PRIVATIZATION IN NACC COUNTRIES Defence Industry Experiences and Policies and Related Experiences in Other Fields COLLOQUIUM 1994 ********* COLLOQUE 1994 PRIVATISATION DANS LES PAYS DU CCNA Experiences et politiques des industries de defense et experiences comparables dans d'autres secteurs Colloquium 29-30 June, 1 July 1994 Brussels ---------------------------------------------------------- FOREIGN INVESTMENTS IN THE BANKING SECTOR Riccardo Iozzo Eastern Europe's money moved about in a financial Neverland where state-owned banks lent to state-owned companies. Today many positive steps have been taken to undo this situation, says Riccardo Iozzo, but more foreign capital, and more foreign know-how are needed. Mr. Iozzo suggests a mix-and-match approach. The American model will create more flexible money markets that are ready to take more risks - which could be crucial in restructuring the defence industry. And the Italian experience shows that the state can help prime the pump. Dr. Riccardo Iozzo is the Brussels representative of the Istituto Bancario San Paolo di Torino. It is now common to think that the economic reform process and the privatization programs in the Eastern European countries need the presence of a solid banking and financial system. Such a system guarantees an efficient allocation of the financial resources and allows an overall control of the firms' profitability. It also favours the development of the financial markets and payment systems, and facilitates the privatization programs either through financial reform assistance, the redistribution of the property rights or financial intervention for the programs themselves on behalf of the private investors. When Eastern European countries abandoned the planned system, absolute priority that had to be given to banking system reform. Actually those countries, unlike the less developed countries and in some way opposite to them, started out in a situation that can be considered as industrially advanced (even allowing for the obsolete plants, the excessive importance of heavy industry,and the technological backwardness, etc.) but certainly underdeveloped from the banking and financial point of view. In fact an important effort and considerable financial commitments have been diverted into the banking and financial system reform process in those countries. The foreign private capital contribution has probably been less important than expected. But it can have a very important role in the reform process, and not only of the banking system - especially if it is conducted in a coordinated and a complementary way with regard to the national resources. In an historical perspective, we can nevertheless say that some Eastern European countries have already achieved substantial results compared to the decades it took to build efficient and extensive financial markets in Western Europe. But the complex economic and political situation in the area makes it necessary to speed up the reform process. Privatization of the banking system ----------------------------------- Privatization is generally acknowledged as the engine of such a reform process. However, the banking system itself has to strengthen its privatization programs and maybe even carry them out before the privatization of state-owned companies. It is sufficient to think of what happens in the huge programs based on the voucher system. They are gathered by investment funds usually created by the banks themselves and so there are vicious circles of control transfers from state-owned companies to state-owned banks. The privatization of the financial system therefore assumes a primary role in the development of the market economy in the Eastern European countries. From this point of view, the problem of "ad loans" (which not only represents an aspect of the vicious circle between state-owned banks and state-owned companies) should also be solved in the short term. In fact the bad loans phenomenon seems to have extended also to the new private banks created recently. Several solutions were put forward. Bank re-capitalization would involve a temporary growth of the public quota in them but it is also an essential condition to attract foreign investors. Bad loans could be concentrated in a new single body, or the debt could simply be cancelled. Some useful information can be taken from the Italian experience, during the years that followed the First World War. At that period the assets of the three national banks included credits and control shares in companies that had great difficulties which were increased by the conversion crisis of war production. To deal with this, a single public entity took upon itself the risk and loss responsibility, and financial support in favor of both banks and companies was agreed upon. This kind of intervention led to the setting-up of companies with government participation. The characteristics of such firms (which are different from the services offered by the public administration) are that they carry out an economic activity for which at the moment there is no private capital available, and where there is the possibility of a future return of the private capital through the partial withdrawal of the state shares. They operated in different sectors with multi-sectorial holdings. It was a fifteen-year-long process that took place in different phases and brought about the recovery and the reorganization of the big public industries. Today in Italy, we are at the end of this phase and we are going through an opposite process. However we cannot deny that state intervention had a very important role not only in the rescue of the Italian banking system but also in the recovery and the development of the Italian economy. The role of foreign capital --------------------------- The role of foreign capital in the economy of Eastern Europe is a delicate question. History shows that foreign investment is essential for the development of industrialization. And the changes in the contemporary world economy demonstrate that internationalization enables development at high rates. In Italy, in the Fifties, the first investments were made by multinational companies and in particular by Americans. They allowed the import of the know-how which produced, in the Sixties, the impressive development of the Italian entrepreneurship and in particular of small and medium-size companies. In the financial sector, the entry of foreign capital is seen with even more suspicion. This is understandable with regards to some experiences encountered with foreign banks, especially for the creation of joint-ventures banks operating mainly as offshore banks. These banks made substantial profits but had no effect on the transfers of know how to the domestic market of such countries. Nevertheless it has to be stressed that foreign investment in the banking sector, if correctly made, is not only desirable, but absolutely necessary. The "debt to equity swap", has not been sufficiently utilized in East European countries. This instrument helps debt reduction, increases foreign investments, and gives support to the privatization of the banking system. Chile had a very positive experience in that field in the late Eighties which contributed significantly to the economic recovery of the country. The role of foreign investors has great importance in the creation of efficient banking systems. Technical assistance programs, such as those provided in a massive way by various international organizations, even if praiseworthy, are not able to substitute entirely for foreign banks in transferring managerial and technical know-how, providing an organizational and managerial model, and bringing in efficient payment systems and risk analysis. An interesting experiment that links technical assistance and private investment is the one set up in Poland and financed by the World Bank in the so called "Twinning exercise". The technical assistance provided by a certain number of western banks for a parallel number of Polish banks can develop into a shareholding. A similar program will be set up in favour of a certain group of Russian banks. The creation of an efficient banking system is a precondition for spread of a managerial mentality in the whole economy. Think of the effects that are reproduced in the entire economy when the banks have recourse to a correct and reliable credit analysis. Therefore the first objective of reforming the financial systems is to develop markets and agents who are able to estimate the credit worthiness of the potential entrepreneur, and thereby allocate financial resources and monitor their usage. Foreign participation and the Italian banking system ---------------------------------------------------- In a parallel way, the role of foreign investors in banks is important in the modernization and the development of the industrial sector. Again it can be useful to take into account the Italian experience in another historical phase (from the end of the 19th Century till the First World War) when the presence of foreign financial institutions in the capital of the main Italian banks enabled a rapid development of the industrial process. It has been said that, in Italy, the history of the evolution of the banking system coincides with the history of industrialization. It is interesting to point out the role of German investments which took, in Italy, various forms such as capital inflow, and human resources when Germany was the major commercial partner of Italy. In particular, next to the commercial firms and financial companies which made investments in industrial activities, the presence of the German capital was considerable in share investments in the two main mixed Italian banks: Banca Commerciale Italiana and Credito Italiano. When they were founded (a few years before 1900 - this year is the hundredth anniversary of Banca Commerciale Italiana) the presence of German banks capital was massive, especially in the Banca Commerciale. Other foreign banks present included the Swiss and, later, the French. The presence of the capital corresponded to an even more massive presence of German representatives in the administration and management bodies of the two banks. Foreign investments in these specific cases were diverted to the creation of new banks and therefore avoided taking over the high credit risk burden of the already existing banks. The presence of foreign management in Italy was decisive in introducing a management system based on the criteria used in the big German banks It stimulated Italian industry and in the process, from 1896 till 1914, there followed one of the most rapid industrialization process in Europe. The presence of foreign management continued even when foreign participation in the capital was considerably reduced. In 1914 the board of directors of the Banca Commerciale was composed of 15 Italians and 18 foreigners (8 Germans, 4 French, 3 Swiss and 3 Austrians). Foreign capital amounted to a little more than 30%. This example appears to be the result of the international cooperation based on market mechanisms. The two banks operated as mixed banks with a decisive role in the development of several strategic industrial sectors. Later on, due to the difficulties in the bank-industry relationship, the two banks were put under the control of the State, and a new banking law was set up in 1936 that imposed the separation of the credit activities. 1994 is, for the Italian banking system a year of radical changes coming back to the institutional situation of the beginning of the century. Starting from this year the new Italian banking law increases the opportunity for the banking institutions to operate as mixed banks. In the last months Banca Commerciale Italiana and Credito Italiano have been privatized. Foreign investors ,and namely German banks, have become important shareholders of the two Italian banks One aspect that appears to be almost absent in East European countries is an internationalization process with a regional basis. The Polish investments made in Hungary are not significant and the same could be said for all the other countries of that area. It is important to favour the development of regional markets - though obviously in a different way with respect to the past. This also represents a precondition for more efficient integration in the whole European economy. Therefore it is important to set up instruments that link these markets. Apart from commercial agreements a greater integration of the banking system of this area is desirable. Integration means both good relations, reciprocity and creditworthiness but also possible shareholding. It means the development of a regional financial center where investments in banking and financial institutions could be channelled. Budapest could play this role owing to its relatively well advanced banking and financial system. Besides, it is very important to create an efficient and modern payment system between commercial banks of the area. Last April an interesting project became operational. It is supported by the European Community and links several banks of Eastern Europe in order to help hard currency payments between these countries. Some aspects could also concern the privatization and restructuring process of defence industry. The question is to find out the most effective answers that the banking and financial system can give to this problem. Contrary to the first expectations the restructuring process of military industry has proved a long and difficult task and it has not produced the hoped for results of giving new vitality chiefly to the economies of Eastern European countries but also to Western Europe. In a more general way, it appears that the restructuring and privatization of military industry reflects the modernization of the industry as a whole. With reference to the role of banks and financial markets it remains to be ascertained whether the model consisting in a high rate of financial intermediation through banks and in a low level role of financial markets, which is prevailing in Europe (especially in Germany) can adequately cope with the problem. Such a model shows its limits as regards to innovation, to the need to set up new methods, productions and new ways having a higher level of risk compared to those already tried. The American model in which the role of the banks is more specialized and the saving allocation is assured through a more flexible financial market seems more capable of answering correctly to the necessity arising from the restructuring of defence industry as it can offer funds for more complex and risky activities. --------------------------------------------------------- Copyright 1994 NATO All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic tape, mechanical, photocopying, recording or otherwise, without permission in writing from the copyright holders. Authorization may be requested for redistribution of the text on a non commercial base by research and educational services. Requests should be addressed to the Economics Directorate, NATO, via e-mail 'scheurweghs@hq.nato.int'. First edition 1994 ISBN 92-845-0079-6 This is the latest in a series bringing together papers presented at the NATO colloquia organised by the NATO Economics Directorate and Office of Information and Press on economic issues in the former USSR and Central and East European countries. For further information please write to the Director, Office of Information and Press, 1110 Brussels, Belgium. The articles contained in this volume represent the views of the authors and do not necessarily reflect the official opinion or policy of member governments or NATO.