Transition to a  Market Economy


5. Conclusions


What are our findings?


The analysis in part 3 indicated that no more than 10 per cent of the market value of the assets acquired by privatization would increase the demand for consumer goods. With 8.65 million registered citizens and at the estimated market value of a voucher book of 14 thousand Kcs the demand for consumer goods would increase by no more than 12 billion Kcs. However, even this relatively small increment of demand can spark a mild inflation and consequently government might consider to offset it by some measure of monetary or fiscal policy.


It is conceivable that many people will wish to convert shares acquired by privatization into another type of assets more acceptable to them. Some will invest in apartments, houses or other types of real estate, others in their private businesses, but because of risk aversion many may want to keep the acquired property in saving accounts or less risky instruments of financial markets. Experience from other countries shows that a considerable portion of shares acquired by privatization may be thrown on the market in a short time. Soon after the final round of the first wave of the voucher privatization an excess supply of some shares may develop.


According to my subjective estimate in part 2 the expected market value of shares per one voucher book is only about 14 thousand Kcs. The privatization funds that issued guarantees for 15 or more thousand Kcs may have to pay off a significant part of their shareholders. To do so they may be forced to throw on the market a large part of shares they acquired during privatization. The excess supply on the secondary capital market would thus be amplified and the share prices further depressed. I f the decline of share prices goes so far that the value of an average portfolio falls bellow 10 thousand Kcs the Harvard Fund and other funds that issued similar guarantees may have to start selling their assets. The danger of a snowballing effect leading to the general financial collapse is therefore quite real.


We can learn quite a lot from the history of investment funds and their regulation in the USA. First of all, it could be expected that at the beginning, before sufficient competitive pressure develops, unethical administrators of funds who will try to profit to the detriment of small investors may appear. Strict rules about disclosure of information and tough penalties for fraud and misappropriation are certainly needed. On the other hand, the American experience shows that the promotion of competition is much better protection of a small investor than any administrative and legal regulation which often inhibits rapid development of competition and in general reduces economic efficiency of the industry.


In the recent months Czechoslovakia jumped almost 50 years of history and as far as the number and extent of investment funds is concerned reached approximately the U.S. level of the seventies. More than 400 funds encompassing about one half of the Czechoslovak households provides certainly an adequate basis for strong competition between funds and their advisers. In no case should government regulation of investment funds hamper the development of competition. It is particularly important to encourage the greatest possible mobility, i.e. the easiest and least costly transfers of investment between funds. Low advisory and redemption fees as well as low sales loads are the best way to this mobility. And the best way to low fees is to foster competition rather than to impose administrative restrictions.


Even if it is likely that at the end of the first wave of privatization many citizens will want to sell their shares or withdraw from privatization funds by which they could create a real danger of a snowballing financial collapse it would be very unwise to try to prevent it by prohibiting the trade with shares or by prohibiting pullouts from privatization funds. Such prohibitions would retard the development of secondary financial markets that are so important for a well functioning market economy. The prohibition of withdrawals from funds would lock up citizens in the funds they may have chosen by accident and as a result competition between advisers would be reduced to minimum.


The slight danger of inflation (see item 1) could be at the first glance prevented by restrictive monetary policy leading to higher interest rates. But this would not be an appropriate response. The increase of interest rate would further repress the stock prices on the capital market and would make saving bank deposits and bonds much more attractive than shares. As a result the excess supply of shares would become even more acute. High interest would also slow down economic recovery and worsen the situation of newly created private firms.


Instead of administrative restrictions the impending financial collapse can be better prevented by the use of market incentives that would reduce supply and enhance demand on the stock market. One of such incentives may be a temporarily imposed relatively high capital gain tax. This tax is regularly used in the USA and other advanced countries with market economy. It, however, has some undesirable by-effects because of which some economists and politicians want to reduce it or even eliminate it entirely. The undesirable effects coincide mainly with a considerable reduction of mobility on capital markets. The capital gain tax makes frequent purchases and sales of securities undesirable. This is because the tax is paid only at the time when the security is sold. Under some circumstances this tax can be avoided providing that the capital gain is reinvested within a certain period of time. In the USA this happens for example if the capital gain from the sale of the family house is used for the purchase of a new house. Similarly the tax need not be paid if the means are transferred between various pension funds. To stabilize the capital market I would suggest to impose temporarily a high - 50 to 75 percent - capital gain tax for let’s say 2 to 3 years. This tax would be paid on almost the full market value of shares acquired by privatization as the only price that a citizen paid for them was the administrative fee of 1035 Kcs. To avoid the undesirable reduction of mobility I would propose exemption from this tax in case the means acquired by the sale of shares are reinvested in real estate, private business or securities of the capital market within three months.


On the other hand, it is also imperative to stimulate the demand for stock with falling market value. Taking into account that people will sell primarily to convert their assets into less risky form the solution is straightforward. Government, banks, investment funds or even private companies could issue long term bonds, sell them to the population and use the proceeds to buy out shares in excess supply. This would, of course, result in concentration of ownership of companies privatized by voucher method in the hands of major institutional owners, a desirable outcome, if we believe that fragmentation of ownership resulting from voucher privatization is unwanted.


Foreign capital could create an additional source of the demand for shares that people might want to sell after the end of the first wave of voucher privatization. Therefore, it would be wrong to impose any further restrictions on sales of stock to foreign investors. By their presence foreign investors may help to maintain high stock prices and thus prevent the financial collapse. Further they may improve the balance of payments and, consequently, help to achieve the revaluation of the exchange rate. Fears of the complete buy-out of Czechoslovakia by foreign capital have no substantiation. First of all, the foreign capital inflow is still very low because investments in Czechoslovakia are more risky and generally less profitable than investment in some other countries. Moreover, free financial markets would have selfregulating function. Inflow of foreign capital would result in appreciation of the exchange rate which would reduce the attractiveness of these investments and eventually reach the level when any further inflow of foreign capital would stop.


Finally, I would like to make another suggestion. In the USA and Western Europe the major part of small investment is concentrated in "pension funds" that are a specific form of investment funds. In these countries individual citizens feel responsibility to accumulate resources for their own retirement. The time when the Czechoslovak government guaranteed to each citizen a full pension financed from the State budget has inevitably come to an end. Therefore, it should be encouraged that some privatization funds are converted into pension funds. They would offer specific contracts according to which all the dividends and capital gains accrued before the retirement age would be fully reinvested and only from the time of retirement the owner would be paid a regular monthly pension. Up to a certain level additional investment in pension funds should be tax exempt.



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