$-terms and in EUR-terms, as measured by the country subindices

of the above mentioned cross-country fixed-income indices.


The conclusion (chapter 3.1.6.) not only summarises the results, but also gives

some indications regarding possible actions by authorities and by market


3.1.2. Comparative Overview of CEE Capital Markets

In the following we present a broad overview on CEE equity and bond markets.

We compare the markets by capitalisation, turnover, liquidity and market

participants. Market Size

Equity Markets

Looking at total market capitalisation of equities at the end of 1998 Poland shows

the highest capitalisation in absolute US$-terms (see Figure 1). To a large extent

this mirrors the fact that Poland is the largest economy (measured in terms of

nominal GDP in US$) among all included countries, except Russia. However, if

we had included the capitalisation of Gazprom whose ordinary shares are not

traded on the RTS system (but on the Moscow Stock Exchange MSE) and cannot

be bought by foreign investors the capitalisation of the Russian equity market

would result as the biggest one with US$ 31 bn. Moreover, the Russian crisis took

its toll. Russia was by far the biggest market at the end of 1997, with US$ 72 bn

(RTS-1, excluding Gazprom), and US$ 129 bn (RTS-1 plus Gazprom).

Total market capitalisation comprises the shares of all listed companies, including

the (larger) strategic stakes held by the state or else by foreign companies. Per

definition, the free-float market capitalisation excludes stakes beyond a certain

threshold, in particular those strategic stakes covering the part of the total market

capitalisation which is principally available to the public for portfolio investments.

As there are no official data on the free-float market capitalisation of the CEE

capital markets available (except for Estonia) we made a bottom-up estimate

based on a set of companies which cover a large part of the total market

capitalisation (ranging from 83% in Russia to 96% in Hungary).

The share of the free-float market capitalisation in total ranged from only 22% in

the Czech Republic, and 32% in Poland to more than 50% in Hungary and in

Russia at the end of 1998. This leads to the result that Hungary was the biggest

market measured in terms of the free-float market capitalisation in US$.

Moreover, Hungary had clearly the highest relative market capitalisation (in

percent of GDP), both as total and (in particular) as free-float capitalisation (see

Figure 2). From the end of 1997 to the end of 1998, the relative total market

capitalisation changed particularly strong in Estonia (end-97: 35% of GDP) which

was certainly linked to the Russian crisis, and in Russia, from 16.5% excluding

Gazprom (29.5% including Gazprom) to 4.1% and 11.5%, respectively.


Figure 1: Market capitalisation of equities 1998: total compared to free-float

(end of period, US$mn)













Poland Hungary Czech





total free-float





Slovenia Estonia Russia



Source: Budapest Stock Exchange, Ljubljana Stock Exchange, Nova Ljubljanska Banka,

Prague Stock Exchange, Raiffeisen Zentralbank Österreich AG, Russian Trading System,

Tallin Stock Exchange, Warsaw Stock Exchange.

Figure 2: Market capitalisation of equities 1998: total compared to free-float

(end of period, in % of GDP)















Poland Hungary Czech








Slovenia Estonia Russia



total free-float

Source: Bank of Estonia, Bank of Slovenia, Budapest Stock Exchange, Ljubljana Stock

Exchange, Nova Ljubljanska Banka, Polish Central Statistical Office, Prague Stock

Exchange, Raiffeisen Zentralbank Österreich AG, Russian-European Center for Economic

Policy, Russian Trading System, Tallin Stock Exchange, Warsaw Stock Exchange, WIIW.

Bond Markets

Also the market capitalisation (at face value) of publicly issued debt-securities

denominated in local currency (LCY) in absolute US$-terms (see Figure 3)

mirrors the absolute size of the total economy to a large extent.

For Russia, the nominal market capitalisation of the GKO/OFZ-market on August

14, 1998 (when the market was closed by the government) was taken as the value

at the end of 1998, because these assets were not restructured until March/April

1999. However, this market capitalisation in US$ (shown in Figure 3) is based on

the exchange rate at the end of 1998.

Figure 3: Market capitalisation of LCY-denominated debt securities 1998

(end of period, US$mn) 59

















Poland Hungary Czech









Slovenia Estonia Russia

short-term long-term

Source: Bank of Estonia, Bank of Slovenia, Czech Ministry of Finance, Czech National

Bank, Hungarian State Treasury, Ljubljana Stock Exchange, National Bank of Poland,

Nova Ljubljanska Banka, Polish Ministry of Finance, Prague Stock Exchange, Raiffeisen

Zentralbank Österreich AG, Republic of Slovenia-Ministry of Finance, Russian-European

Center for Economic Policy, Tallin Stock Exchange.

It was the devaluation which diminished the market size from US$ 64.4 bn at the

end of 1997 to US$ 18.3 bn (15.3 plus 3.0), i.e. below the Polish level, at the end

of 1998.

59 As mentioned in the text, only LCY-denominated debt securities which were publicly

issued are included in this graph. The only exception is Slovenia, where the volume of

publicly issued debt securities is very low, while all privately issued and initially nonnegotiable

government debt securities were transformed into negotiable ones in 1996.

Out of the total amount of LCY-denominated debt securities which were negotiable at

the end of 1998, all those debt securities which were not D-linked (i.e. not linked to

the devaluation rate) were taken for the purpose of this chapter.

Apart from Russia, market capitalisation of long-term LCY-debt securities

includes bonds of both the public and the private sector while short-term papers

exclusively comprise Treasury bills (T-bills). However, bonds of the central

government are predominant in Poland and Hungary where they amounted to 90%

and 87%, respectively, of all bonds. In contrast, they constituted only 72% in

Slovenia and 28% in the Czech Republic, with no publicly issued bonds of the

central government existing in Estonia.

Figure 4: Market capitalisation of LCY-denominated debt securities 1998

(end of period, in % of GDP)

















Poland Hungary Czech









Slovenia Estonia Russia

short-term long-term

Source: Bank of Estonia, Bank of Slovenia, Czech Ministry of Finance, Czech National

Bank, Hungarian State Treasury, Ljubljana Stock Exchange, National Bank of Poland,

Nova Ljubljanska Banka, Polish Central Statistical Office, Polish Ministry of Finance,

Prague Stock Exchange, Raiffeisen Zentralbank Österreich AG, Republic of Slovenia-

Ministry of Finance, Russian-European Center for Economic Policy, Tallin Stock

Exchange, WIIW.

Regarding the maturity structure it is noteworthy that long-term papers were

clearly more important in all countries, except in Russia, at the end of 1998 (see

Figure 4). Thus, within the market of LCY-debt securities of both the public and

the private sector, long-term papers held a share of 72% in the Czech Republic,

60% in Hungary (up from 57% in 1997) and 63% in Poland (up from only 49% in

1997). This certainly reflects the success of financial stabilisation and disinflation,

leading to steadily falling inflationary expectations by the end of 1998, as well as

the response of the market participants to the restrictive monetary policies in

place, implying an inverse interest rate structure. In particular the share of T-bills

in all publicly issued LCY-debt securities of the central government continuously

fell in Poland from 85% at the end of 1994 to 39% at the end of 1998. In addition,

the importance of floating rate notes within the bonds decreased drastically in

Poland. In Hungary, the corresponding share of T-bills fell from 100% in 1990 to

43% in 1994. Then, the financial crisis and the ensuing acceleration of inflation

increased its value again to 49% in 1996, before it decreased to 43% at the end of

1998. A declining share of T-bills could be observed also in Russia up to the close

of the market. In remarkable contrast, the corresponding share of T-bills increased

in the Czech Republic from 43% in 1994 to 59% in 1996 and had the same level

also in 1998, despite a steeply inverse interest rate curve. This fact might cast

doubts on the management of public debt in the Czech Republic. However, also

the competition by higher-yielding (though partly state-guaranteed) corporate and

bank bonds might be part of the explanation, constituting some kind of “reversed

crowding-out” of the public sector by the (state-guaranteed) private sector.

Market capitalisation (at face value) of publicly issued LCY-debt-securities

relative to GDP (see Figure 4) reveals that Poland and Russia were clearly lagging

behind Hungary and the Czech Republic. It is noteworthy that also at the end of

1997 (i.e. even before the devaluation), the relative size of the Russian market

capitalisation (14.8% of GDP, sum of short and long term) was roughly at the

same level than the Polish one and clearly below the levels in Hungary and the

Czech Republic.

Overall, total capitalisation of the equity market was larger than market

capitalisation (at face value) of publicly issued LCY-debt-securities in most

countries, except Poland and except Russia if we exclude Gazprom. However, the

free-float market capitalisation was clearly lower in all countries. Market Turnover

Comparing the countries’ equity turnover (see Figure 5), Hungary was clearly on

the top, followed by Russia and Poland. Including Gazprom does not change the

picture a lot as local turnover in Gazprom shares (about US$ 1 bn) was rather low

measured against Gazprom’s capitalisation. The change over time is remarkable,

not only in case of the Russian equity market which led the list with US$ 15.7 bn

(excluding Gazprom) in 1997. Poland, Hungary and the Czech Republic had all

roughly the same level of turnover in 1997 (about US$ 7.8 bn). While turnover in

Hungary more than doubled from 1997 to 1998, it grew only modestly in Poland

and even fell in the Czech Republic.

Comparing the countries’ turnover in LCY-debt securities (see Figure 5), Poland

had the first rank if measured in absolute US$-terms, followed by Russia. One has

to bear in mind that secondary market trade in these assets has, to a very large

extent, effectively been suspended in Russia since mid-August 1998.

Moreover, the yearly average exchange rate used to calculate the turnover into

US$-terms partly reflects the devaluation of the rouble after August 17, 1998.

Hence, the sharp decline in the turnover in US$ terms from 1997 (US$ 153.5bn) to

1998 (US$ 95.5 bn) is not surprising. In contrast, the turnover of LCY-debt

securities increased by roughly 33% in Poland and in the Czech Republic from

1997 to 1998. However, it is noteworthy that in Hungary we witnessed a decline

in turnover by 16% to US$ 42.4 bn in 1998 which can only partly be blamed on

the depreciation of the forint against the US$. This indicates that not even in the

most developed CEE-countries we can take a sustained growth path of the

secondary market turnover as granted. Regarding the maturity structure, Hungary

seems to have a rather advanced fixed-income market as only 28% of the total

turnover in LCY-debt securities were made up by Treasury bills. Interestingly, the

decline in that share from 46% in 1997 was rather due to a strong decrease in the

T-bills turnover than due to a shift from T-bills to T-bonds. In Slovenia, T-bills


were negligible and in Estonia, T-bills played no role at all. In contrast, the share

of Treasury bills in total turnover was nearly 59% in the Czech Republic and

roughly 78% in Poland and Russia. Although the share in turnover had decreased

in the Czech Republic and in Poland from 1997 to 1998 (from 64% and 94%,

respectively), it was still more important than the share of Treasury bills in the

market capitalisation.

Figure 5: Secondary market turnover: equity compared to LCY-debt securities 1998

(single counted, US$mn)















Poland Hungary Czech






1216 1427


Slovenia Estonia Russia



equity LCY-debt securities

Source: Bank of Estonia, Bank of Slovenia, Budapest Stock Exchange, Czech Ministry of

Finance, Czech National Bank, Hungarian State Treasury, Ljubljana Stock Exchange,

Moscow Interbank Currency Exchange, National Bank of Poland, Nova Ljubljanska Banka,

Polish Ministry of Finance, Prague Stock Exchange, Raiffeisen Zentralbank Österreich AG,

Republic of Slovenia-Ministry of Finance, Russian-European Center for Economic Policy,

Russian Trading System, Tallin Stock Exchange, Warsaw Stock Exchange.

Only in the Czech Republic and in Slovenia turnover in LCY-bonds was

dominated by the private sector’s issues, as the turnover in central government

bonds constituted only 33% and 25%, respectively, of the total turnover in bonds.

In Slovenia, the share of LCY-government bonds in total turnover was much

lower than their share in total capitalisation, while in the Czech Republic both

shares were rather similar in size.

Related to the nominal GDP, the top position of the Hungarian equity market is all

the more impressive, but also the size of the Estonian equity market's turnover has

to be noted (see Figure 6). On the other hand, the first rank of the Polish turnover

in LCY-debt securities is downsized, being clearly below the levels around 90% of

GDP in Hungary and the Czech Republic. Market Liquidity

The Hungarian equity market was clearly the most liquid one if measured by the

turnover ratio based on the total market capitalisation (see Figure 7). As we have

seen, this Hungarian top-position has to be attributed to the much higher turnover,

while the relative market capitalisation (in % of GDP) is certainly not

extraordinarily low, quite the contrary.

The Hungarian liquidity ratio (110%) was twice the Polish one (54%), as the

turnover in Hungary doubled in 1998. One important factor explaining this

increase in turnover and hence in liquidity is the perception of Hungarian equities

by foreign portfolio investors. As we will see in chapter (market

participants), the turnover linked to foreign portfolio equity investors constitutes

the vast majority of the portfolio equity turnover in Hungary, but also (to a lesser

extent) in Poland.

Figure 6: Secondary market turnover: equity compared to LCY-debt securities

1998 (single counted, in % of GDP)


















4.4 0.5

Poland Hungary Czech







Slovenia Estonia Russia



equity LCY-debt securities

Source: Bank of Estonia, Bank of Slovenia, Budapest Stock Exchange, Czech Ministry of

Finance, Czech National Bank, Hungarian State Treasury, Ljubljana Stock Exchange,

Moscow Interbank Currency Exchange, National Bank of Poland, Nova Ljubljanska Banka,

Polish Central Statistical Office, Polish Ministry of Finance, Prague Stock Exchange,

Raiffeisen Zentralbank Österreich AG, Republic of Slovenia-Ministry of Finance, Russian-

European Center for Economic Policy, Russian Trading System, Tallin Stock Exchange,

Warsaw Stock Exchange, WIIW.

Although the net inflow of foreign portfolio capital into Hungary decreased from

1997 to 1998, foreign trading activities in Hungarian equities have increased

considerably. This was partly linked to the Russian crisis. However, some data

indicate that the increase of foreign trading activities seemed to be particularly

more pronounced in Hungarian than in Polish equities, although the Russian crisis

hit Hungary and Poland. One factor specific for Hungary in driving foreign

trading activities were the uncertainties around the Hungarian parliamentary

elections in April / May 1998. In addition, the Hungarian economy is perceived to

be more advanced in the transition process and in the convergence towards the

European Union, and Hungarian listed enterprises are considered to be financially

the strongest and the more integrated in Europe, not only as they are owned to a

large extent by foreign companies (see chapter Not only are more fund

managers allowed and willing to trade in Hungarian equities, but also Hungarian

equities seem to be already more integrated into portfolio investment attitudes and

approaches characterised by shorter-time investment horizons which are

prevailing in the developed equity markets. In contrast, the foreign portfolio

trading activities in Polish equities have risen to a smaller extent than in

Hungarian equities, but the net inflow of foreign portfolio capital into Poland

increased (and not decreased as in Hungary) from 1997 to 1998, although the

stock of foreign portfolio capital had already been higher in Poland than in

Hungary at the end of 1997, both in absolute US$-terms and in % of total market

capitalisation. Hence, in Poland the foreign portfolio investments seem to have

been made under relatively longer-term investment horizons, more typical for

emerging market equity funds.

Figure 7: Turnover ratio of equity markets 1998

(% of year-avg total and year-end free-float market capitalisation)













Poland Hungary Czech


Source: Raiffeisen Zentralbank Österreich AG.








Slovenia Estonia Russia



total free-float

Although the Czech stock market's capitalisation was comparable to the

Hungarian market, one of its characteristic is the lack of liquidity. Trading

activities are concentrated only on the few blue-chips companies traded through

the market-maker based SPAD system. Based on the free-float market

capitalisation, the liquidity of the Hungarian market came second after the

Estonian one (see Figure 7). The high free-float market liquidity in Estonia

benefits from the high relative turnover and the relatively low share of the freefloat

capitalisation in the total market capitalisation. However, the relative total

market capitalisation was not extraordinarily low in Estonia, either.

Comparing the secondary markets in equities and in LCY-debt securities (Figure 7

and 8), the market liquidity (as measured by the turnover ratio) was considerably

higher in the debt market, with the exception of Slovenia. This was due to the fact

that the turnover in publicly issued LCY-debt securities was several times larger

than the turnover in equities in all the countries, apart from Estonia. The fact that

the (year-average) capitalisation of the debt market was lower than the total

market capitalisation of the equity market in Hungary, the Czech Republic and

Estonia had a decisive impact only on Estonia.

What is more, also the LCY-bond market shows a higher liquidity than the equity

market, even if the liquidity of the latter is based on the (lower) free-float market

capitalisation. (Estonia is the notable exception).

In turn, the T-bill market generally has by far a higher liquidity than the bond

market, with Hungary (and Russia) being the exception (see Figure 8). In

Hungary, the liquidity of the T-bill market has drastically fallen from 1997 to

1998, while it stayed roughly at the same level in the T-bond market.

Figure 8: Turnover ratio of markets in LCY-debt securities 1998

(% of year-average market capitalisation)














Poland Hungary Czech


Source: Raiffeisen Zentralbank Österreich AG.








Slovenia Estonia Russia

short-term long-term Market participants

Equity Markets

Corresponding to the total market capitalisation of the equity markets, it would be

interesting to compare the ownership structure of the total capital of all the listed

companies between the different countries. Unfortunately, such a breakdown

exists only for Hungary. Looking at this example (see Figure 9), it is striking that

the share of total foreign investment in these companies is higher than 70%,

comprising both direct and portfolio investment. This does certainly not tell us

anything about the involvement of foreign portfolio investors on the Hungarian

stock exchange. However, it means that on the Hungarian stock exchange

domestic and foreign portfolio investors deal with the shares of companies whose

capital is mainly foreign-owned.

To some extent, this ownership structure is typical for the Hungarian economy

which has a great involvement of foreign companies via FDI, and cannot readily

be transferred to the other countries. However, it seems that the present Hungarian

situation is also an indication for the future in Poland and in the Czech Republic if

we look at the privatisation efforts in Poland and the restructuring plans in the

Czech Republic.

Figure 9: Hungary: ownership structure of listed companies

(end of period, in % of total market capitalisation)






Source: National Bank of Hungary.














The share of foreign portfolio equity investment in the total market capitalisation

can be derived from the international investment position which is calculated by

the central banks. (This position should also cover the stocks of equities held by

foreign depositors who in turn issue depository receipts (GDRs or ADRs), at least

in so far, as a stake is not considered to be too large to be treated as portfolio


As can be seen from Figure 10, the share of foreign portfolio investment into

Hungarian listed companies amounted to 16.5% of the total market capitalisation,

implying that 77% of the total amount of the foreign investment into listed

companies consisted in foreign direct investment (FDI), i.e. strategic stakes held

by foreign investors. Taking a look again at Figure 9, it is obvious that only 18%

of the total market capitalisation is held by domestic private investors, in the form

of both domestic direct investment and domestic portfolio investment. Hence, we

can draw the conclusion that it is very probable that the vast majority of the

portfolio investment into the Hungarian equity market was held by foreign

portfolio investors at the end of 1998, although their share in the total market

capitalisation was not more than 16.5%. And in the other countries (except

Slovenia), the share of foreign portfolio equity investment was substantially

higher, ranging from 24% to 37% of the total market capitalisation.

The low share of foreign portfolio equity investment in Slovenia is linked to the

cautious policy regarding the liberalisation of the capital account in that small

economy, while Estonia as a small economy that had adopted a currency board

followed the opposite way in that it had quickly and comprehensively opened its

equity market to foreign portfolio investors.

Figure 10: Foreign portfolio equity investment 1998

(end of period, in % of total market capitalisation)













Poland Hungary Czech






Slovenia Estonia Russia







Source: Budapest Stock Exchange, International Monetary Fund, Ljubljana Stock

Exchange, Nova Ljubljanska Banka, Prague Stock Exchange, Raiffeisen Zentralbank

Österreich AG, Russian Trading System, Tallin Stock Exchange, Warsaw Stock Exchange.

In Russia, it is clearly decisive when assessing the share of foreign portfolio

investment if Gazprom is included or not. This is due to the fact that there are no

foreign holdings of ordinary Gazprom shares permitted, while Gazprom’s

capitalisation increases the total market capitalisation substantially.

It is difficult to assess the size of the turnover of the secondary market in equities

which is induced by foreign portfolio investors. As no official data exist, one can

try to estimate on the basis of balance of payment data. However, this poses some

problems. On the one hand, gross inflows of foreign portfolio equity capital (gross

increase of domestic liabilities) are only related to foreign buying. On the other

hand, simply adding gross outflows would partly involve double-counting.

Moreover, it is also inaccurate to establish the gross inflows without further

corrections as the minimum estimate of the foreign share in the secondary market

turnover, because these inflows partly comprise the foreign portfolio investment

into the primary market.

Taking all these factors into account, we can estimate the share of foreign

portfolio investors in the total turnover of the equity market for Poland as between

23% of total turnover (gross inflows minus the total public issuance volume) and

86% (sum of gross inflows and gross outflows), and probably amounting to more

than 50% in 1998. Similarly, we can estimate the foreign participation in the

Hungarian equity market as between 57% and 110% (or else 100%), and in the

Czech Republic as between 55% and 90% in 1998.

Although these are rather unprecise estimates, they clearly imply that the share of

foreign portfolio investors in the turnover of the secondary market is substantially

higher than their share in the total market capitalisation (see Figure 10). The share

of foreign portfolio investors in the turnover seems to be more similar in size to

the share of foreign portfolio investment in the total portfolio investment into the

national equity market. Hence, the participation of the foreign portfolio investors

creates to a very large extent the liquidity on these markets. Indirectly, this can be

seen also by the rather low levels of the relative turnover (Figure 6) and of the

turnover ratio (Figure 7) in the Slovene equity market.

It has to be noted here that the trading in CEE-equities by foreign investors does

not only take place on the local stock exchanges, but also outside the country, as

several Depository Receipts (DRs) have been issued and several companies have

also a direct listing of their shares on foreign stock exchanges (see chapter 7.1.).

Hence, it is fair to state that trading in CEE-equities is overwhelmingly a play by

foreign portfolio investors.

Regarding the Hungarian equity market, in particular, it is not exaggerated to state

that it is a market place where mainly foreign portfolio investors make their deals

in "Hungarian" companies whose capital is mainly foreign-owned. In addition, the

fact that this market place is located in Hungary has already been eroded by DRprogrammes

and - to a minor extent - by foreign listings.

Bond Markets

It is not possible to show a comprehensive debt holder structure of all publicly

issued LCY-debt securities, including the issues of the private sector. However,


this problem is limited by the fact that the issues of the private sector are of major

importance only in the Czech Republic. Hence, the following figure comprises

only the LCY-debt securities of the central government (Figure 11).

It has to be added that the share of foreign portfolio investors into all LCY-debt

securities was about zero in Slovenia. In Estonia, it was roughly 20% (with no

securities of the central government available) at the end of 1998, having fallen

drastically from end-1997.

Figure 11: Holder structure: publicly issued LCY-debt securities of central

government (end of period, in %)



























Poland Hungary Czech Republic Russia




1993 1995 1998 1996 1998 1993 1998 1996 1997 1998

domestic non-banks (RU: excl institutional investors)

commercial banks (RU: incl institutional investors and central bank)

central bank

foreign portfolio investors

Source: Czech Ministry of Finance, Hungarian State Treasury, National Bank of Poland,

Polish Ministry of Finance, Raiffeisen Zentralbank Österreich AG, Russian-European

Center for Economic Policy, The Central Bank of the Russian Federation.

Looking at Figure 11, the following points have to be underlined:

The shares of domestic non-banks and of foreign portfolio investors have

increased, at the expense of the banking system, with central banks holding no

such securities at the end of 1998 (except in Russia).

The share of foreign investors exceeded 15% only in Russia (18%) at the end

of 1998. In the Czech Republic, the relatively low level of the share of foreign

portfolio investors in the total volume outstanding of publicly issued LCYdebt

securities of the central government is probably linked to the availability

of higher-yielding (and partly state-guaranteed) corporate and bank bonds. For

the Czech Republic, a rough estimate of the share of foreign portfolio


investors in the volume outstanding of all LCY-debt securities can be derived

from the international investment position, indicating a ratio of 15% at the end

of 1998, down from 20% at the end of 1997.

• In Russia, the increase of the share of foreign investors in 1997 was coupled

with a decrease of the share of domestic non-banks, reflecting the liquidity

constraints in that sector. The decrease of the share of foreign investors in

1998 was substituted by the banking system.

Interestingly, the position “domestic non-banks” can be subdivided further for

Hungary and the Czech Republic. In Hungary, the 57%-share of domestic nonbanks

at the end of 1998 included institutional investors (like funds and

insurances) (21%-points), non-financial firms (15%-points) and households (21%points),

with the share of the households having particularly increased since 1996

when it was 15%. In contrast, in the Czech Republic, out of the 51%-share of

domestic non-banks at the end of 1998 45%-points belonged to institutional

investors and only 5%-points to non-financial firms. It follows that in Hungary the

demand for central government securities is much broader than in the Czech

Republic. Importantly, in Hungary it is directly household-based with a relatively

large and rapidly growing share.

Also for the LCY-debt securities, it is difficult to assess the size of the turnover of

the secondary market which is induced by foreign portfolio investors. No official

data exist on this subject, and the standardised format of the International

Monetary Fund for the balance of payments and the international investment

position which is followed by the central banks does not foresee a separation of

debt portfolio investment into FX-denominated securities and into LCYdenominated

securities. However, the Czech National Bank provides such a

separation. (Moreover, in the Czech Republic, the importance of FX-denominated

debt securities has been very low, so we could even take the total flows to derive

an estimate.) Hence, we can estimate the share of foreign portfolio investors in the

total turnover of LCY-debt securities of the private and the public sector in the

Czech Republic as having been between 14% and 29% of the total turnover in all

LCY-debt securities, including the huge turnover in T-bills, in 1998. Assuming

that the foreign gross inflows were only targeting bonds and not T-bills as well,

the estimated share of foreign portfolio investors in the total turnover of LCYbonds

was between 35% and 70% in 1998. However, these estimates are rather at

the upper end of the band, as part of the foreign gross inflows was probably

dedicated to the primary market and part of the foreign gross outflows stemmed

from the redemption of bonds.

It follows that the CEE markets in LCY-debt securities are much more

domestically based than the CEE equity markets, in terms of both capitalisation

and turnover. Main Characteristics of CEE Equity Markets

The following tables summarise the main characteristics of the Central and

Eastern European stock markets presented in the previous chapters- market

capitalisation and liquidity, main listing requirements and indices. All the figures

are expressed in US Dollar, thus allowing comparison. In addition, the sectors’


weighting of the core regional stock markets - expressed in the terms of

percentage in the total market capitalisation - and its development is shown by the

Figures 12 to 15. Main Characteristics of CEE Bond Markets

The following list gives an overview on the market in publicly issued debt

securities denominated in local currency (LCY) in Poland, Hungary, Czech

Republic and Russia. The list is subdivided in a brief description, the primary

market, the secondary market, the foreign investment regulation and the size of the

market of each instrument. The description provides general information.

Poland: Since 1992, when the first T-bills and floating-rate T-bonds were

introduced to the market, most of the liquidity has been in T-bills. However the Tbond

market could catch up in the meantime. Especially fixed-rate bonds have

displayed the largest pace of growth. For the first time in May 1999 a ten-year

fixed-rate T-bond has been introduced. The coupon is at 6 %.

Hungary: Although foreign participation in T-bills is prohibited, there is a liquid

market for fixed and floating-rate government bonds. In February 1999, the first

ten-year fixed-rate T-bond was auctioned.

Czech Republic: Apart from the T-bills and T-bonds, a relatively developed bond

market exists in municipal, bank and corporate bonds. CNB–bills and its reverse

repo transactions are not accessible to foreign investors.

Russia: The Russian listing provides an overview of the instruments existing after

the restructuring of the GKO/OFZ-market. Certainly, the market size has been

drastically reduced in US$-terms by the restructuring and, above all, the

devaluation of the rouble.

Table 1: Size of CEE equity markets


No. of stocks listed 304 198 63 122 28 363

Total mkt cap, in US$ 13.9 20.7 14.0 3.5 0.8 31.1

bn ***


Total turnover, in 5.3 8.9 16.1 0.9 1.2 10.2

US$ bn, 1998


* of which in the

main market

72% 90% 98% 78% 85% 99%

* of which in the

secondary market

19% 9% 2%

12% 1%

* of which in the

free market

9% 1% 0.1% 22% 2% -

*including OTC-market, **without Gazprom, ***at the end of 1998.


Table 2: Main listing requirements*


Main market

* Min. Capital size** - US$ - US$ - US$




* Min. value of

- US$ US$ US$ US$

shares to be admitted

10mn 40mn 2mn 20mn

* Min. public

US$ US$ - - -


6mn 8mn

* Public offering/total


20% 25% 25% 25% 25%

* Min. number of

- 500 1000 300 300 or 100


Secondary market


* Min Capital size** - US$ - US$ - US$




* Min value of shares - US$ US$ US$ US$

to be admitted

3.5mn 4mn 1mn 1mn

* Min public offering US$ US$ - - -

3mn 3mn

* Public offering/total


15% 10% 10% 10% 25%

* Min. number of


- 300 100 150 100 100

* at the current exchange rate as of 10.09.99, ** Book value of the company's equity, ***

300 investors if each holds shares in value of US$ 670, or 1000 investors.

Table 3: Stock Exchange's main index


Index name PX 50 WIG 20 BUX SBI TALSE IRTS

Index type Mkt. Cap. Adjusted Adjusted Adjusted Mkt. Cap. Mkt. Cap.

weighted Mkt. Cap. Total Mkt. Cap. weighted weighted

price index weighted return weighted price index price index

price index index price index

current No of


50 20 18 21 25 62


Most Blue-chips Blue-chips Blue-chips All listed Listed in

categories highly

on the the


Main and category A

and liquid




Mkt cap of

index, in US$


11.8 16.5 13.8 1.8 1.9 18.7

Cumulated %


68% 53% 67% 63% 90% 88%

*at the end of 1998, ** of the 5 highest capitalised shares in the mkt cap of the



Figure 12: Sector composition of the Polish stock market, in % of total market















Engineering & Machinery


IT & telecom




Pulp & Paper

Utilties & Mining

End of 1997 End of 1998

Notes: the sector composition of the Polish market has been calculated using a bottom-up

calculation, based on the aggregation of a selected number of representatives companies. At

the end of 1998, the aggregated market capitalisation of these companies represented 89%

of the WSE total market capitalisation. Source: Raiffeisen Zentralbank Österreich AG


Figure 13: Sector composition of the Hungarian stock market, in % of total market
















Engineering & Machinery


IT & telecom

Oil & Gas


Pulp & Paper


End of 1997 End of 1998

* the sector composition of the Hungarian market has been calculated using a bottom-up

calculation, based on the aggregation of a selected number of representatives companies. At

the end of 1998, the aggregated market capitalisation of these companies represented 96%

of the BSE total market capitalisation. Source: Raiffeisen Zentralbank Österreich AG


Figure 14: Sector composition of the Czech stock market, in % of total market














Engineering & Machinery


IT & telecom



Oil & Gas


Pulp & Paper

Utilties & Mining

End of 1997 End of 1998

the sector composition of the Czech market has been calculated using a bottom-up

calculation, based on the aggregation of a selected number of representatives companies. At

the end of 1998, the aggregated market capitalisation of these companies represented 87%

of the PSE total market capitalisation. Source: Raiffeisen Zentralbank Österreich AG


Figure 15: Sector composition of the Russian stock market, in % of total market














Engineering & Machinery


IT & telecom


Oil & Gas

Utilties & Mining

End of 1997 End of 1998

* the sector composition of the Russian market has been calculated using a bottom-up

calculation, based on the aggregation of a selected number of representatives companies,

including Gazprom. At the end of 1998, the aggregated market capitalisation of these

companies represented 94% of the RTS + Gazprom total market capitalisation. Source:

Raiffeisen Zentralbank Österreich AG (estimate).

3.1.3. Cross-Country Indices for Equity Securities

In response to the increasing focus on CEE markets by global portfolio managers,

several financial institutions have created proprietary cross-country indices, which

offer competitive alternatives for market participants looking for an appropriate

benchmark in the region’s equity markets. The following section describes the

main features of the regional indices, and assesses their comparative advantages

and disadvantages as a benchmark for the portfolio manager. Nomura CEE Index

Nomura Research Institute Europe launched its first CEE Index series - the NRI-

East European Indices - in 1993. The broader NRI-East European Index initially

included 84 listed equities from four countries: Czech Republic, Hungary, Poland

and Slovakia. This regional index was a composite basket, originally containing

the four sub-indices of each country, and was calculated on a daily basis,

according to the market-capitalisation method. The base value was set at 100 as of

the end of December 1993. In July 1997, Russia was added to the index.

Renamed the Nomura Central & East European Index, it currently consists of

exclusively all equities listed on the main market (with the exception of the Czech

Republic) from 11 countries, including the 5 countries constituting the original

NRI index (Czech Republic, Poland, Hungary Slovakia and Russia), three Balkan

countries (Croatia, Romania, and Slovenia), and the three Baltic States. The

Nomura CEE Index has a base value of 100 as of the end of December 1996, with

history back-calculated to 31 December 1993. The index currently contains 363

stocks, with a total market capitalisation of US$ 63.5 bn as of the end of July



POLAND Treasury bills Fixed-rate Treasury bonds


Maturities 8, 13, 26, 39, 52 weeks 2; 5 years (since May 1999: also 10


Denomination PLN 10000 (US$ 2450) PLN 1000 (US$ 245)

Coupon Discounted Fixed coupons of 10-18% (issues in

98: 2y: 14%, 13%; 5y: 12%, 10%;

issues in 99: 2y: 12%, 5y: 10%)

Repayment Bullet Bullet

Interest payments Single payment at maturity Annual

Interest calculation Actual/360 Actual/actual

Primary market

Type of issue Weekly Bid-price auction Monthly Bid-price auction

Size of issue PLN 0.25bn-1.4bn

(US$ 61mn-343mn)

Secondary market


PLN 0.2 bn-1.4bn

(US$ 49 mn-343mn)

Market organisation OTC Either stock exchange or OTC

Bid/offer spread 15-100bps 20-100bps

Typical size of one


Foreign investment regulations

PLN 5-10mn

(US$ 1.22-2.45mn)

PLN 5-10mn

(US$ 1.22-2.45mn)

Foreign investors Not restricted Not restricted

Size of the market

Market cap (at face

value), end-1998:

Gross issuance

volume, 1998:

Secondary market

turnover, 1998:

LCY 28.9bn

US$ 8.3mn

LCY 42.3bn

US$ 12 .1bn

LCY 328.2bn

US$ 93.9bn

2 y: LCY 8.8bn, 5 y: LCY 16bn

2y:US$ 2.5bn, 5y:US$ 4.6bn

2y: LCY 5.1bn, 5y: LCY 6.3bn

2y:US$ 1.5bn, 5y:US$ 1.8bn

2y: LCY 8.4bn, 5y: LCY 78.9bn

2y:US$ 2.4bn, 5y:US$ 22.6bn

POLAND 1-year floating-rate Treasury




3-year floating-rate Treasury


Maturities 1 year or 13 months 3 years

Denomination PLN100 (US$ 24.5) PLN100 (US$ 24.5)

Coupon Inflation + discount resulting

from the issue price or auction


105% of avg. Auction yield of 13w Tbills

+ discount from auction price

Repayment Bullet Bullet

Interest payments Single payment at maturity Quarterly

Interest calculation Actual/360 Actual/360

Primary market

Type of issue Auction (RP-series) or public

retail (IR-series)

Frequency of Issue two auctions for each series in

two first months of every quarter

Size of issue PLN 200-500mn

(US$ 49-122mn)

Auction (TP-series) or public retail


Quarterly March cycle

PLN 200-500mn

(US$ 49-122mn)

Secondary market

Market organisation Either stock exchange or OTC Either stock exchange or OTC

Bid/offer spread Up to 100bps Up to 100bps

Typical size of one


Block trades for 100+ bonds Block trades for 100+ bonds

Foreign investment regulations

Foreign investors Not restricted Not restricted

Size of the market

Market cap at (face

value), end-1998:

Gross issuance

volume, 1998:

Secondary market

turnover, 1998:

LCY 2338mn

US$ 667mn

LCY 2 338mn

US$ 669mn

LCY 1 169mn

US$ 335mn

LCY 10 318mn

US$ 2 945mn

LCY 5 279mn

US$ 1 511mn

LCY 3 617mn

US$ 1 035mn


POLAND 10-year floating-rate Treasury bonds

Maturities 10 years

Denomination PLN1000 (US$ 245)

Form Dematerialised, bearer

Coupon Avg. auction yield of 52w T-bills + 100bp

Repayment Bullet

Interest payments Annual

Interest calculation Actual/360

Primary market

Type of issue Bid-price auction

Frequency of Issue four times in semi-annual period

Secondary market

Market organisation Either stock exchange or OTC

Bid/offer spread Up to 100bps

Typical size of one trade Block trades for 100+ bonds

Foreign investment regulations

Foreign investors Not restricted

Size of the market

Market cap at (face value),


Gross issuance volume,


Secondary market

turnover, 1998:


LCY 4 098mn

US$ 1 169mn

LCY 1 309mn

US$ 375mn

LCY 1 347mn

US$ 385mn

HUNGARY Treasury bills Government Bonds


Maturities 91, 182, 364 days 2-, 3-, 5-, 7, 10-year

Denomination HUF 10000 (US$ 42) HUF 10000 (US$ 42)

Coupon Zero-coupon 2-, 3-, 5-,10-year: fixed 5 and 7-year:

floating-rate linked to CPI

Repayment Bullet Bullet

Interest payments Single payment at maturity Fixed-rate: Usually semi-annual;

Floaters: annual

Interest calculation 365/365 365/365

Primary market

Type of issue Weekly/ semi-weekly Bid-price


Size of issue HUF 20bn

(US$ 83mn)


Every second Thursday Bid-price


HUF 20bn

(US$ 83mn)

Secondary market

Market organisation OTC, BSE OTC, BSE

Bid/offer spread 20-50bps 30-50bps

Typical size of one


Foreign investment regulations

- 100-200mn

(US$ 416000-US$ 832000 )

Foreign investors Closed to foreigners Restricted to bonds originally issued

with maturities of 1-year or longer

Size of the market

Market cap (at face

value), end-1998:

Gross issuance

volume, 1998:

Secondary market

turnover, 1998:

LCY 1 046 360mn

US$ 4 777mn

LCY 1 482 150mn

US$ 6 911mn

LCY 2 500 980mn

US$ 11 662mn

LCY 1 386 460mn

US$ 6 330mn

LCY 621 350mn

US$ 2 897mn

LCY 6 569 697mn

US$ 30 635mn

CZECH REPUBLIC Treasury bills Treasury bonds


Maturities 13, 26, 39, 42 weeks 1-5 years

Denomination CZK 1mn (US$ 29000) CZK 10000 (US$ 290)

Coupon Zero-coupon Fixed or Pribor +/- spread

Repayment Bullet Bullet

Interest payments Single payment at maturity;




Interest calculation Actual/360 30/360

Primary market

Type of issue Bid-price auction Bid-price auction

Frequency of Issue According to calendar Feb, May, Aug, Nov

Size of issue CZK 5bn (US$ 145mn) CZK 5bn (US$ 145mn)

Secondary market

Market organisation OTC OTC, stock exchange

Bid/offer spread Variable often one sided 30bps

Typical size of one


Foreign investment regulations

CZK 100-200mn

(US$ 2.9-5.8mn)

CZK 20-50mn

(US$ 0.58-1.45mn)

Foreign investors Not restricted Not restricted

Size of the market

Market cap (at face

value), end-1998:

Gross issuance

volume 1998:

Secondary market

turnover, 1998:

LCY 98 981mn

US$ 3 315mn

LCY 410 100mn

US$ 12 707mn

LCY 970 420mn

US$30 068mn

LCY 70 000mn

US$ 2 345mn

LCY 22 100mn

US$ 685mn

LCY 227 304mn

US$ 7 043mn

CZECH REPUBLIC Bank, corporate and municipal bonds


Maturities 1-15 years

Denomination Generally CZK10000 (US$290)

Form Dematerialised, bearer

Coupon Fixed or Pribor +/- spread

Repayment Bullet

Interest payments Generally Annual

Interest calculation 30/360

Primary market

Type of issue Underwritten by syndicate

Secondary market

Market organisation OTC, stock exchange

Bid/offer spread 50bps

Typical size of one



CZK 20-50mn

(US$ 0.58-1.45mn)

Foreign investment regulations

Foreign investors Not restricted

Size of the market

Market cap (at face

value), end-1998:

Gross issuance

volume, 1998:

Secondary market

turnover, 1998:

LCY 181 439mn

US$ 6 077mn

LCY 19 000mn

US$ 589mn

LCY 460 293mn

US$ 14 262mn

RUSSIA Fixed coupon Federal

Treasury Bonds (OFZ-PD)


Maturities September 1999: 4 months to 4



Fixed coupon Federal Treasury

Bonds (OFZ-FD)

September 1999: 2.3-4.3 years

Denomination RUR 1000 (US$ 39) RUR 1000 (US$ 39)

Coupon fixed rate (coupon 5-20% p.a.) step down coupon - declining by 5%

a year (30%p.a. in first year to

15%p.a. in fourth year)

Repayment Bullet at maturity Bullet at maturity

Interest payments Quarterly, semi-annual or annual Quarterly

Interest calculation Actual/365 Actual/365

Primary market

Type of issue Dutch auction (no auctions after

August 1998)

Secondary market

Market organisation MICEX electronic trading

system, remote PC work place

Issued in lieu for defaulted GKOs

and OFZs in H1-99

MICEX electronic trading system,

remote PC work place

Bid/offer spread 150 - 300bps 100 – 500bps

Typical size of one


RUR 0.5mn - 5mn

(US$ 19560-195600 )

RUR 0.5mn - 3mn (US$


Foreign investment regulations

Foreign investors Only via "S" accounts Only via "S" accounts

Size of the market

Market cap (at face

value), end-1998:

Secondary market

turnover, 1998:

LCY 88 000mn

US$ 34 000mn

daily turnover (Sep.99 avg.):

LCY 40-50mn

US$ 1.56-1.96mn

LCY 105 400mn

US$ 4 100mn

daily turnover (Sep.99 avg.):

LCY 30-40mn

US$ 1.17-1.56mn

RUSSIA Zero coupon Federal Treasury

Bonds (0% OFZ-PD)



Ministry of Finance bonds

(tranches III-VII)

Maturities September 1999: 2.2 years September 1999: 3.6 - 11.6 years

Denomination RUR 1000 (US$ 39) US$ 1000 / 10000 / 100000

Coupon none 3%

Repayment Bullet at maturity Bullet at maturity

Interest payments none Annually, on May 14

Interest calculation Actual/365 Actual/360

Primary market

Type of issue

Secondary market

issued in lieu for defaulted GKOs

and OFZs in H1-99


Market organisation MICEX electronic trading

system, remote PC work place


Bid/offer spread 100-500bps 50-150bps

Typical size of one


RUR 0.5mn – 2mn

(US$ 19560-78250)

US$ 2mn-15mn

Foreign investment regulations

Foreign investors Only via "S" accounts No restrictions

Size of the market

Market cap (at face

value), end-1998:

Secondary market

turnover, 1998:

only 1 series (SU25030RMFS)

LCY 30 700mn

US$ 1 200mn

daily turnover (Sep.99 avg.):

LCY 5-10mn

US$ 200 000-400 000

US$ 11 120mn

(including defaulted US$ 1 320mn in

series 3)

daily turnover (Sep.99 avg.)

US$ 10mn-100mn

By covering almost the entire equity market universe in the region, the Nomura

CEE Index is the broadest of the regional indices in terms of the number of stocks

included. This can be an advantage for portfolio managers wishing to cover the

entire CEE region, as the index couples the few investable blue-chips available

with the high risk/return potential of the region’s non-core markets. However, the

primary focus and weighting is given to the CEE 3 markets. For risk-averse

investors or portfolio managers restricted in terms of portfolio volatility, another

advantage is the low relative index weight of the Russian market. Additionally,

only GDR prices of Russian companies are used, in order to take into account

foreign investors’ liquidity concerns and holding restrictions.

Nomura's calculation method is simple, including 100% of each company's market

capitalisation. Levels of liquidity or free-float are not considered. Although

participation is restricted only to those companies listed on the main market within

each country, certainly not all of these companies have equal levels of liquidity. In

addition, the selection criteria from country to country are not identical, as each

exchange applies different listing requirements in their respective main market. MSCI Eastern Europe Index

Morgan Stanley Capital International launched its regional Eastern European

indices at the end of 1994. The most commonly used is its market capitalisation

weighted MSCI EM Eastern Europe Index, which is calculated in both US$ and

local currency terms. The local currency benchmark reflects the theoretical

performance of an index without any impact from foreign exchange fluctuations,

i.e. a hedged portfolio.

The MSCI EM Eastern Europe Index is an aggregate calculation of the country

indices of the Czech Republic, Hungary, Poland and Russia. This composite index

currently includes 58 stocks with a total market capitalisation of US$ 47.4 bn (per

June, 1999). The base value for the US$ index was 85.752 on December 30, 1994

(85.363 for the local currency based index).

Apart from the focus of the index on the highest capitalised, most liquid equity

markets of the CEE region, the stock selection criteria and the calculation method

provide portfolio managers several advantages:

- 60% of the capitalisation of each industry group, and thus 60% of the entire

market, is targeted for inclusion in the index. This insures that the index reflects

the industry characteristics of the overall market, and permits the construction of

composite industry sector indices. In addition, targeting 60% of each country’s

total market capitalisation captures its proportional weight in the regional index.

- As opposed to the Nomura index, the MSCI Eastern Europe index takes liquidity

and free-float into consideration. Including all listed shares at 100% of their

market capitalisation would represent only a theoretical investment universe, since

such a benchmark cannot be fully replicated due to the very low liquidity of

certain shares. Thus, only the most liquid stocks, as defined in terms of monthly

average trading volumes over a 6 to 12 month period, are included in the index

base. The free-float factor is also taken into account by applying a Market Cap

Factor (MCF) to those stocks characterised by large issues with low free float - a

characteristic of many privatisations in emerging markets. These MCFs allow the

partial inclusion of the market capitalisation of SPT Telecom (60%) as well as of

TPSA (40%). The MSCI index includes also only 5% of the market capitalisation

weight of Gazprom, by far the largest company in Russia.

Another advantage provided by the MSCI Eastern Europe index is the calculation

of a total return index, which calculates the reinvestment of gross dividend

payments. For investors willing to avoid a particular high risk exposure, the main

disadvantage of choosing the MSCI EM Eastern Europe index would be the

relatively high weight of the Russian market. ING Barings Eastern Europe Index

ING Barings provides two types of regional indices, both of which were created at

the end of 1994 (base value of 100 as of December 12, 1994):


The Eastern Europe Index (EAEUR), which includes the most liquid markets:

Russia, Hungary, Poland and the Czech Republic (market cap: US$ 20.3 bn on

July 30, 1999).

The Greater Eastern Europe index (GEEI), which adds Croatia, Slovakia and

Slovenia to those contained within the EAEUR (market cap: US$ 22.1 bn on July

30, 1999).

Stocks are included in the EAEUR on the basis of the following three rules:

- The company's market capitalisation must be higher than 0.5% of the ING

Barings database - which covers the broader universe in the respective market.

- The company's free-float must be at least 10%.

- A minimum average daily trading value of US$ 100,000 over the last year is


For Croatia, Slovakia and Slovenia slightly different criteria are applied:

- Wherever possible, companies within these countries will have a market

capitalisation higher than 0.5% of the ING Barings database for that country.

- Minimum free-float of 10%

- Minimum average daily trading value of US$ 25,000

Both the GEEI and EAEUR indices are market capitalisation weighted total return

(including dividends) indices, where each company is included according to its

free-float market capitalisation.

The ING index most frequently used is the core index (EAEUR). Like the MSCI,

this index concentrates on the highest capitalised and most liquid equity markets

of the region. While the stocks selected in each of the CEE-3 are similar - the

selection of MSCI stocks is a little more restrictive - the main difference between

the two indices lies in the importance accorded to Russia. The ING Barings index

does not include Gazprom shares, whereas MSCI does. As a result, the weighting

of Russia in the index represents half of that of the MSCI. CESI - Central European Stock Index

The Budapest Stock Exchange officially launched CESI in February 1996. The

index initially contained equities selected according to specific criteria from only

three central European stock exchanges (Budapest, Prague, Warsaw). In October

1996 the index was expanded to include companies selected from exchanges in

Ljubljana and Bratislava. Following its last revision in April 1999, the CESI index

comprises 44 of the most traded ordinary shares from the above mentioned stock

exchanges, with a total capitalisation of US$ 34.8 bn (July 1999).

The CESI is a US$-based capitalisation-weighted index. Its base of 1,000 points

was established on June 30, 1995. Its value is calculated as the capitalisationweighted

daily average of official prices of individual shares, and does not include

any yield from dividend distributions.

The main advantage of the index is that it is composed only of blue chips listed on

CEE stock exchanges, with a focus on the most developed CEE 3 countries, as


well as Slovenia and Slovakia. All of these countries have close economic links

with the EU, and are front-runners on the road to EU membership.

Eligibility for inclusion in the CESI basket is limited to companies with the largest

capitalisation and liquidity, and without restrictions on foreign investor holdings.

The lowest acceptable level of share liquidity is equal to 1% of the previous six

months total turnover during the period prior to the date of index revision. At the

same time - similarly to the MSCI index - the total market capitalisation of the

basket of shares from a particular stock exchange is required to account for at least

60% of the total market capitalisation of the official securities market in that

country. Additionally, the weight of no company included in the basket may

exceed 15% at review date while the weight of each country is also limited to a

maximum 50%.

As opposed to the MSCI index, no free-float adjustment is considered, and the full

market capitalisation principle is applied. For risk-lovers, this index has the

inconvenience of not capturing the investment opportunities given by the Russian

equity market, with Russia not being included. CECE Indices

The Central European Clearing House and Exchange (CECE), established by the

Vienna Stock Exchange (Wiener Börse AG) - is an important market place for

US$-denominated futures and options on CEE equity markets. Since 1996, The

Vienna Stock Exchange has been calculating a series of Eastern European indices,

which are used mostly as underlying indices for standardised futures and options

traded on the exchange.

The CECE index series consists of four country indices including the major blue

chips in the Czech Republic (Czech Traded Index, CTX), in Hungary (Hungarian

Traded Index, HTX), Poland (Polish Traded Index, PTX), Slovakia (Slovak

Traded Index, STX), and an aggregate benchmark index for the whole region - the

CECE Index. Additionally, the Exchange calculates the Russian Traded Index

(RTX), which - like the other - serves as underlying products for futures and

options, but is not included in the region's benchmark index. Trading options and

futures on the Russian Depository Receipts Index (RDX) - calculated in euro onlyis

also to be introduced in autumn 1999.

The five first indices are calculated as capital-weighted price indices, with base

value of 1000 as of July 15, 1996. The indices are not adjusted for dividend

payments. All indices are calculated in US$, but are also available on a local

currency basis and the historical time series data have been calculated back to

January 2, 1995. At the end of July 1999, the CECE benchmark index had a

market capitalisation of US$ 16 bn.

As a blue-chips regional index, the CECE index selection criteria focus on market

capitalisation, liquidity (defined as percentage of total stock trading volume in

each market) and free-float. Qualitative criteria - like sector representation and

market interest - are considered as well. These selection criteria result in relative

higher weights of the Polish and Hungarian equity markets.


A so-called "representation factor" of 0.5 is used in order to reduce the weighting

of highly capitalised stocks. The main attempt of this representation factor is to

ensure that the index is close to the market interest and portfolio structures, as well

as to better reflect the economic structure of the respective economies. Similarly,

if the free float of a stock accounts for less than 50 percent, a free-float factor of

0.5 is applied allowing the stock is weighted at half the capitalisation in the index.

The following stocks have a representation factor of 0.5 in the index: SPT

Telecom, CEZ, Komercni Banka (Czech Republic), Matav, MOL, Gedeon Richter

(Hungary), TPSA (Poland). A free-float factor of 0.5 is also applied for the

following stocks: SPT Telecom, CEZ, Unipetrol, Ceska Sporitelna and Ceske

Radiokomunikace (Czech Republic), Demasz, Egis, Matav (Hungary), Bank

Handlowy, Bank Slaski, BPH, Debica, KGHM, Polifarb, Softbank and TPSA

(Poland), Slovakofarma, Slovnaft, Vahostav, VSZ and VUB Bank (Slovakia). In

the RTX index, Lukoil, Mosenergo and UES have a 0.5 representation factor, and

these shares as well as Rostelecom, Surgutneftegaz and Tatneft have a 0.5 freefloat


Apart from being a blue-chips index, the CECE index has the main advantages to

offer to investors the possibility of hedging US$-based portfolios, using

derivatives on four different markets on a single trading platform in one single

currency. However, trading in options and futures on CECE benchmark has been

suspended since August 1999, due to insufficient liquidity. This seems to reflect a

lack of interest from international portfolio investors using the CECE as a regional

benchmark. Trading in derivatives in each of the benchmark index components

(CTX, HTX, PTX and STX) and on the RTX separately seems to be a more

attractive option for those investors.


Table 4: CEE Indices: Overview

CEE Indices: Index Type Stock Mkt. Cap Target, in %


categories/Market of total Mkt. Cap

Nomura Central & Capitalisation all companies listed in __

East European weighted price index the countries'

Index series 100% of stocks' Mkt. respective main


market (exception:

Czech Republic)

MSCI Eastern * Capitalisation

__ 60% of the Mkt. Cap of

Europe Index weighted price index

each industrial group in

* 100% of stocks'


(with some


*Total return index

each country

ING Barings * Free-float weighted __ Each company's Mkt.

Eastern Europe price index

Cap. must equal at least


* Total return index

0.5% of the country's

total Mkt. Cap.

CESI Central * Capitalisation BLUE-CHIPS


Eurpean Share weighted price index selected in each


* 100% of stocks'

Mkt. Cap.


CECE Index Capitalisation BLUE-CHIPS


weighted selected in each


Source: Nomura, Morgan Stanley, ING Barings, Budapest Stock Exchange, Vienna Stock



Nomura Index MSCI Index ING Index CESI Index CECE Index

Country No of Weight in No of Weight No of Weight No of Weight No of Weight

stocks index stocks in index stocks in index stocks in index stocks in index

Estonia 7 2.45%

Latvia 9 0.48%

Lithuania 55 1.66%

Czech Rep. 40 18.11% 13 15.4% 13 13% 5 21.5% 8 16.4%

Hungary 20 20.84% 13 25.4% 18 35% 14 29.8% 13 36.8%

Poland 134 41.18% 22 23.3% 32 35% 17 43.4% 14 45.2%

Slovakia 9 0.66% 3 1.1% 7 1.5%

Croatia 6 2.88%

Romania 21 0.31%

Slovenia 25 3.60% 5 4%

Russia 37 7.83% 10 35.9% 10 18%

Total 363 100% 73 100% 58 100% 44 100% 42 100%

Mkt. Cap.,

(US$mn, eop)

63,531 49,300 20,307 34,800 16,062

As of July 31, 1999; Source: Nomura, MSCI, BSE, ING Barings, VSE.

3.1.4. Cross-Country Indices for Bond Securities

Although the development of the CEE markets in publicly issued LCYdenominated

debt securities has been gradual during the transformation process

and still remains incomplete, a number of fixed income market indices have been

developed and are used to track and evaluate the respective markets. In this subchapter

we will turn our attention to two indices in particular.

One of the first and most widely used indices for emerging fixed income markets

has been the Emerging Local Markets Index (ELMI) from JP Morgan, which was

introduced in June 1996. It originally covered 10 countries including the Czech

Republic and Poland. As a growing number of emerging market countries has

liberalised and expanded their money markets since then, the ELMI+ was

launched in November 1997. It covers 24 countries and includes the Czech

Republic, Poland, Hungary and Slovakia. Both are money-market indices and

their portfolio consist of FX forwards wherever they are available. For countries

that do not have developed FX forward markets, either deposits or Treasury bills

are used.

More specialised on the CEE markets, the Vienna Stock Exchange developed its

CECE index family which also includes bond indices since Mai 1999. For now,

there exist bond indices for the Czech Republic, Poland and Hungary, while a

further implementation for Slovakia, Russia, Ukraine, Romania and Croatia is in

the making. There is also a planned supra-regional CECE bond index covering the

respective CEE bond markets. Emerging Local Markets Index + (ELMI+)

Originally introduced in June 1996, JP Morgan expanded its Emerging Local

Markets Index (ELMI) coming up with the ELMI+ in November 1997 to cover 24

countries, including the Czech Republic, Poland, Hungary and Slovakia from the

CEE region.

The ELMI+ tracks total returns for local-currency-denominated money market

instruments in these countries. It also employs a liquidity-sensitive weighting

system and uses FX forwards as the preferred instrument. If this is not possible,

because a country does not have a developed FX forward market, either deposits

or Treasury bills are used.

Also the so-called “three-rung-ladder” approach is intended to ensure the index’s

ease of replicability. Compared to the original ELMI the number of instruments

contained in each country's sub-index has been reduced to three, with maturities of

one, two and three months. While the ELMI+ therefore experiences a slightly

stronger duration drift (between one and two months) than the ELMI, there exists

the important advantage that investors who wish to replicate the ELMI+ exactly

will need to reinvest their country portfolio proceeds only on a monthly basis.


Within the liquidity-sensitive weighting system, a country’s initial index

allocation is derived from its relative export and import levels, while also taking

into account accessibility and liquidity through a series of caps. Although we are

mostly concerned with the country sub-indices rather than with the ELMI+ as a

whole, we still want to list the prerequisites for emerging markets countries to be

included into the ELMI+ as they were described by JP Morgan in 1997:

Prerequisites for ELMI+ Countries

There are the following prerequisites for a country to be member of ELMI+


1. The country must be of the universe of emerging markets countries. These are

defined as all countries except those that have been classified by the World

Bank as high-income OECD economies for the past consecutive five years.

Also excluded are Kuwait, Oman, Saudi Arabia and the United Arab Emirates,

who are net creditors to the IMF and in general not considered traditional

emerging markets.

2. The country must have at least one fungible investment vehicle that offers

foreign investors local interest rate and currency exposure, either on- or


3. The foreign investor must be able to invest without any restrictions and must

be able to repatriate capital or income at will.

4. There must be at least two international dealers quoting two-way prices for the

country’s selected money market instrument (FX forwards, deposits or

Treasury bills), thus providing a minimum degree of liquidity.

5. The country must have a minimum value of total foreign trade (exports plus

imports) of US$ 10 bn.

The last criterion was intended to identify which emerging markets country can

realistically sustain adequate capital inflows. Originally, there was the idea of

using market capitalisation as a proxy to identify those emerging markets

countries with a significant participation in the international capital markets. FX

forwards, however, have no observable amounts outstanding. The use of total

foreign trade was chosen as the most appropriate alternative, since there exists a

rather high correlation between this and capital flows.

Benchmark Instruments

When available, deliverable FX forwards were chosen as the benchmark

instruments in all countries. This was done with the purpose to ensure an easy

replicability of the index for investors. If deliverable FX forwards do not exist,

non deliverable FX forwards are used. This allows countries with restrictions on

foreign participation in the local market, but with a liquid offshore market to be


included. In the absence of an FX forward market, deposits are used and finally

Treasury bills, if there is no liquid deposit market.

Table 5: Instruments used in the ELMI+ sub indices for CEE countries







Source: JP Morgan.

Czech Republic Poland Hungary Slovakia

Forwards Non deliverable Non deliverable Deposits

Forwards Forwards

Construction of the ELMI+

Deposits Treasury bills - -

June 1996 December 1996 - -

In the construction of ELMI+ three main desired characteristics were pursued:

a range-bound average life (duration);

a performance that remains independent of a specific transaction entry date or

investment cycle;

a replicable performance, which also takes into consideration bid/ask spreads and

relevant taxes.

Other than the 13-week ladder approach of ELMI, the ELMI+ incorporates a

ladder of 3 instruments by initially investing in one-, two- and three-month

instruments. Each month, the proceeds of the maturing instrument is reinvested in

a new three-month instrument. While the former approach allowed for a more

stable duration, the use of only three instruments makes a country sub-index of

the ELMI+ easier to replicate and involves fewer transaction costs.

Alternative construction methods were rejected because of some serious

drawbacks. A single-instrument, hold-to-maturity approach creates an unstable

index duration and also requires a specific transaction entry date and investment

cycle, while a failure to do so could result in the investor’s portfolio underperforming

the index. On the other hand, a single-instrument, constant duration

approach, despite creating a stable index duration, would cause excessive

transaction costs from daily re-balancing for investors who intend to rebuild the

index. CECE Bond Index

In May 1999, the Vienna Stock Exchange expanded its CECE Index family for

Central and Eastern European capital markets with the introduction of the CECE


ond indices. These were aimed to provide comparable bond indices for the Czech

Republic (CBX), Poland (PBX) and Hungary (HBX). These indices are available

for maturities of 1.5 to 2.5 years and for 2.6 to 5.2 years. A supra-regional bond

index of the three large Visegrad countries along with additional bond indices for

the Slovak and Russian bond market are also in the pipeline.

The CECE bond indices are available both as clean price indices and as total

return indices in local currency (LCY), and both as clean price and as total return

indices in EUR terms. All indices incorporate a weighted average yield, coupon,

maturity and duration. Clean price indices were calculated back to reach 100 on

April 1, 1999, while performance indices are slightly above 100 at this point due

to the effect of accrued interest.

Main Features of the CECE Bond Indices

• calculated real-time, based on the OTC quotes of all active market participants

• delivered real-time to the main electronic information services

• easy replicability with reasonable transaction costs and suitability as a base for

derivative products, thanks to the limitation to the five main bonds and regular

index adjustments

index committee consisting of international traders, investors, and scientific


• fixed index adjustment dates according to the schedule of futures (March 10,

June 10, September 10, December 10)