This chapter considers the stock markets that have emerged during the transition from centrally planned to market economies. The transition occurred over the last 20 years and covered a wide geographical area spreading from Central and Eastern Europe (CEE) through Central Asia to China and Vietnam. A complete description of the different paths of transition in each individual country would be too voluminous for this forum. Instead, this chapter concentrates on the common features and most important differences in the development of stock markets in the more than 30 countries that underwent transition.
The following analysis identifies the most important factors that contributed to the success or failure of individual stock markets that were re-established from a fresh start in the early 1990s.
2. Historical background
During the pre-Communist period, practically all countries described below had functioning commercial exchanges that dealt both in commodities and securities. Most exchanges were established as formal institutions in the 19th century (St.Petersburg 1816, Warsaw 1817, Moscow 1839, Budapest 1864, Prague 1872, Bucharest 1882). They provided facilities for trading government loans, corporate bonds and shares, promissory notes and other instruments. The proportion of traded instruments differed across markets. For example, in Warsaw, securities trading clearly dominated, but in Moscow, securities trading was small in comparison to commodity trading.
In 1912, 275 Russian companies were listed at the St Petersburg Exchange, with one third of them cross-listed in Paris, London or Brussels. At the Budapest Commodity and Stock Exchange at the time, 177 companies were listed, many of which also traded in Vienna. The Warsaw Exchange listed 130 companies and 82 bond issues in 1938, a number of which also listed on western exchanges.
The operations of exchanges in the CEE were, in most cases, interrupted during the World Wars and finally terminated when the communist political system was installed (Russia 1917, Central Europe 1945). In the following decades of central planning, the human experience in stock markets was largely lost. However, the recorded rules and practices of exchanges were not forgotten. When political conditions changed after 1989, memories of local stock exchanges influenced the transitions to market economies.
3. Privatization strategies as drivers of capital markets
Political events of the 1980s triggered the process of transition in Central and Eastern Europe. Among the more important movements and events were the Solidarity (Solidarnosc) movement in Poland, the Russian perestroika, the June 1989 elections in Poland, and the tearing down of the Berlin Wall later that year. During the next few years the governments and political systems changed dramatically in most of these countries.
Concerning the economic dimension, the transitions were based on liberalization, i.e., the removal of the commands and restrictions typical of centrally planned economies. Structural reforms included also privatization which involved the sale or distribution of state-owned enterprises as well as the establishment of new private companies.
In many countries ‒ particularly those in Central and Eastern Europe (CEE) ‒ speed was an essential element of transition. Privatization, being always politically controversial, was carried out relatively quickly to reach a point of no return to the previous regime. In the early 1990s, the scope of privatization carried out in CEE was unprecedented in economic history. Privatization transformed thousands of state-owned enterprises (in Russia alone more than 30,000). The public debate during 1989-91 concentrated on how to privatize as rapidly as possible large numbers of companies, while taking into account shortages of available capital.
Examples of previous privatizations carried out in some Western countries in the late 1980s were available, but these privatizations (for example, British Telecom and British Steel in the UK and Paribas in France) were more similar to the IPOs of individual companies, rather than privatization of whole economies.
The challenge in CEE was much bigger: privatization of whole industries and economies. Case-by-case offerings would take dozens of years to carry out the privatization process. Hence, the idea of mass privatization through coupons or vouchers distributed among citizens. The concept of coupon privatization, discussed in Poland in the late 1980s, was effectively introduced in Czechoslovakia during the early 1990s. It was followed ‒ with many modifications ‒ in Russia, Ukraine, Romania, Bulgaria and other countries. Mass privatization was adopted, to a limited extent, in Poland and not at all in Hungary. Those countries sold most of their large state-owned enterprises either through public offerings or through direct sales to strategic ‒ mainly foreign ‒ investors.
The adopted privatization strategies (coupon privatization, employee ownership, IPOs, sale to strategic investors) were crucial factors in determining the future shape of securities markets in the transitioning economies. The framework of the securities markets that emerged in each country was to a large extent a by-product of the privatization method.
In the debate of the early 1990s, coupon privatization was considered to be most conducive to the development of domestic stock markets. Theoretically, before the process started, nobody could deny the best opportunities for the securities markets would arise when thousands of companies were readily available to millions of potential investors. The critical mass of liquidity would be easily achieved. In contrast, employee ownership was not considered as economically efficient and conducive to the development of public markets. Although politically popular, employee ownership was implemented mainly in the former Yugoslavia.
Privatization through IPOs was seen as very positive for the market, but too slow given the large volume of the planned privatizations. The direct sale of privatized assets to strategic, mostly foreign, investors seemed to be most effective from the productivity point of view. Future developments proved this point. However, it was the politically least popular method of privatization. Unfortunately, the positive externality effects on the local securities markets proved to be very limited. International strategic owners in most, but not all, cases are not interested in local public listings of their affiliated companies. This is particularly true, if the local markets are in early stages of development, but already impose additional local reporting and compliance costs.
4. Mass privatization markets
In those countries that opted for coupon privatization, securities markets were seen as mechanism for secondary trading of the coupons and/or shares in privatized companies. In Czechoslovakia, the nationwide RMS system ‒ used initially for coupon privatization ‒ was subsequently transformed into a secondary trading platform. It started with periodic auctions and then moved later to continuous trading. More than 1,600 companies were registered for trading on RMS in 1993. Registration should not be understood as listing, as no disclosure and reporting requirements were imposed. In the early 1990s, thousands of newly privatized companies in CEE were not ready for disclosure standards similar to those used in mature markets. When speed and scale of transformation were essential, standards had to be compromised.
Regulation of the post-voucher-privatization markets was deliberately light. The slow process of regulation was not accidental. The idea behind light regulation and supervision of securities markets was to facilitate the concentration of ownership. Less informed investors were expected to sell their shares more readily and at lower prices to potential strategic investors. In Russia, this phase of development (until 1998) was nicknamed “the vacuum-cleaner market”.
When millions of accidental, first-time investors became ‒ free of charge ‒ owners of securities, most of them wanted to sell out as soon as possible. Hence, all sorts of “investment funds” became popular. In Czechoslovakia, one such fund very quickly accumulated two thirds of distributed vouchers. In non-regulated environments, pyramid schemes spread quickly (Russia, Romania, Albania), destroying investor confidence and hampering the development of regulated markets. The price paid for mass and quick privatization, with very low standards of disclosure and reporting, was high.
Only a small fraction of people who received privatization vouchers became individual shareholders in the following years. Mass privatization ‒ which initially looked very promising from an investor’s perspective ‒ has not produced a shareholder society. The markets originating from coupon privatization turned out to be transitional and have not transformed themselves into significant regulated markets. In Czech Republic, the RMS market accounts for only 2% of total equity trading in the country.
Equally transitional was the development of unregulated or loosely regulated “stock and commodity exchanges” in CEE. Liberalization and deregulation of economic activity in the early 1990s produced a legal environment where an enterprise called “commodity and stock exchange” could be easily established without any licensing process. This was in line with simplified liberal ideology of removing all “communist” restrictions of economic activity. The idea of free markets was initially understood in a literary sense. In Poland, before the first securities law was introduced in March 1991, more than 60 “commodity and stock exchanges” were established during 1989-90. The corresponding figure for Russia was more than 600 establishments. Most of those “exchanges” dealt with all sorts of wholesale goods and some early issues of securities, including shares in the exchanges themselves. The period of spontaneous, unlicensed activity in securities markets was short lived in Poland, ending effectively in 1991. In other countries, some loosely regulated exchanges operated throughout 1990s. Practically, all of them subsequently disappeared.
5. Regulated securities exchanges in the 1990s
In the early 1990s, many governments and other institutions in the CEE regarded the period of spontaneous activity as detrimental to market confidence. Governments (Poland), central banks (Czechoslovakia, Russia) and scientific institutes (Hungary) actively supported the initiatives to establish a modern infrastructure for the emerging securities markets. They assumed that securities markets played much more important role than just enablers of privatization. The markets were seen as a mechanism for mobilizing savings, allocating capital, providing price discovery and monitoring listed companies. This required the establishment of a modern infrastructure, consisting of a stock exchange, a central securities depository, licensed brokers and, last but not least, a regulator with adequate authority.
In each country, the extent to which the historical tradition of local stock markets could be used in rebuilding the necessary infrastructure was a fundamental decision. As indicated in the introduction to this chapter, the history of national stock exchanges in CEE had been broken for too long during the communist period to be operationally continued in the 1990s. Despite some efforts (Budapest, Prague, Warsaw), local expertise was not available.
The necessary know-how to assist local initiatives came from abroad. It originated from individual stock exchanges (SBF Paris Bourse, Deutsche Börse, NYSE, NASDAQ), professional federations (FIBV/WFE, FESE), regulators (US SEC, French COB), securities depositories as well as institutions like US AID, British Know-how Fund, German FBF, Canadian government, the IFC, World Bank and others.
If a securities market is to operate in a professional manner, it has to be organized in every detail. The post-communist countries had a unique opportunity to organize their markets from scratch. There were no established institutions, practices or vested interests. If a strong leadership and support of interested parties were provided, the market infrastructure could be established in a proper way from the beginning. In practice, however, many compromises had to be introduced.
The first three regulated stock exchanges in transition economies were those in Ljubljana in March 1990, followed by Budapest in June 1990 and Warsaw in April 1991. In Slovenia and Hungary, the financial community set up the exchanges, but in Poland, the government took the initiative. It took only six months for Poland to build the necessary infrastructure, including the Warsaw Stock Exchange, Central Securities Depository and Securities Commission. The Polish team was aided by the French experts of SBF Paris Bourse and Sicovam, as well as regulation experts from the US SEC. The simple market infrastructure was based on modern principles of electronic call auction trading, paperless central depository clearing and settlement, and high disclosure standards. Brokers had to be licensed by the Securities Commission, both as firms and as individuals. The first IPOs, which took place in Poland in December 1990, included prospectuses comparable with Western standards. The same can be said about the first Hungarian IPO (Ibusz travel agency) in early 1990. Poland, Hungary and Slovenia, the early developers of regulated stock markets in CEE, decided to build, right from the beginning, an institutional framework for their markets based on modern standards and practices. The established infrastructure was simple, but covered all the basic processes of a stock market.
Creating properly regulated exchanges and other market institutions was more difficult in other countries. In the Czech Republic, the Prague Stock Exchange (PSE), which started trading in 1993, was sometimes viewed as an unwanted child that the government did not support. Competing from the beginning with the RMS over-the-counter market, the PSE had to admit for trading more than 1,600 privatized companies, most of which were gradually delisted. The conflict between the PSE and RMS resulted in unnecessary fragmentation of the market and the failure to establish a single settlement and depository system in Czech Republic.
During the transformation, it soon became evident that establishing a stock exchange was not as difficult an aspect of building the market infrastructure as was initially thought. Central depository for securities, and particularly an independent and active regulatory body, often turned out to be missing infrastructural components.
Whereas in Poland, Hungary, Slovenia, Baltic countries, the entire market infrastructure was build relatively quickly, in other countries the process was much longer and controversial. In Russia, a Securities and Exchange Commission, having been established in 1992, only became active in 1996. In Czech Republic it was established as late as in 1998. Loose regulation and supervision in many countries was motivated by vested interests, rather than lack of expertise. The economic interests of oligarchs, accumulating capital during privatization, were opposite to those of small shareholders, whose interests were best served by the principles of transparency and minority protection. Not all stakeholders equally appreciated tight regulation. Politicized enforcement and discretionary decisions brought disillusionment and loss of trust to public institutions and financial firms. In a number of countries, low confidence in stock market was strengthened by banking crises (Russia, Bulgaria, Romania) or general political instability (Ukraine).
The first decade of economic and political transition in CEE brought the establishment of basic stock market infrastructure in most countries of the region. The level of development was highly uneven. Whereas Hungary and Poland were most advanced, successfully initiating derivatives markets in the late 1990s, other countries like Ukraine and Bulgaria still struggled with early problems of assuring ownership rights and bringing securities trading to regulated markets. The processes of building national markets proceeded largely autonomously, almost unaffected by consolidation trends in Western Europe during the 1990s.
6. The long march towards maturity
After 2000, development patterns in the CEE markets, based on different principles, remained diverse. The most distinguishing factor was accession to the European Union (EU), which included 10 countries: Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia, Hungary, Slovenia, Romania and Bulgaria in 2004. A few years before the accession, the markets in those countries went through the process of harmonization of national regulations in accordance with EU rules and practices.
As a result, national regulations and structures of the 10 new members became closer to each other and similar to Western Europe, but different from the rest of the CEE region. In each of the accession countries, market forces primarily, and regulation to a lesser extent, brought about a single, dominant stock exchange. The initial competition among trading venues practically disappeared.
The post-accession period, which coincided with prosperity in the world economy, brought the CEE markets to much higher levels of capitalization, turnover and general development of local markets. The beneficial effects of EU accession were not spread evenly among stock markets of the region, however. In Poland, rising trading volumes and valuations triggered a wave of new listings, averaging more than 40 companies annually during 2004-2008, putting the Warsaw Stock Exchange among the top three European exchanges in this category. During the same period, the number of listed companies in Budapest and Prague remained rather stagnant, despite much higher valuations and trading volumes.
In Poland, an important change was observed in the behavior of listed companies. Whereas in the 1990s, companies were content with public listing, during the next decade they succeeded in raising new capital, usually through secondary public offerings. In terms of the value of public offerings, Russia has become the undisputed leader in CEE. Macroeconomic and political stability in the country in the early 2000s sharply increased the market capitalization of listed companies, particularly those owning natural resources. MiCEX, originally a platform for interbank trading, became the dominant trading venue in Russia, with turnover close to that of the leading exchanges in Europe. At the same time, neighboring Ukraine still faces the problems of inadequate regulation, decentralized infrastructure, resulting in dispersed, mainly OTC, trading in equities.
The first decade of economic transformation in 1990s created individual national stock markets in CEE. Their institutional development was not influenced by the worldwide trends of demutualization and consolidation. The post-2000 decade brought significant change. Many smaller markets started looking for partners that were able and willing to increase their level of activity. Two exchanges: Vienna and OMX Nordic were particularly active in the consolidation process. OMX succeeded in taking over stock exchanges in Lithuania, Latvia and Estonia, while Vienna acquired dominant positions in the stock exchanges of Hungary, Slovenia and Czech Republic. Thus, during 2004-2008, six out of ten exchanges from the accession countries joined larger exchange networks.
The Warsaw Stock Exchange, the biggest in the region, did not participate in the consolidation process on either side. It plans its own IPO and listing in 2010, striving successfully to attract more remote members and foreign listings.
During the last 20 years, many observers predicted that the biggest and most liquid companies of the CEE region would move their primary listings to bigger European or American financial centers. By and large, this migration has not happened. Companies from Central Europe trade mainly in their home markets. International investors find it easy to trade using either local or remote brokers who can access the main pool of liquidity. The situation is different with regard to Ukraine, Kazakhstan and, until very recently, Russia. Big companies from those countries, particularly those launching IPOs, chose to list in world financial centers, first of all in London, but also in New York and Frankfurt. A number of smaller issuers registered their secondary listings in Warsaw. ?
7. Centrally managed capital markets in China and Vietnam
The rise of stock exchanges in the transition economies of China and Vietnam lies in sharp contrast to the CEE experience. In Europe, a stock market, its institutions and mechanisms, were seen to be in total opposition to central planning and the political system supporting it. There a stock exchange had symbolic meaning as the ultimate expression of a free market, capitalist economy. It was, therefore, almost unthinkable in the CEE that a genuine stock market, particularly in equities, could be tolerated in centrally planned economy. Before the fall of the Berlin Wall in 1989, in the CEE region, a stock exchange was an academic and historical concept.
In contrast, in China, the stock exchanges in Shanghai and Shenzhen were established at the end of 1990 with the toleration and support of the Communist Party. It was seen as yet another step in the ongoing liberalization of the Chinese economy, which had begun in the late 1970s. In contrast to CEE, the change of ownership of Chinese state owned enterprises (SOEs) was meant to be limited and gradual. Instead of privatization, the concept of “corporatization” was introduced, later called “equalization” in Vietnam.
The development of these stock markets followed a top-down approach. The exchanges were not only established and supervised, but also indirectly managed by the government. According to a central plan, a stock market was supposed to raise new money for SOEs, monitor performance, and improve capital allocation and efficiency of listed companies. To retain state control, only a minority of shares in Chinese companies, usually 35%, were tradable. The majority was to be maintained by the State and other SOEs. A separate class of shares was available to foreigners. The market was regulated and supervised by the Chinese Securities Regulatory Commission, set up in 1992.
Raising new money required investor interest. Traditionally very high savings ratios, coupled with willingness to take risks, provided good prospects on the demand side. Idle capital, kept in mattresses, was to be mobilized to develop listed companies. The initial response of Chinese investors was very encouraging. During 1991, 370,000 investment accounts were opened. Interest was so intense that in October 1992, a shortage of subscription certificates triggered investor riots in Shenzhen.
In 2009, after two decades of transition, the Chinese stock market looks very impressive in more ways than just absolute size. From the operational point of view, the market infrastructure proved robust and resilient during the high volatility in 2008-09. The listed companies, no longer exclusively majority state-owned, are able to raise seemingly unlimited capital in the domestic market. In raising capital, Chinese corporations have been far more successful that the CEE listed companies. With nearly 100 million investment accounts in China, it is not surprising that the stock exchanges in Hong Kong, Shanghai and Shenzhen were the world’s top three exchanges in terms of aggregate IPO value in 2009. The functioning of the market is still policy-based. The government has used a number of unorthodox policy measures related to IPOs, such as regional quotas, recommended price ranges or temporal bans (October 2008-June 2009).
In Vietnam, the role of the state in the development of the stock market was similar to that in China. The process of “equalization” proceeded “under the Party resolution and Government’s action plan to restructure, reform, develop and raise efficiency of State Owned Enterprises [..]”. Public trading in securities started 10 years later than in China. A securities trading centre began to operate in Ho Chi Minh City in 2000, followed by Hanoi in 2005. Both centers were renamed as stock exchanges in 2007. The Vietnamese market, although actively trading over 200 securities, is still in the early phase of development. It still is developing its settlement, depository, regulatory, and supervisory facilities. A complicating challenge in Vietnam relates to the government’s double role as majority owner and regulator of listed companies.
Even a cursory review of the Chinese and Vietnamese markets shows that their emergence and pattern of development are far from the traditional, spontaneous origins of the European and American exchanges. On the other hand, their day-to day operations, market practices, investor behavior are not different from those observed in other world markets. It seems that stock exchanges throughout the world, while performing similar functions, will always have many local, distinctive features.
8. Twenty years after: results and challenges
Starting from scratch in 1989, the emerging markets of formerly centrally planned economies developed rapidly, though unevenly, over the next 20 years. To assess their current position, comparable markets in emerging and mature economies should be analyzed. Both absolute and relative measures will be taken into account.
In terms of absolute size, the undisputed leader is China (Shanghai and Shenzhen Stock Exchanges), followed by Russia (MiCEX, RTS). Despite their immature regulatory and market infrastructures, both markets rank high not only in absolute terms but also relative to their GDP. The sheer size and liquidity of many Chinese and Russian companies has attracted international investors who tolerate many regulatory issues in the domestic market environment.
Among medium-size markets, Warsaw, Budapest and Prague have achieved the highest positions in terms of stock market significance. If we compare market capitalization and turnover in equities to GDP, they are still below, but not far from, comparable mature European markets.
A major weakness of Prague and Budapest is the very high level of concentration of trading in the top five companies. Warsaw, on the other hand, is unique in attracting an impressive number of new listings, both in its main market and its ‘New Connect’ alternative trading platform.
In some other CEE markets, statistical figures, particularly those relating to the number of listed companies, should be interpreted with caution. At many exchanges, the quoted companies have not passed the listing process and do not provide periodic and current disclosure. Such figures should always be compared with corresponding data on turnover and market capitalization.
The remaining markets of CEE, even those of Ukraine and Romania are small, both in absolute and relative terms. When we compare stock market turnover with GDP of those countries, the corresponding figures are below 5%, i.e. 3-4 times lower than those of Budapest, Prague and Warsaw.
The stock markets that emerged from the centrally planned economies are very different. In terms of size, the capitalization of the Shanghai Stock Exchange is 1,000 times that of the Banja Luka in Montenegro. Even in the neighboring countries of Poland, Slovakia and Belarus, the differences in size and maturity are enormous.
In qualitative terms, the contribution of domestic stock exchanges to the transition and economic development their economics is significant, but not crucial. Almost from the very beginning, stock exchanges provided a price-discovery mechanism – in stark contrast with previous bureaucratic procedures. The valuations obtained in the listing process were subsequently used as benchmarks for other listed and unlisted companies. Stock exchanges and market authorities have initiated public disclosure of audited financial statements, providing standards of transparency previously unknown in centrally planned economies. Even in China and Vietnam, where markets are more centrally managed than elsewhere, the rule of law has become more widely accepted.
The most important, textbook contribution of stock markets is in providing an alternative source of capital to listed companies. In this respect, very few domestic markets have been successful, with China and Poland as notable examples. Raising capital has become more international, with the world financial centers taking the lead. The most recent developments have shown, however, that Shanghai and Moscow are becoming strong contenders in this field.
Are the many advantages of local domestic markets sufficient to allow them to survive? Integration and consolidation in the financial sector has been occurring in the more developed countries for almost two decades. As noted above, it has already involved the six national exchanges in CEE. Certain functions of a stock exchange, and particularly those of clearing and settlement, are subject to economies of scale, which favors consolidation. Some other services can be provided from abroad. Nevertheless, certain functions like searching for local companies suitable for listing, market surveillance, investor education, and building an investor community are better managed locally since they depend critically on knowledge of the local language, customs, local daily media coverage, and local networking. These observations do not imply that domestic exchanges cannot be owned by foreign entities or should not be parts of bigger structures. There are many ways to create synergies and economies of scale.
In my opinion, domestic exchanges in these markets will survive, although not necessarily with all their present functions or as independent entities. The evolution of markets has never been unidirectional. This is clearly seen in the post-MiFID market structure in Europe, which is, contrary to initial expectations, more fragmented and less transparent than before. Keeping this in mind, and taking into account the growth potential in the region, one can optimistically look into the next 20 years. I am confident that by the end of that period the common denominator of “stock markets of formerly centrally planned economies” will disappear altogether.
9. Conclusions: requirements for a successful securities market
The economic transition to the market economy started in over 30 countries almost simultaneously at the beginning of the 1990s. Having reviewed their relative performance, some crucial success factors can be identified. The most important of these factors seems to be a long-term strategy, based on high standards of organization and regulation of the markets. The strategy should be comprehensive, covering the total range of securities markets. A major deficiency in the area of regulation or post-trading activities can disrupt a smooth transition.
Investor confidence accompanied by an appetite for risk is the most valuable asset. The emphasis on speed and quantity, however politically justified, has not produced quality in the long run. The transformation of state owned enterprises to become more compliant with listing standards and investor needs for governance structures has taken longer than initially expected. Moreover, initial conditions and, more specifically, historical traditions of stock exchanges have turned out to be positive but not decisive. Finally, the potential size of the market and the high-rate of economic growth of a country have contributed positively to the overall development of the capital markets.
Relative stability and the rule of law are also important factors in creating securities markets. Extreme free-market liberalism or a laissez-faire approach produced unregulated securities markets, but did not prove to be the right recipe for success, either at the very early or later stages of market development. The lessons learned in the transition process have universal value: success in establishing new exchanges and the accompanying infrastructure is achievable but not guaranteed. Finally, let us hope that the exercise of rebuilding securities markets after a long period of non-existence does not arise again.
About Wieslaw Rozlucki
Wieslaw Rozlucki, PhD graduated from the Foreign Trade Faculty of the Warsaw School of Economics in 1970. He has a PhD in economic geography. Between 1973 and 1989, he worked as a researcher at the Polish Academy of Sciences. During 1979-1980 he studied, as a British Council scholar, at the London School of Economics.
Between 1991 and 2006, during five terms, Dr. Rozlucki was the President of the Management Board of the Warsaw Stock Exchange. He was also the chairman of the Supervisory Board of the National Depository for Securities and a member of the governing bodies of the World Federation of Exchanges (1994-2006) and the Federation of European Securities Exchanges.
Dr. Rozlucki is a member of supervisory boards of large listed companies including Telekomunikacja Polska, TVN, BPH Bank. He runs a strategic and financial consultancy, acting as a senior adviser to Rothschild and Warburg Pincus International.