Financial systems in Eastern Europe and the NIS are changing before our eyes, as stock and bond markets spring up in the ex-socialist world. This headlong rush indicates that the old socialist contempt for finance is becoming a thing of the past. Increasingly, transition countries discover that domestic savings are mobilized, and foreign capital attracted, only by modernizing and unleashing their capital markets.

"We're the revolutionaries now," quipped Igor L. Boutickov on closing Tashkent's infant stock exchange after its weekly mid-morning session of trading. Almost stealthily, in a bland second floor room crammed with a few dozen men and women seated before flickering computer screens, the Tashkent Republican Stock Exchange that Boutickov invented (though it trades shares in only a dozen or so firms) is bringing to Uzbekistan the financial revolution now taking place from the Baltics to Bishkek. So keen is the Uzbek government to promote the exchange that a three year tax holiday on income from dividends and share trading started in July.

This momentum is infectious. Voucher privatization turned millions of ordinary Czechs, Kazakhs, Lats, Lithuanians, Moldovans, Slovaks, and Russians into wary shareholders. In 1995 new exchanges opened in Moldova, Romania, Estonia, Kazakhstan, Kyrgizstan, and Uzbekistan, while the prices of shares listed on established markets in Russia and Central Europe rode a roller coaster of prices. The speed with which these markets grow owes much to the region's ruling financial fact: the huge capital requirements needed to restructure old industries and create new businesses, which is forcing dramatic changes in the ways governments and firms raise money.

Thirst for capital is obvious. Consider infrastructure needs. Long waiting lists for telephones, power shortages, decrepit road and rail lines: all are endemic. Fixing these problems is vital because poor infrastructure imprisons growth. Estimates of the capital needed to finance such investments between 1995 to 2000 range from $750 billion (the EU) to over $1 trillion (the EBRD). These numbers look worryingly big, but that does not mean that the ex-socialist countries will need to raise all these enormous sums from foreign sources alone. For savings are on the rise throughout the region, meaning that it may be possible for much of the financing to be done domestically. But the thirst for capital does mean that countries must compete for it by deregulation, scaling down exchange controls, and other forms of liberalization.

Capital thirst is not the only reason for the rush to capital markets. A recognition that the market must have a bigger say over credit allocation also plays a significant role. If firms are to become efficient, they must be weaned from government transfusions, the old socialist standby, and increasingly turn to a more demanding (as well as more flexible) source of funds: private investors, domestic and foreign.

Teething pains abound. A myriad of flimflams incited a belief among many ordinary people that finance was nothing more than a casino, and a rigged one at that. Thousands of Russians and Romanians lost their life savings in the MMM and CARITAS scandals. By some reckonings, between 1991 and 1994 a third of adult Latvians lost money in financial scams. Public cynicism deepened when only three financial crooks were arrested, and none jailed. The Bank of Latvia shrugged off its policing duties. "If someone does not observe the rules (of the road) and a car crashes," said Mr. Repse, the bank's chairman," it is not the rule maker who is to blame." Seeming political disdain incited formation of a "cheated investors" party with a one-note program: pay us back! Indifference, infects voters too. The party failed to pass the threshold of votes needed to be seated in parliament and now wants to ally itself with the Luddite social democratic and labor parties, who remain ideologically opposed to financial deregulation.

Less headline-grabbing flaws also hinder capital markets. In most markets settlement of share trading is a nightmare and laws regulating and taxing capital gains are either non-existent or a muddle. Some of the bigger companies in countries such as Russia, where insiders are firmly in control, still seem far from sure that they recognize that outside shareholders -- local or foreign -- have any rights at all, and they try to keep them out as much as possible. Purneftegaz, a big Russian oil company, for example, keeps its share registry in a village in the West Siberian marshes. So any buyer must fly from Moscow to Surgut, catch a train to Khanty Mansiisk and then drive for a few hours in order to register his or her shares and thus make ownership legal.

Custody (asset safe-keeping and accounting) is always a big worry for investors, foreign and domestic. They do not want to entrust their shares to fledgling brokers with scant track records. The problem is one of safekeeping. In the west, most shareholders trust their brokers to hold their shares until they want to sell them. Because most brokers in the transition countries are new to the game, and stock exchanges are untested watchdogs of broker integrity, investors do not have the same trust in the honesty and reliability of brokers and are left in the lurch about where to place their shares for safekeeping.

For mutual funds with overseas investments custody is an especially serious problem. By law designed to prevent manipulation, American mutual funds (which are the biggest) must place their shares with an "independent custodian" satisfying certain stringent integrity requirements which new domestic institutions in the transition countries are not likely to meet. (That's why Chase Manhattan, Citicorp, and Credit Suisse have all established custody businesses in Moscow. But Russia is huge, with a potential for huge profits. Other countries lack this lure. That's also why the laws of some countries mandating that shares be deposited with domestic custodians are potentially quite damaging.) The problem is particularly serious in countries in which shares are "immaterial" (ie, don't exist on paper), and the only documentation of ownership is found in a company's share register. This makes it next to impossible for mainstream funds to invest, because the local companies could never be qualified as proper custodians.

This is the dull end of finance -- dull, but vital. By definition, markets involve transactions, right through to the point when the seller is paid by the buyer. Until that point, the deal remains uncertain. A financial system is often compared to an inverted pyramid; it is seldom appreciated that every stone of that pyramid involves uncertainty. The more primitive the system -- ie, the more delay between agreeing to pay and payment -- the greater the uncertainty. The nightmare scenario is that an institution will go under leaving huge bills unpaid. Since other individuals and institutions proceed on the assumption that settlement will be made, they will be damaged not just by the direct loss of the unpaid bills, but also by the extra business they already wrote for the next layer of the pyramid. Without reliable settlement mechanisms, a financial system is vulnerable to what may start as only a local problem.

But the most fundamental problem with investing (for locals and outsiders) in Eastern Europe and the NIS is that capital markets are virtually information-free. Managers in the insider-dominated companies of the region have a vested interest in not releasing information about their firms, even if they have it, which often they don't. According to a recent study by the World Bank and the CEU Privatization Project, an astonishing 49% of large outside owners of Russian companies report that they receive no financial information from most companies in their portfolio. Even when insiders do not block access, market institutions whose job it is to collect, interpret, and distribute this information are in their infancy. As a result, investing in the region is often more like playing roulette than an informed choice about one's portfolio.

Place Your Bets

Although such figures are slippery, capital investment is growing fast despite these hurdles. In 1990 foreign direct investment (FDI) and portfolio equity investment were only about a third as big as development and standby loans from the World Bank, IMF, EBRD, and individual governments. By 1993, although official loans increased in absolute terms, FDI and portfolio investment were a bigger source of funds (see chart 1). Direct investment (meaning that one firm buys a stake in another, and is active in exercising its ownership rights) in the region has waxed and waned, with Poland, Hungary, and the Czech Republic benefiting in the early 1990s, Russia in late 1993-94. Now, the Baltics, Ukraine and even tiny Moldova (which saw FDI rise 75% -- admittedly from a small base -- this year alone) are becoming somewhat fashionable.

If the early years of transition from socialism were the era of FDI, the next era looks like being the age of portfolio investment. The coming of portfolio investment is important because it forms the world's biggest source of capital. Portfolio investors -- primarily institutions like mutual and pension funds -- buy shares not because they want to manage companies, but because they expect them to grow, providing increasing share value as well as dividends. They largely leave managers to run the companies as they see fit, monitoring them through their trading in the stockmarket -- with share prices acting as a sort of approval rating. In 1992 portfolio investment was almost nonexistent in Lithuania, while FDI stood at over $100 million. In 1995, however, portfolio investment reached $62 million, while FDI remained constant. The EBRD reckons that between 1996 and 2000, portfolio investment in shares, bonds and other instruments of East European and NIS firms will catch up and surpass the level of FDI.

All this creates great excitement in the region's bourses, attracting domestic as well as foreign buyers. Russian, Polish, Czech, and Hungarian equity markets rose to dizzying heights, only to collapse and regroup (see chart 2). Despite the ups and downs, Hans-Joerg Rudloff, once king of the Eurobond market and, as head of CS First Boston in Europe, the who man led the world's charge into the Russian market, says that "if everything comes together -- capital market development, economic growth with lowering inflation, an increase in liquidity -- it is conceivable that the region will be able to meet damn near all of its own capital needs." Rudloff is putting his money where his mouth is; he left CS First Boston to set up his own investment bank specializing in East European and Russian equities.

But if growth of investment is to continue, functioning capital markets must become permanent pillars on the financial landscape. Even in the most free market oriented countries of the region, Estonia, the Czech Republic, Poland, Slovenia, companies continue to rely heavily on bank finance. Some banks are enjoying wide margins and fat profits. Now these countries need to free corporate borrowers from their reliance on costly bank lending and direct them to the emerging capital markets.

Capital markets are needed even more urgently as catalysts for growth in countries like Belarus, Ukraine, Romania, Macedonia, Kazakhstan, Uzbekistan, and Bulgaria that came late to (or have not even arrived at) the reform table. In all six countries state banks show little interest in profit and loss, and huge rafts of companies continue to depend on state handouts. How to allow useless companies to go bankrupt is a knotty problem that no one in the region has yet solved. But for profitable enterprises, developing capital markets mean that access to money need not be dependent on the goodwill of bureaucrats. Investors, who provide the alternative sources of cash, may be more demanding about the kind of information and accountability they expect from companies. That, in turn, should only encourage firms to become more efficient.

Dynamic new intermediaries to facilitate financial transactions must emerge if capital markets are to function. Some are doing just that, and in the most unlikely places. FICO, a financial firm in Belarus, grew in two years from a tiny three person currency exchange tucked away in a faded Minsk hotel into a 200 employee company with a turnover of $10 million a month and ownership stakes in 20 companies. "When we started," says Natalia Shevko, FICO's general director (who borrowed $40,000 in Moscow to get the firm running), "nobody knew how to deal in currencies or trade shares. We borrowed some books and tried to implement the Western experience here." Despite murky laws and political hostility, the firm is positioned, says Tom Jenkins of Coopers & Lybrand "as a full-service merchant bank" that mediates for institutions as varied as Belarussian state banks and the Exarchate of the Russian Orthodox church in Belarus.

That robust financial activity is underway in the harsh economic climate of Belarus points to a lesson for most policy makers: the region's thirst for capital, both domestic and foreign, means that those countries that want to succeed must produce competitive financial markets as well as competitive products to market. To meet this goal will mean significant changes to stock markets, bond markets, banks, and most importantly, the way governments themselves do business.

All about Bourses

Stock and bond markets exist -- primarily -- to introduce those with capital to businesses that need it. Their second function is to provide an after-sales service -- a market in which shares and debt instruments can be easily and reliably traded. (The two goals are not unrelated: the more liquid the markets, the more easily people invest in securities traded on them without fear of being locked in to their holdings.)

Differing national traditions effect the relative strength of stock and bond markets. Shares in many German companies, for example, are privately held, which means that relatively few are traded on the Frankfurt stock exchange. Companies instead secure capital through the close, longterm relations they have with German banks. These companies, like those in Japan, also raise a lot of cash by selling corporate bonds. Long term government bonds are popular with those financial institutions that have long term liabilities -- insurance companies and pension funds committed to paying out predetermined amounts to individuals many years ahead. In the west, an ever increasing portion of private personal savings are managed by these institutions. America and Britain, however, possess highly developed stock markets and companies widely use them to raise capital through floating shares.

Stock markets channel money into existing companies and new ones. The former get the lion's portion. But there are many ways in which a company can issue new shares. One way is for an already quoted company to offer them to its own shareholders. In such a "rights issue," shareholders subscribe for new shares in proportion to their existing holdings at a discount to their market price. If they do not want to exercise their rights, they can sell them to others who want to buy the company's shares.

A stock exchange is also a way for companies to "go public". The most common method is an "initial public offering" (IPO), in which a company first sells shares to an intermediary (an "underwriter") that specializes in issuing new shares, such as an investment bank or a stock-broking firm. These shares are sold on to the public, usually at a small premium. A key feature of this "flotation" is the publication of a prospectus, outlining the company's record and prospects. It has to be vetted by lawyers and auditors and, in some countries, advertised in the press.

Less common -- in any stock market -- is an issue by tender, in which shares are not offered at a fixed price. The prospectus quotes only a minimum price and investors must name their price and the number of shares they would take. Allocations are made at the highest price that will clear the issue. Small issues can also be accommodated by a "placing," where investment banks sell the shares to their clients -- normally pension funds and insurance companies.

Because in many countries new issues must be registered with a special government agency, such as the American Securities and Exchange Commission, and must comply with various special requirements of the exchange on which they are to be traded, the legal and auditing fees make going public a costly proposition. Underwriters also charge a commission amounting to at least 1 1/4% of the proceeds in exchange for their obligation to take up any shares the public does not buy.

Small, cash-strapped but innovative companies can avoid some of this cost by tapping the alternative "unlisted securities market." These markets are tailored to allow people to invest in fledgling companies that would have flinched at the cost of a full listing. The costs of going public here are smaller because the exchange listing requirements are less demanding.

America has long offered alternative routes to capital for small or new companies. The New York Stock Exchange -- the only exchange actually located on Wall Street -- is the senior market, founded in 1792. It overshadows all other exchanges. The much smaller American Stock Exchange, operates a nursery for small and mid-sized companies. There are also 14 regional exchanges. Last but not least, there is the over-the-counter market (NASDAQ) that has no trading floor but operates via a network of computer screens. Here shares are traded without most of the demanding listing requirements of the NYSE. NASDAQ is a market for companies that may not choose or be able to meet the strict criteria for a quotation on the formal exchanges.

Trading on American stock exchanges works on the auction principle, in which securities brokers arrange trades by competitive bidding. Responsibility for keeping an orderly market rests with specialists, to each of whom a certain number of stocks are assigned. A specialist's job is to buy or sell for his own account in order to maintain a continuous market if there is an imbalance in supply and demand. He also maintains a book of so-called "limit orders" -- ie, orders to buy or sell a share at a preset price or a better one. If these orders cannot be immediately satisfied, they are entered in the specialist's book in order of time and price. When market prices match specifications, the order must be executed before other business and before later orders at the same price. For his troubles the specialist collects a floor brokerage commission.

Not all bourses use specialists. Some exchanges, such as the French, which is a model for many transition countries, make all trades within a (computerized) central system. All bids and offers are collected by licensed brokers and processed by the central exchange. After a certain time, prices are fixed by a computer that matches bids and offers. Although there are some disadvantages to this system when large blocks are traded, it solves one problem endemic to developing markets: low liquidity is dealt with as bids and offers can be collected over a longer period of time than that allowed in the American system. Consequently, it has strong appeal in Eastern Europe, where the Lithuanian, Latvian, Romanian, Polish, Czech and other bourses mimic the French model.

In America, unlike most other countries, customers can buy shares "on margin" -- ie, by paying pay only a percentage of the cost, with the balance advanced on credit by the broker. (Margin trading allows the investor to leverage his own funds and thus make money more quickly. But the reverse is also true; when a speculator makes a wrong bet, losses may be lightening and devastating.) Since 1934 margin limits have been set (and varied) by the Federal Reserve Board, America's central bank. In addition, exchanges have their own margin requirements. Since margin players can loose more money than they invest, they may be required to top up their margin (put up additional money) from time to time if prices move against them.

Official margin limits were established in response to abuse and widespread speculation in the 1920s. This also resulted in the creation, by legislation, of a formal watchdog, the Securities and Exchange Commission. SEC has become the model for regulatory bodies around the world, including Eastern Europe and the NIS. It has regulatory powers over all the leading US stock markets. All new issues have to registered with the commission, which scrutinizes the registration statement for errors and omissions. The SEC and individual investors can sue the issuer, the underwriters, and sometimes lawyers and accountants for any misrepresentations.

Privatization by Trading

To novice privatizers, flogging state industries on a stock exchange seems like a perfect device. Companies are sold, not given away; a stock exchange is kick started. Every government that tried this gambit has had its fingers scorched.

Hungarians and Poles were first to be taught this lesson. The much vaunted "First Privatization Program" in Budapest was supposed to be a model for the sale of a large number of state firms. Twenty companies deemed the "flagships" of Hungarian business were chosen for the first sale. Foreign investment banks and consulting firms advised the State Privatization Agency (SPA) in the process and elaborate plans were made to prepare the companies for privatization and design the post privatization ownership structure. Following French methods, a strategic investor was to be found for each company and a portion of the shares was to be floated on the Budapest exchange (sometimes together with Vienna's bourse) in a series of IPOs.

What was projected as a way to usher Hungary into the family of Western nations turned abject failure, as no chosen company was sold for several years. Instead, with managers firmly opposed to SPA-led sales and Hungary's economy worsening daily, firms languished in an ownership limbo until the program was abandoned.

Poland's "capital privatization" was more successful in creating a lively stock exchange in Warsaw, but not in making a dent in state control of most Polish industry because the number of floated companies is still quite small. One reason for Warsaw's bourse's dizzying rise in 1993-94 was that a mere 21 companies were listed on the exchange, meaning that there were not enough shares to go around. More issues are now traded, but they are still a fraction of Polish firms.

The problem with using stock exchanges as a vehicle for privatization is that the process is far too cumbersome. Preparation of the companies, involving a valuation and a change over to a new system of accounting, is time consuming and very costly. Too many government agencies -- finance ministries, privatization agencies, securities commissions, central banks -- dip their hands in the pot, and the officials in charge of the flotation quickly learn that they can rarely lose by not selling, but can very easily be accused of corruption if the selling price is too low.

Take the case of IBUSZ, a Hungarian company privatized on the Budapest Stock Exchange. The company's IPO soared at first, from Ft 4,900 to Ft 12,500 within days. Political attacks about squandering state assets soon popped this balloon. From success story, the IBUSZ became a scandal of profiteers. The head of the privatization agency (SPA) was sacked, damaging and delaying the entire privatization process and the Budapest Stock Exchange (BSE). Much the same happened in Poland when Bank Slaski was privatized through a sale of shares. A political firestorm erupted, with cries of corruption and ministerial sackings rupturing the privatization program. (The government of Guyla Horn seems headed for another political disaster. In November, in order to raise funds for a state unwilling to bring its budget into order a group of investment banks -- Merrill Lynch, Deutsche Bank, Kleinwort Benson, CS First Boston -- will try to sell off the commanding heights of the Hungarian economy: the state's oil, gas, and electricity companies as well as major banks. But public opinion remains mired against sales to foreign owners, and Laszlo Pal, the former minister of Labor, a dyed-in-the-pink opponent of privatization, was named head of the state energy monopoly. So these sales, too, may be doomed.)

The lesson that IPOs are a hard way to privatize is apparently difficult to learn. Consider the case of Macedonia. Feuding erupted between the country's Privatization Agency and its Security Commission last February, when the latter denied the former permission to open a stock exchange, which the country lacked. The Privatization Agency wanted to use the exchange to flog the 50% of company shares that were transferred to it in 1990-91. (Macedonia's state pension fund was to receive 15% of the shares for its capitalization.)

Good reasons animated the commission's obstruction. Its charter calls for a stock exchange initiated by the private sector -- banks, savings institutions, investment funds, brokerage houses -- not the state. Moreover, the Privatization Agency favors insider-privatizations, a method distinctly unfriendly to the needs for a developing capital market. Managers, who like to keep company information close to their vests, are able to buy their firms by putting down as little as 10% of the company's book value and promising to buy up to 51% within five years. Insider buyers have a ready-made interest in suppressing share prices, not maximizing shareholder equity.

Beaten not broken, the Privatization Agency tried to start a spontaneous market for shares by offering the 5% of OTEX (a textiles company and one of the country's few success stories since the breakup of Yugoslavia) it held to banks, savings institutions, and individuals that registered with it. Television, newspaper, and radio advertisements touted the sale. It flopped, as only 17 shares were sold on the first day, and only 200 more in the month that followed.

Similar efforts in Belarus and Latvia incited similar fates. When the Belarussian authorities sold shares in PromStroi Bank, one of the country's largest, prices at the bank's initial public offering in October 1993 scarcely reached $.17 per share. Since then they have fallen to $.052 per share. To be sure, rampant inflation pushed the share price (as measured in dollars) down, but economists at the EBRD reckon that the bank's managers also played a role, as they are buying out the bank's nationwide network and extensive property on the cheap. Latvia's Privatization Agency doomed its two attempted IPO's to failure by concocting a confusing scheme that fixed a ladder of different share prices for different categories of bidders.

Too much of a not-so-good thing

Mass privatization is another way privatized firms emerge on infant equity markets. Problems that bedevil countries that went this route are the opposite of those that privatized using sales: a surfeit of companies not ready for public trading makes for a very spotty market.

The Prague stock exchange is proof positive of the fact that even strong economic growth and government encouragement are not enough to ensure that investors will make money or new capital will be raised. Four years after establishment, Czech stock markets are sleepy backwaters, of little import in the country's growth. Blame for this must go, in part, to the country's rapid privatization. The market remains indifferent to most of the hundreds of issues that have flooded on to it. (Moldova faces like problems. Of the 600 plus joint-stock companies created during privatization, a mere 25 have been able to complete shareholder registration, the first step toward listing on the Moldova stock exchange.)

Traded companies in the Czech Republic do not need to disclose much information about themselves and the market lacks a strong supervisor to deter insider trading and other abuses. Concentration of ownership among a few investment funds means that most trades are struck privately, at unpublished prices and off the Prague stock exchange. The Prague stockbrokers Wood & Company have argued that such off-the-books trading is a key reason why the Prague market has the lowest ratio of turnover to market capitalization in the world.

Public and private officials are not blind to these flaws. "I am not enthusiastic when I read in the foreign press that the difference between the number of companies traded in New York and Prague is very small: 500 - 600 companies," says Kamil Janacek, chief economist at Komercni Banka, the big Czech commercial bank. The problem is that "there are many companies that in normal economies would be either non-tradable or not joint-stock companies at all." Only 200 companies should be on the exchange, says Janacek. "Our main problem is how to get 'non-standard' shares' off the exchange and "not damage the rights of existing shareholders." Jiri Skalicky, the current minister of privatization, agrees: "Step-by-step" we must push "many joint-stock companies off the capital market." The first step in this direction has been taken recently when the exchange separated all the issues into three categories, effectively downgrading most of the ineligible stocks.

Equally at fault is the performance of privatized firms themselves. New owners are mainly investment funds, many run by banks with little experience in restructuring companies. So long as their own loans to a firm are being paid, they keep their mouths shut at board meetings. But foreign investors have bought Czech shares at high prices in the expectation that private ownership and a growing economy would spark strong growth in profits. They were wrong.

Such mistakes are likely to be repeated in Kyrgizstan, as it transforms bodies built with privatization in mind into everyday financial institutions. The coupon exchange, where privatization vouchers were traded, is to become the Kyrgiz stock market. Investment funds are to become brokerage houses. Certainly Kyrgizstan pushed privatization farther and faster than anyone expected -- 55% of all industry is now in private hands. So speedy was the privatization process, however, that investment funds (as in the Czech Republic) have little time to engage in industrial restructuring. Because they needed to gain managerial support in order to secure employee coupons, it is feared that relations are far too cozy between managers of privatized firms and investment fund bosses, and that this stifles business reform.

Though privatization may be no cure-all for existing capital markets, it remains the best catalyst for getting a capital market off the drawing board. Even in slow moving Romania the expectation of the (long postponed) mass privatization program created powerful inducements to create new financial institutions. Romania's central bank made registration of investment funds far easier than that of banks, with a corresponding ease in regulatory oversight. Banks themselves ran fast into this loophole, with Dacia Felix and Credit Bank opening their own mutual/investment funds that used bank facilities for selling certificates and giving loans as well as for holding fund deposits from ordinary Romanians. Although these funds are currently restricted from getting involved in Romania’s coupon privatization program, they are eagerly waiting for the time when coupons are exchanged for shares in Romanian companies at which point they will certainly become a major player on the market.

Competition among Romanian investment funds is fierce. The biggest are fast approaching t

Copyright Project Syndicate 2012