At the brink

Czech Prime Minister Vladimír Spidla proposes far-reaching economic reforms. But the business community argues that they’re much too tame.

If you can’t beat ‘em, join ‘em.

In June, Czech Prime Minister Vladimír Spidla faced political disaster. Opposition from both his fellow Social Democrats and right-wing Civic Democrats to his controversial plan to shore up public finances had reached a crescendo. With many legislators clamoring for him to step down, he surprised rivals and supporters alike by threatening to resign if the plan wasn’t passed. A resignation would have precipitated an early election -- the last thing his Social Democrats wished to see happen. With polls indicating that many of them would lose their seats, they grudgingly rallied behind their prime minister.

Spidla’s brinkmanship proved a galvanizing force. The rumpled, soft-spoken former archaeologist has been transformed into a confident, assertive politician.

“Spidla has matured on the job,” concedes Senator Mirek Topolánek, chairman of the Civic Democrats. And although Topolánek’s party has vowed to press ahead with a no-confidence vote against Spidla in Parliament, the senator says that he doubts “we would get enough votes.”

“Spidla sees his career is on the line and realizes that he has to take risks and fight,” says Jirí Pehe, a Prague-based political commentator and chairman of New York University’s branch in the Czech capital.

But occasional resignation threats, however effective, do not translate into enduring political power. Spidla’s approval ratings remain below 30 percent. He will need to tackle the host of obstinate problems that plague the Czech Republic today -- swollen fiscal deficits, anemic economic growth, a costly pension system and an ailing judiciary. The Czech government must confront these pressing issues even as it prepares to join the European Union in May.

Spidla’s proposed financial reforms are even more critical today than when he assumed office in July 2002. To rein in the budget deficit, which hit 3.9 percent of GDP in 2002 and is projected to reach 6.2 percent this year (well above the EU target of 3 percent), Spidla advocates a combination of tax hikes -- mostly value-added levies -- and spending cuts. He will also jump-start the recently postponed privatizations of the Czech Republic’s telecommunications, petrochemicals and electricity companies, though he vows to proceed with caution in selling state-owned assets. “It is important that we get good prices,” Spidla says.

As the prime minister pursues his ambitious agenda, he must contend with tough critics, a group that prominently features President Václav Klaus, a Civic Democrat who took over the mostly ceremonial role from Václav Havel when Spidla refused to support the bid of Social Democrat Milos Zeman, his predecessor as prime minister. They argue that Spidla’s proposed reforms do not go far enough and may even do more harm than good.

“They won’t bring about economic growth,” says Senator Topolánek. Jan Svejnar, a Czech economist at the University of Michigan, notes that “increasing taxes will certainly make the economy less competitive.”

Spidla, for his part, staunchly defends his leadership and predicts a long tenure in office. In an interview with Institutional Investor, he asserted that he will be in office when the Czech Republic enters the EU and will stay on to oversee economic reforms that will enable his country to adopt the euro by 2008 (see box, next page). “I don’t intend to step down even then, because I think there will be a lot of work left to do,” says Spidla.

No challenge will be more demanding than reform of the state-run, pay-as-you-go pension system, which racked up a deficit of $582 million last year, almost 1 percent of GDP. To ease this strain on the public coffers, Spidla advocates a Swedish-style arrangement in which pension benefits more closely reflect individual contributions. The prime minister also promises an overhaul of the judicial system and a new bankruptcy law to better protect business interests.

In his 14 months on the job, Spidla has already faced more than his share of tough trials and controversy. In August 2002 the worst floods to strike Prague in a century caused several billion dollars worth of damage in the capital and elsewhere. The budget was further strained when three major privatizations, from which the government had expected to raise $8.5 billion, fell apart. And this past May an international arbitration court ordered the Czech government to pay $355 million to Central European Media Enterprises, founded by U.S. cosmetics heir Ronald Lauder, for failing to protect the company when its Czech partner illegally forced it out of TV Nova, a Czech television station. Exacerbating all these strains, Spidla’s coalition claims a mere two-vote majority in the 200-seat lower house of Parliament.

Spidla must confront, first and foremost, the swollen budget deficit. “Fiscal developments during the past few years have been unsustainable,” the International Monetary Fund declared in May, in its most recent report on the Czech Republic. It is a dilemma shared by Poland and Hungary as they too move toward EU membership next year.

“All these countries face the challenge of reducing large budget deficits to the 3 percent of GDP level required by the Maastricht criteria for adoption of the euro,” says Radoslaw Bodys, a Warsaw-based economist covering Central Europe for J.P. Morgan Chase & Co. Czech GDP growth has fallen from 3.3 percent in 2000 and 3 percent in 2001 to 2 percent in 2002 and an estimated 2.3 percent this year.

“Business investment and exports have slowed,” says Pavel Mertlik, a former Finance minister who is now chief economist for Raiffeisenbank in Prague. “Economic momentum is being sustained mainly by household consumption and government expenditures.”

Spidla, however, is caught in a political deadlock. His proposed tax increases and spending reductions aim to reduce the deficit to 4 percent of GDP by 2006 and to 3 percent a year or two later. But even this gradualist approach has been opposed by the more left-wing Social Democrats who are members of his wafer-thin majority coalition: They argue that Spidla’s strategy violates their party’s 2002 campaign promise not to reduce social services. Meanwhile, the Christian Democrats and the Freedom Unionists -- the two small center-right parties in the government’s coalition -- have threatened to abandon Spidla if he fails to carry through the reforms.

And Spidla faces another pitfall. “These reforms will culminate in 2006, which is an election year,” says Radomir Jac, an economist at Commerzbank in Prague. “I don’t know if the government will have the discipline to carry them out.”

Fiscal problems aside, Spidla inherited a reasonably solid economy and political situation. His predecessor, Zeman, sold off most of the deficit-ridden state companies and the dreadfully indebted banking system, raising the private sector’s share of the economy from less than two thirds in 1998 to 80 percent last year. After lagging behind Poland and Hungary throughout the 1990s, the Czech Republic under Zeman attracted more cumulative foreign direct investment on a per capita basis ($2,233) than any other Eastern European country. Initially, too, Zeman helped swing skeptics in his own party behind Spidla, who had a reputation as a leftist out of sync with the new capitalism.

But the prime minister squandered these considerable assets in what some observers describe as a psychodrama between Spidla and Zeman. In personality and ideology the two politicians could not be more different. Where Spidla is dour, terse and puritanical, Zeman presents himself as a hard-drinking, outspoken extrovert who courts controversy.

Even though Zeman had belittled Spidla’s leadership qualities, he expected that Spidla would support his bid for the presidency -- after all, Zeman had helped Spidla become prime minister. That scenario collapsed because Spidla could no longer tolerate being overshadowed by Zeman, who even after stepping down as prime minister continued to try to influence government policy through intermediaries. “Spidla reacted badly to this,” says Milan Ekert, one of the more candid Social Democrats in the lower house of Parliament.

It’s a story of ego and emotion, suggests NYU political commentator Pehe. “There is no rational explanation for their feud,” he says.

Not long after he became president, the outspoken Klaus became another thorn in Spidla’s side, criticizing the government’s enthusiasm for Czech membership in the EU and its backing of the U.S. in the war with Iraq. Klaus has also taken aim at the prime minister’s economic policies, which he insists are unfavorable to the business community. Few people doubt that Klaus is acting as a partisan and even overstepping the bounds of his office, but his criticism still carries weight in the business community.

Nor is he alone. Although Czech entrepreneurs and executives appreciate the government’s general sentiment of support, they urge the prime minister to enact more business-friendly reforms -- most critically, a reduction in the corporate taxes that cover entitlement spending. Corporate taxes linked to pension and health care benefits are the equivalent of 35 percent of employee salaries and unlikely to be lowered by the government’s proposed financial reforms.

Spidla says that even though his proposed reforms aren’t specifically tailored to the business community, they will “provide enough resources to maintain balanced budgets in the foreseeable future” -- a requisite for the smooth economic transition into the euro zone that many Czech executives are hoping for.

But for some business lobbyists, this isn’t nearly enough. “Spidla has not been able to put forward any sort of economic message that is understandable to the business community,” says Weston Stacey, executive director of the American Chamber of Commerce in the Czech Republic. “Nobody knows what he intends to do with pension reform, health care, long-term tax policy and the judiciary, which is out of control on business issues.”

But the prime minister won’t be rushed, especially when it comes to the three major pending privatizations. “We want to make sure market conditions are right,” he says.

In December his government scuttled a deal to sell its 51 percent stake in Ceský Telecom, the fixed-line telephone monopoly, to a group of investors led by Deutsche Bank, because it deemed the $1.8 billion bid too low. The government has since hired a former Dell Computer Corp. executive, Gabriel Berdár, as chairman and chief executive officer, with a brief to run the outfit like a private company and prepare it for sale before the end of 2005. By then, presumably, the telecom industry will have recovered from its global meltdown and the company will command a better price.

“We have to make everybody here understand the need for profitability in every product line, even though the years of significant market growth are over,” says Berdár. Last year the company’s net profits fell to $129 million on revenues of $1.59 billion, down from 2001 net profits of $167.2 million on revenues of $1.53 billion.

Berdár’s biggest move thus far has been the $1.25 billion purchase in June of Verizon Communications’ and AT&T Wireless Services’ 49 percent share in Eurotel Praha, the country’s leading mobile phone company. Ceský Telecom already owned the remaining 51 percent of Eurotel. But the wireless market is saturated -- 90 percent of Czechs already use cell phones -- and Eurotel faces tough competition from Germany’s T-Mobile and homegrown Ceský Mobil.

“It would be difficult to privatize Ceský Telecom if it remained only a fixed-line company,” says Jan Schiesser, head of research at Atlantik Financial Markets, a leading brokerage in Prague. In fact, Czechs use fixed-line phones more for Internet connections (53 percent of calls) than for voice communications -- yet voice remains the most profitable part of the telecom business.

Two other privatization attempts faltered last year. The sale of state-owned petrochemicals company Unipetrol fell apart because Czech fertilizer company Agrofert was unable to raise the financing for its winning $360 million bid. But this time around, the government has lowered the floor price and expects to sell its 64 percent stake for at least $230 million by the beginning of 2004. The other failed privatization was of electricity producer CEZ. Spidla now thinks any sale of this company could be years away.

The government rejected two bids in 2002 for its 67 percent stake in CEZ -- one from Italy’s Enel and Spain’s Iberdrola, the other from Electricité de France -- because they failed to approach the $5.6 billion minimum set for its shares. Since then CEZ has bolstered its value by acquiring several small, state-owned electricity distributors. “Once the consolidation of distribution companies is completed in another year or so, CEZ will look more like a Western European utility -- that is, it will combine generation, distribution and sales to end customers -- and become more attractive to potential buyers,” predicts Jan Slaby, an analyst at Wood & Co., a brokerage in Prague. But the government worries that if CEZ is privatized, the new owners will insist on seeking less costly sources of energy than the inefficient Czech coal mines and will throw thousands of miners out of work. That may be one reason why Spidla says no timetable has been set for a sale.

Though Czech businessmen generally support Spidla’s strategy for privatization, many of them worry that the government is moving too slowly to resolve a greater long-term threat to public finances -- the increasingly burdensome social security system. The state-run system faces a crippling deficit as soon as 2010. Today the ratio of economically active to retired people stands at 3 to 1. But if no changes are made in the pension system, that ratio will be 2 to 1 within a generation: The Czech Republic has one of the fastest-aging populations in Europe.

To ease this burden, Spidla has suggested some mild reforms. He would raise the retirement age from 55 for women and 60 for men to 63 years for both; and he would adopt a version of the Swedish pension system, which allows taxpayers to invest part of their state pensions in mutual funds and offers them a tax break for putting some of their own money in private pension funds.

Any proposed economic reform must confront the reality of the country’s fragmented electoral system, which makes it difficult for any party to become dominant or even to weld a stable majority coalition. In the Czech Republic economic reforms can be neither quick nor dramatic. “Real reforms won’t be adequately addressed until there is a government with 120 out of 200 seats in Parliament,” says the American Chamber of Commerce’s Stacey. “And that’s something that nobody foresees, even if this government falls.”

Still, some Czech observers offer a more hopeful perspective. “I agree with business criticism of the government’s proposals,” says former Finance minister Mertlik. “But not enough reform is better than none at all.”

Surprising strength

Czech Prime Minister Vladimír Spidla neither looks nor behaves like a man who relishes being a politician. The 52-year-old former archaeologist, with rumpled suit and thinning gray hair, seems as if he would be more comfortable engaged in his hobby of restoring historical monuments than glad-handing fellow Social Democratic pols or delivering speeches to constituents. Before the 1989 Velvet Revolution that ended the Communist regime, he had never been affiliated with a political party. In the democratic era however, he has held governmental and parliamentary posts in health care, labor and social affairs.

In an interview at his offices in a 19th-century Prague palace with Institutional Investor Contributing Editor Jonathan Kandell, the prime minister demonstrated his characteristic impatience with rhetoric and anecdote even as he strove to lay out his ambitious timetable for a host of economic reforms.

Institutional Investor: What was your biggest surprise upon becoming prime minister?

Spidla: The fact that so much of my agenda was taken up by foreign policy -- especially the Iraq War and our prospective membership in the European Union. I realized that a country of our size must make itself heard abroad to strengthen its position among larger countries.

What has been the biggest disappointment of your term?

None I can think of.

Since your threat to resign unless Parliament passes your proposed financial reforms, your government looks a lot stronger and more stable. How do you explain these results?

The reform of public finances is an absolute necessity, and everybody is aware of this. The public at large backs it, and now legislators are showing realism and willingness. As we debated the reform, it became clear that even though my strategy isn’t ideal, nobody has been able to come up with an alternative.

Do you see the proposed financial reforms calling for more taxes and spending cuts as the ultimate solution to the budget deficit?

These reform measures are only a first stage. Once they are passed we shall move toward the second stage -- pension reform. This will involve a shift from the pay-as-you-go system toward a system like Sweden has, in which pensions will more closely reflect individual contributions. A third stage of reform will involve a battle against the underground economy and corruption. And a final stage will be the completion of privatizations. Taken altogether these reforms will provide enough resources to maintain balanced budgets in the foreseeable future. I estimate we shall need one-and-a-half terms as prime minister to accomplish all this -- which means until 2008. At that time, we should be ready to join the euro zone. And I don’t intend to step down even then, because I think there will be a lot of work left to do.

What plans do you have for the three most important remaining privatizations -- fixed-line telephone monopoly Cesk´y Telecom, petrochemicals giant Unipetrol and electricity producer CEZ?

The privatization of Unipetrol is under way now and should be completed by next year. We are planning to privatize Cesk´y Telecom by the end of 2005, but it will depend on whether we get a good price. And we haven’t even made a decision yet to privatize CEZ, so there is no timetable to sell it.

Are you planning to reform the judiciary -- in particular the bankruptcy courts?

We are working on a new bankruptcy law that should simplify proceedings, and we plan to present the draft in Parliament before the end of this year.

What would you be doing differently if you had a comfortable majority in Parliament?

I don’t think much would change. It is very difficult in our system for one party to achieve a majority, and we would still have to accommodate our coalition partners. The only way to have a comfortable majority coalition would be to make a deal with the Communists, and that’s something I would never do.

Is your feud with former prime minister Milos Zeman and his faction in the Social Democratic Party finally over?

The former prime minister no longer has a faction.

What does entry into the EU mean for the Czech Republic?

As a historian, I feel a special satisfaction that we are joining the rest of Europe. Hardly a decade has gone by without blood being shed in Europe. The EU offers a great opportunity to put all that behind.

What ales the Czech Republic

As their country prepares to join the European Union next May, Czechs wonder how well their agriculture and industry will hold up against the more advanced EU economies. But they harbor no doubts about their beers, which they know to be superior. No other nation has a higher per capita beer consumption -- 160 liters a year for every man, woman and child. That adds up to some 1.6 billion liters a year.

An almost equal volume is exported, but many foreign consumers don’t wait for Czech beers to come to them. The streets of Prague regularly swarm with beer-guzzling Western European youths, many of them from the U.K. No fewer than seven low-cost British airlines fly young men to Prague directly from Birmingham, Leeds, London and Manchester for what are promoted as “stag parties.” They come to drink the cheap, good-quality beer and to ogle attractive women.

“I intend to drink myself silly all weekend, and maybe get lucky with a girl,” says Andy Thorpe, a 22-year-old lad from Leeds.

The ladies of Prague feel less fortunate. Letters columns in the local press carry bitter accounts of women accosted on the streets and on the trams by intoxicated tourists who can seem as if they’re in search of a soccer riot. But with tourism down because of the global economic slowdown and fears of terrorism, local hoteliers and barkeeps are delighted by the influx of free-spending drinkers.

Understandably, Czechs at the higher end of the travel business aren’t enthralled by the beer blight on a country that has marketed itself as a highbrow cultural destination. “There really are some extraordinary Czech wines, but they get overlooked because of this unbelievable beer tradition,” says Prince William Lobkowicz, an American-born Czech who owns both vineyards and breweries. He exports several beers under variants of his name but would much rather talk about his wines, some of which were served at a 1999 state dinner for Queen Elizabeth at Nelahozeves, his castle in Bohemia.

Even the biggest beer producers seem uncomfortable with the fact that their fame is being spread abroad by word of often-inebriated mouth. Plzensky Prazdroj, which produces more than half of all Czech beer, is marketing its bestselling Pilsner Urquell ($600 million in total sales last year, half of which were exports) on its cultural and historical merits.

“The main message we are trying to get across to consumers in the EU and the U.S. is our originality,” says Alexej Bechtin, spokesman for Plzensky Prazdroj, which is owned by U.K.-based SABMiller, the world’s second-largest brewer. “We have the world’s first pilsner.” It’s a technique invented in 1842 in the Czech town of Pilsen -- and since adopted by most modern beer producers -- to brew a pale golden lager rather than the old-fashioned, muddy, dark, flat ale still prevalent in parts of the British Isles.

Though the message seems to have enhanced Pilsner Urquell sales in Europe, which has a tradition of beer connoisseurship, a similar campaign vaunting the brew’s Czech cultural values may fizzle in the less sophisticated U.S. market. “Americans don’t even know where the Czech Republic is or how to pronounce ‘Urquell,’” says Philip Wilson, who was until recently a creative director with McCann-Erickson WorldGroup in Prague. He suggests that Urquell follow the profitable route taken by Corona, which jettisoned its Mexican cultural roots and created a tropical island lifestyle image for itself.

Or maybe Urquell should market the same “stag party” image among young Americans that has proved so successful in the U.K. “Get them to come to Prague, where everything is cheap and the women are beautiful,” says Wilson, “and they’ll bring back word of the good Czech beer.” -- J.K.