The Czech Miracle

Why Privatization went right in the Czech Republic.

Thomas W. Hazlett from the April 1995 issue

(Page 4 of 4)

The book value of the 1,491 Czechoslovakian companies scheduled for voucher privatization had been about 299 billion Crowns ($11 billion), although initial market valuations turned out to be roughly half that. Hence, the state was endowing each participating citizen with a stake in the new society, albeit something less than 40 acres and a mule--about $700 per voucher player (in the first wave) at November 1994 market prices.

And the physical process of transferring the assets went sensationally well. The daunting task of evaluating firm values was handled smoothly and efficiently--by fund managers. These experts compete to be agents for investors for a modest percentage commission. The lack of sophistication of Czech citizen-investors turned out to be a non-issue: Despite the prevailing skepticism and the virtually ubiquitous condemnation of mass privatization by Western policy analysts, the market institutions needed to make a non-traumatic transformation arose instantly in the newly privatized world. The mere existence of private assets spontaneously created--as if by an "invisible hand"--the means needed to manage capital shares.

Western experts had warned that giving away stock shares to citizens was doomed to failure because of the "dispersion" issue. Where stock ownership is so widely distributed that no one party has an incentive to monitor the value of firms or the performance of managers, financial chaos reigns. Investment does not go where it is best utilized, and company managers tend to goof off. The classic example, of course, was state socialism itself: Although everyone "owned" state enterprises, such nominal ownership placed no effective constraint on managerial behavior; hence the state managers looted the enterprises they ran.

Yet the Czechs again relied on a bottoms-up strategy: Simply hand off equity ownership to individuals and allow markets to find a solution. Poland, on the advice of the World Bank, employed precisely the reverse strategy. There the state has searched for responsible new owners by attempting to place large state enterprises into 10 or so investment portfolios, to be managed by professional stock experts. The plan required agreement on how the funds would be structured as well as how assets would be allocated between them. The plan has been debated for four years.

Conversely, the Czechs simply let the market decide ownership structure. What spontaneously emerged was a competitive mutual-fund market. Hundreds of competing investment portfolios were created, with about 12 large funds accounting for half of total investment points. The competition keeps fund managers focused, and the funds' scrutiny keeps the privatized firms' management honest and efficient.

Restructuring companies that have been run for the benefit of state managers, often in conspiracy with feather-bedding employees, is a brutal task. Firm insiders will continue to depreciate the capital base unless confronted by well-informed and highly motivated monitors. To monitor managerial performance on the stockholders' behalf, Czech mutual-fund managers have climbed onto corporate boards, becoming intimately involved in managerial decision making. Each fund is, really, an army of takeover artists: It sets its agents upon state enterprises with the assignment to take the assets back for productive use.

Stanislav Ryska is a socialist manager who is happy to be a takeover target of capitalism. Director of development for Tonak, a Czech manufacturer of hats since 1799, Ryska was perpetually frustrated by the internal contradictions of socialism. Despite excellent export opportunities for its products, the state enterprise was at the mercy of another state firm, Centrotex, which had been given a monopoly over textile exports. For reasons known only to the bureaucrats themselves, increasing Tonak's exports was considered uninteresting. Freed of these shackles, Tonak's exports are booming--indeed, total Czech exports to the European community shot up 116 percent from 1989 to 1992--and Ryska's salary is up 300 percent.

Managers are not supposed to take so kindly to the brutal efficiency-enforcers of financial markets. But good managers, of course, prosper more than ever; the cries of anguish come from those who lose their access to fluffy jobs, ill-gotten perks, and socialized slush funds. Ryska, who now works closely with mutual-fund managers representing Tonak shareholders, is the pillar of corporate diligence, constantly on the alert for new export possibilities. Once suppressed by a system that rewarded mediocrity on the job and subservience off it, the entrepreneurial manager is today on the rise.

Competing privatization proposals for Tonak were submitted by the firm's managers. The winning proposal included a sale of 2 percent of the company's assets to a group of employees, with 78 percent of stock equity to go into voucher privatization. (Twenty percent of ownership shares were given to the National Property Fund, which pays restitution claims to people who cannot recover physical assets--for instance, those thrown in jail by the communists.) Emphasizing voucher privatization was a common ploy by managers who thought dispersed ownership would help keep them solidly in charge. But after the dust settled on five rounds of voucher bidding, 45 percent of Tonak's shares were owned by three mutual funds, with 24 funds accounting for 58 percent. Just 20 percent of shares are owned by individuals--fairly typical. Of the five members of the executive committee of the board of directors, three represent investment funds (Harvard Capital & Consulting, the largest fund, Srejber Investing-Mutual Fund, and the Czech Savings Bank).

The new owners cut employment at Tonak from 2,050 to 1,750, mainly by attrition. About the same time, the firm's eastern export market collapsed: It shipped 30 percent of its output to Russia in 1989, but only 3 percent in 1993. Yet sales overall surged, and real output per worker--in just the first year of privatization--increased 20 percent.

The way in which it happened demonstrates the complexity of the economic system. The company's main product is furry hats made from rabbits. In fact, Tonak produces more traditional rabbit fur hats for Orthodox Jews than any other supplier in the world. Prior to privatization it had largely exported components to be assembled elsewhere. Since privatization it has been exporting finished product--with enormous marketing success. It has also found a ready market for its hats in...Australia, of all places.

Tonak has also rationalized its manufacturing, buying new Swiss machinery to monitor the quality of its skins and getting more final product out of each animal. Under state ownership, the factory used only 34 percent of each rabbit pelt. Now, it plans to squeeze 75 percent out by the year 2000. Part of this efficiency push is motivated by a desire to economize on the firm's waste-disposal fees. Labor practices are likewise adjusted; about 30 percent of employee compensation now depends on the number and quality of hats produced.

Each of these steps represents a step toward economic rationality, and it is the sum of millions of such tiny productivity gains that will stitch together the Czech Republic's coming prosperity. Each requires a modicum of imagination and an abundance of fortitude--there is always and everywhere resistance. Under state socialism, Ryska had to battle his managers, other managers, and Tonak's workers with each little push toward a more efficient world. Worse than enemies were his lack of friends: Who will join the battle for social prosperity when all it brings is trouble?

But Stanislav has found some new friends. They are called stockholders and they--or their paid agents--conspire with him regularly. "Mutual funds played a very positive role in reforming management," he says today. They supply a pressure for efficiency--a vacuum under socialist management. And while this new tension satisfies profit-hungry shareholders, it also serves the larger social interest. The new regime forces firms to be consumer friendly, to reward industrious employees, and to invest in productive assets and technology (no matter whose petty fiefdom is challenged). This ruthless drive to economic rationality is what will finally yield the fruits of material prosperity in an advanced market economy, and it is today what fuels the striking optimism uniquely observed in the Czech Republic's recovery from communism.

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