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A Boiling Stew of Trouble

In this country we think there’s something special about the countries between the former Soviet Union and Western Europe—the old Warsaw Pact countries, the buffer of land and people that Stalin snatched to protect himself from the rapacious Europeans, who twice in history had attacked and ridden roughshod over the Russian motherland.

We seem to think these are emerging countries with a difference. Whereas in Africa and many parts of Asia, our press reasons, the population is only recently educated enough to be aware of the industrial importance of Western Civilization, these countries—such as Hungary, Poland, Czechoslovakia, and Yugoslavia—are a part of the grand tradition of European civilization, and now that they are liberated from the yoke of Communism, they are buds ready to blossom under the nurturing rain of capitalism. As if it were the next frontier, American MBAs have winged their way to this part of the world since the Berlin Wall was torn down, eager to make their fortunes.

Take a look at Poland, the largest of these countries, with about 40-million people in an area the size of New Mexico, and from an economic and political view, the healthiest.

Its government is a parliamentary democracy; its literacy rate, 99%; and its population almost all Polish. Along with China, Argentina, South Africa and eight other countries, the U. S. government has billed Poland as a "Big Emerging Market." Poland claims its imports have increased from $8 billion in 1990 to $19 billion in 1993, and that with expected increases in the United States’ share of Poland’s import market, U. S. exports to Poland should grow from $912 million for 1993 to $7 billion by 2000.

After the fall of the Berlin wall, the Polish economy underwent a profound transformation as the government introduced a free-market system to replace the 40 years of centrally planned communist economy. This "shock therapy," introduced in 1990, liberalized prices, "stabilized" the currency, and privatized most small enterprises, bringing to an end the chronic shortages of consumer goods. In 1996 Poland was admitted into the OECD and now hopes to join the European Union sometime after the year 2000. The government claims it’s committed to continuing market reform, providing the legal, political, and economic infrastructure for a thriving market economy. Combine this with strong U.S.-Poland ties, and some investors have reasoned Poland should be a fast-growing, stable economy in which U. S. businesses might invest.

However, amid such sunny news, there are dark clouds. Compare the number of our neighbors with those of Poland; we have two, whereas they have seven—Germany, Czech Republic, Slovakia, Ukraine, Belarus, Lithuania, and Russia—three-and-a-half-times more opportunities for strife in a region notorious for its eagerness to mix it up. It’s ironic that capitalism, that mode of economic organization Marx felt was careless about raping and pillaging the earth, should treat the environment as well as it has in the U.S. While Poland has regions of unspoiled natural beauty, such as the Bailowieza forest, its forests suffer damage due to air pollution and the resulting acid rain. A holdover from the rapacious, careless communists, hazardous and industrial waste as well as air and water pollution also pose huge environmental problems.

Moreover, the legacy of 45 years of indifferent communist oversight means that the Polish infrastructure is decaying. The newly privatized Polish businesses face the difficulty of having to modernize their business systems in order to compete in the global market economy. Late last year the Solidarity Election Action Party, a collection of small, centrist, right-wing parties, received 34% of the vote. This coalition has called for a stop and even a take-back of many of the market reforms that have taken place since 1990. While both major political parties are anti-Communist, the new ruling party wants to increase social spending and support for many of its working-class supporters, not a prelude to a robust future for capitalism in Poland. I wonder if a government made up of almost 40 political parties will be able to govern.

Others, closer to the scene and more involved than we are, have been recently asking similar questions and charting a new course. Of all the Europeans, the Germans should know Central Europe the best. After all, they paid a large penny for East Germany, where they’ve had a first-hand lesson in the opportunities and difficulties that arise from investing in a former Communist state—a move that’s crippled them financially. In the first six months of 1997, German businessmen bought 13 businesses in Poland. This year, however, that figure has dropped to one. In Hungary, German takeovers have also declined, from four in the first half of 1997 to one in 1998.

According to Arno Burchhardt, the managing director of M&A International of Konigstein near Frankfort, takeovers and joint ventures involving German businesses have virtually stopped in eastern Europe and Russia. Part of the reason were the red tape and uncertainty about the laws. Investors from Germany criticized eastern European countries for their "lack of fair play towards foreign investors."

American investors eager to invest in eastern Europe might well ask themselves what these German investors know that they don’t. As regular readers of this column know, I find it useful to examine the basics of a geographical area in evaluating it for investing.

What I’m going to call Central Europe here was organized during the Cold War into the Warsaw Pact, a mutual-defense organization that was to absorb the first blow when the mad dog that was NATO attacked the Soviet Union. A region of 13 countries, with more every month as the endemic ethnic splits of the region continue, it’s roughly the size of Texas, Oklahoma, and New Mexico with a population of about 115 million. Poland and Rumania make up half the region; and when Hungary, the Czech Republic, Bulgaria, and Yugoslavia are thrown in, these six countries occupy three-quarters of the region. The rest are smaller and becoming smaller month by month as they sub-divide: Albania, Slovakia, Slovenia, Bosnia-Herzegovina, Moldavia, Macedonia, and Croatia.

So far, so good. But if the next couple of paragraphs are difficult to grasp, their complexity is but a small fraction of the complicated mix that is Central Europe today.

From an ethnic point of view, the region is as disordered as human affairs become. While Poland is almost all Polish and Roman Catholic, its neighbor Romania has nearly 10% Hungarians, a potential for friction. Romania, with a high debt, is in trouble financially. Its religions are mixed: Romanian Orthodox, 70%; Roman Catholic, 6%; and Protestant, 18%. Yugoslavia—if it still exists as a nation--contains Serbia and Montenegro, with a 63% Serb population; 14%, Albanian; and 6%, Montenegrin. While 65% of its population are Orthodox, Muslims are 19% of the population, leading to the strife that hits our front pages ever week. Hungary, once the breadbasket of Europe, has two-thirds Roman Catholics and a quarter Protestants. According to the best information I can gather, the inhabitants of Czechoslovakia are 40% atheistic and 39% Roman Catholic, although how anybody can be that certain is beyond me. Bulgaria’s population is nearly 10% Turkish and 13% Muslim. The Croats are but 78% of Croatia, alongside a Serb population of 12%. Ten percent of the population of Slovakia is Hungarian.

Dip into the granularity of these population mixtures and the politics quickly become Byzantine. Serbia and Montenegro have asserted the formation of a joint independent state, but this entity has not been formally recognized as a state by the United States. Our view seems to be that yes, the Socialist Federal Republic of Yugoslavia has dissolved, but that none of the successor republics represents its continuation. In 1995 the Yugoslavian government spent 24% of its GDP on the military. It has disputes with Bosnia and Herzegovina over Serbian population areas. The Albanian majority in the province of Kosovo seeks independence from the Serbian republic. Eastern Slavonia, which was held by ethnic Serbs during the ethnic conflict, is being overseen by the UN Transitional Administration for Eastern Slavonia. Serbia and Montenegro are disputing Croatia’s claim to the Prevlaka Peninsula in southern Croatia because it controls the entrance to Kotor Bay in Montenegro.

The statistics on Bosnia-Herzegovina—poor and agriculturally based--tell the story of the region and explain much of the conflict there: 40% Serb, 38% Muslim, and 22% Croat. Its religions are 38% Muslim, 31% Orthodox, and 15% Catholic.

The religious and ethnic mixtures in Moldavia, Albania, and Macedonia are much the same.

I could go on, but a few recent headlines will illustrate the point: "Cross-Purposes in Kosovo;" "Lawlessness Pervades Albanian Border Region;" and "Serbia Attacks Ethnic Albanians." The clippings could be multiplied by the hundreds.

In a nutshell, here is a region bursting with strife, with enough of a mixture of cultures, languages, religions, and ethnic groups to fuel several Hundred Years Wars. The wonder is that there have been as few wars as there have been.

For centuries central Europe has been an important crossroads of Europe. In their heyday some of these countries were great successes: As early as the sixteenth century the Poles were a political force with which to reckon, and the Austro-Hungarian Empire was one of the great achievements of Europe. However, when Napoleon’s armies marched on Russia, they tramped across this region without minding their manners, and of course these countries were the first targets of Hitler on his march to Russia. After World War II, Stalin snatched up all these countries, fixing borders without regard to religion, language, or ethnicity.

The Balkan Wars early in this century foretold its fate. Two short wars, one in 1912 and one in 1913, were fought for possession of the European territories of the Ottoman Empire (the old Turkish Empire). In the first, Serbia, Bulgaria, Greece, and Montenegro expelled Turkey from all of its European possessions except Constantinople (now Istanbul). The second war was brought on by Serbia, joined by Greece, Romania, and Turkey, which demanded that Bulgaria cede to it the larger part of Macedonia. Bulgaria lost and was forced to cede territories to the four victors. This epidemic of nationalism became one of the causes of World War I.

After World War II, Stalin followed much of the structure established by the Versailles Treaty after World War I, but of course like any sensible ruler he rewarded his friends and punished his enemies as he divvied up the region. As in Africa, this sort of rough-and-ready border establishment meant that the borders were inherently unstable. The lines might have been good for communism and the needs of the Red Army, but they were not good for the region over the long haul.

After the fall of the Berlin Wall in 1989 the peoples of eastern Europe were eager for democracy. As a result of the spread of television, the east Europeans had all seen American TV shows such as Dallas and Knots Landing, and they made the (I suppose somewhat reasonable) assumption that democracy meant automatic prosperity. Now that their Soviet masters had been overthrown, they figured they were all going to be rich, with homes to match those they saw on American TV. However, anybody with any knowledge of history has to look only at the history of the United States to know that isn’t always true. The Great Depression left us poor for a decade, and parts of the South and the West have had democracy for many decades without generating much in the way of wealth.

As a result of these erroneous assumptions and aroused expectations the east Europeans were doomed to a huge disappointment. TV drama doesn’t picture the hard work, decades of discipline, and mounds of reserves behind the easy prosperity it depicts. Behind the carefree teen-agers and sappy housewives of sitcoms some unseen person has labored long and hard to create the prosperity they so easily enjoy.

Soon unfulfilled expectations are what tend to cause political revolt, not grinding poverty and harsh conditions.

These aroused expectations are the chief root of the strife now exploding in this part of the world. The former Czechoslovakia is now in two parts, while the former Yugoslavia seems to have become four. Since nobody knows whether Moldavia should be a part of Rumania, the Ukraine, or independent, it makes perfect sense to fight about it. Should Macedonia be a part of Greece, which wants it, or Yugoslavia, or be independent? Of all things East Prussia is now part of Poland—what could be more unnatural? Of course in these situations every leader points his finger at everybody else—usually those who can’t vote for him—and says it’s their fault matters have come to such a nasty pass. Judging from the universal way politicians handle both good and bad news—they accept credit for the good and blame others for the bad—it must be a skill taught in the first year of politicians’ school.

Not that I think the strife in this region will start World War III. We can afford to allow this region to go through what it needs to go through to settle down. Throughout history the breakup of empires has reverberated in strife for decades. Even today we see on-going repercussions from the break-up of the British Empire in the fight between India and Pakistan and the African borders drawn by the British.

If we had some magic hand that could redraw the borders and create perfect groups of like-minded religions, languages, and ethnic groups, there might be a chance for this region to enjoy immediate peace and posterity—but there is no such magic hand. For the time being, these folks are stuck with the wrong-headed borders much as were laid out by the Treaty of Versailles—drawn almost 80 years ago. We Americans, who often believe every problem has a fast solution, need to understand that for many conflicts decades are needed for their resolution.

As a comparison, look at Ireland today. For a century and a half, while Ireland was a byword for poverty, every party involved blamed the others. Now that the miracle of prosperity has arrived, so have sweetness and light. What’s actually happened is that when people have a choice between carrying on a grudge match and getting rich, almost all of them opt for the money.

So why is eastern Europe poor? Between the two world wars Hungary was the breadbasket of Europe, and Czechoslovakia had high abilities in engineering and manufacturing. For all their fabled history, their culture, and their bred-in-the-bone business sense, the east Europeans today have little to sell. For decades after World War II they sold only to the USSR under a sort of casual barter system, one without much accountability. Their manufacturing savvy deteriorated, as they pretended to manufacture goods for the USSR, which pretended to pay for them. The result was they lost their competitive discipline. While the Japanese were refining just-in-time manufacturing and the highest quality control on the planet and surveying the U.S. market to make sure their products had all the features and then some that would prise money out of the Americans, the Central Europeans were shipping whatever they liked to the USSR.

Now that poverty and hopelessness have descended on this region, politicians, using their age-old tricks to stay in power, are distracting their constituents by pointing fingers at others and creating religious and linguistic fights. If the constituents are thus distracted, their leaders hope they won’t notice what a poor job they’re doing to make matters better.

We must be careful not to be drawn further into these fights. We already have troops in Macedonia, Bosnia, and Kosovo. It’s interesting to note, however, that those outsiders best in a position to know, the West Europeans, are conspicuous by their absence.

None of this is to say that today’s problem is that former Communists are still in power. They are, but nobody any longer wants to be a real communist, everybody wants to be a rich communist. The real problem is an economic one—that these countries have nothing to sell. Even East Germany, with the massive help it has obtained from its big brother West Germany, is finding it hard to compete. Ruined by Communism, the work discipline is not there, and neither is the discipline to educate the people to do the work.

Another giant pull on this region is Russia, itself a cauldron of ethnic strife. Today Russia is in a horrendous financial crisis. Short-term T-bills have risen to 120% a year; the stock market has plunged 75% from its peak; and the ruble has been falling for months. If the ruble devalues suddenly—which it might--the Ukraine, with its close economic ties to Russia, will have to follow, and these events will have a devastating effect on their Central European neighbors; economic ruin, panic, and widespread suffering are likely, much as we saw earlier this year in Asia. In 1996 and 1997 the Russian budget deficit was eight percent of GDP; in 1998 it can hardly be reduced to much less than five percent. Thus, much in the region depends on the Russian government getting its budget under control so that its currency stabilizes and curbing the lawlessness of its bureaucrats and big businessmen. Frankly, not only don’t I believe this can be done, but I’ve gone so far as to short the ruble.

In the past few years, there have been some good short-term plays in Hungary, Poland, Czechoslovakia, Rumania, and Bulgaria, but long-term investors have not fared well. Examples are Levi Strauss (jeans) and GE (bulbs) in Hungary, who fared poorly. I believe these markets are only good for nimble short-term traders who have the skill and local knowledge to jump in and out of the markets. For serious long-term investors, Central Europe’s markets are too treacherous and unsure.

My question to potential investors in Central Europe is: why invest here, where the wind is blowing against you, when you can invest in so many other places in the world, be they China, South America, Africa, and Ireland, where the wind is a gale at your back?

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