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The World Bank’s Czech Capital Market Assessment
A
Strategy for a ‘Top Tier’ Capital Market?
Disappointingly, publication of the World
Bank’s detailed assessment of the Czech Capital Market has been greeted with
deafening silence. The timing of the report’s publication[i],
last September, just ahead of the general elections and more recent
Presidential elections, undoubtedly didn’t help attract attention. That only
the main recommendations, rather than the body of the report, were translated
into Czech language probably didn’t help either. That is a pity because the
World Bank’s report, which utilised input from market participants, provides
not only a comprehensive overview of the Czech capital market but also gives
numerous insights and constructive suggestions. In particular, how a ‘top tier’
capital market can be developed.
The report addressed, 3 issues:
(1) The importance of developing the
capital market.
(2) The characteristics of the Czech
capital market.
(3) Concrete suggestions to develop the
Czech Republic’s capital market.
Why
is the development of the Czech capital market important?
It is also disappointing that the World
Bank should have even felt the need to address this question. That the World
Bank did reflects the ‘’concern consistently expressed…that
high-level policy-makers do not view developing the Czech capital market as a
priority item.’’
In justifying the need to develop the Czech
capital market, the authors of the report note that there is a direct
correlation between a country’s capital market and economic growth. In
particular, that there is clear evidence that ‘’broader and deeper capital
markets lead to better investment, more growth, increased employment and higher
material standards of living.’’ Chart 1 shows the correlation between
the size of a country’s stock market (measured by market capitalisation) and
income of a country’s citizens (measured by GDP per capita). There would indeed
appear to be a positive correlation between these two variables. Compared to
other EU Members States, the World Bank observes: ’’The Czech Republic may be a
leader in capital markets development among the new entrants, but its capital
market lags almost by a power of ten behind the leading economies of the UK,
Germany, France, Spain, Italy and the Netherlands.’’
Chart
1: Global Correlation: Market Capitalization to GDP per capita
Real
GDP per capita (US$)
(avg.
1990–2010, log-scale)
Market
capitalization (%GDP) (avg. 1990–2010, log-scale)
Sources: World Bank Development Indicators;
Financial Development and Structure Database; Milken Institute.
Furthermore, it was noted that
‘’capital markets create economic opportunities for the ordinary citizen that
would otherwise be denied to him/her. Capital markets provide the chance to participate
in a wide range of investment opportunities.’’ Without access to a
well-developed capital markets ordinary citizens have few choices other than to
invest into bank deposits paying minimal yields (often below the rate of
inflation). With a savings rate of 28.71% of Gross National Income (GNI),
higher than other countries with similar GNI (Chart 2) and the 3rd
highest of all EU member states, there would appear a huge unmet demand by
Czech investors for investment products.
Chart
2: Savings Rates Comparisons to GNI per capita Peers
Savings Rates (2015)
GNI per
capita (EUR)
Source: World Bank Development Indicators;
Financial Development and Structure Database.
Finally, in a related point, it was also
noted that [broad and deep] ‘’capital markets serve to spread systemic
risk. They are an antidote to bank-centric structures where the great majority
of credit risk rests within the banking system itself and exposes the
Government to high levels of fiscal risk in the case of bank failures’’.
As an example, when corporate bonds are issued (as opposed to bank loans),
banks are essentially disintermediated. The risk of borrower default is then
borne directly by the end savers [and not the banks].
What
are the Key Characteristics of the Czech Capital Market?
To address this question, the World Bank
Report focuses on the key actors in the Czech capital market and identifies the
significant characteristics governing their participation in the capital
market. Encouragingly, World Bank staff noted that the Czech Republic
‘’possesses a well-developed securities market infrastructure’’.
Competent
Authorities
Oversight of the Czech capital market is
split between the Ministry of Finance (MoF) and the Czech National Bank (CNB).
While the MoF is the lead ministry in creating the legal framework for the
Czech capital market, the CNB acts as the capital market regulator/supervisor.
Interestingly, in addition to its supervisory role, the CNB is also charged with ‘’ the development of the capital market,
investor protection and encouraging investor awareness (perhaps to be read as
financial literacy)’’. The inherent contradictions of the MoF’s[ii]
and CNB’s[iii]
multiple mandates are diplomatically not discussed. Furthermore, and somewhat
surprisingly, neither CzechInvest nor the City of Prague are mentioned in the
context of capital market development.
In terms of EU regulations: ‘‘A consistent theme running throughout
technical discussions with market participants was that the regulatory costs imposed on the Czech capital market, mostly
through EU rules, are damaging its growth.’’ In particular, these costs
are more difficult to absorb in a small market such as the Czech Republic,
placing the Czech capital market at a competitive disadvantage. [Author’s note: the EU’s recent flagship
MiFid II legislation runs to a more than 1.7m paragraphs creating a huge
regulatory burden for legislators (who must transpose the directive into
national laws), regulators, and market participants alike.]
Banks
The World Bank notes that a ‘striking’ but
not ‘surprising’ feature of the Czech Republic’s financial system is that it is
highly
bank-centric. A feature attributed, at least in part, to the inherited
financial system of former eastern-bloc countries. By bank-centric, the authors
are alluding to the dominance of commercial banks in terms of both savings and
lending.
A second, related, characteristic is the
high level of ‘liquidity’ in the Czech financial system. An analysis of the
financial statements of 18 Czech commercial banks shows a substantial portion
of idle, unused resources. Applying different methodologies, the World Bank
asserts that Czech banks lend only between 56%-68% of their available funds to their
customers. In other words, somewhere between Eur19.7bn-Eur36.8bn in
funds are sitting idly in Czech banks, representing a whopping 11.6%-22% of
Czech GDP. So what do the banks do with the money which isn’t lent out? Once,
inter-bank lending and holdings in government securities are excluded only 6.3%
is invested into non-government securities (Table 1). The clear implication
being that the current bank-centric capital market may not be the best way to
turn savings into investment.
Table
1: ‘’Idle Funds?’’ Banks’ Use of Available Funds (CZK)
Source: World Bank staff calculations based
on 2015 bank financial statements
The World Bank also noted a third
‘’striking factor’’ related to the Czech interest rate environment, namely the low interest rate environment, both in
absolute and real (inflation adjusted) terms. As of writing, however, it should
be noted that post the CNB’s currency ‘cap’ interest rates have surged higher.
Factoring
The report notes the importance of factoring
in the Czech Republic, i.e. the ability to use ‘receivables’ from
customers as collateral for credit. This market is dominated by the banks with
only one non-bank factoring firm. Contrary to the experience of some other
countries, ‘factoring’ enjoys clear
legal status in the Czech Republic.
Investment
Funds
The dominance of banks is also apparent in investment management. It is noted that
foreign and domestic banks have, between them some 76% of clients and 80% of
total client funds. The market is also highly concentrated, with the
top 3 Fund Management Group’s accounting for about 65% of total fund assets. Including
the top 7 Fund Management Group’s, this figure reaches an astonishing 87%. Despite this high degree of concentration,
the World Bank asserts that it ‘’it would not appear that this raises
competition issues’’ due to the cross-border nature of the investment fund
industry in the EU. Of course, the World Bank’s reassuring assertion only holds
true if one ignores the fact that many Czechs understandably wish to hold Czech
Crown denominated funds rather than the Euro denominated funds typically
offered from elsewhere in the EU.
The World Bank does, however, raise an
important issue with regard to the taxation of investment funds. Unlike an
investor who invests directly in a security and pays tax only once upon receipt
of dividends, tax or capital gains, an
investor who invests indirectly via an investment fund pays tax twice, once at
the fund level (5% profits tax) and then again upon any distributions.
While domestic investors benefit from a capital gains tax exemption on both
direct and indirect (i.e. fund) investment after 3 years, foreign investors do
not. This anomaly, places Czech domiciled funds at a competitive disadvantage.
Despite this handicap, one ‘bright spot’ has been the strong investment flows
into domestic investment funds, albeit from a low base.
Pension
Funds
A key feature of the pension fund market is
that some 95% of pension assets are held
in so called ‘Transformed’ funds which are required by law to prohibit negative
returns. As a consequence,
investments are invested very conservatively, with some 78% invested in
government related securities[iv].
Although the regulatory limit for equity investment is some 70% of the
portfolio, the need to always produce a positive return means on average only
0.12% is invested by these funds in equities. Reflecting this very
cautious investment mix, in recent years, rates of return on Czech pension
funds has averaged less than 2% p.a.
Despite the poor returns, individuals are
encouraged to invest into pension funds by ‘matching’ contributions from the
State and the ability to offset pension contributions from taxable income.
However, the amounts contributed by the State, and the amounts which can be
offset against tax, are capped at somewhat low levels.
Retail
Investors
There is widespread mistrust in the Czech
capital market by the public. The World Bank notes that this stems from the
mass privatisation programs during the 1990’s. Though roughly 1,700 companies
were listed, over time most companies failed, delisted, or were ‘taken private’
‘’often through less than transparent means. The practical result, for the
ordinary investor, was a loss of the investment. Understandably, ‘’the Czech public are risk averse in their
investment choices.’’
Venture
Capital (VC) /Private Equity (PE)
Significantly, according to the Czech
Private Equity and Venture Capital Association, ‘’the Czech Republic lags behind
not only Western European countries, but also some CEE countries with regard to
the level of VC/PE investment relative to GDP.’’ The absence of large
institutional investors in VC/PE funds was highlighted; as was the fact no VC or
PE funds are actually domiciled in the Czech Republic. The 5% profit tax at the
fund level was cited as an issue.
Potential
Issuers (Companies)
In the past, this author has commented on
the dwindling number of companies on the Czech Stock Market[v].
Despite this disturbing trend, the World
Bank identifies no less than 1,640 large enterprises[vi],
which are potentially able to support broader participation in the Czech
capital market. The number of potential issuers of securities (companies)
would therefore not appear to be a constraint.
In terms of mid-sized companies, 6,794
companies are identified which could potentially grow to a scale where they can
access the capital market directly[vii].
These medium sized companies are also able to access the capital market indirectly
through private equity and venture capital firms.
Currently only listed companies are
required to report IFRS (International Financial Reporting Standards) while
most companies use Czech Accounting Standards (CAS) for their records and tax
reporting. A listing therefore involves the extra costs of maintaining ‘two
sets of books’. The MoF is currently working on a schema that will allow for
the adjustments to me made directly from the IFRS for tax reporting purposes.
Leasing
Companies
Once again, the leasing industry in the
Czech Republic is dominated by the banks. Given that these groups enjoy credit
lines supplied by their parent banks, they are not regarded as potential
issuers of either asset-backed bonds or securitisations.
Government
Securities
As already discussed, responsibility for
the development of the Czech Capital market is shared between the MoF and CNB. However,
the MoF also acts on behalf of the government in the issuance of government
debt. Meanwhile, ‘’the CNB, acting as fiscal agent for the government, is both
the creator, operator and regulator of the government securities market.’’
The World Bank questions whether the
distribution of tenors (maturity profile of the government’s various debt
issues) helps or hurts the wider capital market. This is important, because in
practice, the Government bond market forms the starting point upon which other
securities are priced. However, numerous
small bond issues (there are 23 tenors outstanding) from the government have
made Czech bond market a somewhat illiquid market with limited trading, with
the associated uncertain pricing. The
World Bank questions whether fewer but larger bond issues might be desirable
with emphasis on ‘’benchmark maturities
that government security traders like to see’’, e.g. 1, 2, 5, 7 and 10
years.
Surprisingly, no explicit discussion
appears with regard to the extremely short maturity profile of Czech debt
compared with other OECD countries (though a chart showing maturities is
presented). This bunching of debt issuance, towards short-dated maturities,
requires large amounts of debt to be continually refinanced and has resulted in
a clustering of debt around short maturities. Immediately post the September publication
of the World Bank’s report, this became an issue with October’s failed auction
of shorter-term debt. Against this backdrop, the MoF may be reluctant to adopt
measures that might further reduce appetite for Czech government debt.
The
World Bank’s Recommendations
The World Bank emphasises that there is no
single ‘’magic’’ solution. Nevertheless, numerous constructive suggestions are
made. A list of recommendations in English can be found on pages 20-22 of the
report (see link at endnote). In Czech language, the recommendations can be
found here: http://www.mfcr.cz/assets/cs/media/Zprava_2017-10-02_Table-1-Translated.pdf
Organisationally, it is suggested that the
MoF form a working group, drawn from a broad group of interested parties, to
address these reforms. Readers may review the entire list of recommendations at
their leisure. In this author’s opinion, the following recommendations are
particularly noteworthy:
·
Encourage the Czech Republic’s participation in EU-wide
committees impacting capital market regulation.
Though note explicitly sated, the suggestion seems to be that the Czech
Republic’s participation may act as somewhat of a restraining influence against
over-zealous regulation.
·
Look at ways to eliminate unnecessary regulatory burdens applied
at the local level.
·
The potential privatisation of remaining State Owned
Enterprises (SOE’s). Where SOE’s cannot be privatised, their financing needs
could be met via the corporate bond market. There could be as many as 7 SOE’s
or State Agencies able to issue such bonds.
·
The need to build trust and confidence in the market is
stressed, as is the need to ensure a better information flow.
·
Consider an Individual Savings Account (ISA) Regime. ISA’s
are common in many developed markets and usually provide tax incentives to
encourage individuals to invest, with account holders able to make their own
investment decisions.
·
Creation of a web-based ‘’Securities Information Centre’’. Currently,
information related to securities is often ‘’scattered in various places around
the web’’. Furthermore, many important documents are found only in Czech
language inhibiting investment by foreigners. [viii]
·
To encourage VC and PE firms to domicile in the Czech
Republic authorise the use of the tax-transparent Limited Partnership (LP)
legal entity.
·
It is not recommended to change the current tax
treatment on investment funds. While the 5% profits tax on investment funds
could be reviewed, the World Bank stresses not if that meant the removal of the
exemption from capital gains after 3 years. Removal of the capital gains tax
exemption would have the net effect of making the capital market less
attractive to domestic investors.
·
Eliminate taxation of foreign investors on Czech income.
·
The regulations governing the use of direct internet
marketing and sales of investment funds should be reviewed with a view to
encouraging such marketing. Offering clear and attractive investment choices,
with little or no commissions to agents, would help the investment fund
industry grow and mitigate the dominance of banks in investment management and
fund distribution.
·
Modify the Minimum Return Guarantee Provision. The “no loss”
guarantee should not exist on a year by year basis during the contribution /
accumulation period. Instead gauge this at longer, stated intervals; or apply
the guarantee only from retirement age onward to preserve the capital paid out
to the pensioner.
·
Perfect and finalise the Translation Tables for using IFRS
to generate tax reports. A standard and official method to turn IFRS to CAS tax
reporting would lessen the burden of reporting under IFRS.
Concluding
Remarks
The World Bank’s report represents a very
positive development. Drawing from the input of capital market participants,
the report highlights the key issues which need to be addressed before a ‘top-tier’
capital market can emerge. For participants in the Czech capital market, many
of the observations made will not be new, however, it is one of the few
occasions where a broad overview has been published. As such, it represents an
excellent starting point for policy discussion.
The recommendations themselves are
generally incremental in nature. That is probably the right approach. The
current structure of the Czech capital market, with its ‘bank-centric’ nature
and ‘repressive’ regulations, is clearly sub-optimal. However, sudden
liberalisation could be extremely damaging both to the capital market and the
wider economy[ix]. In particular, while the development of the
non-bank sector and the non-governmental issuance of securities, i.e.
corporate, is to be encouraged, policy makers would be ‘shooting themselves in
the foot’ if their actions ultimately provoked a banking crisis or undermined
support for the government bond market (against which other securities are
priced).
So what then of the World Bank’s Report?
The lack of reaction to the publication of the report is a disappointment. However,
it may just be the case that the report has a ‘slow fuse’ and that its impact
will be felt later. Hopefully, once the Czech Republic’s domestic political
situation settles-down, more attention will be paid to the report and many of
the recommendations implemented. In this way, perhaps some positive momentum
can develop and the Czech Republic will find eventually find itself not only with
a top-tier capital market but also as a regional financial centre.
Jeremy
Monk
Investment
Director,
AKRO
investiční společnost, a.s.
Prague
13th March, 2018
13th March, 2018
Email: jeremy.monk@akro.cz
All posts are the
opinion of the author. As such, they should not be construed as investment
advice, nor do the opinions expressed necessarily reflect the views of CFA
Institute or the author’s employer.
[i]
Capital Market Assessment/ Market Development Options Czech Republic. World
Bank Group. September, 2017 http://www.mfcr.cz/assets/cs/media/Zprava_2017-10-02_CZ-CM-Assessment-Report-Final.pdf
[ii] Author’s
note: as we have seen, the MoF somewhat benefits from the current status quo
due to the large holdings of government debt, issued by the MoF, held by Czech
banks and pension funds.
[iii] In
the UK, there is an active debate whether the UK’s Financial Conduct Authority
(FCA) should lessen the requirements for a ‘premium’ listing on the London
Stock Exchange to attract Aramco to float in London. Some commentators argue
that relaxing regulatory requirements is the wrong way to attract business.
[iv]
It is a classic example of so-called ‘financial repression’ – rules and
regulations that favour investment into government securities. It therefore
represents a hidden ‘tax’ on savers.
[v] https://www.akatcr.cz/public/vypisNovinku.do?id=3923
‘’Investiční banky ztrácejí zájem o český akciový trh’’ 21st
November, 2017. http://cfasocietycz.blogspot.cz/2017/11/investment-banks-lose-interest-in-czech.html
‘’Investment Banks Lose Interest in the Czech Stock
Market’’
[vi] A
company is defined as large if it meets any two of the three criteria: More
than 250 employees, revenues above Eur50m and assets above Eur43m.
[vii] A
company is defined as medium size if it meets any two of the three criteria: between
50-250 employees, revenues between Eur10m-Eur50m and assets between 10m-Eur43m.
[viii]
A major motivation for this article was that the World Bank’s report wasn’t
translated into Czech and therefore didn’t attract the attention it deserved.
[ix]
Historically, financial liberalization or innovation has also been a recurrent
precursor to financial crisis. For example, Kaminsky and Reinhart (1999) have
presented evidence of a link between crisis and financial liberalization. For
the period since 1970, they noted in eighteen of the twenty-six banking crisis
they studied, the financial sector had been liberalised within the preceding
five years.
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