Commentary: Now, Can The Czechs Rise To The Reform Challenge?

Czech Prime Minister Vaclav Klaus has departed the world stage in disgrace. At midnight on Nov. 29, after half his Cabinet had resigned, he stepped down over a party funding scandal. But the scandal was just a pretext for his Civic Democratic Party and its junior partners to force out a leader whose time had passed. Rigid and unwilling to countenance criticism, Klaus had alienated colleagues and voters alike.

It's a sad exit for a Prime Minister who began his four-and-a-half year tenure as a champion of free-market capitalism. But Klaus is no martyr. True, he navigated a Central European economy through its postcommunist transition. But unlike Polish Finance Minister Leszek Balcerowicz, Klaus didn't get crushed by sticking to his beliefs. Balcerowicz enforced painful economic reforms that got Poland on track beginning in 1990. Vilified for years, he is now again Poland's Finance Minister and a hero. Although Klaus's supporters say he is being similarly punished for a vision that required tough measures, nothing could be further from the truth.

BUREAUCRATS. In fact, Klaus talked a good free-market game while sidestepping the decisions that would have forced Czech companies to become more competitive. His privatization program, which transferred ownership of companies to citizens via vouchers, left the same inexperienced bureaucrats in the corner offices. To keep unemployment down, they failed to restructure. Klaus also coddled the state-owned banking system despite its mounting losses, as the banks lent money to failing companies. So foreign capital has long favored Hungary and is streaming into Poland.

Klaus's legacy--an economic Potemkin village--means that his successors will have an even tougher time turning the Czech Republic into a more efficient economy. Investors have grown so cynical that they are not even looking for bargains, despite a 4%-plus drop in the stock market on Dec. 1 to a 22-month low. "I don't know how many times I've hoped for change in the Czech Republic and been disappointed," says Luca Parmeggiani, portfolio manager for $500 million in Eastern European funds for Zurich-based Vontobel Asset Management. He has had no money invested in Prague for several months.

Indeed, the Czech financial markets are another place where Klaus's free-market rhetoric went haywire. Murky, unregulated transactions scared off investors. Bank-owned investment funds elevated insider trading to a fine art. "Klaus thought the invisible hand meant the ethereal hand," says David Aserkoff, emerging European equity strategist for Credit Suisse First Boston in London. "His mistake was in not realizing that a free market must be well-regulated--not unregulated."

MORE SLEAZE. Most likely, Klaus counted on a second term to finish the job. But voters never gave him the chance, handing him a tenuous minority coalition in elections last June. Now, long-debated steps to introduce transparency in the markets lack teeth. A new securities exchange commission, for example, will be funded by the state, raising questions about its independence from political interference.

The danger now is that crucial economic reforms will get bogged down in politics. More sleaze is likely to emerge in coming weeks, entangling other members of the ruling coalition. The best scenario would be for President Vaclav Havel, charged with inviting a candidate to form a government, to call on a nonpolitical technocrat, such as respected central banker Josef Tosovsky, to take charge.

Even such a solution could prove fragile, leading to early elections next year. With Social Democratic Party leader Milos Zeman rapidly ascending in popularity polls, a quick vote could produce a socialist government and toss the economy into a deeper quagmire. As Poland and Hungary have proved, a leftist government in Central Europe is not necessarily a terrible thing. But last month, the Social Democrats said bank privatization threatened future prosperity, and some party members have said they want to reexamine privatization deals of the past five years.

Klaus's departure is a good first step toward helping the Czech Republic live up to its potential. But only if it is followed by a government committed to reform in word and deed.

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