What's going on in the Czech Republic?

Conference organised by Central European Research and Development Unit

University of Glasgow, 14 March 1997

Where is the economic transformation going?

Martin Myant, myan-em0@paisley.ac.uk


The aim of this contribution is to give an overview of the current position of the Czech economy and the point reached in the transformation process. The starting point is an optimistic recognition that, in many respects, the long-term prospects for the Czech economy should be very good. It has a solid industrial base, a reasonably well-qualified labour force and an excellent location close to the economic heart of Europe. There were warnings several years ago from German trade union leaders that they could be facing a serious threat to jobs from a 'far east right on their doorstep'.

More recently, however, there have been growing worries in the Czech Republic that something may have gone seriously wrong. The country does not face an immediate economic disaster, at least not on the scale predicted by some of the government's strongest critics in the past. Nevertheless, it is suffering from a decline in the rate of economic growth, which has in fact never really got going, and from a balance of payments deficit which seems to be escalating into the danger zone.

Three tables give the key indicators, with the last one showing the position in manufacturing industry, which should be seen as the key to the country's long-term economic success. The `shock' of early 1991 led to a sharp drop in output. The optimistic assumption was that steady and accelerating recovery could be expected in the following years. The continuing decline into 1993 could be partly attributed to the effects of the break-up of Czechoslovakia and recovery did seem to be under way by 1995. Figures for 1996, unfortunately only for more broadly defined sectors, point to strong growth in only a very few branches with renewed, or continuing, deterioration across light industry.

Several explanations have been put forward for this disappointing performance. The most optimistic attributes the slowdown, and the failure of exports to grow as rapidly as imports, to recession in Germany. It could therefore be a temporary setback on the way to rapid and sustained growth. This is at best only a very partial explanation. A second emphasises the creeping revaluation of the currency, with inflation in the Czech Republic somewhat above the EU level: this undoubtedly has affected much of Czech manufacturing, but the explanation itself begs the further question of why Czech exporters are so vulnerable to a mild revaluation when the exchange rate is still substantially below the purchasing power parity level.

A third explanation concentrates on the effects of voucher privatisation which has left a complex and confusing ownership pattern and an emphasis on financial dealings and takeovers rather than productive investment. There is some evidence that could support this view, but effects are very difficult to quantify or to relate to specific failures. It is unclear, for example, that a different method of privatisation alone would have led to radically different results from particular sectors of industry.

This paper suggests a slightly different perspective, starting from the experience of Czech enterprises. The form of privatisation has generally not been particularly helpful, and sometimes has been harmful, but it is not the major culprit. In fact, it often appears as a diversion from the key issues of strategy formulation and implementation on which the future of the Czech economy depends.

Competitiveness in manufacturing

Available figures leave little doubt of a very substantial gap in labour productivity in manufacturing between the Czech Republic and the advanced market economies. It is under one third of the EU average across almost all branches. To some extent, this results from outdated equipment and poor organisation of work. However, even when those weaknesses have been overcome, Czech productivity still appears low. The key factor in modern manufacturing is frequently the perceived quality of the product and the possession of a well-known brand name. Thus fashionable clothing may be made by exactly the same process as a Czech-made garment, but still command a much higher price. Similarly, Czech firms may participate in major investment projects around the world, but if they are only subcontractors for another firm, then they will miss the most lucrative parts of the contract and, as a result, domestic productivity will appear lower. Some Czech vehicle manufacturers may have excellent products, but they need a back-up network and a solid reputation: without those they can only sell on a limited scale and with the help of an often very low price.

This could point to two broad alternatives for the future of the Czech economy, although not all sectors or firms need experience the same fate. It could become a genuinely competitive economy with incomes rivalling Western European levels, or it could be integrated into the EU economy essentially as a subcontractor for Western firms. Light industry could rely on what has been termed work-for-wages only. Engineering firms could produce the simpler components for big Western firms. This, however, could only support a low-wage economy. In fact, in view of the rapidly rising trade deficit, it is a perspective that could not be guaranteed to support the living standards that the population is now taking for granted. A dependence on this kind of integration into the Western European economy could be expected to lead to a cycle of balance of payments problems, devaluations and continuing inflation.

There is, of course, no universal prescription for moving from the `middle income' into the `high income' range of countries, but a few have clearly moved up the scale in the post-war years. In the Japanese case key factors included a choice of the most promising sectors and high levels of investment but, above all, success depended on the strategies of big firms. They typically undertook careful market research to find the markets for the future, evolved appropriate long-term strategies and were able to undertake investment on very substantial scales. They also cultivated close and stable links with a relatively small number of subcontractors. A completely different route emerged in Italy in which networks of small, and often very small, firms have won substantial shares in markets for light, consumer goods. They can counter low-wage competition, which has destroyed much of those industries in other advanced countries, by responsiveness to rapidly changing demand.

The Czech transformation - 'survival' phase

The question, then, is whether the Czech transformation is leading to the emergence of firms that can cooperate and link together to respond to changes, undertake investment when required and win ground in new markets, or whether the Czech firms will survive only as isolated units that effectively subordinate themselves to foreign companies.

The original philosophy behind the Czech transformation was that tough conditions and macro-economic stability would force enterprises to improve their efficiency and thereby make them more competitive. However, tight internal discipline and cost cutting is only one element of international competitiveness and often not the most important. Moreover, in practice, the adaptation process could not centre on improving efficiency or preparing for the long-term future. The conditions created in 1991 were often best met by strategies that amounted to a disruption of, or deviation from, what would appear as a sensible long-term approach. This meant that, for many firms, the whole adaptation process can be split into two distinct phases. The first was dominated entirely by a struggle for survival, while only in the second, subsequent, phase was there potential for implementing a lasting longer-term strategy.

The first, starting in January 1991, was initiated by three factors. The first was the collapse of demand in the old CMEA. Those Czech firms that continued exporting to the former Soviet Union through 1991 generally received no payment for the goods and were plunged into still deeper financial difficulties. The second was a drop in domestic demand, caused largely by government macro-economic policies. The third was a collapse of the distribution system, with both domestic and foreign trade organisations frequently ceasing to function altogether. The situation through 1991 was so serious that many Czech firms felt they were threatened with extinction and many even received clear hints from the government that they were on a notional hit list.

How, then, did firms react? Many responses were possible, but the following six provide a reasonable overview;

1. Very few had made any preparations at all. One that did was Desta of Decin, a firm making fork-lift trucks with significant sales in western Europe. It looked to a longer-term future, insisting on maintaining its own research potential, but also saw the need to evolve a crisis strategy to spread overheads and to maintain its labour force. The key was an expansion from 8 to 42 product types.

2. Much of light industry could react very quickly during 1991, with firms reactivating any contacts they had with western firms and arranging `work-for-wages' deals. This meant, for example, manufacturing to precisely-defined guidelines and using materials provided by a German company for immediate export. This was attractive to the Czech firm only because it provided work plus immediate and reliable cash payment. In fact, there was an element of absurdity here as the materials could be manufactured by Czech firms, but they were refusing to deliver to other Czech companies that could not be trusted to pay their bills. The important point, however, is that this kind of arrangement has limited long-term potential. Czech firms were soon complaining at how low the profits were, particularly with the creeping currency revaluation, and would much rather have been producing under their own brand names.

3. Some engineering firms followed a similar sub-contracting route and could do well with particular kinds of products. They were well placed for heavy objects that required a skilled and organised labour force but that did not require the most modern forms of technology or a strong research base. This could also keep alive the potential for finished products, should demand pick up again.

4. Some firms stuck with their old products, still believing that the good times would soon return. In some cases they had so much fixed capacity that an alternative would have been very difficult to find. Thus CKD, the giant engineering combine in Prague, had shortly beforehand built new capacity capable of turning out 1,800 trams per annum. 950 were produced in 1989, but total world sales in the early 1990s were only around 2,000 per annum. By 1991 CKD's output had fallen to 13. The firm survived thanks to some state help in handling debts and thanks to better results from sub-contracted work especially in other parts of the combine.

In some other cases managements simply could not believe that their product was not bound to sell in the end. An example is the Tatra lorry, an exceptionally sturdy vehicle ideal for construction work in remote areas with extreme weather conditions. Around 15,000 were being produced annually in the 1980s, but sales effectively disappeared as construction slowed in the Soviet oil industry.

5. Some firms actually experienced broadly manageable falls in demand. Parts of the food and drink industries survived reasonably comfortably. A number of capital equipment producers had orders to complete, particularly in the nuclear power programme, or won orders for the modernisation that was taking place in sectors such as steel or the motor industry.

6. A final 'strategy', discussed further below, was to link up with a foreign partner. That effectively meant by-passing the `survival' phase altogether.

Czech transformation - 'recovery' phase

For the most part this `survival' phase contributed very little for the long-term future of enterprises. It had to be survived and firms generally have survived. They have been helped by a number of factors which could be seen as countering the worst effects of the over-zealous restrictive policies of 1991;

1. The government has taken a number of steps to help enterprises overcome serious financial difficulties. This, however, applies most clearly to large and politically powerful engineering firms. Those in light industry feel they have been left to sink.

2. Firms have struggled towards rebuilding distribution networks. Capital goods producers have frequently established new international contacts and benefited from some pro-export measures introduced by the government, albeit rather reluctantly.

3. Traditional domestic, and to a lesser extent eastern European, demand has picked up with some firms undertaking investment and public bodies looking at renewing transport and energy systems.

How have firms responded?

1. Some have been able to develop a perspective from their past activities, from new international contacts or out of their `survival' strategies;

* By the end of 1993 Desta was expanding its service network across Germany and planning to invest $5 million in a plant in China to assemble ultimately 10,000 light goods vehicles annually. The model, which uses a Volkswagen engine, had been developed initially to keep the parent plant busy.

*Skoda-Plzen, a huge combine with now slightly under 20,000 employees excluding those in a number of partly-owned subsidiaries, has started producing parts for leading foreign firms in electricity generation while also winning big contracts for projects in developing countries. It has started assembling and selling trolley-buses in the USA and is deeply involved in China.

* ZPS, a machine-tool firm based in Zlin, has found a solid place in the US market. Like the other examples cited here, it is taking advantage of possibilities opened up by the post-1989 changes. Again like the others, it is not operating at the peak of technology. It relies on Japanese or US electronics for its machine tools. In general, however, the best of the Czech engineering firms are frequently playing a dual role, operating as subcontractors to western firms while also making some effort to compete at least on the edges of the world stage.

2. Light industry has generally fared worse. Firms in those sectors have seen their home markets undermined by cheap imports from the far east, while they cannot compete on quality with western goods. As a result, they have very limited financial resources for new investment. In many cases they live in hope of finding a market for their traditional `solid' products, but that market, squeezed somewhere between low price and high quality, may simply not exist. Some have tried to overcome problems of falling demand by investing in Russia or the Ukraine, but the risks have proved to be very high and the resources available for investment are inadequate for a serious venture. Not surprisingly, many managers in these sectors are deeply pessimistic about the chances of their industry's survival without devaluation and possibly also specific measures to restrict imports.

3. Some firms have stuck to a minimal change in product and where demand has not picked up significantly they face continually escalating debts. They are, however, kept alive by hope. Thus the Tatra lorry firm has been very slow to try new products, insisting that it has a unique product that must eventually sell. The problem for this and other similar firms is that escalating debts make it impossible to raise bank loans for investment in new products or to interest a foreign partner in a link-up. The only solutions are ultimately liquidation or financial restructuring and takeover by another Czech firm. Thus these enterprises become parts in a small number of burgeoning industrial empires with no certainty that that offers a satisfactory long-term solution. In effect, this incorporation into one of the big combines, such as CKD or Skoda-Plzen, can mean a reprieve during which the `survival' period can be prolonged in the hope that demand will pick up again for the traditional products.

Foreigners to the rescue?

The original conception of Czech privatisation embodied a very substantial role for foreign ownership. Enterprise managements frequently sought a foreign `partner' who could solve their financial, marketing and strategy-formulation difficulties. In some cases this has been extremely successful, but the overall results have been disappointing. A significant body of shares was frequently held back in the voucher programmes in the hope of finding a suitable foreign partner at some point in the future. These are now frequently sold off to existing Czech firms. Overall, foreign ownership has brought substantial benefits to fewer branches of manufacturing than hoped. The situation can be summarised around three points;

1. A foreign partner is vital where substantial investment is required or where access to mass consumer markets is sought. It has brought modernisation to the Škoda car producer and to individual firms across much of Czech industry. The difference can be quite dramatic even in light industry or heavy capital goods where firms have survived with low levels of investment. Thus in the garment industry it means an end to the strategies geared purely to survival, a level of investment per employee well above the industry's average, and a clear focus on dominating a part of the domestic market. In heavy engineering it can mean the necessary investment to match western European productivity levels, thereby removing the dependence on low wages.

2. Nevertheless, reliable foreign partners have no interest in much of Czech industry. In light industry they frequently prefer sub-contracting arrangements that in practice give them a position of greater power. In many cases the aims and potential of those that express an interest are unclear and some that did buy into Czech firms have subsequently pulled out, or even suffered bankruptcy themselves.

3. The crucial cases for destroying exaggerated hopes in foreign takeovers came in heavy engineering. Attempts to find partners failed around Czech concerns that they would secure a future only for particular parts of a combine. Škoda-Plze_ effectively rejected a takeover attempt by Siemens that would have left much of the combine at risk and has preferred cooperation arrangements with a number of foreign companies. It was able to push the government into backing a financial restructuring package and has been able to find enough new markets for enough of its products to stabilise its accounts. It is now building an industrial empire by taking over failing Czech firms, but it has limited resources for investment and remains heavily dependent on sub-contracted manufacture of relatively simple engineering products. Its position is reasonably secure - these kind of products are not threatened by imports from the far east - but the scope for expansion is limited. Moreover, the failure to conquer the most sophisticated part of markets means that success still depends on maintaining low relative wages.


The balance of payments situation, set alongside the figures showing the performance of different branches of manufacturing, suggest that the Czech economy faces serious difficulties. It needs to improve manufacturing performance if current living standards are to be supported, let alone raised. The position can be summarised around three points;

1. The only really clear success is the motor industry. This, however, is threatened by dependence on Volkswagen which may choose to expand the volume of imported, rather than Czech-made, components. In fact, many Czech component manufacturers are threatened by Volkswagen's strategy of finding a single source for many components. If the Czech firms could free themselves from their financial constraints, they could hope to invest and compete for lucrative contracts for the whole Volkswagen group.

2. A number of firms across most branches face desperate problems and light industry as a whole seems very precariously placed. Italian experience clearly demonstrates that it is possible to compete against production from low-wage countries. There is, however, no sign of a Czech strategy emerging that would make this possible.

3. A number of Czech engineering firms have gone beyond the `survival' stage, won new markets and introduced new products. They are, however, still struggling to match the level of their strongest rivals. For many, the best hope would be a return of stability and growth in traditional markets so that they can sell their traditional products again.

The final conclusion, then, is neither totally pessimistic nor fully optimistic. The policies of the Czech government have enabled much of manufacturing to survive, but there has been no effort to seek policies that would enable it to prosper.

Martin Myant,

Department of Accounting, Economics and Languages,

University of Paisley,