Privatization in Transition Economies, Volume 90: The Ongoing Story (Contemporary Studies in Economic and Financial Analysis) (Contemporary Studies in Economic and Financial Analysis)

PRIVATIZATION IN TRANSITION ECONOMIES: THE ONGOING STORY

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CONTEMPORARY STUDIES IN ECONOMIC AND FINANCIAL ANALYSIS VOLUME 90

PRIVATIZATION IN TRANSITION ECONOMIES: THE ONGOING STORY EDITED BY

IRA W. LIEBERMAN LIPAM International Inc., Bethesda, MD, USA

DANIEL J. KOPF LIPAM International Inc., Bethesda, MD, USA

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo JAI Press is an imprint of Elsevier

JAI Press is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands 525 B Street, Suite 1900, San Diego, CA 92101-4495, USA First edition 2008 Copyright r 2008 Elsevier Ltd. 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, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://www.elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-7623-1463-8 ISSN: 1569-3759 (Series) For information on all JAI Press publications visit our website at books.elsevier.com Printed and bound in the United Kingdom 08 09 10 11 12 10 9 8 7 6 5 4 3 2 1

CONTENTS vii

ACKNOWLEDGMENTS PRIVATIZATION IN THE TRANSITION ECONOMIES: AN INTRODUCTION Ira W. Lieberman CHAPTER 1 AN OVERVIEW OF PRIVATIZATION IN TRANSITION ECONOMIES Ira W. Lieberman, Ioannis N. Kessides and Mario Gobbo CHAPTER 2 LEAPS OF FAITH: LAUNCHING THE PRIVATIZATION PROCESS IN TRANSITION John Nellis

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CHAPTER 3 MASS PRIVATIZATION IN TRANSITION ECONOMIES Daniel Kopf, Ira W. Lieberman and Raj M. Desai

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CHAPTER 4 WHY IS CHINA SO DIFFERENT FROM OTHER TRANSITION ECONOMIES? William P. Mako and Chunlin Zhang

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CHAPTER 5 PRIVATIZATION IN ROMANIA FROM 1989 TO 2007 Dick Welch

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CHAPTER 6 BALKAN LATECOMER: THE CASE OF SERBIAN PRIVATIZATION Mirko Cvetkovic, Alexander Pankov and Andrej Popovic

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CHAPTER 7 THE RISE AND FALL OF RUSSIAN PRIVATIZATION Ira W. Lieberman

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CHAPTER 8 METHODS AND INSTITUTIONS – HOW DO THEY MATTER?: LESSONS FROM PRIVATIZATION AND RESTRUCTURING IN THE POST-SOCIALIST TRANSITION Itzhak Goldberg and John Nellis

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ABOUT THE AUTHORS

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ACKNOWLEDGMENTS This book would not have been written had it not been for the support of Professor J. Richard Aronson, the Director of the Martindale Center for Private Enterprise at the Rauch School of Business at Lehigh University. We thank him for both his support and for urging us to write this volume. I would also like to thank my co-editor, Daniel Kopf who has worked tirelessly from the inception of this volume to edit the chapters delivered by the various authors and to ensure that the volume is a work of quality. Several of the authors have worked together at the World Bank for a number of years and spent much of that time in the field in the transition countries advising client governments on the design and implementation of their privatization programs. Two of our colleagues, who we worked closely with are no longer living, otherwise they surely would have been contributors to this volume. We would like to dedicate this volume to Andrew Ewing and to Paul Siegelbaum. Andrew co-managed the World Bank’s Privatization Assistance Program to client governments. Andrew, John Nellis (one of the contributing authors) and I worked together for some eight years managing the group that worked in virtually all of the transition countries in the CEE, CIS and SEE. After retiring from the World Bank, Andrew then spent considerable time in Serbia advising the Privatization Agency on its privatization program. Paul Siegelbaum was the Country Director for Ukraine, Belarus and Moldova. Subsequently he was appointed Director for the Private and Financial Sector Department of the Europe Central Asia (ECA) Vice Presidency (ECA includes all of the countries in the CEE, CIS, SEE and Turkey). Paul was my last Director at the World Bank, before my retirement, and a close friend. He was also the Director for several of the authors of this volume. His soaring intellect, sharp wit and passion for our work inspired all of us. I would also like to thank all of our counterparts and colleagues we worked so closely with in the transition countries during the last 15 years or so. Much of Eastern Europe and the CIS had been largely closed for some 45 years before the fall of the Berlin Wall. Our initial perceptions were that it would take many years for reform to take hold in the transition economies. Our frame of reference was our prior work in developing countries. But the level of education, the commitment and quickness of the early reformers to vii

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adapt to free market concepts and ideas and to implement complex privatization programs involving virtually all of the assets and property of their countries and most of the work force, within this relatively short period of time, was absolutely astonishing. We, as well as the citizens of their respective countries, are indebted to these early reformers. Finally, I would like to thank all of the contributors to this volume, all of whom I have had the pleasure to work with, for their willingness to contribute their respective chapters, without which this volume would not have been possible. Ira W. Lieberman Editor

PRIVATIZATION IN THE TRANSITION ECONOMIES: AN INTRODUCTION Ira W. Lieberman The question that may well be raised is why now? Why discuss privatization in the transition economies now after more than 15 years of reform and privatization experience in most of these countries, thousands of transactions completed, billions of dollars in assets divested or transferred from the state to the private sector, and countless books and articles written on all aspects of privatization? The answers are relatively straightforward. First, some 15 years have now passed since the Berlin Wall fell. Transitional reform in Central and Eastern Europe (CEE) and Commonwealth of Independent States (CIS), sometimes referred to as the Former Soviet Union (FSU), has been substantially completed. Exceptions are China, having started earlier and still carrying out major reforms of its very large state-owned enterprises (SOEs) in a more gradual process, South East Europe (SEE), with the major exception of Slovenia, having started later due to the years of conflict in the region and isolation thereafter and, finally, those countries that have barely reformed or privatized at all, for example, Belarus, Turkmenistan, and Uzbekistan. The authors of this volume, the majority of whom participated actively in the privatization process in these countries, now believe we can tell the story objectively with some distance and time away from the battle. Second, as we take stock of privatization programs in the transitional economies, it is clear that despite all of the initial success in privatization, Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 1–8 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00009-5

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primarily in the accession countries (countries in the CEE and SEE that have recently joined the European Union), there is still a great deal to do. Many of the transition countries have passed through the initial stages of privatization – sale of small-scale companies and companies in the tradables sector, but there is a large inventory of larger, more strategic companies, primarily in banking, infrastructure, and energy still to privatize. This is particularly true in the CIS and SEE. Third, there has been criticism of earlier approaches to privatization – the speed or pace of privatization, the techniques used such as voucher programs, sales to insiders – management employee buy-outs (MEBOS), and the lack of distributive equity or social consequences of privatization. In fact, the populations of many countries in the region have negative perceptions of privatization as corrupt and favoring the nomenklatura. So it is appropriate to take stock of lessons learned and try to apply these lessons going forward, especially to countries that still have a large stock of stateowned companies to divest. Fourth, the external economic environment has grown more competitive and more difficult for many of these economies with the rapid globalization of the world economy. This is particularly true for the CIS and SEE economies which remain outside the European Community (EC). The CIS economies are also adversely affected by the move by Russia away from subsidizing energy – oil and gas. The SEE countries no longer operate within an integrated market, as was the case with the former Yugoslavia. Foreign direct investment (FDI) is no longer attracted to many of these economies as foreign direct investors focus on the emerging Asian powers – China and India, and next in line countries in East Asia such as Vietnam. So there is a need for lagging reformers in the CIS and SEE to complete their reforms, including privatization, to attract FDI, and to increase productivity and efficiency in their economies. Lagging cases such as Serbia have still to meet accession requirements. Potential direct or strategic investors in advanced industrial economies in specific sectors such as transport (airlines), and utility sectors such as telecommunications, water, and electricity have had to face their own restructuring and, in a number of cases, their privatization in the latter part of the 1990s. Many of the companies that have previously invested in ECA, such as Deutsche Telecom, France Telecom, PTT Telecom Netherlands, and Vivendi to name a few, may not have an appetite for acquiring companies in transition economies in the foreseeable future. Some have gone into bankruptcy, such as Enron, while others have withdrawn from their privatization holdings, such as Tractabel in Kazakhstan. For all of the

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above reasons, the market price or valuation for larger, strategic companies in ECA may depend on how well Governments carry out pre-privatization restructuring/re-organization of the sectors and how much confidence there is in independent (free from political interventions) and qualified regulation of the relevant sector. For example, fixed-line telecommunications and national airlines may find few buyers.

BUT WHY PRIVATIZATION? In 1993, the author labeled ‘‘Privatization: The Theme of the 1990s.’’1 This may or may not be true in the developing world but it was certainly accurate for the CEE and the CIS. Privatization was central to the structural reform that has taken place in the region and it is central to the creation of a market economy. The common explanation as to why privatization became so important to developing and transition countries is the debt crisis which emerged in 1981/1982. In the case of many of these countries their external sovereign debt problem led them through a decade of low to negative growth, macroeconomic instability, and a series of forced adjustments. Developing countries were simply unable to continue absorbing the fiscal burden of their SOEs. But while the impact of the debt crisis cannot be minimized, privatization would have become a pivotal issue in any event. Other factors or issues have emerged to require the adoption of privatization as a critical feature of countries’ economic policy.2 The first key factor in the 1970s and 1980s was the successful economic performance of Japan and the Asian Newly Industrialized Countries (NICs) (Korea, Singapore, Hong Kong, and Taiwan). Despite significant differences in their domestic economies and industrial structures, all followed a model for growth characterized by intense competition, an outward orientation that has emphasized exports and international competitiveness, and a very significant role for the private sector. Second, at the time that the growth model of Japan and the Asian NICs was proving so successful, there was a growing recognition that other models for economic development, such as the command economy as practiced in the transition countries and the import substitution model as practiced in much of Latin America, had outlived their usefulness and needed to be changed. A particular weakness of the inward-looking approach to development was that it incorporated within it an inversion of the ‘‘infant’’ industry argument. It implied that developing countries once having developed ‘‘strategic’’ or

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‘‘priority’’ industries such as steel, cement, fertilizers, oil refining, and petrochemicals, most often through state monopolies and almost always through subsidies, had to continue protecting them because they were too fragile and too uncompetitive to export to world markets and face domestic competition. Moreover, the anti-export bias of these regimes has made it difficult for industry to compete in world markets, even if it were inclined to do so. A third factor that emerged in the 1980s is what some analysts were calling the fourth industrial revolution. Driven by information-based technologies, this revolution primarily involved non-smoke-stack industries such as telecommunications, computers, microelectronics, robotics, fiber optics, biotechnology, and advanced and composite materials. The technology embodied in a number of these industries affected competitiveness in a wide range of industrial sub-sectors. These drivers of new technology were largely absent in the developing and transition countries. An important aspect of this revolution is new managerial practices that emerged, such as ‘‘justin-time’’ or time-based inventory and distribution systems, ‘‘total quality control,’’ CAD/CAM, and computer integrated manufacturing systems (CIM). These new managerial tools, which have had a profound effect on productivity and competitiveness, also, in large part, passed by countries that were inwardly orientated. The pace of change and the necessary commitment to applied research and development have made it impossible for many firms to remain under the control of the state, where decisions are politicized and response to market pressures is so sluggish. This brings us to the fourth factor, the role of SOEs in core sectors. In Latin America, as well as a number of other developing countries such as Turkey, Egypt, and much of Africa, SOEs had become of major importance in both the industrial and service sectors. In Latin America by the end of the 1970s SOEs were dominant players in extractive industries (mining, oil, and gas), in basic industrial subsectors (steel, petrochemicals, fertilizers, and shipbuilding), and in services, utilities, and infrastructure (electricity, telecommunications, railways, ports, and shipping). In the CEE and the CIS, the state enterprise sector accounted for some 90% of industrial production in most countries prior to privatization. The monopoly status of SOEs has generally bred inefficiency and lack of competitiveness. In the transition economies, where SOEs dominated every aspect of the economy, the focus on heavy industry crowded out any efforts to develop a service sector. SOEs in many of these closed economies were characterized by  poor financial performance,  overstaffing,

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dependence on subsidies and unilateral budget transfers, highly centralized and politicized organizations, exclusion of competitive imports, exclusion of domestic competitors, poor export performance, corrupt practices, and vehicles for capital flight.

Moreover, as SOEs were often monopolistic suppliers of goods and services to the private sector (excluding the transition economies, where a cooperative sector might have existed such as in Poland), but not a true private sector, their poor performance meant that the private sector could not be competitive, particularly in a protected market environment. In the mid-1980s, a number of countries, such as Mexico, sought to restructure their large SOEs mainly through changes in their management and operation. It soon became apparent, however, that the process was a long and difficult one, the human resource requirements were intensive, and the gains were elusive. The bureaucracies that were incapable of managing these firms in the first place were certainly not capable of turning them around. Moreover, these countries were running out of budgetary resources to continue feeding these enterprises in the interim, until they turned around. Many of the SOEs, reliant on subsidies and unilateral budget transfers, were de-capitalized and increasingly obsolescent in the aftermath of the debt crisis. The attempts to reform socialism in Hungary over an extended period of time and in Poland in the late 1980s were equal failures. A fifth factor influencing privatization in the developing and transition countries is that in the 1980s advanced industrial countries such as the United States and the United Kingdom expressed strong ideological commitment to private enterprise. Prime Minister Margaret Thatcher sought to revive Britain’s flagging industrial performance through a large-scale program of privatization. The creation of millions of new small shareholders, on a preferential basis, through the privatization of British Telecom and British Gas, as examples, was a cornerstone of the Thatcher Administration’s political and economic reform agenda. It was designed to make private ownership of these former SOEs irreversible by a future Labour-led government. The intellectual discussion and debate that arose over privatization and restructuring spurred an interest in this subject throughout the world. Perhaps the earliest and most successful effort among the developing countries was in Chile which began a two-phase program in 1974 following

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the overthrow of the Allende regime, with major accomplishments throughout the 1970s. The country’s deep economic crisis in 1982–1983, provoked in part by excessive concentration of ownership rights in a few financial–industrial groups and the over-leveraging of the process, forced the government to intervene in the operation of a number of financial holding groups. Chile subsequently re-privatized successfully from 1984 onwards. Above all, Chile’s privatization of pension fund management has been emulated by several Latin American countries, such as Argentina, Peru, Bolivia, and Mexico, and in Hungary almost a decade later. Chile initially served as less of a model than should have been the case because of the nature of the Pinochet regime, but its accomplishments are significant and the approach taken to privatization, specifically in its ‘‘second round,’’ applicable to both Latin America and transition economies. Sixth and finally, the political revolution in the CEE starting in 1989 with the fall of the Berlin wall, and in the FSU in 1991 with the formal break-up of the FSU, gave an entirely new impetus to the privatization process. The newly emerging democracies in most of these countries utilized privatization as a cornerstone of their economic reform process to create the basis for a market economy. Privatization in these countries has had profound economic, social, and political implications that go well beyond those in most of the developing countries. By the end of 1995, most countries in the CEE and the CIS had over 50% of their work force employed by the private sector and had privatized more than 50% of SOEs, primarily through smallscale privatization of retail and service firms and firms in the tradables sector through voucher privatization and management and employee buyouts.2

ORGANIZATION OF THE BOOK In seeking to answer this basic question why discuss privatization in the transition economies, why discuss it now, this book is structured as follows: (i) this chapter is Introduction. (ii) Chapter 1: An Overview of Privatization in Transition Economies will initially revisit the objectives of privatization, the reasons why approaches to or methods of privatization in these countries differed from more classical or case-by-case privatization in the advanced economies such as the UK, New Zealand, and Latin America as examples, the timing and sequencing of privatization, and then what has been achieved to date, so that there is a clear understanding of where the process stands at the present time. The note will then discuss achievements by key sectors – commercial companies or companies in the tradables sector,

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infrastructure and energy privatization, and the financial sector, with an emphasis on bank privatization. (iii) Chapter 2: External Advisors and Privatization in Transition Countries discusses the early decisions by reformers in transition countries and their advisors to privatize and where they succeeded and failed. The chapter is a rich discussion and comparison of privatization in countries such as Poland, the Czech Republic, and Russia as examples. (iv) Chapter 3 goes on to examine a form of privatization prominent throughout the nineties in a large number of transition countries: Mass (voucher) Privatization (MPP). While early wisdom accepted MPP as the correct route for a large number of transition countries, the approach was eventually heavily criticized, especially among academic commentators. The chapter initially describes the approach and then goes on to discuss the MPP in the Czech Republic, Poland, and Russia. (v) Chapters 4–6 discuss individual country cases – China, Romania, and Serbia, which are quite different than the cases discussed in the earlier chapters. Russia is also presented as a country case, due to its complexity, its controversy, and the linkage to what is currently occurring in Russia, both politically and economically. (vi) Chapter 4 discusses China’s privatization and the State Enterprise Reform Program as it has evolved over the last 15 or more years. The focus is on the stages of SOE reform and the policy decisions taken by China’s leadership to guide or steer China through the process, one that is still evolving and progressing at present. (vii) Chapter 6: Balkan Late Comer: The Case of Serbian Privatization analyzes privatization in Serbia, a case still in progress, but sufficiently far along so that lessons can be drawn. In fact, Serbia is due to wind up privatization in 2007; however, there is much left to be done and some of the authors of this volume are engaged in preparing proposals for a newly elected government to consider as soon as the government is formed. (viii) Chapter 7 discusses the most controversial of privatization programs: the Rise and Fall of Russian Privatization. The chapter goes beyond the MPP to discuss small-scale privatization, cash sales and tenders, loans-for-shares and one prominent case, privatization of the national telecommunications company, Svyazinvest. The chapter examines the political economy of these various stages of privatization, ending with a discussion of concentrated ownership in Russia by financial industrial groups (FIGS), with some of these FIGS owned by what some have called Russia’s ‘‘Robber Barons,’’ while others more commonly refer to them simply as the ‘‘oligarchs.’’ Finally the chapter presents a short postscript on recent political–economic events in Russia that have led to some renationalization and the focus by the Putin Administration on building large state-owned energy – oil and gas companies, as an extension of state power.

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(ix) The concluding chapter, Methods and Institutions How Do they Matter? Lessons From Privatization and Restructuring in the Post-Socialist Transition discusses lesson learned from the experience of the transition economies to date. It is both the concluding chapter and a forward-looking chapter for the late reformers in the Balkans and the CIS, and remaining Asian transition economies such as North Korea and possibly Cuba. Excluded from our discussion in this volume is the privatization of agriculture in the transition economies, a topic that requires its own volume and those with the experience and expertise to address it. Also banking and infrastructure privatization are only discussed explicitly in the Overview Chapter. Again, each of these topics merit their own volume and in fact there is much that has been written on each of these subjects.

NOTES 1. Ira Lieberman. ‘‘Privatization: The 1990s.’’ The Columbia Journal of World Business (Spring 1993). 2. Hungary, as an exception, focused primarily on joint ventures and ‘‘classical’’ case-by-case privatization to divest its larger firms: Poland utilized a menu of privatization options to divest larger firms, including initial public offerings (IPOs) for the first five privatization transactions in December 1990.

CHAPTER 1 AN OVERVIEW OF PRIVATIZATION IN TRANSITION ECONOMIES$ Ira W. Lieberman, Ioannis N. Kessides and Mario Gobbo 1. INTRODUCTION This chapter is intended to provide the reader with information and insights on the transition or transformation from socialism to a market economy in what are generally termed the transition economies. This includes countries in Central and Eastern Europe (CEE), the Commonwealth of Independent States (CIS), sometimes referred to as the Former Soviet Union (FSU), the South East European (SEE) countries, sometimes referred to as the Balkans and the major socialist economy of Asia, China. The chapter covers the critical years of reform for most of these countries, from 1990 to 2000. Some transition economies started reforming earlier, such as China which has continued state-owned enterprise (SOE) reforms to the present time. Other transition countries, primarily the SEE economies, lagged due to the conflict which raged throughout most of the region and the period of isolation which followed, particularly for Serbia. China and Serbia are sui generis for

$

This chapter draws heavily on a previous paper by the authors, prepared as a policy note for the ECA Region of the World Bank. The previous paper was for internal purposes and was not published.

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 9–80 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00001-0

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a number of reasons. They will be referenced as examples in this chapter, but they will not form part of the core statistical and data analysis. In this chapter, the author’s goal is to answer the following three questions based on the privatization experience of enterprises in transition economies:  What has been achieved with respect to privatization in the region?  What has worked?  Where are their problem cases and failures to date? The chapter discusses the background to privatization in the region, including why it was necessary. It then moves on to discuss privatization objectives, the diverse methods of privatization employed in the region, and privatization of different sectors – commercial firms, banking and infrastructure. Lessons learned are discussed in the concluding chapter to this book.

2. BACKGROUND The fall of the Berlin wall, in 1989, and the formal breakup of the FSU in 1991 gave an entirely new impetus to the privatization process. The newly emerging democracies in most of these countries utilized privatization as a cornerstone of their economic reform process to create the basis for a market economy. Privatization in these countries has had profound economic, social and political implications that go well beyond those in most of the developing countries, starting in 1990 with virtually 100% state ownership of their economies1 including small retails shops, service establishments and restaurants, which were in short supply throughout the region. By the end of 1995, most countries in the CEE and the CIS had over 50% of their workforce employed by the private sector and had privatized more than 50% of SOEs, primarily through small-scale privatization of retail and service firms, and voucher privatization and management and employee buyouts for firms in the tradeables sector.2 The sale of larger firms in banking, natural resources and infrastructure largely occurred later than the sale of firms in the tradeables sector. But by 2000, a great deal had been accomplished, particularly the sale of telecoms companies in infrastructure and the privatization of the banking sector, largely to European foreign direct investors. There were a number of lagging country cases, discussed later in the chapter. However, by 2000, reforms for the countries in the CEE

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and the Baltics and some countries in the SEE, for example Croatia and Bulgaria, were largely driven by the prospects of European Union (EU) accession. These countries agreed to a process of reform with the EU known as the Acquis Communautaire (strictly speaking the Acquis Communautaire is a body of laws which must be adopted by a country before it can accede to the EU).

3. OBJECTIVES OF PRIVATIZATION REVISITED Privatization programs have often cited a laundry list of objectives; increasing efficiency and productivity of privatized firms and of the economy more broadly, improving the quality of goods and services, reducing the state’s role in the economy and the Government’s fiscal deficit, raising revenues for the budget and generating additional tax revenue, creating a critical mass of private firms, promoting direct foreign investment and increasing the level of overall private investment, deepening domestic equity markets and boosting public participation and confidence in a market economy. Some of these objectives, such as reducing the fiscal deficit by retiring debt through revenue received from privatization have been met as a direct outcome of privatization. Others, such as increasing efficiency and productivity, are longer-term objectives and depend on the management know-how, technology, market access and funding that new private owners bring to a company. Privatization is but the first step, albeit an important one, in restructuring former state-owned companies. Reformers in transition countries and international agencies such as the World Bank and International Monetary Fund (IMF) have often expected too much from privatization itself. Consequently, insufficient attention has been paid to other issues such as the environment in which the private sector operates, liberalizing entry to ensure competition and training managers postprivatization. This is particularly true for CIS countries, where they have had little or no exposure to what it takes for firms to compete in a market economy. Privatization objectives should boil down to three key issues:  Getting government out of the business of business, by strengthening market forces to promote competition and efficiency;  Generating new sources of cash flow and financing for enterprises, not only through attracting Foreign Direct Investment (FDI), broadening

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and deepening capital market access for privatized firms and increasing availability of bank financing, but also through eliminating government crowding out of capital markets and preferential subsidies and transfers to SOEs;  Reducing fiscal deficits by utilizing privatization revenues to retire external and domestic debt, increasing tax revenues from profits generated by privatized enterprises and reducing what is often a serious drain on state budgets, the fiscal transfers to SOEs. The quality of a country’s privatization program has a direct bearing on the country’s ability to meet these objectives. However, often governments are confused about their objectives with respect to privatization, and introduce distortions into their programs and adopt mutually conflicting objectives with respect to privatization.

4. ATTEMPTS TO REFORM SOCIALISM: AN OVERVIEW OF THE REGION IN THE LATE 1980s Formal privatization in the CEE and FSU began in 1990. However, during the Gorbachev Reforms known as Perestroika (1988–1989), an informal type of privatization, also known as ‘‘spontaneous privatization,’’ occurred in countries such as Russia, Ukraine, Poland and Hungary.3 A second form of quasi–privatization, known as leasing-out, also took place throughout the region. In the wake of political reforms, which spread throughout the region in the early 1990s, spontaneous privatization was viewed as unacceptable because it concentrated the returns on insiders, i.e., workers and managers. Finance ministers, privatization ministers and other reform leaders in the CEE and CIS began to seek solutions to privatize the massive numbers of SOEs.4 It quickly became apparent that the ‘‘classical privatization’’ model practiced in the United Kingdom and New Zealand and emulated by other countries such as Mexico and Argentina would simply not work in the region.5 First, there were too many state-owned companies in the CEE and FSU that needed to be privatized rapidly. Implementing privatization on a case-by-case basis over many years risked missing the ‘‘window of opportunity’’ for real structural change. Second, the socialist economies lacked real markets and competition at all levels of the economy. Privatizing companies one at a time would have left them vulnerable to SOEs not interested in competing or creating real markets. Therefore, reformers began

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to experiment with a rich menu of privatization methods. The alternatives depended on the type of company or the assets to be sold, the sequencing and the timing.

5. PRIVATIZATION PROGRAMS: A DIVERSIFIED MIX OF METHODS The early privatization discussions or debates in the region,6 which were primarily held in leading CEE countries (Poland, Hungary and what was soon to be the Czech Republic) and Russia, were dominated by a few core issues:  Methods of privatization;  Corporatization, creating legal entities from the SOEs to be privatized, generally in the form of joint stock companies;  Sequencing – what should come first;  Timing – the speed with which privatization could be implemented;  Protection of property rights – the necessary laws and regulations surrounding privatization;  The creation of an irreversible basis for a market economy; this meant creating a sufficient core of private firms so that the large state-owned firms would not crowd out the newly formed private sector;  Restructuring, pre- or post-privatization, especially for the very large SOEs that characterized the excessive industrialization of many of the transition economies; and  Capital market creation and development. Consideration of bankruptcy laws and institutions, competition or antimonopoly laws and institutions, corporate governance, reforming the judiciary and the business environment were all part of the reform mix, but clearly subordinate to these primary issues at the start. Each of these countries were also faced with serious considerations and timing with respect to macro economic reforms, primarily liberalization of prices and trade and macro-stabilization, especially control of inflation, following price liberalization and the subsequent release of ‘‘pent-up’’ or repressed inflation. It soon became clear that privatization worked well within a mix of reforms. Poland, for example, moved quickly on macro and other reforms such as imposing hard budget constraints on firms to quell wage inflation, a process known as the ‘‘big bang.’’ Their Finance Minister,

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Balcerowicz, was to note at the beginning of the reforms that there was a period when politics as usual was largely suspended; this gave the reformers a year or so to make great progress on reforms. Therefore, one had to be bold. The Russians, on the other hand, lagged on macro reforms and inflation was rampant until the financial crisis of 1998. Privatization was one of the few reforms that was implemented successfully. It became clear in retrospect that privatization, on its own, could not carry the day.

6. METHODS OF PRIVATIZATION7 Perhaps the sharpest debate on privatization initially was over methods to be utilized (see Box 1 for a list of methods eventually utilized). A few countries at the beginning, starting in not too dissimilar circumstances, dominated this debate – Poland, the Czech Republic, Hungary and the Baltic Countries. They were later joined by Russia. Virtually all countries in the region opted to start with small-scale privatization, the privatization of retail stores, small service establishments such as restaurants, barbershops and beauty salons. Thereafter countries parted ways. Poland opted for a menu of privatization alternatives that included: (1) initial public offerings (IPOs) for its first five large privatization cases; (2) a process called liquidation that was really a form of installment sales to managers, workers and outside investors such as an important supplier or customer; (3) sector privatization (selling bundles of firms in the same sector such as cement

Box 1. Privatization Methods in Eastern Europe: Former Soviet Union. Spontaneous privatization Small-scale privatization Restitution Management/employee buyouts (MEBOs), leasing and management contract Mass (voucher) privatization Trade sales (foreign/domestic strategic investors) Public offerings (IPOs) Residual share sales Privatization through restructuring or liquidation

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factories, cosmetic companies, etc.); (4) case-by-case or ‘‘classical’’ privatization of larger strategic companies, in particular the banks and infrastructure companies; and (5) mass privatization. The Czechs focused on mass (voucher) privatization, which was initially a focus of discussion in Poland as well. In time a large number of countries throughout the region adopted mass (voucher) privatization programs (MPP). Virtually all of these countries reverted to more traditional or ‘‘classical’’ privatization methods to sell large, strategic companies, such as banks and infrastructure companies.8 The Hungarians, initially enmeshed in slow reforms under socialism, what some referred to as ‘‘goulash socialism,’’ privatized through management and employee buyouts and, to attract much needed foreign capital and technology, through joint ventures between Hungarian and foreign firms. In fact, Hungary was a lagging case until 1995.9 Eventually, facing macro economic difficulties and heavy external indebtedness, Hungary privatized several of its banks and several of its largest companies on a case-by-case basis during 1995 (through ‘‘classical’’ methods of privatization) and generated some $8 billion dollars in foreign exchange to retire a substantial chunk of external debt. Russia, on a somewhat delayed basis, starting in 1992, also privatized its small-scale firms, but not as well as the other countries, and then opted for voucher privatization to privatize some 16,500 medium to large companies largely in the tradeables (commercial) sector, in just two years between 1992 and 1994. Russia also held cash sales and tenders for residual shares held by the state in companies privatized through voucher auctions. Russia then proceeded to divest large stakes in strategic firms, which turned out to be a closed process that favored four large Moscow Banks, owned by the so-called oligarchs, through a process known as ‘‘loans for shares.’’10 China also started with small-scale enterprises, so-called town and village enterprises, which gave early momentum to Chinese reforms. For the larger SOEs, the issue was really corporatization, creating legal structures that might include investors from the Chinese diaspora and other owners such as the municipality who would form part of the ownership group beyond the managers and the workers. The early stages of Chinese privatization resulted in substantial insider control, just as in Russia. However, the Chinese retained administrative oversight over these companies at various levels of government depending on the nature of the company.11 Serbia, starting over in 2001 after years of conflict and isolation, and its early reform program under the Markovic regime in 1992, faced a challenge that was distinct. A large number of its companies were obsolescent as a result of the years of conflict and isolation. Serbia, as the rest of the countries

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in the former Yugoslavia, had social ownership, a form of ownership that is best described as worker ownership. Since many of the socially owned companies were deeply indebted to the state and were propped up by state subsidies, Serbia opted to privatize socially owned firms. Smaller firms were privatized through auctions, larger firms through tenders and the large groups through restructuring through privatization (there were some 79 large systems as they were called, mostly conglomerates, that each held a myriad of companies and service units) of obsolescent groups that were socially owned. The latter method utilized restructuring as the basis for selling the group as a going entity or otherwise its subsidiaries and other assets. Also, some thousand or so socially owned firms were privatized through management and employee buyouts as they opted to ‘‘jump over the fence’’ just before a new privatization law was due to come into effect in 2001.12 Discussed below are the most important methods or approaches to privatization in the region. Each method had its champions and critics. In our view, each method had its merits, given the circumstances these countries found themselves in – thousands of firms and an enormous number of underutilized assets all controlled by the state. The changing political landscape was also critical. Privatization, above all, is a highly political decision – that private ownership matters and that a capitalist model would serve their populations better than socialism. Many of the countries in the region, in particular in CEE, sought to break away quickly from socialism and a command economy, as well as from communist control over their political system.13 The CIS countries faced a more difficult problem. They had lived under communism and a command economy for some 70 years; the communist ideology was propagated throughout the world by Russia and the FSU. Many leaders in these countries resisted the move to a market economy and few had any experience with how such an economy should function. So privatization was much more difficult in these countries, and some of them, such as Belarus, Uzbekistan and Turkmenistan, have resisted all market reforms. Some of the countries in the SEE faced yet a different situation, debating whether they should put an end to social ownership, a model distinctly different from socialism and a command economy developed while some of these countries were under the umbrella of Yugoslavia.

6.1. Spontaneous Privatization Spontaneous privatization was the product of an experiment to reform socialism under Perestroika; a 1987 law allowed the labor collectives and the

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managers of the SOEs to operate independently of state intervention and, therefore, effectively become owners of their firms. A 1988 Law on Cooperative Activities allowed the formation of cooperatives within the enterprise headed by the managing director.14 Managers of SOEs assumed responsibility for their own enterprises. Some analysts suggest that this was the most efficient method of privatization as the best assets were stripped out or utilized as private assets, even if they remained within an SOE. In countries such as Poland, Ukraine and Russia there was a considerable amount of spontaneous privatization, which led many reformers to believe that they needed to move quickly with more formal approaches to privatization, rather than allowing the managers to own these firms on a de facto basis.

6.2. Small-Scale Privatization and Liberalized Entry for New Firms Virtually every transitional country in the region has benefited from the privatization of small-scale establishments.15 Small-scale privatization, as well as related liberalization of entry for small-scale startups, has brought quality goods and services to the public; it has created job opportunities; it has built backward linkages along the supply chain in a number cases (e.g., in Poland, there were dynamic linkages leading to privatization and privatesector entry into the trucking, wholesale distribution and the warehouse sectors); and it has expanded the severely underdeveloped service sector common to the transitional economies. Developing the service sector was very important because it created millions of new jobs in the region, jobs which were needed as the large SOEs were eventually restructured or went bankrupt and workers were laid off. A World Bank team, considering the growth of small business over the decade of the 1990s, concluded that small entry and growth was the dividing line between successful reformers and those that were less successful,16 The share of total employment and value added accounted for by small enterprises (defined as employing fewer than 50 workers) as a proxy for new enterprises divides transition economies into two groups. In the Czech Republic, Hungary Lithuania, and Poland new enterprises grew very rapidly. They now account for 50 percent or more of employment, the average of the European Union and for between 55 and 65 percent of value added. But in Kazakhstan, Russia and Ukraine, which have seen modest or no growth in new enterprises, the share of employment has stayed at or below 20% and the share of value added has stayed between 20 and 30 percent.

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6.3. Restitution A number of countries adopted restitution laws to restore land, property and small firms to previous owners where it was deemed that the communists had illegally confiscated property. These laws proved contentious and often slowed down privatization in countries where the original property was meant to be returned to the owners, or restitution in kind was provided for. In other cases, where the property no longer existed, cash payments were allowed, but in these cases valuation often became a problem. Albania adopted a restitution law to return agricultural land to its private owners and some 95% of land was privatized in this way. The Czechs had an active restitution program that proved very difficult and slowed down privatization that mainly dealt with agricultural land, small businesses, houses and other small properties.17 Bulgaria adopted a restitution law in 1992, and between 1992 and 1995 some 22,155 small firms – shops, restaurants, pharmacies, hotels, ware, flour mills, bakeries, etc. – were acquired via restitution.18

6.4. Management and Employee Buyouts Privatization methods were not mutually exclusive. Virtually all privatization in the region has included some form of management and employee participation or buyout (MEBO). Poland was able to sell some 1,000 small and medium enterprises via installment sales to management and employees and other investors associated with them; Russia offered its employees a large share of the MPP. This was particularly true for small- and mediumsized companies where under Option 2 of the MPP managers and employees could gain absolute control of the enterprise. In its initial phases of privatization, Hungary focused on acquisition by domestic buyers through a variety of schemes, management buyouts (MBOs), leasing, and installment sales, all on very favorable terms to buyers.19 In Russia, many enterprises were leased during the period of Perestoika, following the passage of the Cooperatives Law in 1988, with a privatization option, a type of grandfather clause, so that during the 1992–1994 (MPP), a few thousand enterprises were legally privatized under lease/purchase agreements. In Ukraine, the parliament made leasing so attractive that thousands of enterprises were leased to the workers cooperatives. Leasing endorsed by the Ukrainian parliament for medium and large enterprises made it very difficult for other forms of privatization to get off the ground.

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6.5. Mass Privatization20 MPPs emerged in the CEE and the FSU countries and rapidly spread throughout the region, including Albania, Armenia, Bulgaria, Georgia, Kazakhstan, the Krgyz Republic, Lithuania, Moldova, Poland, Romania, Russia, the Slovak Republic and Ukraine. The key to mass privatization was that it rapidly created a core of privately owned enterprises (e.g., 16,500 state enterprises privatized in Russia in 18 months); it distributed ownership widely (e.g., Czech and Slovak programs had 8.2 million participants); it minimized valuation problems; it decentralized the restructuring efforts; it allowed governments to rapidly divest companies in the tradeables sectors; it gave purchasing power to people without ‘‘money’’ (e.g., vouchers); and it was supposed to begin the development of capital markets through the creation of voucher funds that would operate as quasi mutual funds or unit trusts. The MPPs in Russia and Ukraine in part ensured the irreversibility of enterprise reforms and created the core or base for a market economy. Furthermore by utilizing vouchers and investment funds, companies that failed to attract a strategic investors could still be privatized. The very concept of a MPP was highly criticized by the academic community due to its failure to attract ‘‘real owners,’’ and to create such widespread ownership that good governance was basically impossible. The propensity of the MPPs, particularly in Russia and other countries in the CIS, was to exacerbate insider ownership. With little capital available domestically in most of these countries and almost no foreign investment poised to enter these markets, especially for companies in the tradeables sector, reformers responsible for privatization in these countries felt that MPPs were their only feasible alternative. Reformers understood that an MPP was always a second best solution and better suited to smaller economies. It is clear in retrospect that auctions for smaller companies and tenders for larger companies, as suggested by Goldberg in the concluding chapter in this book, would have been a better alternative. Despite the extensive criticism of the MPP it is not clear what else would have worked in a massive economy such as Russia spread over 11 time zones and 89 oblasts and autonomous republics. In the case of Russia, we then get caught up in the argument over the counterfactual. What would have worked better than the MPP?21

6.6. Trade Sales In virtually all of the countries in the region larger industrial companies with perceived value, banks and large-scale infrastructure companies were sold

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via trade sales. Trade sales usually followed the route of ‘‘classical privatization’’ in the developed and developing countries. Sales were supported by financial advisors, the company was tendered through competitive bidding and sales were closed under pre-established criteria set forth in tender documents. Most often, price was the sole or most important criteria for awarding a sale, but countries did set other conditions, such as labor retention, investment programs commitments and the quality of the firm buying. Quality – position of the bidding firm in the industry, size of the firm, its technology or know-how and its market niche were often the basis for pre-qualification of firms prior to submission of bids. While many countries followed the trade sale route, no country did so in as dramatic a fashion as Hungary. In 1995, Hungary adopted a new privatization law and proceeded to sell the majority ownership in two of its major banks and in MOL, the national oil and gas company, as well as minority stakes in the electrical distribution companies to foreign investors. Also, Hungary privatized the gas distribution companies, all sold to foreign investors, and sold a majority interest in Hungarian telecom, MATAV, to the existing minority investors.22 Starting over again in 2001, Serbia has sold a large number of companies via trade sales, utilizing traditional techniques of competitive tender. Serbia has also auctioned off a large number of smaller companies via competitive auctions.23 The focus in all these cases was on transparency of process.

6.7. Initial Public Offerings (IPOs) Historically under Socialism, there were no capital markets in any of the countries in the region. Privatization soon became linked to capital market development. Perhaps no country took that more seriously than Poland, where the first five privatization transactions for larger companies were IPOs on the Warsaw Stock Exchange, conspicuously located in the former headquarters of the Communist Party. Poland also developed a strong capital market regulatory regime, with substantial assistance from the U.S. Securities and Exchange Commission (U.S. SEC). By the end of 1995, some 25 companies were privatized through IPOs.24 In addition, National Investment Funds (NIFs), created to support the MPP, were also floated on the Warsaw Exchange, as a way of offering a means of exit for Polish citizens as shareholders and liquidity for the funds.25 Following its financial crisis in 1998, a number of Russian larger companies, hungry for financing, sought to improve their governance in order to sell American Depository

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Receipts (ADRs) in the U.S. capital markets.26 However, no country utilized the capital markets to the extent the Chinese did. China utilized three markets for IPOs – Shanghai, Shenzhen and Hong Kong. It also had several classes of shares that were issued – H shares for Hong Kong, B shares for foreigners on the Shanghai and Shenzhen exchanges and A shares for Chinese investors on these exchanges. For a long time there was a thin float in many of these companies as the state remained the majority owner with shares that did not trade. More recently, the government has been using IPOs for major Chinese companies, so-called champions, in an effort to improve their governance and transparency. From 1990 to 2002 there were some 1,446 IPOs in China of SOEs.27

6.8. Privatization Through Restructuring/Liquidation Conventional wisdom that emerged from the transition process was that governments should not restructure prior to sale. The buyer should be left to restructure based on his/her own view of the market. But buyers only want to buy viable assets. Since many large companies in the transition countries were large vertically and/or horizontally integrated monopolies, structural reorganization was invariably required prior to sale. Other defensive restructuring measures in preparation for sale included closure of loss-making factories and non-core lines of business, change of management to management supportive of privatization and severance of excess staff. Few buyers wanted to go through the layoff process immediately after purchase, so that governments often needed to face up to severance of excess employees. Financial re-engineering to remove or convert excess debt to equity and to write down obsolescent assets was invariably required. Of particular difficulty were one-company towns, where the company employed most of the workers in the town and invariably supplied all municipal services including canteens for meals, vacation resorts, sports teams, health clinics, schools, transport and utilities. A number of countries tried focusing on restructuring their major problem cases. For example, Poland set up a special restructuring group to restructure those companies that were highly reliant on CMEA trade, especially trade with Russia. Hungary simply selected some 100 of its largest loss-making companies for restructuring prior to privatization. Slovenia also selected some 100 companies for restructuring. Romania set up both privately owned and state-owned holding companies, so-called POFs and SOFs, to restructure companies prior to privatization. More recently,

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Serbia selected some 79 large groups, conglomerates that were largely obsolescent and operating at very low capacity, following the 10 or so years of conflict and isolation faced by the country until 2001. In each of these cases the country found the process to be very difficult. The large companies had significant lobbying power; they were able to get subsidies from their governments to keep themselves afloat or if they did not receive adequate direct subsidies, they simply stopped paying taxes, social security and state utilities and survived through indirect subsidies. Poland was almost unique in imposing hard budget constraints on SOEs, but this applied primarily to wage constraints. In the case of Serbia, the government has been steadily reducing subsidies and increasing funding for layoffs to accelerate privatization.

7. TIMING AND SEQUENCING Reformers in the region, particularly in the CEE, almost universally expected that they would complete privatization very quickly. Small-scale privatization was virtually completed in the first two years of privatization throughout the region. Countries then occupied themselves with MPPs usually for some three years thereafter, so that by the end of 1995 most of the small- and medium-sized companies in the tradeables sector had been sold; the majority of employees in the region now worked in nominally private firms and an increasing percentage of production and value added came from the private sector. The sale of large strategic companies in industry, banks and infrastructure companies took more time than reformers anticipated, but from 1995 to 2000 considerable progress was made in selling banks, telecom companies, gas and electrical distribution companies and trucking companies, and in contracting out air and sea ports, peri-urban transport and some municipal infrastructure.28 Countries in the SEE accelerated reforms and privatization when hostilities ended in the region. An exception is Serbia, which started its reforms once the Milosevic regime was overthrown and the period of isolation ended. Serbian privatization is still on-going and there has not been much progress on large strategic SOEs such as electricity.

8. SPEED VERSUS GRADUALISM As reforms progressed there was a sharp debate about speed versus gradualism of reforms in general and privatization in particular (Fig. 1).

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RISK Infrastructure, Energy, Transport

High risk

Financial Sector Tradeables Small Businesses Low risk

SPEED Gradualism

Fig. 1.

High Speed

Speed versus Gradualism in Privatization.

The argument was exacerbated due to Russia’s very rapid MPP.29 To the extent client countries had a large number of companies in the tradeables (commercial) sector to divest, some argued that privatization should progress as quickly as possible and draw on the lessons learned from previous privatization programs. The sale of larger strategic firms – infrastructure, energy and natural resource companies – requires much more effort and time to implement structural reforms prior to privatization. Examples of some of these structural reforms are sector reorganization/ restructuring, unbundling of networks and the quality of regulation and supervision. In banking it was the development of an appropriate regulatory structure and trained regulators. It was often assumed that transaction preparation, structural reform and regulatory work could proceed in parallel, but that may not have been appropriate in many cases. Given the time needed to carefully restructure/unbundle both the sector and the firms (in the case of utilities the sector and the firm may be the same) and establish adequate regulatory frameworks, there was a clear argument for gradualism in these sectors. But gradualism does not imply abandoning privatization and the end objectives of providing goods and services with the efficiency that results from competitive market pressures. In most of the countries in the CIS and SEE, gains from improving the environment within which SOEs operate and other measures to improve their operating performance, such as corporatization and contract management, have proven short term at best and more often elusive. Most governments have failed to follow-through on the full set

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of measures needed to better manage their SOEs. Moreover, SOEs are always potentially subject to politicization. That is why we argue in this chapter that it has generally proven better to privatize wherever feasible.

9. SEQUENCING OF INFRASTRUCTURE PRIVATIZATIONS Gradualism leaves countries with a dilemma. Most firms reside in a gray zone prior to divestiture, and often during this period between corporatization and sale, their performance deteriorates (Fig. 2). Sequencing of the process, therefore, becomes critical as the privatization process stretches out, as it did for the larger strategic companies, especially infrastructure companies where the sector usually was made up of one monopolistic stateowned company. Based on the last 10 years of experience in the region, as well as elsewhere in the world, it is important that governments are made more aware of the entire sequence of events and the likely timing to achieve the end objective of privatization. The sequence that developed for wellimplemented privatizations in infrastructure sectors was as listed below, with a number of these steps moving in parallel: (a) Structural reforms. Reorganize or unbundle the sector. This requires a careful evaluation of the sector with due consideration for both competition and business viability. Mechanistic formulas for unbundling simply did not work. There may be significant loss in privatization value, but more important to success is ensuring that the sector is properly structured or reorganized prior to privatization; (b) Corporatize. Once the sector or industry is reorganized, corporatizing the resulting firms with an emphasis on improving their profitability and operating performance becomes paramount. This must be done prior to their sale as commercialize SOEs. This requires, inter alia, the following: defensive restructuring, including financial re-engineering, improved

Technical Review of Sector Physical Inspection

Unbundling Sector Re-organization

Fig. 2.

Corporatization of Resulting Companies/ Defensive Restructuring

Regulatory Reforms

Preparation for Privatization

Privatization

Post Privatization Assistance

Sequencing of Privatization for Infrastructure Companies.

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governance such as the appointment of independent boards of directors, improved accounting, reporting and disclosure, and the use of external independent auditors. Improving the quality of information available both to government and to prospective buyers also enhanced the due diligence process; (c) Develop a regulatory framework. This usually required a new law, or at a minimum, decree for each sector, as well as detailed supporting regulations. Also, governments needed to create independent regulatory capacity separated from the line ministry. This proved difficult to achieve in CIS countries. In the case of utilities, governments had to carefully evaluate whether this implied one regulator with divisions covering each sector or separate regulators for each key sector – telecommunications, electricity, water, transport, etc. Alternatively, governments had to consider whether regulation was best accomplished by contractual agreement, within the license, or concession governing the divestiture. However, even contractual regulation required an oversight body capable of independently arbitrating contractual differences that arise, even when international arbitration is acceptable to both parties. The quality of these preliminary processes – structural reform, corporatization and establishing an independent regulatory framework – played a large role in driving the success of the privatization process, namely the price attained and the quality of the buyer. It also played a large role in determining the economic gains from privatization. Russia, for example, could attract billions of dollars in necessary FDI, but the failure to date to properly unbundle and restructure its telecom and electricity sectors has kept investors at bay.30

10. DONOR FUNDING AND THE SO-CALLED WASHINGTON CONSENSUS Substantial funding was required for all of the privatization programs. The World Bank Group, the European Bank for Reconstruction and Development (EBRD), the Asian Development Bank focused on Central Asia, USAID, the British Know-How Fund, the German aid agencies and others, all played a prominent role in funding these programs (though countries reliance on aid varied). The IMF played the key role in macroeconomic reform and central bank reforms, and played a role with other agencies in

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banking reform and other structural measures. Given the role of donor agencies in funding these programs, finding international experts and advising governments on how to implement aspects of their programs, the view arose that there was a ‘‘Washington Consensus’’ on privatization and related reforms. It has been suggested that somehow those who were a part of the ‘‘Washington Consensus’’ coerced these client governments into ill-advised programs that they were not prepared for. This view became fodder for the academic gristmill, including distinguished economists such as Joe Stiglitz.31 In an address after becoming a senior vice president and chief economist at the World Bank he said, ‘‘I want to review what I see as the major ways in which for want of a better term, I shall refer to as the ‘Washington Consensus’ doctrines of transition, failed in their understanding of the core elements of a market economy.’’ Not only did Stiglitz and many of the others who commented have no understanding of what the situation was on the ground in individual countries, but the facts are each of the key countries – Poland, Hungary, the Czech Republic and Russia as examples – designed its own privatization program that was distinctly different from the others. If there was a ‘‘Washington Consensus,’’ and a so-called best way to do privatization, then one would imagine a ‘‘cookie cutter’’ approach to reform. Perhaps the MPP under USAID funding was the closest to this cookie cutter approach, but this was applied to countries in the CIS that had done little to reform, had little of their own institutional capacity and needed some approach with which to begin the process.

11. ACHIEVEMENTS UP TO THE YEAR 2000 This section does not attempt to provide a comprehensive inventory of privatization in each transition country. Instead it establishes a typology categorizing countries and the status of their privatization program. These categories are not mutually exclusive, but they do illustrate the primary constraints faced by different transition countries. From the typology, it is clear that each country requires a unique privatization strategy based on its own endowments, its political and social constraints to reform, how far it has progressed with respect to transition and how the country and its privatization program is perceived by the market. China’s case is particularly unique, so it is not included in this typology. Much privatization in transition countries took place during the decade of the 1990s within a generally robust external economic environment focused

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on globalization. For emerging market economies, especially transition economies, this meant they would likely benefit by the well-defined strategies of liberalization, stabilization and structural adjustment. Privatization was viewed as the primary structural reform to move countries as rapidly as possible toward a market economy (Lieberman, 1993). The relatively rapid success of many countries in CEE and the Baltic states, now known as the accession states, in implementing comprehensive privatization programs, led to the general assumption that privatization could be implemented rapidly in all of the former Yugoslavian or SEE countries and in the CIS. But this has proven not to be the case. There are many reasons why countries have not privatized – reluctance to reform due to political and social constraints, lack of transparency of process, war and civil strife, poor endowments, small market size and companies not perceived as attractive privatization candidates. There are also cases that are sui generis such as the former Yugoslavian countries that lived under social ownership and required different approaches to privatization from other transition economies. Moreover, there are countries that have reformed little or not at all such as Belarus, Uzbekistan and Turkmenistan. Finally, as rapidly as many countries privatized, there is still a large inventory of companies to privatize, particularly large strategic companies in utilities, infrastructure, transport, natural resources, as well as banks. A basic typology of achievements to date is discussed below. Table 1 provides basic indicators by country of progress to date in privatization – revenues from privatization, related private sector share of GDP and FDI by country. Appendices A and B provide further backup to these basic indicators. A. Slow reformers/privatizers. Many of the transition countries have been either reluctant to privatize or late in their reforms, or have faced difficult starting conditions such as war or civil war, internal political opposition to privatization and poor market conditions. Examples of this type are Azerbaijan, Belarus, Bosnia, Georgia, Tajikistan, Turkmenistan and Uzbekistan. These countries are still at early stages of privatization and are limited less by external market conditions than by the pace of their own reform programs and the constraints of their own internal markets. B. Poor initial starts and problems of transparency. Other CEE and CIS counties have started badly and/or have privatized in a non-transparent way. This has devalued their programs and led to less than optimal market conditions with respect to the quality of buyers attracted to the

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Table 1.

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Private Sector Share, Privatization Revenues and FDI to GDP, 1990–2000 (%).

Czech Republic Hungary Slovak Republic Albania Estonia Bulgaria Lithuania Poland Russia Latvia Slovenia Armenia Croatia Georgia Kazakhstan Kyrgyz Republic Romania Ukraine Macedonia Moldova Azerbaijan Uzbekista´n Tajikistan Yugoslaviaa Bosnia-Herzogovina Turkmenistan Belarus

Private Sector Share of GDP

Privatization Revenues to GDP

Foreign Direct Investments to GDP

80 80 80 75 75 70 70 70 70 65 65 60 60 60 60 60 60 60 55 50 45 45 40 40 35 25 20

10.4 30.1 14.7 7 8.8 10.0 9.8 11.6 3.8 4.1 2.6 8.8 10.1 23.0 18.7 2.4 8.9 3.2

8.21 2.15 9.16 4.66 5.05 8.17 4.94 5.72 0.14 6.46 0.58 2.81 3.98 6.05 5.53 (0.35) 3.02 1.34 3.42 4.68 3.50 0.62 0.92 0.19 2.47 1.83 0.63

11.2 2.7 2.7 5.4

0.3

Source: ECSPF Strategy Paper on PSD. a Refers to Serbia and Montenegro before they separated into two independent countries.

program and to lower-than-anticipated valuations for their companies (e.g., Romania, Russia and Ukraine). Their programs are largely constrained by their own poor practices to date and market perceptions about the risks associated with investment in these markets. C. Strategic companies still in inventory. Many of the CEE and CIS countries have now completed the initial phase of privatization – smallscale privatization (the sale of small retail shops and service establishments) and the divestiture of most companies in the tradeables or

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commercial sector. But they have left some or all of their larger, strategic companies for future sale, including large commercial companies in steel, coal or petrochemicals (Poland), transport, infrastructure and utilities32 (Croatia, Serbia and Bulgaria are key examples) and banks (Russia). D. Ex-Yugoslavia (SEE) and social ownership. With the cessation of hostilities in the former Yugoslavia, most countries in the region have begun to implement transitional reform programs, including privatization in the independent states that have now emerged. Property rights and governance, known as social ownership, were distinctly different in Yugoslavia than the virtually monolithic state ownership of the traditional transition countries in the CEE and CIS. These countries therefore required a different approach to privatization than other transitional economies. These countries needed to decide how to treat social ownership and to what extent they were willing to break with their past and privatize socially owned firms, in addition to SOEs and mixed ownership firms. Serbia made such a decision, for example, and therefore had thousands of socially owned firms to privatize. Serbia is in the late stages of its program to privatize small companies and the large socially owned groups. The process is scheduled to be completed in 2007. However, Serbia has done little to privatize SOEs in major infrastructure sectors such as electricity, oil and gas and railways. Others, such as Slovenia (not affected by the conflict in the region) and Croatia, have made substantial progress in privatization and privatized many of their SOEs through vouchers and other means. The chapter on Serbia in this book provides rich detail on the process of reform and privatization in that country. It should be clear from this typology that there is much still to do with respect to privatization in some transition countries. While it is clear that external market conditions will inhibit some programs, other programs have significant room for improvement and for achievement.

12. PRIVATIZATION OF INFRASTRUCTURE, UTILITIES AND NATURAL RESOURCES COMPANIES A good deal has been achieved with respect to infrastructure privatization in the region, but much more needs to be done including municipal

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privatization of infrastructure. The discussion below highlights key issues that have had to be addressed in infrastructure and natural resource privatization and provides policy prescriptions for future privatization efforts in these sectors.

12.1. Legal Framework Complex policy and legal issues often surround the sales of utilities and natural resource companies. Creating a regulatory framework invariably requires a supporting law. Hence, privatization of infrastructure and energy companies may well require their own unique law prior to privatization (Guislain, 1998). The failure to create an adequate legal framework has slowed privatization programs and often derailed transactions.

12.2. Capacity to Privatize Sales of companies in the tradeables sector have required that governments create institutional capacity largely focused on a privatization ministry and/or agency. But the ability to sell larger strategic companies requires much more policy capacity – detailed knowledge of the sector and the need to make decisions on tariffs that impact citizens more broadly – than does the sale of companies in the tradeables sector. This means that the decisionmaking process for the sale of these strategic companies needs to be elevated to a higher political level, for example, to the level of the prime minister. A privatization commission involving the privatization ministry, the appropriate line ministry and the ministry of finance or economy should be formed to follow the process, to make the necessary policy decisions prior to sale and maintain oversight over implementation of the pre-privatization process as discussed above under sequencing. The privatization agency, normally with acquired expertise in sales transactions, should still be left with the responsibility for handling the privatization transaction – hiring advisors, handling the bids, negotiating the sale and closing the transaction. Decentralizing the privatization of infrastructure, energy and natural resource companies to line ministries has proved to be problematic, as the ministries usually cling to their source of power (the enterprise to be privatized) and lack the competence to implement privatization transactions.

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31

12.3. Non-Traditional Buyers With respect to larger strategic companies – energy, infrastructure and banks – much of the privatization efforts in the region were Euro-centric and focused on strategic buyers in the advanced industrial countries. See Table 2 for a list of the 10 largest investors in the energy and telecom sectors, many of which had their own financial difficulties and were divesting holdings in the region in the late 1990s and have continued to do so until recently. A Euro-centric focus on divestiture made sense for countries in CEE or the Baltics (many of these countries at that time were progressing toward EU accession). That makes little or no sense for many of the CIS countries, especially in the Caucuses and Central Asia. These countries and their advisors will need to consider marketing efforts that are more globalized and that focus less on advanced industrial countries and more on investors who can and may be willing to operate in more difficult markets. Investors from Korea, India, Turkey, Malaysia, China and the Chinese diaspora and Russia are possible examples.

12.4. Alternatives to Privatization For countries unable to attract strategic buyers at present, alternatives to privatization need to be considered. SOE reform has a long track record Table 2. Privatization of Energy and Telecom Sectors in the CEE and CIS Countries by Top 10 Largest Investors, Million $US. Sponsor (Energy Sector)

Amount Invested

Sponsor (Telecom Sector)

Amount Invested

InterGen, Enka Alcatel, Gama, Phillip Holzmann Siemens AG, Steag AG CS First Boston RWE Energie Enron Corp. Tractabel National Power AES Corp. NRG Energy

2,200.00 1,590.00

Deutsche Telecom France Telecom

11,276.00 7,160.00

1,375.00 1,100.00 1,084.00 911.00 858.00 808.00 760.00 714.00

Sonera PTT Telecom Netherlands Swiss Telecom PTT Telecom Italia Ericsson Telia AB

6,776.00 5,150.00 4,846.00 3,525.00 3,386.00 3,261.00

MFK-Renaissance

1,890.00

Source: Calculated by Staff from PPI database.

32

LEAST MARKET ORIENTED

IRA W. LIEBERMAN ET AL.

SOE Corporatization

Fig. 3.

Contracting Contract Out Management

MOST MARKET ORIENTED Concessions

Alternatives to Privatization.

without much to show for it.33 On a scale moving from least marketoriented to most market-oriented (Fig. 3), alternatives consist of corporatization, contract management, contracting out and concessions. Lease purchase agreements and installment sales are alternative methods of privatization that deserve mention because they are forms of divestiture which reduce the upfront capital required by a strategic investor to acquire a company. 1. Corporatization should be considered a starting point in SOE reform. It allows the SOE to be operated according to commercial principles and encourages important governance changes such as the appointment of independent boards of directors, changes in accounting standards, improved disclosure and use of qualified external auditors. Corporatization should be preceded by structural changes/unbundling in the sector that sets the stage for competition. Also, countries such as Poland that have managed to impose hard budget constraints on SOE subsidies and transfers and on excessive wage increases appear to have succeeded in improving SOE performance. But corporatization is not an alternative to privatization; experience has shown that many of these improvements in SOEs are temporary in nature, if not followed up in time with changes in ownership. 2. Contract management establishes incentives for the managers of corporatized SOEs to operate as if they were in the private sector. The theory is good and many countries have tried to develop contract management systems, but few have done so effectively.34 The reasons for failure of contract management systems appear to boil down to a few key issues:  Asymmetric information. Managers have all of the detailed information on the company and are inclined to negotiate soft targets. This could be mitigated, in part, by improving standards of disclosure and reporting. Where the SOE is in a commodity sector or utility, performance can presumably be benchmarked against international best practice standards and performance targets raised over time.

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33

 Government commitment. Government failure to adhere to the contract system is a frequent source of failure in contract management.  Targeting is too complex. Contract systems generally utilize too many parameters to be monitored effectively. Setting targets implies that an independent, regulatory institution should be created to evaluate performance, such as a panel or commission. But governments, especially their line ministries, have rarely been willing to cede such authority over their SOEs.  Sanctions are not enforced. Negative sanctions for poor performance, such as firing managers who do not perform adequately, are rarely enforced.  Lack of ownership change. Finally contract management does not imply an ownership or even a control change. The state must still provide financing for operations if there is a deficit and for new investments. 3. Contracting out. The appointment of private management to operate an SOE for a fee that normally includes incentives.35 Contracts are normally for a medium-term period, 5–15 years as an example. The state, as owner, is still required to finance the firm’s operations and required capital expenditures. Contracting out has been commonly and successfully utilized in the hotel and services industry to take advantage of the marketing and reservations systems of international groups or hotel chains. But contracting out has also worked well in tandem with concessions. For example, in airport concessions the retail shops will be contracted out or in port concessions ancillary service providers will often be contracted out. In these cases, the quality of services normally increases markedly. Contracting out is also appropriate in the spin-off of social services from large SOEs in transition countries with a broad range of social services such as canteens, kindergartens, health clinics and vacation spas. Contracting out could also be utilized well in industries with relatively undifferentiated products – commodity sectors such as steel, water, cement, power generation and network carriers such as gas pipelines or electrical transmission grids. In addition, contracting out has been widely utilized for municipal services such as bus transportation and garbage pickup. Contracting out to private managers has often proved successful as opposed to contract management.36 But why is this the case? According to Shirley the key issues are  Information. Governments are in a better position with respect to information on the SOE than when contracts are offered to SOE

34

IRA W. LIEBERMAN ET AL.

managers. The quality of information can be substantially improved when a contract is bid out competitively and the potential contractors’ due diligence and bid submission then enhances government’s knowledge about the SOE.  Incentives. Most successful contracts employ success fees and earned equity stakes in addition to a fixed-fee component in the contract.  Independence of operation. The most successful cases were those where governments allowed the contractor to operate independently without political interference.  Commitment. Many successful contracts were concluded with corporatized SOEs where government allowed its board of directors to oversee the contract. Commitment was also enforced by international binding arbitration. Other contract features that increased commitment were contracting with established, reputable firms that would strive to maintain their good name, performance-based renewal clauses and increasing terms of the contract to allow it to be fine-tuned over time. Then why are contracts with private managers used so infrequently?  Some sectors are more suitable than others to management contracts, largely because performance can be benchmarked more easily in sectors with undifferentiated products.  Management contracts offer no visible, upfront gains to government. In fact, governments generally are required to pay contract fees and other incentives to foreign multinationals and also need to continue investing in the firm. Therefore, contracting out has political costs which may proximate those from privatization without the benefits.  Calibrating the incentives correctly is very difficult. For example, if the incentives are all profit-oriented, then the contractor may be tempted to allow the facilities to run down due to inadequate attentions to maintenance. On the other hand, contractors may push governments to over-invest so as to maximize their contract returns. Negotiating a balanced management contract may in fact be as difficult as outright privatization. Despite its difficulties, where government cannot privatize at present, contracting out to private parties might serve as an important interim step pursuant to eventual privatization. Moreover, the contract can always include a purchase option. 4. Concessions. Long-term concessions are in most cases an excellent proxy for outright privatization. Concessions have been utilized widely throughout the world where countries, mostly for constitutional

An Overview of Privatization in Transition Economies

35

purposes, cannot alienate their natural resources or network. So concessions have been utilized in oil and gas exploration, timber cutting, mining, water systems and toll roads. A concession is generally longterm, 20–30 years for example, to match the lumpiness of investments required. The concessionaire is responsible for greenfield investments where a startup is involved, such as a new mine, ongoing capital investments as required as well as maintenance of facilities. The concession agreement is usually focused on profit-sharing arrangements, royalty and/or tax payments, the rate of allowable production or depletion of natural resources, and the level of investment commitment. Concession agreements are also very complex, but their length allows government and private investors to fine-tune or adjust the concession agreement and to amortize the cost of preparation over time. Experience has shown that a large percentage of concessions are renegotiated within the first two years of operation (Guasch, Kartacheva, & Quesada, 2000). That is generally perceived as problematic, and in fact may be, if the concession holder ‘‘low-bid’’ the concession and then expects to renegotiate with the government. But it is also true that concession holders often bid with inadequate information and once they are in they find that conditions in the company are far worse than disclosed. Concessions usually allow for renegotiation in the event of some material issue or arbitration. All of the alternatives discussed herein have advantages and disadvantages, but the central issue is that governments having difficulty privatizing have employed a diverse menu of alternatives rather than leaving these firms as SOEs. But governments should still focus on best practices in selecting buyers or contracting parties, such as transparency, meaning competitive and open processes, and use of independent professional advisors.

12.5. Regulatory Framework for Infrastructure and Energy Privatization of large strategic enterprises such as energy and infrastructure where state monopolies largely dominate – telecom, electricity, water, oil and natural gas pipelines, and natural resource companies such as oil and gas, and mines and timber – require that a regulatory framework be established, including laws and institutional capacity, in advance of or in

36

IRA W. LIEBERMAN ET AL.

parallel with preparation for privatization. This framework should at a minimum allow for the following:  Create conditions for future competition in the sector. Increasingly, changes in industry or network structure occur through a process called unbundling, specifically in electricity and telecom. Allowing competition to prevail is viewed as the best approach to ensure technological development and delivery of service (Kessides, 2004);37  Provide for consumer and investor protection by establishing the basis upon which tariffs or prices are set. This process of tariff rebalancing, if not regulated correctly, can either lead to substantial distributive inequity as consumers bear the burden of excessive profits accruing to the privatized utility, or on the other extreme fail to lead to service improvements and extensions as price increases fail to allow for business viability and expanded investment in the sector;  Define maximum rates of depletion or exploitation in natural resource sectors such as oil and gas, timber and mining. Regulation of these resources will hopefully allow for sustainable development and encourage future investments. Regulation should also clearly establish licensing fees, royalty rates on production and taxes for downstream processing. It is increasingly clear that the quality of the regulatory framework and the independence of the regulator have been and still are important drivers of successful privatization in these sectors. The quality of the regulatory framework will determine whether the benefits of the privatization are distributed equitably and also allow the sector to develop. These issues are complex and even the advanced industrial economies have had difficultygetting it right.38 Important questions need to be addressed such as: how networks should be unbundled to allow for competition while still leaving in place viable business structures? How many regulators should there be – one for each utility sector or a super regulator covering all such sectors? Should regulation be conducted primarily through a regulatory body, allowed reasonable discretion over issues such as tariffs and competition in the sector, or through detailed regulation embodied in the contractual agreement with the buyer or concessionaire? Which regulatory formulas should be used in sectors such as electricity (rate of return, benchmarking or price cap regulation) is difficult to get right. The responses to these questions depend on the quality of information available to the regulators, the incentive structure of the regulations, the commitment of the country to live up to its own regulations, the mechanisms for resolving regulatory disputes

An Overview of Privatization in Transition Economies

37

and the transparency of the process (how does the affected public weigh in to ensure distributive equity?). In some cases, it is not physical assets, but licenses that are for sale. Examples of these cases are the licensing of addedvalue services in telecommunications, such as mobile and wireless services, paging and data transmission. Licensing often involves third-party access to a public or privatized fixed-line carrier. Increasingly, the problem in countries in the region is not just a failure to privatize, but the risk inherent in regulatory failure, including regulatory capture, in countries with weak institutional capacity and little traditional of regulatory independence.39 All of these issues with respect to regulation take time to consider and to develop adequate laws and regulations and regulatory capacity. There is an important argument for gradualism of process in privatizing energy and infrastructure companies.40 For example, one of the difficulties that Latvia faced in the privatization and liberalization in electricity, telephone and gas was the weakness of its regulatory agencies that had neither the skill nor the strength to provide robust regulation or to stand up to government interference on rates. In Lithuania the situation was better with a strong and experienced regulator. This has eased the privatization of telephone, gas and electricity, and delays in the latter two have been due to lack of government commitment or transparency. In Romania, on the other hand, slowness in setting up adequate regulation held back the unbundling and privatization of electricity and gas.

12.6. Competition The development of contestable markets that allow competition to thrive should normally be an important outcome of privatization programs. In fact, some analysts would argue that competition drives restructuring and efficiency, and not changes in ownership at all. As Sir Roger Douglas, former Finance Minister of New Zealand and architect of the country’s privatization program, notes, ‘‘We were prepared to sacrifice price to get maximum competition. Competition drives innovation, providing the impetus for seeking new and better ways for doing things’’ (Douglas, 1994). However, in many countries in the region, the utilities often have strong political and insider ties and have tried to defend themselves against liberalization and competition. One of the significant examples in the region is Svyazinvest, the Russian telephone monopoly. The Russian government turned the domestic telephone system servicing all of Russia’s 81 oblasts (regions) into a company and tried to privatize it as such.41 The obvious

38

IRA W. LIEBERMAN ET AL.

alternative would have been to create a number of regional ‘‘baby bells’’ that in time would be allowed to compete with each other. After failing to sell a 25% stake to the Italian state telecom company, the government managed to sell a 25% stake to an investment consortia that included the Russian oligarchs, Victor Potanin and George Soros for a billion dollars. Eventually, Soros sold his shares back to Russian interests, with little to no reform in the sector.42

12.7. Pricing Policies In infrastructure sectors with progressive liberalization and privatization, the realignment of prices with underlying long-term costs is necessary to support investment into the sector for necessary modernization and future expansion. This often includes providing access to poorer segments of the population without prior access. Table 3 reveals the extent of underpricing in the electricity services in the transition countries. In almost all CIS countries as of 2000, household electricity prices covered less than 50% and industrial prices less than 70% of long-run marginal costs. It would be difficult to imagine that even an independent and transparent regulatory regime would be able to facilitate private investment under those pricing conditions. However, tariff rebalancing is a politically difficult and potentially costly process. Meanwhile, to attract investment into these Table 3. Power Prices in Transition Countries in 2000. Country

Albania Czech Republic Estonia Georgia Hungary Kazakhstan Poland Romania Russia Slovenia Ukraine Source: EBRD.

Residential (¢/kWh)

Industrial (¢/kWh)

Industrial/ Residential Price Ratio

Residential Price/ LRMC Ratio

2.8 4.5 6.7 4.4 5.9 2.7 8.4 4.9 0.9 7.6 2.0

2.6 4.3 6.7 4.3 4.5 2.8 3.1 3.9 1.6 7.0 2.3

0.9 1.0 0.9 1.0 0.8 1.1 0.4 0.8 1.8 0.9 1.1

0.3 0.6 0.8 0.5 0.7 0.3 1.1 0.6 0.1 1.0 0.2

An Overview of Privatization in Transition Economies

39

sectors, infrastructure companies must produce an adequate level of revenue that would provide an investor with an acceptable return on equity (ROE) or investment (ROI). An acceptable ROE/ROI is likely to be high for many transition countries given the perceived economic and political risks, and still higher at present due to difficult conditions in world markets as discussed previously. This leaves policy makers in transition countries with an apparently irreconcilable dilemma. Their own predilections on top of powerful political pressures have motivated them to pricing below the longterm cost of sustainable operation, with elements of centralized price setting and heavy cross subsidization that are unsustainable in an environment of open competitive entry. Regulation that relies on centralized price setting and disallows price differentiation and flexibility can seriously undermine the anticipated benefits of privatization or liberalized entry.

12.8. Technological Change Another factor contributing to changes with respect to privatization, deregulation and competition is the pace of technological change in industry generally, but especially in infrastructure sectors. For example, the telecommunications sector is introducing third-generation wireless technology that will drive down the importance, and hence the value of fixed installation systems (i.e., traditional telecom companies).43 Some sectors simply may not easily allow for competition, such as the sale of water companies, mines, oil and gas production, gas pipelines, ports, airports, toll roads and municipal services that include bus transportation or garbage and sewage treatment and disposal. There is an endless debate about whether public monopolies should be privatized. But privatization of ports, toll roads, wastewater and sewage disposal and water facilities has worked well. Competition in these sectors can be induced by auctioning or bidding-off services, or horizontal breakup by region. Horizontal breakups entail allowing more than one water carrier to bid for regional water companies and allowing them to compete with each other by utilizing benchmarking regulation to monitor their performance. This is an example of where other forms of privatization such as concessions and contracts, combined with contractual regulation, can come into play. Concessions, with the high level of investment usually necessary, are common for natural resource investments or natural monopolies such as ports, airports, toll roads or railroads where governments may be

40

IRA W. LIEBERMAN ET AL.

unwilling or constitutionally unable to alienate the underlying resource via outright sale. But the quality of the concession or contracting agreement, often as difficult as or more than straight divestiture, will drive the benefit to the country. Not surprisingly, concessions and contract operation have played a limited role in privatization to date in the region because of the complexity of the contractual arrangement and the need for the concessionaire to have confidence that the government will live up to the concession agreement.44 Reliable judicial enforcement or international arbitration is essential if issues arise over the contract as they invariably will.

12.9. Competition versus Business Viability In some cases, the market may be so small that competitive restructuring, such as the model pioneered in the U.K. and currently recommended by international institutions to induce competition into the electricity sector, may not prove viable from a business perspective. By separating distribution into a number of regional companies, leaving transmission as a publicly regulated monopoly, and by breaking power generation into a number of companies depending on the sources of energy and their location, countries may create the possibility for competition but find no buyers. In smaller economies such as the Kyrgyz Republic, Tajikistan, Armenia, Georgia and Moldova, for example, such models may not work. In Latvia and Lithuania, the gas companies were too small to unbundle and sell and they were sold as regulated monopolies. Staff of institutions such as the World Bank and EBRD, which provide policy advice to governments and their appointed financial advisors, will need to carefully evaluate the issue of business viability and attractiveness for sale versus optimal competitive structure. The same is true of telecom. It is ideal to separate fixed-line carriers and added-value services such as long distance, satellite, cellular, internet and data transmission services, but increasingly fixed-line systems are a wasting asset and may need to be sold with one or more service licenses. Again business viability is an important issue and a potential tradeoff. Another important issue is the size of the market. In the Czech Republic, for example, many operators were interested in CEZ – the partially integrated and partially split – electricity company because of the Czech Republic’s key position in an integrated Central European market, which would include some of the southern German states. The hope of a liberalized gas and electricity market spurred many investments based on

An Overview of Privatization in Transition Economies

41

trading of these commodities. The Enron debacle led buyers toward a more conservative approach to acquisitions in the electricity industry in the region. Countries in Central Asia and the Caucuses may find that there is little investor appetite for the purchase of their infrastructure companies, until there is an effort to demonstrate more commitment to regional agreements and integration in key sectors such as electricity, water and telecommunications. Structural reorganization prior to sale will need to be carefully thought out as an integral part of an advisor’s mandate. It is also important to bear in mind what potential buyers may want to acquire. For example, in the case of telecoms, some Western operators like Telewest were interested primarily in cellular telephony and cable, while others like the integrated France Telecom or Deutsche Telecom were comfortable acquiring incumbent operators, although they too preferred to buy wireless assets as margins were higher. Governments should also ensure that access to the market is maintained. Early telecommunications privatizations gave buyers excessive periods of exclusivity, shutting the market to competition. A situation where an incumbent is given unfair advantages and then competitors are let in is probably an undesirable and inefficient way to lower costs to consumers.

12.10. Social Impact No public policy can be justified on purely efficiency grounds if the polity regards its results as insufficiently just. There is a strong emerging consensus that the worldwide policies of privatization and market liberalization in the infrastructure sectors have brought about significant benefits in terms of enhanced productivity and cost-effectiveness, greater responsiveness to consumer and business needs and increased investment driven by market incentives rather than bureaucratic preference. However, concerns are increasingly being expressed about the distributional consequences of these reform programs, especially the price increases that frequently accompany privatization and their impact on the provision of basic service to poor households and other disadvantaged groups. The sale or concession of water companies in the region has become particularly contentious. Water is seen in most of the developing and transition countries throughout the world as a public good that should not be owned by commercial interests. Therefore, water privatization may not prove to be feasible in the region for some time to come.

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12.11. The Distributive Impact of Privatization Privatization of network utilities that provide services broadly to the public, such as telecom, electricity, water and other infrastructure including urban transportation, railways and district heating, is particularly important with respect to its distributive impact on the population. Tariff balancing may have uneven distributive impact depending on the required tariff increases to cover the costs of doing business, and the returns required by investors in the sector to justify its rehabilitation, extending services and continuing investment in the sector post-privatization. This is a difficult balance to achieve and, in large part, will depend on the quality of the regulatory process as discussed previously.45 An important social feature of infrastructure and energy privatization is the extension of services to the poor. While overall subsidization has not worked well in the past, targeted subsidies may be appropriate to expand services to the poor, for example to overcome higher one-time connection costs in remote areas (see Harris, 2002). The further a country is from cost-covering tariffs, the more difficult the privatization process is likely to be. The political and social costs of increasing tariffs 50–75% in a short period of time are daunting to officials facing the decision to privatize. This is perhaps one of the major dilemmas for governments facing infrastructure privatization. At the time of privatization, all of the explicit and hidden subsidies are flushed out. The real costs of service must be reckoned with plus a return on investment necessary to justify the acquisition costs by a buyer, as well as anticipated post-privatization investments in the sector. Policy solutions that are consistent with both economic efficiency and social equity are not always available or politically feasible. In this context, the policy makers in the transition countries face no more challenging task than to design and implement urgently needed pricing reforms that strike a more satisfactory balance between the overarching public policy goals of economic efficiency and distributional equity. Clearly, pricing policies that lead to fiscal drain, under-investment and inadequate maintenance do not serve the public interest well in the long run. Both the level and structure of infrastructure prices are badly in need of rebalancing. However, although such rebalancing can be expected to benefit all affected groups in the long run and certainly contribute to the social welfare, there is some reason to resist too abrupt a transition to the new pricing regime. In view of the socioeconomic characteristics of many of the transition countries, radical, acrossthe-board price rebalancing schemes can cause large and often difficult

An Overview of Privatization in Transition Economies

43

adjustment costs to consumers and firms alike, and thus seriously conflict with poverty alleviation and social fairness. Even optimal prices, if instituted extremely rapidly, can lead to a transition process that is damaging and costly and hence far from optimal. However, there are also significant distortions inherent in a gradual transition process and making the transition as short as possible helps minimize these distortions. The welfare consequences of infrastructure and energy privatization are yet another issue. The welfare consequences reflect which stakeholders – the public, the investor, government and employees – receive the benefits of privatization and how those benefits are divided up.46 This is particularly relevant, for example, where business charges for electricity stay high, so governments can avoid raising tariffs to consumers. The distributive consequences of privatization may then not be adverse to the public because it would have captured the majority of the rents. However, the economic benefits from privatization may be lower than anticipated – to the government in a lower purchase price, to the buyer in less than anticipated returns from the investment and to the public due to the investor’s reluctance to continue extending and/or modernizing services while earning lower returns. So balancing tariffs and their welfare impact proves very difficult in network privatization and goes to the heart of the issues faced by government contemplating such a decision. Transparency, particularly as to who oversees and is involved in the regulatory process, though not often discussed in relation to the distributive equity and welfare consequences of privatization, may also be very important. In the United States, utility rate increases have been subject to public hearings for years, with the public represented by independent economic and legal tariff experts, subjecting company proposals for rate increases to careful public scrutiny. Not only is the quality of the initial regulatory framework a key issue at the time of privatization, but also the institutional capacity of the regulator and transparency in examining the distributive impact of subsequent tariff changes may be equally as important.

12.12. Data on Infrastructure Privatization in Transition Economies Figs. 4, 5 and 6 below present data on privatization, private investment and other methods (OM), as well as alternative approaches to privatization for infrastructure and energy through 2001 in the transition countries. Also, see Appendix A for additional statistics on privatization and Appendix B for

44

IRA W. LIEBERMAN ET AL. Divestiture 48.3% Greenfield 45.3%

OM_with Major Private 6.2%

OM Project 0.2% Total $85,677 (millions)

Fig. 4.

Transition Countries Infrastructure Projects with Private Participation by Class, 1990–2001 (%). Source: World Bank, PPI Database (2001). Transport

Greenfield 17%

Telecom

OM_with Major Private 65%

Divestiture 18%

Greenfield 49%

Total $56,429 (millions)

Total $ 4,599 (millions)

Water OM_with Major Private 46%

Divestiture 51%

Energy

Divestiture 6%

Divestiture 53% Greenfield 44%

OM Project 4% Total $3,137 (millions)

OM_with Major Private 4%

Greenfield 43% Total $ 21,512 (millions)

Fig. 5. ECA Private Participation by Class for Infrastructure Sectors, 1990–2001 (%). Source: World Bank, PPI Database (2001). OM, other methods of sale contracting out and concessions as examples; OM with major private, other method of sale with a major private investor.

matrix of cases on a select list of transition countries. Fig. 4 points to the importance of greenfield investments in the sector, almost equal to privatization revenue numbers. Figs. 4 and 5 point to the relatively small role played by other methods of privatization. Only some 6.4% of total investments were accomplished via OM, with the exception of the water and transport sectors, where other methods of privatization account for 50% and 65% of

An Overview of Privatization in Transition Economies

45

Telecom 69%

Energy 28%

Water 2%

Transport 1%

Total $ 30,614 (milliions)

Fig. 6.

ECA Revenues from Infrastructure Privatization, 1990–2001 (%).

investments, respectively. However, the absolute level of private investment into these two sectors from 1990 to 2001, some US$3.2 billion into the water sector and US$4.6 billion into transport, is relatively low in comparison with US$6.4 billion into telecom and US$21.5 billion into electricity. With respect to revenues from privatization, Fig. 6, 69% came from telecom, 28% from electricity, 2% from water and 1% from transport.

13. FINANCIAL SECTOR PRIVATIZATION 13.1. Background Given that the privatization of banks needs to progress within a context of economic reforms, it is not surprising that such privatization has progressed more rapidly in those countries that have moved most quickly toward a market economy. Thus, CEE and some SEE countries such as Bulgaria and Croatia have moved much further than many of the CIS states toward privatization of their financial sectors (Table 4). EU accession countries have stabilized their economies much faster than nations further east, from Ukraine to Russia and the Central Asian Republics. Another interesting fact is that privatization has been accompanied by a noticeable decline in the number of banks, due to consolidation and the disappearance of both small, ineffectual, newly created banks and large state-owned institutions. The total number of banks in Central Europe decreased from an average of 43 per country in 1993 to 34 per country in 2000, while in the CIS, excluding the Russian Federation, the average went from 104 to 45 per country. A similar pattern was seen in the SEE, where the

46

Table 4. Selected Bank Privatization in Eastern Europe (1993–2002). Date

Bank

1993

Wielkopolski Bank Kreditowy (I) Polnobanka (I) MKB–Hungarian Foreign Trade Bank (I) Budapest Bank OTP (I) Bank Gdanski (I) Zagrebacka (I)

1993 1994

1995 1995 1995 1995

1995

1996 1996 1997

1997 1997

Stake Sold

Form of Privatization

Name(s) of Strategic Investor(s) Listed

Poland

37%

Initial public offering

Slovakia Hungary

20% 32%

Sale to strategic investor Sale to strategic investor

EBRD Bayerische Landesbank Girozentrale

Hungary Hungary Poland Croatia

60% 34% 59% N/A

GECC, EBRD

Poland

50%

Sale to strategic investor Initial public offering Initial public offering Initial private placement+privatization offering Initial public offering

Hungary Hungary

89% 27%

Sale to strategic investor Sale to strategic investor

ABN Amro Bayerische Landesbank Girozentrale

Poland Poland

31% 20%

Sale to strategic investor Sale to strategic investor

BIG Bank Allied Irish Banks

Hungary

56%

Sale to strategic investor

KBC, Irish Life

Hungary Poland

25% 60%

Secondary offering Initial public offering

If IPO, Where

Warsaw

Budapest, Luxembourg Warsaw

Warsaw

Budapest, Luxembourg Warsaw, London

IRA W. LIEBERMAN ET AL.

1996 1996

Bank PrzemyslowoHandlowy (I) Magyar Hitel Bank MKB-Hungarian Foreign Trade Bank (II) Bank Gdanski (II) Wielkopolski Bank Kreditowy (II) Kereskedelmi es Hitel Bank (K&H) OTP (II) Bank Handlowy (I)

Nationality

1998

1998 1998

1999 1999 1999 1999

1999 2000 2000 2000 2000

2000

Ceskoslovenska Obchodni Banka (CSOB) Pekao (II) Polnobanka (II) Bank Gdanski (III)

Hungary Czech Republic

84% 36%

Sale to strategic investor Sale to strategic investor

Erste Bank Nomura

Poland

37%

Sale to strategic investor

Bayerische Vereinsbank (HVB)

Poland Romania

15% 51%

Initial public offering Sale to strategic investor

Poland Croatia Romania

80% 66% 45%

Sale to strategic investor Sale to strategic investor Sale to strategic investor

Czech Republic

66%

Sale to strategic investor

Poland Slovakia Poland

53% 51% 50%

Sale to strategic investor Sale to strategic investor Sale to strategic investor

Bulbank Investicni a Postovni Banka (II) Powszechny Bank Kredytowy SA

Bulgaria Czech Republic

98% 100%

Poland

57%

Slovenska Sporitelna

Slovakia

87%

Sale to strategic investor Resale to strategic investor following government intervention Sale to strategic investor (merger)

Sale to strategic investor

Warsaw SG

Allied Irish Banks BCI – Intesa GECC, Banco Portugues de Investimiento KBC

UniCredito, Allianz UniCredito Banco Portugues de Investimiento UniCredito, Allianz CSOB (KBC controlled)

First it merged with Bank Austria Creditanstalt Poland then with BPH (HVB Group controlled) as a result of the Bank Austria – HVB merger Erste Bank

47

2001

Mezobank Investicni a Postovni Banka (I) Bank PrzemyslowoHandlowy (II) Pekao (I) Banca Romana Dezvoltare (RDB) Bank Zachodni Privredna Banka Banc Post

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1997 1998

48

Table 4. (Continued ) Date

Bank

Nationality

Stake Sold

Form of Privatization

Banca Agrı´ cola

Romania

98%

2001

Bank Handlowy (II) Zagrebacka (II)

Poland

80%

Croatia

96%

Nova Ljubljanska Banka Commercial Bank Biochim

Slovenia

38%

Sale to strategic (merger) Sale to strategic (merger) Sale to strategic (buyout) Sale to strategic

Bulgaria

99%

Sale to strategic investor

2002

Splitska Banka

Croatia

88%

Sale to strategic investor

2002

Komercni Banka

60%

Sale to strategic investor

2002

Rijecka Banka

Czech Republic Croatia

85%

Sale to strategic investor

2002 2002 2002

investor

Raiffeisen

investor

Citibank

investor

UniCredito, Allianz

investor

KBC

If IPO, Where

First to Bank Austria Creditanstalt and then it merged with HVB Bulgaria First to Unicredito and then to Bank Austria Creditanstalt SG First to Bayerische Landesbank Girozentrale then to Erste Bank

Note: Banks that have been privatized in different tranches are listed more than once. Source: David Todria, East European Banks, Europe Review, Times Publications, 2000 plus World Bank Staff’s own research.

IRA W. LIEBERMAN ET AL.

2001

Name(s) of Strategic Investor(s) Listed

An Overview of Privatization in Transition Economies

49

total number of banks decreased during the same period from 109 to 42 institutions, while the Russian Federation saw a slight increase from 2009 to 2084 banks.47 Taken as a whole, the countries in CEE and Central Asia saw the number of lending institutions increase dramatically soon after the liberalization of their economies, only to undergo a sharp decrease during the last 10 years or so. One important conclusion from the data of consolidation and concentration in the region is that pressure in this direction is due to liberalization and privatization, as well as to administrative decisions linked to the regulation of the sector, and not only due to competitive pressure.48

13.2. Regulation and Supervision In the financial sector – banks, pension funds, insurance companies and capital markets – there is a need for a regulatory framework that sets prudential guidelines for the operation of institutions, licensing requirements, an independent regulator and detailed disclosure and reporting requirements for the industry. Ideally, liberalization should open the sector to the entry of and competition with foreign banks. The World Bank and the IMF have emphasized creating adequate regulatory and supervisory capacity within client countries. This has been a difficult lesson learned postliberalization and privatization in many countries, following deep financial crises in Mexico (1995), East Asia (1997–1999), Russia (1998) (that washed over smaller countries in the region) and Turkey (2001). The World Bank and the IMF have also cooperated on systematic reviews of the financial sector in most of these countries known as financial sector assessment programs (FSAPs). There is still a large inventory of state-owned banks and in some countries non-bank financial institutions, such as insurance companies, to be privatized, and this will require strengthening regulation throughout the region.49

13.3. Banking Sector Privatization Achievements In addition to the establishment of a solid regulatory regime, three additional factors are also important in bank privatization: the availability of transparent and complete financial information, which is key for bank regulators and for any potential investors; a commitment from the government to a competitive environment free from interference by state-owned

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IRA W. LIEBERMAN ET AL.

banks, or pressure to make directed loans to state-owned and/or preferred enterprises; and independent supervision based on a strong and enforceable mandate against non-compliance. Banking system reforms and the development of non-bank financial intermediaries such as leasing companies have lagged behind privatization of the real sector in many CIS countries. For the most part, banks were not reliable sources for enterprise financing by the end of the decade (see Fig. 7), nor were they mature enough financial institutions for the financial discipline and external governance that banks can bring to enterprises. While donors pushed countries to eliminate subsidies and directed credits, many enterprises were cash-starved following privatization. Political pressure remained great even after privatization, as in the Czech Republic, where several banks had to be reprivatized following their failure. This failure was a result of making too many non-performing loans (NPLs) to privatized, but nevertheless politically important companies, such as Skoda Pilsen, Tatra and several steel mills. The countries in the whole region can be split into several groups as far as their approach to privatization:  EU accession countries (Poland, the Czech Republic, Slovakia, Slovenia, Hungary and the Baltic states);  Other Central European countries, some who have been recently included in the next wave of EU accession (Romania, Bulgaria) and others a bit 140 120

ECA Region

SEE

Turkey

EU Accession

CIS

EU members

100 80 60 40 20

Fig. 7.

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0

Domestic Credit by the Banking Sector (as % of GDP). Source: Calculated by Staff Based on Data in ECSPF Financial Sector Strategy Paper.

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51

further behind in the EU accession list (Croatia, primarily on political not economic grounds, Macedonia, Bosnia and Herzegovina, Albania and Serbia-Montenegro);  Russia and Ukraine;  Countries in the CIS that have eliminated (Armenia and Georgia) or extensively diminished state participation in the banking sector (Kyrgyz Republic, Moldova and Kazakhstan);  Countries in the CIS that have made little or no progress toward privatization (Belarus, Azerbaijan, Uzbekistan, Turkmenistan and Tajikistan). The accession countries have aggressively privatized most of their banks – though Slovenia was a slower reformer – primarily to foreign banks, increasingly integrating their banking systems into the banking system of Western Europe. This has proved important in strengthening the banking system in each of these countries. But the drawback is that these acquired banks, controlled from abroad and with credit decisions made in London, Vienna or Frankfurt, may be more sensitive to banking risks in these local markets and less willing to support local firms. The CIS countries, on the other hand, moved slowly on banking reforms and have also shown reluctance to allow foreign banks into the sector in any significant way (i.e., Russia and Ukraine). Belarus, Azerbaijan and Uzbekistan have retained largely state-owned banking sectors and the respective governments, while publicly supporting privatization, find it difficult to disengage from the larger state-owned banks. While commercial banks in the Kyrgyz Republic are for the most part private, they were badly affected by the Russian financial crisis and large-scale fraud in a couple of banks. Uzbekistan has pursued an industrial policy that has utilized its state banks to extend directed credits to particular sectors such as cotton, automobile assembly and auto parts manufacturing. Consequently, these banks are loaded with NPLs under government guarantee. There is a mixed picture in the SEE. For example, Serbia has liquidated its four largest state-owned banks, which were loaded with NPLs from the prior regime, in order to allow liberalized entry of new, primarily foreign banks. It has also moved aggressively to intervene in poorly performing smaller banks and to prepare them for privatization. Moreover, it has worked to improve supervision and regulation and to tighten licensing requirements. Bosnia’s banking sector, on the other hand, remains largely state owned. Finally, Croatia offers a relatively good example of banking

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IRA W. LIEBERMAN ET AL.

privatization, even though the result was the domination by German and predominately Italian banks. Privredna Banka was first cleaned of its nonperforming assets and subsequently sold through a competitive bid process to the Italian Banca Commerciale, while a majority of Zagrebacka Banka was floated on the Zagreb and London stock exchanges, only to be acquired in a public bid by Unicredito of Italy in conjunction with Allianz, the German insurance giant. Needless to say, there was a great deal of work left to do in CIS countries and some SEE countries at the end of the decade with respect to restructuring, privatization, supervision, regulation and liberalization of the banking sector to allow competitive entry into the sector. As can be seen from Table 5, many countries still had more than 20% of the total banking assets in state hands, and many NPLs have been either sold or parked in government-owned entities that are trying, not very successfully, in one way or another to recover the highest number of cents to the dollar. In this context, it is interesting to examine the experience of various governments in restructuring banks before or after a sale or even using the level of NPLs as a bargaining chip in attracting foreign investors, though in some cases it definitely turns them away.

13.4. Remaining Role of State Banks Most countries in transition in the region still have several state banks that account for a large share of total bank assets, loans and deposits. In addition, many of the loans are non-performing, especially those to state owned or formerly government-controlled enterprises. Strict provisioning and written rules and practices would substantially reduce the value of many loan assets. Such bad asset quality lowers the earnings of the state-owned banks, thus decreasing their capital formation ability, increasing costs to borrowers and generally slowing down the growth of both the financial sector and the economy as a whole.50 Sherif, Borish and Gross make the following points about the continuing presence of state-owned banks in the region:  State banks that engage in non-commercial directed lending and other political purposes threaten macro economic and financial sector stability. In turn, poor performance by state banks has undermined the public’s confidence in the whole sector;

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53

Table 5. Statistics on Public Sector Banks in ECA Countries, 2000.

Albania Armenia Azerbaijan Belarus BosniaHerzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russiaa Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekista´n Yugoslavia

Number of State Banks as of End-1992

Number of State Banks as of End-2001

State Bank % of Assets (End-2000)

State Bank % Deposits (End-2000)

State Bank % Capital (End-2000)

State Bank % Credit (End-2000)

3 5 4 17 23

1 0 2 6 9

61.7 2.6 64.7 77.1 10.2

73.3 5.4 88.8 111.2 18.9

11.3 0.0 13.0 85.0 32.2

91.4 1.3 93.6 100.0 7.8

10 13 4 3 4 10 5 4 5 3 1 5 16 7 4 major banks 6 13 5

4 1 4 0 0 2 2 3 2 1 1 1 4 3 5

20.1 10.9 25.9 0.0 0.0 7.8 23.3 9.4 9.2 13.8 1.1 10.8 26.6 60.0 44.1

28.1 8.9 30.2 0.0 0.0 7.4 32.7 10.3 19.4 16.5 0.0 15.3 31.7 58.9 58.0

11.2 23.0 21.4 0.0 0.0 21.0 9.6 12.9 6.9 10.4 1.0 4.5 14.6 116.2 18.6

32.2 14.1 36.0 0.0 0.0 9.1 24.0 10.0 18.3 14.8 1.1 12.8 32.1 92.3 41.1

5 5 1

32.2 56.0 6.8

34.8 72.3 N/A

21.8 40.2 N/A

35.3 74.3 N/A

7 5 8 6

5 2 16 6

100.0 13.6 100.0 N/A

100.0 17.1 100.0 N/A

100.0 4.9 100.0 N/A

100.0 13.1 77.5 N/A

Source: ECSPF Strategy Paper on the Financial Sector. a One report claims that as of October 1, 2001 Russia had more than 1,300 lending institutions, of which 638 were at least partly owned by the state when including shares of the central bank in commercial banks and other lending institutions. See Builov (2002).

 Poor economic performance is directly correlated with delayed reforms in the financial sector; and  Experience seems to indicate that the costs for delaying bank privatization, liquidation and/or quick resolution of NPLs are larger than any upfront decrease in value of state-owned banks. The last point is examined in more detail below.

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IRA W. LIEBERMAN ET AL.

13.5. Restructuring of State Banks Prior to Sale In the banking sector, the experience is somewhat the same as in the commercial sector. Extensive restructuring has proven unproductive for governments, with the danger that the bank being restructured remains under state ownership and is again politicized and utilized to offer directed and subsidized credits. But prior to sale, most bank privatization efforts clean up a bank’s balance sheet by creating a ‘‘good’’ and ‘‘bad’’ bank from the original bank. The bad banks hold NPLs and other non-saleable banking assets. Sometimes instead of creating a ‘‘bad’’ bank, bad assets are transferred to an asset management agency. But publicly owned asset management agencies in the Czech Republic, Slovakia and countries outside the region such as Mexico, Thailand and Indonesia have had a poor track record, and more thought needs to be given to commercializing the process of asset management. Other defensive restructuring measures may include closure of branches and termination of excess staff. In cases where the size of the ‘‘bad’’ bank far exceeds the potential ‘‘good bank,’’ governments have chosen to liquidate state banks and have liberalized the sector to allow private banking entry, in particular for foreign banks which provide technology and banking expertise and give the public confidence in the sector. Serbia recently liquidated the four largest state-owned banks and has allowed liberalized entry of foreign banks. There are several clear examples where attempts to restructure, consolidate and rehabilitate banks prior to privatization resulted in a very costly and time-consuming exercise. In the Czech Republic, for example, the government tried to privatize certain banks partially through the voucher system, keeping influence and a large stake and attempting to carve out some non-performing assets. The result was heavy losses in several of these ‘‘partially privatized banks,’’ which had to be absorbed by the state through Konsolidacni banka (the Consolidation Bank), which was still in the process of trying to recover cents to the dollar on many assets several years later. The entire process delayed bank privatization in the Czech Republic for several years later than anticipated. Many important and formerly famous Czech enterprises were kept alive in part by lending from these banks. The net result was not only the creation of NPLs but also the failure of many firms or their sale for a fraction of what they could have been worth.51 In Poland, the government attempted to minimize costs of restructuring and promoted a bank-led corporate restructuring followed by bank re-capitalization, with government bonds created ad hoc for this purpose. This resulted in the creation of a successful banking environment, albeit one

An Overview of Privatization in Transition Economies

55

not without its difficulties. In Poland, the government also attempted to consolidate certain banks, as was the case with Pekao SA and three regional banks, before the government sold them to the highest bidder, the Italian Bank, Unicredito. Although Unicredito has stated that it is happy with its purchase and the privatization can be called a success, it is unclear what advantages or additional privatization revenues this brought to the Polish government and economy.

13.6. The Effect of Technology on Banking It is clear that technology has had a great effect on the financial sector, perhaps more than any other change that occurred during the last 10 years. Earnings from credit spreads diminished due to lower transactional costs, higher competition for scarce deposits from both individuals and corporations and high international borrowing costs. Fee-based earnings increased as a result of more sophisticated intermediation and advisory needs for foreign trade, forfeiting, leasing, project financings and complex working capital arrangements with varied forms of collateral, among other things, and because of increased focus on these earnings away from more traditional spread lending. Also, the takeover of local, often less sophisticated banks by international financial institutions with global financial expertise also introduced new instruments and contributed to the increase of fee-based earnings. Thus, technology is helping to bring about a more competitive, market-oriented financial sector. But it has also had some negative side effects, like leaving behind some of the small- and mediumsized, unsophisticated local enterprises that do not need or cannot make use of some of the newer instruments and do not utilize fee-based lending. They then tend to have much lower access to debt, are largely less well serviced by the internationally owned banks and tend to slow their growth. This is of course a rather negative side result of technology and innovation brought in by foreign players, as SMEs are arguably the primary engine of growth in transition economies.

13.7. Maintaining a Domestic ‘‘Champion’’ in the Banking Sector Another aspect of into privatization is the attempt of many governments to create a privatized ‘‘national champion’’ that would tender to the needs of local firms and probably also to the government or domestic influential

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IRA W. LIEBERMAN ET AL.

businessmen. Three examples of this are Zagrebacka Banka in Croatia, Bank Handlowy in Poland and OTP in Hungary. They were all quoted in the local stock exchanges and, in the case of Zagrebacka, also in London as examples of local management success and, potentially, future centers of consolidation, not only nationally, but also regionally. Of these, only OTP remains independent (although the Hungarian government still holds a golden share), the other two having been taken over in little-contested capital market offers by Unicredito and Allianz for Zagrebacka and Citi for Handlowy. It is difficult to judge whether these attempts to hold on to some kind of national identity were misguided or not. The outcome from bank restructuring, consolidation and privatization in the region is that foreign banks, mostly European banks, own up to 80% of the banking assets in the CEE accession countries and also the next in line countries of Bulgaria, Croatia and Romania in the SEE. Further consolidation and concentration of banks will take place in the region. The CIS has lagged considerably. Little banking reform occurred after the Russian financial crisis in 1998 and the system remains a mixed ownership system with state-owned banks still controlling a significant amount of banking assets and the vast majority of deposits through the Sber Bank, the state-owned savings bank. The major private banks, mostly located in Moscow, are part of financial industrial groups (FIGs). Banking reform and privatization varies greatly in the CIS, with countries such as Belarus, Uzbekistan and Turkmenistan having reformed very little toward a market economy, they also, not surprisingly, have not restructured or privatized their banks.

13.8. Capital Market Development Over the last decade, many transition countries have put great effort into building national stock and capital markets as part of their shift to a market economy. The linkage between stock markets and privatization has always been apparent,52 but in many cases has been elusive because few countries have markets with sufficient depth to support more than a limited number of IPOs, secondary offerings or even secondary trading to any extent (see Table 6). Poland and Russia are exceptions. For example, Poland floated its first five large privatizations on the Warsaw Stock Exchange (WSE) in 1991, and has floated many more since then. But even in these examples, there is little hope that the WSE will develop into a liquid, international stock exchange, especially since the trend is toward integrating stock exchanges in Western Europe (Fig. 8).

An Overview of Privatization in Transition Economies

57

Table 6. Stock Market Capitalization and Number of Companies Listed on Major ECA Stock Exchanges as of End-2001. Stock Market Capitalization as a % of GDP

Number of Companies Listed

Stock Exchange

Romania Bulgaria Latvia Lithuania

3 7 9 10

65 30 63 46

Poland Czech Republic

14 16

246 102

Slovakia Hungary Estonia Slovenia

19 20 28 30

9 56 17 38

Bucharest Stock Exchange BSE Sofia Riga Stock Exchange National Stock Exchange of Lithuania Warsaw Stock Exchange PSE (Prague Stock Exchange) Bratislava Stock Exchange Budapest Stock Exchange Tallinn Stock Exchange Ljubljana Stock Exchange

Source: ECSPF PSD Strategy Paper.

Capital markets in the region have not provided a ready exit strategy for many SOEs, nor have they provided a way to raise funds for mid-size companies with high growth potential. At least equally problematic is the relative lack of liquidity and thin float in many of these markets. Moreover, the bond markets in these countries are generally crowded out by the governments’ need to borrow, so it is virtually impossible for utilities or infrastructure companies to raise the medium-term financing domestically which they need in order to expand. Foreign borrowing exposes these firms unduly to exchange rate risk, as they generally do not export a high percentage of their output, if they do at all. Also, few countries in the region have been able to take advantage of listings in Vienna, Frankfurt or Luxembourg, not to mention GDRs/ADRs in London or New York. Some countries have sought to create investment vehicles to boost the domestic institutional support for capital market development and to diversify investors’ risks-voucher investment funds (in Russia, the Czech Republic and Poland), private pension funds (in Kazakhstan and Poland), private investment funds (PIFs; in Uzbekistan) and mutual funds (in Russia). These efforts have not been entirely successful for many reasons – lack of experience and fund management expertise, corruption, poor governance practices, lack of adequate regulation or oversight or inadequate liquidity (see Pistor & Spicer, 1997).

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IRA W. LIEBERMAN ET AL. 160

Russia Turkey

140 Billion of US$

120 100 80 60 40 20 0 Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Period 40

Czech Republic Hungary Poland

35

Billion of US$

30 25 20 15 10 5 0 Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Period

Fig. 8.

Stock Market Capitalization (1996–2003, in Billion US$). Source: Emerging Markets Database (EMDS), Standard & Poor’s.54

Stock markets have remained very volatile in transition countries because of their dependence on portfolio investments from abroad, largely from hedge funds – country funds, regional and global emerging market funds – the so-called hot money.53 Capital markets are still important, but with international market convergence it may be time for countries to rethink the dedication in ECA countries to building national markets – it is like the national airlines of the 1960s and 1970s; they will always lose money and not meet their service objectives (see Cadogan Financial, 2002). It is probably important to consider how regional markets such as the Visegrad countries can integrate

An Overview of Privatization in Transition Economies

59

their markets into a major international market such as Frankfurt, Luxemburg, Vienna or a European NASDAQ.

14. CONCLUSIONS From 1990 to 2000 there was a massive amount of privatization in the region in all sectors – small business, larger industrial companies in virtually all sectors, companies in infrastructure and natural resources, particularly telecom, electricity distribution and power generation and oil and gas, and banking. These changes in asset ownership created an irreversible movement toward a market economy in all but a few of the countries, the non-reformers such as Belarus, Turkmenistan and Uzbekistan. Privatization also changed the employment status of many workers who moved from the protective umbrella of the state to firms that were privately owned. With privatization of smallsized firms in the service sector came a massive entry of new small enterprises that created millions of job opportunities in what had been a universally under-dimensioned service sector. Clearly privatization was but the first step in enterprise reform, fundamental restructuring, including bankruptcy where appropriate, had to follow. That has proved more difficult, yet it has happened in many countries in the region, especially in the CEE where the prospects of EU accession continued to drive reforms, when basic reform fatigue set in. Not all has been positive. The Gini coefficient in virtually all of the countries has increased and poverty has increased substantially, especially in the CIS, where Russia no longer props up the other countries in the CIS with virtually free energy. Public perceptions are that privatization in the region was often corrupt and concentrated the gains in the so-called nomenklatura. Amazingly, this ownership revolution has been accomplished with very little worker dissent or popular demonstrations; perhaps it is due to the fact that in many countries insiders became substantial owners in the firms in which they worked. And the general increase of GDP coupled with additional working opportunities in the tertiary sector acted as a safety valve. Overall all measures of private sector development, as indicated by the data in the tables in Appendix A and B, demonstrate a very rapid development of a market economy throughout the region. Privatization therefore achieved what was expected of it as a leading structural reform in the region. What still amazes many of us who worked on privatization throughout this period in the transition countries is how quickly the transformation happened. However, there is more to do with respect to privatization in many countries in the region and transition economies elsewhere in the world.

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NOTES 1. Yugoslavia was an exception where most firms were socially owned, meaning, according to some, owned by no one specifically and by enterprise insiders. It meant owned by management and workers. Privatization in Yugoslavia began actively in 1992 under the Markovic government, but was suspended during the conflict in the region which resulted in the breakup of Yugoslavia into a number of independent states such as Slovenia, Croatia, Bosnia, and Serbia-Montenegro and a period of isolation, especially for Serbia. Privatization in Serbia is discussed in a separate chapter in this book as it has mostly taken place after 2001, while for the most part our comparative analysis in the CEE and CIS ends in the year 2000. 2. Hungary, as an exception, focused primarily on joint ventures and ‘‘classical’’ case-by-case privatization to divest its larger firms. Poland utilized a menu of privatization options to divest larger firms, including initial public offerings (IPOs) for the first five privatization transactions in December 1990. 3. See Johnson and Kroll (1991). Managerial strategies for spontaneous privatization. In: Soviet economy, 1991, 7, 4, pp. 281–316. 4. SOEs accounted for some 6,000 large enterprises in the Czech and Slovak Republics, some 25,000 in Russia, some 8,500 of medium to large enterprises in Poland, as well as hundreds of thousands of small businesses in these countries. 5. The classical privatization model emerged in the United Kingdom from the merger and acquisition practice of merchant banks. It is characterized by relatively few enterprises to privatize and builds on the base of an existing market economy. It is usually part of a more comprehensive economic reform and requires top-down political commitment. 6. The prime ministers and privatization ministers of several of the reform countries in the CEE formed the Central and Eastern Europe Privatization Network (CEEPN) in June 1991. CEEPN’s secretariat was located in Ljubljana, Slovenia. CEEPN had annual conferences each year starting in 1991 and published its proceedings each year through the mid-1990s. It also held various workshops on topics such as restructuring, investment funds, bank privatization, etc. throughout the region. CEEPN was largely a forum for an exchange of views on privatization in the region. There were many other such opportunities with meetings supported by the OECD, by the Open Society Institute (the Soros Foundation) for parliamentarians in the region, etc. 7. For information on privatization by country and method see CEEPN Annual Reports 1991–1995; also see Frydman, Rapacyznski and Earle, The privatization process in Central Europe, Central European Press, 1993; for an early discussion of progress by country and method, and finally, the European Bank for Reconstruction and Development (EBRD) has published an annual report, called Transition, on progress on transition by country and topic from 1995 to the present. 8. See the chapter in this book on mass (voucher) privatization for a discussion of the Czech MPP. 9. For an interesting early discussion on the transition see Janos Kornai (1990). The road to a free economy, shifting from a socialist system, the example of Hungary, W.W. Norton. 10. See the chapter in this book on Russian privatization; also for more detail on the mass privatization program and related reforms see Eds. Lieberman and

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Nellis (1994). Creating private enterprises and efficient markets. World Bank; or see Lieberman and Veimetra (1996); or for a discussion of the oligarchs and somewhat of loans-for-shares see Chrystia Freeland (2000). The sale of the century, Russia’s wild ride from communism to capitalism. Crown Business; for an inside view from the reform team that actually led the privatization program see Boycko, Shleifer, and Vishny (1995). 11. See the chapter in this book on Chinese privatization for a detailed discussion of the earlier phases of Chinese privatization. 12. See the chapter in this book on Serbian privatization. 13. Rapid democratization went hand in hand with full liberalization, including quick privatization. There was a concern by Russian reformers, above all, that the communists might soon take control again; their desire, therefore, was to move as rapidly as possible, i.e., to create ‘‘facts on the ground’’ that made a market economy irreversible. 14. See World Bank (2002). Transition the first ten years, analysis and lessons for Eastern Europe and the Former Soviet Union. Washington, DC, p. 77 (Box 7.1). 15. See Frydman et al. (1994). Eastern European experience with small-scale privatization. CFS Discussion Paper Series, No. 104, World Bank and Central European University Privatization Project, April; also Wineki (2001). Entreprenurial private sector in transition and economic performance in light of the successes in Poland, the Czech Republic and Hungary. Bank of Finland, Institute for Economies in Transition, Discussion Papers No. 12; Robert J. McIntyre (2001). Small enterprises in transition economies: Casual puzzels and policy relevant research. May 15, 2001 (mimeo); and Andras Inotai. The Recent Experiences of SMEs in CEECs (mimeo), for a comprehensive discussion of the potential role of micro, small and medium enterprises in the lagging reformers in the region see Lieberman (2003). The CIS 7: Micro, small and medium enterprises and access to financial services. April 2003. 16. World Bank, Transition the first ten years, Op. cit., p. xviii. 17. See CEEPN (1992). Annual report, privatization in Central and Eastern Europe 1992, Albanian Privatization, p. 48, p. 54 on the Albanian restitution process and constraints due to restitution without an adequate restitution law; also a discussion of the Czech restitution program and the laws governing it, Privatization in the Czech Republic, pp. 89–90. 18. CEEPN (1995). Annual report 1995, privatization in Bulgaria, p. 102. 19. Ibid., Privatization in Hungary, p. 187. 20. For a comprehensive discussion of mass privatization see Ira W. Lieberman, Andrew Ewing, Michael Mejstrik, Joyita Mukherjee, and Peter Fidler (eds.) (1995), Mass privatization in Central and Eastern Europe and the Former Soviet Union: A comparative analysis. The World Bank; and Lieberman, Nestor, and Desai (1997) (Studies of Economies in Transformation, No. 23). 21. Transition the first ten years, Op. cit., p. 76. 22. CEEPN (1995). Annual report 1995, privatization in Hungary, pp. 194–198. 23. See the chapter in this book on Serbian privatization. 24. See CEEPN (1995). Annual report 1995, Privatization in Poland, p. 386; and Privatization and capital market development, pp. 412–418.

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25. Ibid., p. 396. 26. See Troika Dialog Research, Corporate Governance in Russia, November 2000, pp. 98–99. Effective ADR Programs. By 2000, 46 Russian companies had issued ADRs. ADRs are shares sold mostly to institutional investors in the U.S. that are proxies for share ownership in foreign companies, in this case Russian companies. There are several levels of ADRs, depending on what standard of disclosure these companies meet with respect to U.S. SEC regulations. 27. See the chapter in this book on China for a more extensive discussion of IPOs. 28. See World Bank (2004). Infrastructure and energy strategy note: Privatization and private sector entry in ECA region. 29. Stiglitz’s article ‘‘Wither Reform’’ led the charge on this issue. It was particularly critical of Poland’s ‘‘big bang’’ approach to reforms and above all Russia’s privatization process. See Joseph E. Stiglitz (1999). Wither reform, ten years of transition. World Bank Annual Bank Conference on Development Economics, Keynote Address, Washington, DC, April 28–30, 1999. Stiglitz’s views were countered by Andrei Shleifer, and earlier writings by Jeffrey Sachs on the ‘‘big bang’’ in Poland. 30. The subject of unbundling RAO UES in Russia has been prominently discussed in the press. Minority investors concerned with a non-transparent process have driven down the trading value of UES shares, which has led to sharp criticism of Anatoly Chubais, Chairman of the company. 31. Joseph E. Stiglitz (1999). Wither reform, ten years of transition. World Bank Annual Bank Conference on Development Economics, Keynote Address, Washington, DC, April 28–30, 1999, p. 4. 32. Poland has a surprisingly large number of strategic companies yet to privatize such as steel, fertilizers, petrochemicals, mining e.g., coal, copper, sulfur and electricity. Several of these companies were in distress in 2002–2003 and the government passed a law proposing restructuring support for them prior to EU membership in 2004. 33. See Shirley (1995) for a comprehensive discussion of such efforts. 34. Ibid., pp. 112–133 for a detailed discussion of Performance Contracts: With Public Managers. Mary Shirley concludes after examining a sample of such systems all over the world, ‘‘Thus the evidence from this sample gives little support to the premise that explicit contracts help improve SOE performance.’’ 35. See ibid., pp. 133–150, ‘‘Management contracts: With private managers,’’ for a detailed discussion of international experience with contracting out. 36. See ibid., pp. 139–147. 37. See Kessides (2002) for a very detailed discussion on the benefits of deregulation and competition in infrastructure sectors. 38. Ibid. 39. See Energy and Infrastructure Department (2002) for a detailed discussion of cases in the ECA region illustrating those issues. 40. See Shirley (1995), pp. 150–168 on regulatory contracts and Guislain (1998), Chapter 7: Privatization of Infrastructure, for more detailed discussions of these issues. 41. See the chapter in this book on Russian privatization and the case of Syvazinvest.

An Overview of Privatization in Transition Economies

63

42. The author worked for George Soros at the time the shares in Syvazinvest were resold to Russian interests. 43. See Kessides, op. cit. 44. See Shirley (1995), op. cit., Chapter 3, pp. 133–150 on management contracts and pp. 150–170 on regulatory contracts and concessions, for a detailed discussion of what has worked well and what has not. 45. For a very balance discussion on the distributive equity of infrastructure privatization, see Birdsall and Nellis (2002). 46. See Galal, Jones, Tandon, and Voglsang (1994) for a pioneering early study on privatization and the welfare effect as divided among the stakeholders. 47. Russia was an exception to the development of banks in the region. When the Russian Federation was created from the FSU, banking licenses were liberalized to a Central Bank closely allied with big industry. Many large companies, or holdings often representing a sector or the line ministry converted to a corporate structure, established pocket banks to service companies in their group. Banks were also created at the oblast level, supported by regional governors, to support the oblast’s financing needs and as part of regional financial industrial groups (regional FIGs) discussed in this book in Chapter 7 on Russian privatization. 48. Bank consolidation in the ECA Region: A multi-country study (summary report). 49. Joe Stiglitz argues in Globalization and its discontents that premature financial sector liberalization has been a major factor in recent financial crises. 50. Sharif, K., Borish, M., & Gross, A. (2002). State-owned banks in the transition: Origins, evolution and policy responses. Washington, DC: World Bank, p. 77 (mimeo). 51. A stunning example is the difference in profitability, productivity and productive capacity between Skoda Auto, sold to Volkswagen during the early years of the post-Velvet revolution era, and Tatra, the truck and car manufacturer kept alive by loans from IBP and KB (respectively, a quasi-privatized bank and a financial institution still owned by the government) recently sold for less than US$10 million to a group of American entrepreneurs who will try to turn it around. Skoda Auto is now producing several car models exported all over Europe and is one of the more profitable arms of the German auto company. 52. See Kirkness and Lieberman (1998) for a deeper discussion of privatization and capital markets and a description of IPOs in a number of countries throughout the world. 53. See Lieberman, ‘‘The Evolution of Emerging Market Equity Funds,’’ in Lieberman and Kirkness, Op. cit., Chapter 5.11. 54. EMDS methodology defines market capitalization (M) as the sum of the market value of all stocks included in the index. The market value of each stock is M ¼ Pi dni where Pi = the last transaction price for the stock in period i; ni = the number of shares issued and outstanding at the end of the period i.

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REFERENCES Birdsall, N., & Nellis, J. (2002). Winners and losers: Assessing the distributional impact of privatization. Working Paper, No. 6, Center for global development. Boycko, M., Shleifer, A., & Vishny, R. (1995). Privatizing Russia. Cambridge, MA: MIT Press. Builov, M. (2002). Who owns Russia: Russia’s banking sector: The situation today. The Russia Journal. Cadogan Financial. (2002). Report on the capacity of capital markets in relation to the proposed privatisation programme, for the Privatization Agency of Serbia, May (mimeo). Douglas, R. (1994). Privatization: Lessons from New Zealand. In: A. Galal & M. Shirley (Eds), Does privatization deliver? EDI Development Series, Washington, DC: World Bank. Energy and Infrastructure Department. (2002). Privatization experience in the power sector in ECA countries. World Bank (mimeo). Galal, A., Jones, L., Tandon, P., & Voglsang, I. (1994). Welfare consequences of selling public enterprises. Oxford: Oxford University Press. Guasch, L., Kartacheva, A., & Quesada, L. (2000). Concessions contracts renegotiations in Latin America and Caribbean region: An economic analysis and empirical evidence, Washington, DC: World Bank. Guislain, P. (1998). Privatization and basic legal norms for a detailed and comparative analysis on legal aspects of privatization (Chapter 2). The privatization challenge. World Bank. Harris, C. (2002). The beginning or the end of the beginning? A review of private participation in infrastructure in developing countries. World Bank (mimeo). Kessides, I. (2002). Reforming infrastructure: Privatization, regulation and competition. Washington, DC: World Bank. Kirkness, C., & Lieberman, I. (1998). Privatization and emerging equity markets. Washington, DC: The World Bank, London: Flemings. Lieberman, I. (1993). Privatization the theme of the 90’s. Columbia Journal of World Business. Lieberman, I., Nestor, S., & Desai, R. (1997). Between state and market: Mass privatization in transition economies. Washington, DC: World Bank, Paris: OECD. Lieberman, I., & Veimetra, R. (1996). The rush for state shares in the ‘klondyke’ of wild east capitalism: Loans-for-shares transactions in Russia. George Washington Law Journal, 29(3). Pistor, K., & Spicer, A (1997). Investment funds in mass privatization and beyond. In: I. Lieberman, S. Nestor & R. Desai (Eds), Between state and market: Mass privatization in transition economies. Washington, DC: World Bank and OECD. Shirley, M. (1995). Bureaucrats in business, the economic and politics of government ownership. Washington, DC: The World Bank, Oxford: Oxford University Press.

FURTHER READING Artemiev, I., & Haney, M. (2002). The privatization of the Russian coal industry: Policies and process in the transformation of a major industry. Policy Research Working Paper 2820, World Bank. Desai, R. (1997). Section 3 Residual share management and divestiture. In: I. Lieberman, S. Nestor & R. Desai (Eds), Between state and market: Mass privatization in transition economies. Washington, DC: World Bank, Paris: OECD.

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65

Guasch, L., Laffont, J., & Straub, S. (2002). Renegotiation of concession contracts in Latin America. Washington, DC: World Bank (mimeo). Gupta, P., Lamech, R., Mazhar, F., & Wright, J. (2002). Regulatory risk mitigation for distribution privatization – The World Bank partial risk guarantee. Washington, DC: World Bank. Havrylyshyn, O., & McGettigan, D. (1999). Privatization in transition countries: Lessons of the first decade. Economic Issues 18, International Monetary Fund. Nellis, J. (2001). Time to rethink privatization in transition countries. IFC Discussion Paper, Number 38. Nellis, J. (2002). The World Bank, privatization and enterprise reform in transition economies: A retrospective analysis. OED Background Paper, World Bank. Schwartz, A. (1997). The Czech approach to residual share management. In: I. Lieberman, S. Nestor & R. Desai (Eds), Between state and market: Mass privatization in transition economies (Studies of Economies in Transformation). World Bank and OECD. Stiglitz, J. (2002). Globalization and its discontents. New York: WW Norton & Company. Vandycke1, N. (2002). Private sector development in the CIS-7 countries. World Bank, ECA Region policy note (mimeo). Welch, J., & Fremond, O. (1998). The case-by-case approach to privatization. Technical Paper, No. 403, World Bank.

APPENDIX A. STATISTICAL APPENDIX – PRIVATIZATION STATISTICS Table A1.

Revenues from Privatization by Infrastructure Sectors, 1990–2001 (all Values are in US$ Million). Energy

Albania Armenia Azerbaijan Belarus Bosnia-Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia

Telecom

Transport

Water

85.60 142.00

891.00 26.50 42.00 3,075.50 720.16 99.00

878.00 227.30 247.00 2,988.60 505.00 88.00

285.20

212.80 81.00 170.50

Total 85.60 142.00 – – – – 878.00 1,331.10 639.70 42.00 6,234.60 1,225.16 88.00 99.00

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IRA W. LIEBERMAN ET AL.

Table A1.

Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Total

(Continued )

Energy

Telecom

20.00

670.00 582.30 19.60 6,757.70 559.00 2,298.10 689.70

85.30 871.60 100.00 2,411.30

Transport

Water

4.30

6.10

289.50 1%

470.40 2%

3,525.00 160.00

138.90 950.00

8,502.36 28%

21,351.80 70%

Total 690.00 582.30 104.90 7,639.70 659.00 4,709.40 689.70 – – 3,525.00 – 298.90 – 950.00 30,614.06 100%

Source: World Bank PPI Database.

Table A2.

Infrastructure Projects with Private Participation by Class, 1990–2001 (all Values are in US$ Million). Divestiture

Albania Armenia Azerbaijan Belarus BosniaHerzegovina Bulgaria Croatia Czech Republic Estonia

Greenfield Project

102.20 442.00 – – –

38.00 – 141.60 550.00 –

– 850.00 6,393.20 898.90

460.40 795.20 2,740.50 267.70

OM Project

OM with Major Private

Total

– – – – –

– 50.00 230.00 – –

140.20 492.00 371.60 550.00 –

– – 52.90 –

152.00 672.20 426.50 81.00

612.40 2,317.40 9,613.10 1,247.60

An Overview of Privatization in Transition Economies

Table A2.

67

(Continued )

Divestiture

Greenfield Project

OM Project

OM with Major Private

Total

Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia

36.00 10,805.00 2,871.76 88.00 736.60 957.80 582.30 85.30 6,308.80 1,271.00 6,572.60

65.40 2,088.10 403.50 6.00 454.40 314.50 25.00 84.60 5,626.50 1,183.70 4,169.90

– 84.50 – – – – – – – – –

29.00 1,090.00 663.20 – – – – – 617.00 1,025.00 –

130.40 14,067.60 3,938.46 94.00 1,191.00 1,272.30 607.30 169.90 12,552.30 3,479.70 10,742.50

930.70 – – – – 367.10 – 1,050.00

630.00 – 1.00 16,515.70 – 1,048.40 359.90 879.50

– – – – – – – –

– – – 305.00 – – – –

1,560.70 – 1.00 16,820.70 – 1,415.50 359.90 1,929.50

Total

41,349.26 48%

38,849.50 45%

137.40 0%

5,340.90 6%

85,677.06 100%

Source: World Bank PPI Database.

Table A3.

Telecom Projects with Private Participation by Class, 1990–2001 (all Values are in US$ Million). Divestiture

Albania Armenia Azerbaijan

102.20 442.00 –

Greenfield Project

38.00 – 141.60

OM Project

OM with Major Private

– – –

– – –

Total

140.20 442.00 141.60

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IRA W. LIEBERMAN ET AL.

Table A3. Divestiture

Belarus BosniaHerzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Total

(Continued ) Total

OM Project

OM with Major Private

50.00 –

– –

– –

50.00 –

– 850.00 5,163.40 573.00 – 6,979.20 1,370.00 88.00 582.60 937.80 582.30 – 5,245.70 1,171.00 2,688.70

460.40 128.00 2,461.40 267.70 65.40 1,716.10 403.50 6.00 379.40 314.50 25.00 84.60 4,926.90 1,160.30 4,049.10

– – – – – – – – – – – – – – –

– – – – – – – – – – – – – – –

460.40 978.00 7,624.80 840.70 65.40 8,695.30 1,773.50 94.00 962.00 1,252.30 607.30 84.60 10,172.60 2,331.30 6,737.80

930.70 – – – – 207.10 – 1,050.00

630.00 – 1.00 7,868.70 – 1,048.40 359.90 879.50

– – – – – – – –

– – – – – – – –

1,560.70 – 1.00 7,868.70 – 1,255.50 359.90 1,929.50

28,963.70 51%

27,465.40 49%

– 0%

– 0%

56,429.10 100%

– –

Source: World Bank PPI Database.

Greenfield Project

An Overview of Privatization in Transition Economies

Table A4.

Energy Sector Projects with Private Participation by Class, 1990–2001 (all Values are in US$ Million). Divestiture

Albania Armenia Azerbaijan Belarus Bosnia– Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Total

69

Greenfield Project

OM Project

OM with Major Private

Total

– – – – –

– – – 500.00 –

– – – – –

– – 230.00 – –

– – 230.00 500.00 –

– – 1,041.00 26.50 36.00 3,825.80 1,501.76 – 154.00 20.00 – 85.30 1,051.60 100.00 3,381.30

– 368.50 259.10 – – 237.00 – – – – – – 597.00 – –

– – – – – – – – – – – – – – –

– – – – 29.00 – 623.20 – – – – – – – –

– 368.50 1,300.10 26.50 65.00 4,062.80 2,124.96 – 154.00 20.00 – 85.30 1,648.60 100.00 3,381.30

– – – – – 160.00 – –

– – – 7,285.20 – – – –

– – – – – – – –

– – – – – – – –

– – – 7,285.20 – 160.00 – –

11,383.26 53%

9,246.80 43%

– 0%

882.20 4%

21,512.26 100%

Source: World Bank PPI Database.

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IRA W. LIEBERMAN ET AL.

Table A5.

Albania Armenia Azerbaijan Belarus BosniaHerzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Total

Transport Projects with Private Participation by Class, 1990–2001 (all Values are in US$ Million). Greenfield Project

OM Project

– – – – –

– – – – –

– – – – –

– 50.00 – – –

– 50.00 – – –

– – – 299.40 – – – – – – – – 5.40 – 502.60

– – 20.00 – – 135.00 – – 75.00 – – – 86.60 23.40 12.80

– – – – – – – – – – – – – – –

– 672.20 370.40 – – 1,004.00 – – – – – – 617.00 – –

– 672.20 390.40 299.40 – 1,139.00 – – 75.00 – – – 709.00 23.40 515.40

– – – – – – – –

– – – 419.80 – – – –

– – – – – – – –

– – – 305.00 – – – –

– – – 724.80 – – – –

807.40 18%

772.60 17%

– 0%

3,018.60 66%

4,598.60 100%

Source: World Bank PPI Database.

OM with Major Private

Total

Divestiture

An Overview of Privatization in Transition Economies

Table A6.

Albania Armenia Azerbaijan Belarus Bosnia– Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Total

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Water Projects with Private Participation by Class, 1990–2001 (all Values are in US$ Million). Divestiture

Greenfield Project

OM Project

OM with Major Private

Total

– – – – –

– – – – –

– – – – –

– – – – –

– – – – – 152.00 298.70 297.80 81.00 – 170.50 40.00 – – – – – 22.10 1,025.00 108.00

– – 188.80 – – – – – – – – – 6.10 – –

– 298.70 – – – – – – – – – – 16.00 – 108.00

– – 52.90 – – 84.50 – – – – – – – – –

152.00 – 56.10 81.00 – 86.00 40.00 – – – – – – 1,025.00 –

– – – – – – – –

– – – 942.00 – – – –

– – – – – – – –

– – – – – – – –

137.40 4%

1,440.10 46%

194.90 6%

Source: World Bank PPI Database.

1,364.70 44%

– – – 942.00 – – – – 3,137.10 100%

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APPENDIX B. STATISTICAL APPENDIX – PRIVATE SECTOR INDICATORS Table B1. Countries

Employment Index of Infant Adult Telephones Telephone % of % of Rate Productivity Mortality Literacy (Main Subscribers Households Households (% of Growthb Rate (per Rated Lines) per (Main with with Labor Force 1,000 100 Lines+Cellular Access to Access to Employed)a Live Residentse Subscribers) Electricityg Improved c Births) per 100 Waterh Residentsf 81.0 90.4 98.7 97.8 59.9 82.6 84.7 91.1 87.3 89.7 94.3 89.0 94.4

6.5% 5.0% 9.3% 5.7% 2.8% 6.2% 3.3% 2.4% 7.4% 1.6% 5.2% 9.4% 3.3%

20.20 14.60 12.80 11.30 12.80 13.33 7.50 4.10 8.40 17.33 9.20 21.13 23.07

85.3 98.5 99.6 98.5 98.4 99.8 99.3

5.0 14.0 11.1 27.9 11.1 35.9 36.5 37.4 35.2 15.9 37.4 11.3 7.7

13.8 14.6 19.1 29.2 16.8 55.1 74.2 103.3 80.8 21.3 87.2 12.5 7.9

100.0 84.0 100.0 100.0 95.0

97.0 99.8

76.0 99.0 91.0 77.0

IRA W. LIEBERMAN ET AL.

Albania Armenia Azerbaijan Belarus Bosnia-Herzeg. Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Rep.

Indicators of Jobs, Productivity and Access to Basic Services.

86.9 83.0 69.5 97.9 82.7 91.4 91.0 80.2 94.1 97.5 91.7 96.3 99.4 72.7 87.97

8.1% 3.8% 3.1% 1.5% 3.4% 1.3% 8.3% 1.3% 4.2% 6.9% 4.7% 14.4% 6.3% 1.6% 4.5% 5.06%

9.90 8.60 14.33 18.40 8.60 18.70 16.20 8.30 4.57 20.60 34.45 27.27 12.80 21.53 13.00 14.75

99.8 99.6 99.0 99.7 98.2 99.6 99.6 99.3 85.6 99.6 99.2 97.70

30.8 31.3 26.3 15.4 29.5 18.3 24.3 28.8 40.1 3.6 28.5 8.0 21.2 6.6 22.9 22.22

58.8 56.6 37.3 20.2 55.5 35.5 28.1 68.5 116.1 3.7 58.7 8.4 25.6 6.8 41.6 41.33

67.0 99.0 100.0 58.0 99.0 100.0 100.0 44.0 83.0 58.0 99.7 99.6

85.0

99.35

84.17

Source: ECSPF Private Sector Strategy Paper. a Data are for 2000 for Bosnia, Georgia, Kyrgyz Republic, Turkey, Uzbekistan and Yugoslavia. Source: EBRD (2002) except Turkey (WDI). b Data are for 2000. Measure is based on growth of GDP per worker. Source: WDI. Alternate measures are available. c Data are for 2000. Source: WDI. d Literacy rate is 100–illiteracy rate. Source: UNDP Human Development Indicators. e Data are for 2000 for Kazakhstan and Kyrgyz Republic. Source: ITU. f Data are for 2000 for Kazakhstan, Kyrgyz Republic and Ukraine. Source: ITU. g Data are from Clarke and Wallsten (Kazakhstan, 99; Kyrgyz, 97; Uzbekistan, 96) and Komives, Whittington and Wu (Albania, 97; Bulgaria, 95; and Ukraine, 96). h Data are for 2000 for all countries except Armenia and Tajikistan. Source: World Development Indicators except Armenia and Tajikistan (UNDP Human Development Indicators).

An Overview of Privatization in Transition Economies

Latvia Lithuania FYR Macedonia Moldova Poland Romania Russia Slovak Republic Slovenia Tajikistan Turkey Turkmenistan Ukraine Uzbekistan Yugoslavia Unweighted Average

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Table B2. Countries

Private Credit (in $ Billions)a

Private Credit (as % of GDP)b

0.256 0.184 0.281 0.680

5.86 8.75 5.05 8.79

2.049 8.147 24.212 1.569 0.241 18.016 3.420 0.058 1.804 1.411 0.636 0.212 44.046

15.70 41.32 40.91 27.55 7.61 33.79 15.94 3.92 23.21 11.53 17.85 14.75 25.49

Private Investment (as % of GDP)c

2.12

3.51 4.33 8.77

8.30

3.91

4.16

Foreign Direct Investment (as % of GDP)d 3.8 4.4 4.3 0.9 2.8 8.4 7.1 9.0 9.9 4.4 4.7 12.4 0.2 2.7 1.5 4.9 10.7 5.9

Foreign Portfolio Investment (as % of GDP)e

Foreign Investment (% of GDP)f

0.0

3.8

0.4

0.5

1.0 3.6 0.9 1.9 0.0 2.9 0.2 0.0 2.5 2.0 0.0 0.2 2.2

7.4 10.7 10.0 11.8 4.4 7.6 12.6 0.2 5.2 3.5 4.9 10.9 8.1

Foreign Direct Investment ($ per Capita)g

42 31 28 11 30 123 330 446 395 26 239 184 0 86 53 86 39 242

IRA W. LIEBERMAN ET AL.

Albania Armenia Azerbaijan Belarus Bosnia-Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania FYRMacedonia Moldova Poland

Private Lending, Investment and Capital Flows.

2.780 46.082 5.426 7.285 0.109 0.101 4.623

7.82 15.36 26.18 40.04 11.03 2.30 12.57

0.760

9.00

1.54

2.8 0.8 10.6 2.3 0.9 3.7 2.1 1.2 1.1

0.2 0.3 5.3 1.0

3.0 0.5 15.9 3.4

2.3

0.2

46 18 380 222 1 24 16 3 14

a Data are for Belarus, Macedonia, Tajikistan, Yugoslavia and Turkmenistan for 2000. Source: IMF IFS except Tajikistan and Yugoslavia (Domestic Credit to Private Sector from EBRD, 2001). b Data are for Belarus, Macedonia, Tajikistan, Yugoslavia and Turkmenistan for 2000. Source: IMF IFS except Tajikistan and Yugoslavia (Domestic credit to private sector from EBRD, 2001). c Data are for 2000. Source: World Bank Indicators. d Data are for Albania, Azerbaijan, Bulgaria, Czech Republic, Georgia, Kyrgyz Republic, Macedonia, Moldova, Poland, Romania, Slovak Republic and Turkey for 2000. Source: IMF IFS except Armenia, Bosnia, Tajikistan, Turkmenistan, Uzbekistan and Yugoslavia (EBRD, 2002). e Data are for Albania, Azerbaijan, Bulgaria, Czech Republic, Georgia, Kyrgyz Republic, Macedonia, Moldova, Poland, Romania, Slovak Republic and Turkey for 2000. Source: IMF IFS. f Data are for Albania, Azerbaijan, Bulgaria, Czech Republic, Georgia, Kyrgyz Republic, Macedonia, Moldova, Poland, Romania, Slovak Republic and Turkey for 2000. Source: IMF IFS. g Data are for Albania, Azerbaijan, Bulgaria, Czech Republic, Georgia, Kyrgyz Republic, Macedonia, Moldova, Poland, Romania, Slovak Republic and Turkey for 2000. Source: IMF IFS except Armenia, Bosnia, Tajikistan, Turkmenistan, Uzbekistan and Yugoslavia (EBRD, 2002).

An Overview of Privatization in Transition Economies

Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan Yugoslavia

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Table B3.

Credit Exposure by Private and State Sector.

Albania Armenia Azerbaijan Belarus Bosnia and Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania Macedonia, FYR Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan Yugoslavia Unweighted Average

State Share of Bank Credit

Private Share of Bank Credit

83.1% 15.2% 38.2% 51.6% N/A 27.3% 26.1% 26.0% 6.7% 7.8% 23.1% 15.6% 14.9% 21.6% 36.4% 15.8% 24.1% 33.8% 37.7% 32.3% 62.9% 23.1% N/A 96.0% 15.7% N/A N/A 33.35%

16.9% 84.8% 61.8% 48.4% N/A 72.7% 73.9% 74.0% 93.3% 92.2% 76.9% 84.4% 85.1% 78.4% 63.6% 84.2% 75.9% 66.2% 62.3% 67.7% 37.1% 76.9% N/A 4.0% 84.3% N/A N/A 66.6%

Source: World Bank, ECSPF Sector Strategy Paper.

Countries

State Sector (as % of GDP)b

3.0 3.0 3.0 4.0 5.0 3.0 3.0 2.0 2.0 3.0 1.0 2.0 2.5 2.0 2.0

25 40 55 80 65 30 40 20 25 40 20 40 40 35 30

Entry Barriersc

11.0

10.0 12.0 10.0 13.0 8.0 12.0 9.0 7.0 10.0

Degree of Property Rights Protectiond

Quality of Regulatione

Index of Political Riskf

Index of Judicial System Efficiencyg

Index of Corruptionh

4.0 3.0 4.0 4.0 5.0 3.0 4.0 2.0 2.0 4.0 2.0 4.0 4.0 3.0 3.0

4.0 4.0 4.0 5.0 5.0 4.0 4.0 3.0 2.0 4.0 3.0 4.0 4.0 3.0 3.0

39.5 41.0 40.0 39.5

2.3 2.0 2.0 1.7 3.0 0.3 0.7 1.3 0.0 2.0 0.3 0.3 1.0 0.3 0.7

5.5 5.8 6.3 5.3 5.8 4.8 4.5 3.8 2.8 5.3 3.0 6.3 6.0 3.5 3.8

26.0 25.0 22.5 26.0 19.5 30.5 25.0 25.0

77

Albania Armenia Azerbaijan Belarus Bosnia-Herzeg. Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Rep. Latvia Lithuania

Degree of Government Interventiona

Indicators of the Investment Climate.

An Overview of Privatization in Transition Economies

Table B4.

Countries

State Sector (as % of GDP)b

3.0 2.5 2.0 3.0 2.5 3.0 3.0 3.0 4.0 4.0 3.0 3.0

45 50 30 40 30 20 35 60 75 40 55 60

Entry Barriersc

11.0 16.0 20.0 12.0 9.0

13.0

(Continued )

Degree of Property Rights Protectiond

Quality of Regulatione

4.0 3.0 2.0 4.0 4.0 3.0 3.0 4.0 4.0 4.0 4.0 4.0

4.0 4.0 3.0 4.0 4.0 3.0 2.0 4.0 4.0 4.0 5.0 5.0

Index of Political Riskf

Index of Judicial System Efficiencyg

32.0 22.0 31.5 36.5 25.0 19.5 100.0

1.7 1.0 0.0 0.3 1.7 1.0 0.3 2.3

42.5 100.0 50.0

2.0 1.3 3.0

Index of Corruptionh

5.0 6.0 2.3 4.5 6.3 3.8 2.0 6.0 6.3 6.0 6.0

Source: World Bank, ECSPF Private Sector Strategy Paper. a High values imply high levels of government intervention. Source: Heritage Foundation (2002). b Figure is the residual from private sector share of GDP. Data are for 2000 (except Moldova and Russia for 1999). Source: EBRD (2001). c High values imply difficult to enter. Source: Number of procedures needed to start a business (Djankov et al., 1999). Data are for 1999. d High values imply weak protection. Source: Heritage Foundation (2002). e High values imply poor regulation. Source: Heritage Foundation (2002). f High values imply greater risk. Source: ICRG (June 2002) (100-ICRG political risk score). g High values imply poor performance. Source: EBRD (2001) (4-score on legal effectiveness). h High values imply greater corruption. Source: Nations in Transit (2001).

IRA W. LIEBERMAN ET AL.

FYR Macedonia Moldova Poland Romania Russia Slovak Rep. Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan Yugoslavia

Degree of Government Interventiona

78

Table B4.

An Overview of Privatization in Transition Economies

Table B5. Countries

Albania Armenia Azerbaijan Belarus BosniaHerzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyz Republic Latvia Lithuania FYR Macedonia Moldova Poland Romania Russian Federation Slovak Republic Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan Yugoslavia

79

Indicators of Corruption.

Transparency, Accountability and Corruption in the Public Sector (CPIA-confidential)

Corruption (ICRG, March 2002)

Corruption (KKZ)

Corruption (Nations in Transit)

2.5 3 2.5 3.5 3

2 1.5 2 2

0.6 0.8 1.1 0.1 0.5

5.5 5.75 6.25 5.25 5.75

3.5 4 4 4 2.5 4 2.5 3 3.5 3.5 3 2.5 4 3 2.5 4 4.5 1 1 2.5 2 3

2 3 3 3

0.2 0 0.3 0.7 0.7 0.7 0.8 0.8 0 0.2 0.5 0.8 0.4 0.5 1 0.2 1.1 1.1 1.1 0.9 0.7

4.75 4.5 3.75 2.75 5.25 3 6.25 6 3.5 3.75 5 6 2.25 4.5 6.25 3.75 2 6 6.25 6 6

3 1.5 2 2.5 1.5 2 2 1 2.5 3

1

Note: High scores are good. Source: World Bank, ECSPF Private Sector Strategy Paper.

80

Table B6.

IRA W. LIEBERMAN ET AL.

Size of the Informal Economy in Transition. (As a Share of GD, in 2001, and Employment, in 1999).

Country Armenia Azerbaijan Belarus Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Kyrgyzstan Latvia Lithuania Macedonia Moldavia Poland Romania Russia Serbiab Slovakia Slovenia Ukraine Uzbekistan a

Share of GDP

Share of Employmenta

45.3 60.1 47.1 36.4 32.4 18.4 39.1 66.1 24.4 42.2 39.4 39.6 29.4 45.1 44.1 27.4 33.4 45.1 34.5 18.3 26.7 51.2 33.4

40.3 50.7 40.9 30.4 27.4 12.6 33.4 53.2 20.9 33.6 29.4 29.6 20.3 35.1 35.1 20.9 24.3 40.9 34.6 16.3 21.6 41.2 33.2

Working age population between the ages of 16 and 65. Report on Hidden Economy by Ekonomski Institut, 1997.

b

CHAPTER 2 LEAPS OF FAITH: LAUNCHING THE PRIVATIZATION PROCESS IN TRANSITION$ John Nellis ABSTRACT This chapter analyzes the early post-transition privatization and enterprise reform efforts of three major countries: Poland, Czechoslovakia (subsequently the Czech Republic), and the Soviet Union (subsequently Russia). For each, it discusses the prevailing ideologies of key decision makers and their external advisors prior to and during the transition process, the initial conditions faced by reformers and advisors, the policy frameworks that evolved, the results achieved, the mistakes made, and the opportunities missed. The ultimate conclusion is that while privatization could have and probably should have been done better, it nonetheless had to be done. The Czech Republic and Russia, and others in the region, are better off after the flawed privatizations they carried out than they would have been had they avoided or delayed divestiture. Poland, which did quite well at first in the absence of mass and rapid privatization, now finds itself $

Anders Aslund, Nancy Birdsall, Harry Broadman, Simeon Djankov, Bernard Drum, Oleh Havrylyshyn, Janos Kornai, Lars Jeurling, Michael Lav, Peter Murrell, Roberto Rocha and Herbert Schmidt offered comments on earlier drafts that led to changes. Alex Kuo prepared the bibliography. Remaining errors are the author’s.

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 81–136 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00002-2

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burdened with a number of expensive and unproductive state firms. This chapter shows how and why these outcomes came about, and discusses the role of external advisors in the process.

1. INTRODUCTION The present chapter is a revised and shortened version of a background study commissioned in 2001 by the Operations Evaluation Department (OED) of the World Bank. It presents the approach to and outcomes of privatization and enterprise reform of three major countries in the transition region: Poland, Czechoslovakia (subsequently the Czech Republic), and the Soviet Union (subsequently Russia). It discusses for each the states of mind concerning enterprise reform and privatization that prevailed in the countries and among those advising the countries on this matter at various moments in the process, the initial conditions faced by reformers and those who assisted them, the policy frameworks that evolved, the results achieved, the mistakes made, and the opportunities missed. It is now commonplace to insist that errors were made and opportunities overlooked, and this chapter acknowledges and reviews these. But the ultimate conclusion is that while privatization could have and probably should have been done better, it nonetheless had to be done. The Czech Republic and Russia, and others in the region, are better off after the flawed privatizations they carried out than they would have been had they avoided or delayed divestiture. Poland, which did quite well at first in the absence of mass and rapid privatization, now finds itself burdened with a number of expensive and unproductive state firms. This chapter tries to show how and why these outcomes came about, and what the role of the external advisor community was in the process, with emphasis on advice from the World Bank, where the author worked from 1984 to 2000. Sections 2, 3, and 4 discuss the three country cases. Section 5 then offers a general discussion of what has been learned concerning what works and what does not. Conclusions are offered in Section 6.

2. POLAND In Poland at the beginning of 1990 one found a radical reformist regime, willing and able in this period of ‘‘extraordinary politics’’1 to undertake

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sweeping reform, and convinced that privatization of the massive state enterprise sector was an essential next step. As in Hungary, and to a lesser extent the Soviet Union, enterprise reform efforts of the 1980s (and even earlier) had tried to overcome falling rates of return on investment by lightening the amount of control of planners and decentralizing decision making to the level of the firm. One result, here and in every country that tried this approach, was the increase of enterprise autonomy and the margin of maneuver of firm managers. This produced only modest benefits in terms of increased production and cost cutting, while in most settings the disadvantages of increasing managerial autonomy, without introducing other elements of the market system, proved to be high. Another feature of pre-transition Polish enterprise reform was that workers’ councils had been created and empowered to negotiate with management and branch ministries on the entire range of production issues. The Soviet Union and Czechoslovakia too had created such councils, but at the last minute, in the latter half of the 1980s. In Poland, this was a much more serious and longstanding effort, partly in response to the decentralization ethos, but also clearly in an effort to placate Solidarity, the powerful and popular workers’ movement (Hungary’s experience with workers councils was somewhere in between). By the time World Bank and assistance teams from bilateral donors arrived in Poland at the end of the 1980s, the responsibility for stateowned enterprises (SOEs) had been substantially decentralized from a discredited central government and weakened sector (‘‘branch’’) ministries; decision-making powers at the level of the firm were split basically between managers and workers. The second factor of import was the sheer number of medium- and largesized firms to be dealt with. The official starting count in Poland was 8,400 SOEs,2 accounting for between 70 and 80% of GDP; and this did not take into account a number of subsidiaries of the larger firms, nor a good number of economic entities controlled by sub-national governments. Most Polish authorities encountered at this time announced their complete support for rapid privatization of this mass of firms. The official goal was, as soon as possible, to ‘‘develop an ownership structure akin to that of industrially developed nations.’’3 The question was, how? Privatization of small business was, indeed, implemented very rapidly. By the end of 1992, small privatization in Poland was almost complete, with the divestiture of 194,000 units, that is, 82% of those existing in 1989. Most were in retail trade and services; they went to former employees at well below market value. Small-scale privatization in Poland (and almost everywhere else in transition) was relatively non-contentious, and has been

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judged a great success, in terms of improving the quality and quantity of the services and goods provided, in creating a large number of jobs for those shifting out of the restructured SOEs and privatized firms, and in general smoothing the path for the return of capitalism. The importance of smallscale privatization in the region is very great, yet the topic has been neglected.4

2.1. The Basic Problem The fundamental privatization problem quickly became apparent: the issue was the medium- and large-sized firms. Methods and experience derived from the OECD and middle-income privatizing countries clearly showed how slowly the process normally unfolded. In the United Kingdom, Mrs. Thatcher’s enthusiastic and dedicated privatization team had managed to divest about 20 companies in a 10-year period. Mexico, starting with a larger number of (much smaller) firms, had by the early 1990s sold off about 150 entities over six years. Assuming that the Poles could employ well the methods used elsewhere, and somehow double or even treble the average annual sales numbers of these leading privatizers, it was estimated they might be able to sell, say, 30 large firms a year. This seemed an insufficient number. The math was daunting: 8,400 – or even 3,177 – divided by 30, or by 60 or 100, yielded ludicrously long periods of time before privatization would be substantially underway, much less complete. In the early days in Poland, and as we shall see, even more so in Czechoslovakia and Russia, most reformers and many external analysts and observers were aghast at the prospect of privatization unfolding slowly over a decade.5 Just why was it thought that extensive delays in privatization would be a serious, indeed dangerous problem? The primary reason was one of political economy: the fear that delaying change of ownership would provide opportunities for the return of the communists. The very speed and relative ease of the victory over the communists had its worrisome aspects. It raised concerns that the victory might just as readily be reversed; that the communists, with or without external assistance, might somehow regain power and attempt to set back the economic clock.6 The idea gained credence that one way to quickly increase support for the reintroduction of capitalism was to create more capitalists; that is, through privatization, to build up rapidly and dramatically the number of private owners of productive entities. This, it was thought, would create a group of people with a stake in and

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commitment to the market reforms so vigorously pursued by the new, noncommunist Mazowiecki government. A second justification for speedy privatization was the fear that leaving the firms in the control of largely unaccountable managers would open the door to more ‘‘wheeling, dealing and stealing.’’ It was apparent from the beginning that the breakdown of the old order and the increase in control rights of managers in the firms was leading, in Poland and elsewhere, to ‘‘spontaneous privatization,’’ whereby managers obtained full or partial ownership of the firms they had worked in, at low or no cost, and in a nontransparent manner. The assumption at the outset was that delays in privatization would exacerbate unfair transfer and asset-stripping in the unsupervised firms, and that when formal privatization did occur, there would be little remaining of value. Ironically, given privatization’s present reputation in many transition countries as a prime cause of increased corruption, it was originally viewed as the best available measure to increase transparency and probity. The belief in the necessity of mass and, in particular, rapid ownership change was widely but not universally held. The most eminent of those with reservations was Janos Kornai. In his writing in 1990, he offered the contrary view that the state, even the post-communist state, ‘‘y is obliged to handle the wealth it was entrusted with y until a new owner appears who can guarantee a safer and more efficient guardianship. The point now is not to hand out the property, but rather to place it in the hands of a really better owner.’’7 A decade along not many would contest the wisdom of Professor Kornai’s point. But at the time the assessment of most – in which group I numbered – was that his prescription was perhaps applicable to Hungary, which had since 1968 (with the launching of its ‘‘New Economic Mechanism’’) been experimenting with piecemeal introduction of market mechanisms into a modified central planning structure. But it was thought that what might work in evolutionary Hungary was unlikely to work in more closed, less liberalized countries, especially those that had not wrested a margin of maneuver from their internal hardliners. Thus, most reformers and observers, while acknowledging their respect for Kornai, retained their conviction in the need for speed.

2.2. Differences in Views However, it soon became clear that there were deeply conflicting views among Polish reformers themselves on how to proceed with privatization.

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The period of extraordinary harmony among the various partners in the anti-communist coalition was real, but – as elsewhere – it proved easier to gain consensus on seemingly abstract pricing and trade policy reform than on the more tangible question of precisely how to privatize a state-owned firm. The conflict played out in the formulation of the law on privatization, which went through some twenty or more drafts and endless and heated debate in the first semester of 1990, before finally receiving passage in July, well behind schedule. The saliency of Solidarity within the coalition was the cause. As with unions worldwide, Solidarity leaders were suspicious of privatization and wanted workers to have some substantial say in how, and to whom, an SOE would be sold. They first suggested a process whereby each workers’ council would have to be consulted before a firm could be put on the market. If the council rejected the privatization option the firm would simply remain in state hands. World Bank staff, strongly supported by a vocal and visible cadre of external analysts and advisors (most notably, Jeffrey Sachs and David Lipton), argued against this position. The fear was that this was a recipe for inaction and continued losses and inefficiencies in the mass of firms. Bank staff and others cited evidence from socialist and non-socialist countries showing that workers, when given ownership or management powers, tended to use them to protect their jobs and increase their wages rather than restructure firms to enhance their competitiveness.8 Bank staff, along with the external advisors and many in the Polish government, thought that restructuring of Polish state firms was desperately needed, to cut costs and improve quality – or shift product lines entirely – to allow these firms to compete in non-socialist markets. Recall that the extent of the trade shock due to the collapse of COMECON was becoming apparent. By mid-1990 Poland had lost huge amounts of its pre-transition export markets. Production in Polish state firms had declined 30% from the year before, and official unemployment had risen from 10,000 in early 1989 to 640,000 just a little over a year later. The perception was that this growing crisis could not be contained unless the mass of productive assets, presently being used sub-optimally in state firms, was shifted quickly to better use. The consensus view among Bank staff and external observers was that acceding to the claims of the workers would compound Poland’s economic difficulties by delaying or halting restructuring.9 In sum, based on non-transition experience and a first reading of evidence on the ground, World Bank staff and western advisors generally thought that Polish privatization would take time to unfold, and that the claims being made on behalf of the workers would further delay and dilute divestiture. Believing that these delays might

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prove fatal to reform, advisors suggested that the Polish government reassert centralized, government control over the firms so that (i) they could more readily be privatized, and (ii) be more effectively and efficiently managed in the interim. Polish authorities rejected this suggestion, arguing, ‘‘If the state was capable of managing firms effectively, then central planning would have worked.’’ Their ‘‘y main rationale for this position was that the workers had better motivation than bureaucrats in ensuring efficient work by their managers.’’10 Bank staff were taken aback by the vehemence of the rejection, and the faith in the workers’ councils. At the outset they did not comprehend the depth of the mistrust of state apparatuses that communism had left in the minds of reformers, or the extent of the debt the reformers owed to Solidarity. Reformers’ deep-seated suspicion of bureaucrats translated into rejection of any tactic of withdrawing one step – by reasserting state control and disempowering workers’ councils – in order to jump two steps ahead. Bank staff may have still been thinking in terms of SOE reform and privatization in mixed economies, where it was sometimes supposed that a new regime could more or less impose its will on to the bureaucracy. Those who came to power immediately after the communists had no such illusions. This was a principal reason for the failure of World Bank personnel to persuade reformers to introduce centralizing measures aimed at more effective asset management in the run-up period to privatization. The reformers realized how thin was the veneer of change so far imposed on to the largely unreformed, and in their eyes, unreformable, inherited administrative machinery. The Polish privatization law passed in July 1990 thus stipulated that enterprises would only be sold with the approval of insiders, meaning the managers and workers councils. Insiders were encouraged to voluntarily submit their firms for sale to the newly created Ministry for Ownership Change. As a compromise, the law allowed the Ministry the possibility of designating a firm for sale without the approval of insiders, and the insiders could appeal a ministerial designation to a parliamentary committee, whose decision would be final. But this feature was rarely if ever applied. Ministry officials acknowledged in private that only firms voluntarily entering the process would be privatized. The hope was that insiders in a group of highpotential firms – most likely consisting of those already exporting to hardcurrency markets, in fairly good financial shape, and not likely to require major layoffs – would be persuaded by self-interest to submit themselves for privatization, thus gaining skilled management, capital, market access, and

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technical know-how for their companies. The authorities hoped that 80–150 firms would enter the process in the first year. ‘‘Trade sales’’ – negotiated case-by-case transactions – and sales through share offerings on the rejuvenated Warsaw Stock Exchange were the anticipated methods. Article 37 of the law also allowed for what was termed ‘‘privatization through liquidation.’’ Mainly applied to smaller SOEs, this article permitted firms, without passing through a court insolvency procedure, to sell assets (usually but not exclusively to insiders, and usually by means of installment payments), lease out assets (also to insiders), enter into joint ventures, and merge with other firms. Thirty-three transactions were concluded by these means in 1990, but the number jumped to 397 in 1991 and continued high thereafter. This became a principal, invaluable method for providing small and SME start-up businesses with the assets and real estate they required.

2.3. Funds and Vouchers Some reformers and advisors recognized at once that the procedures sanctioned by the law would move slowly, and that the interim asset management problem had not at all been solved. They thus began to cast about for additional measures to speed and deepen the process. In March 1990 the Ministry of Finance proposed that between 10 and 20 ‘‘state holding companies’’ be formed, ‘‘guided by purely commercial criteria,’’ fully managed by reputable and experienced (and thus most likely foreign) private businesspeople, with the objectives of first shifting firms in their portfolios to market-oriented operations, and then privatizing them.11 The idea was at first solely of asset management leading to privatization. Over the next year it became combined with a second notion; that of distributing widely a portion of the ownership in the holdings and thus indirectly in the firms in the holdings’ portfolios, to the populace by means of share giveaways, or vouchers.12 Vouchers became the chief and most widely applied innovation in privatization in transition countries.13 The Polish government’s original intention in using vouchers was not necessarily to speed privatization; rather it was designed, stated a high privatization official in November 1990, to deal with ‘‘y the disparity between household savings and the net asset value of state enterprises y .’’14 That is, vouchers were viewed as a means of providing citizens with the power to purchase shares and assets in state firms that, if sold strictly for cash, would go only to wealthy locals (who were assumed to have amassed their cash in dubious ways) or to foreigners.

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The marriage of the holding company idea with a give-away scheme took root in 1991, as evidence mounted as to the very meager results of privatization through either trade sales or share offerings. There were no IPOS concluded in 1990, as opposed to the dozens that had been predicted by authorities (the Warsaw stock exchange did not officially re-open until April 1991, trading the shares of precisely five privatized firms); and the number of trade sale transactions was also very small and far less than anticipated. This slow pace of sales of large firms continued to be the case for years to come. The authorities responded in 1991–1992 in two ways: first, by dividing the SOEs into nine sectors,15 and seeking advisory assistance on how to deal with the set of firms on a sectoral basis; and second by what was called a ‘‘Mass Privatization Program,’’ or MPP; a combination of the asset management concept with a give-away scheme. The basic idea of the MPP was as follows: between 400 and 600 (eventually 512 firms entered the MPP) medium- to large-sized SOEs would be selected, converted to joint stock companies, and allocated in an equitable manner to 15 ‘‘National Investment Funds’’ (NIFs) – all of which would be managed by ‘‘international firms that have demonstrated experience in managing investment funds and giving strategic guidance to companies y .’’16 Firms being privatized by some other route, in severe financial difficulty, or monopolies requiring post-privatization regulation were excluded. Sixty percent of the shareholding in each selected firm would be held by the NIFs; 33% by a lead NIF (for this firm), and 27% distributed equally among all other NIFs. Ten percent of shares were to be distributed free of charge to employees in the affected firm. The remaining 30% would continue to be held for a time by the State Treasury. NIF managers would receive a fee for their services, plus a portion of the sale price upon subsequent privatization, thus giving them an incentive both to privatize and maximize the value of their holdings. Finally, for a small fee, any and every adult citizen of Poland could obtain a ‘‘bearer MPP share certificate,’’ giving the holder a share in each NIF. Though conceived in 1991, the law establishing the MPP was not passed until April 1993. Moreover, due to bitter and divisive arguments over the powers and selection of the foreign managers, exactly which firms should and should not enter the program, and fears of workers that entry into the MPP would mean loss of jobs, the system was not started until the end of 1995 – and did not list the shares of the funds in their portfolios and enter an active phase until the first half of 1997, almost six years after the scheme had been devised.17

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This saga illustrates the intense and enduring difficulty of forging a consensus in Poland on privatization procedures for the large-scale firms.

2.4. Outcomes The upshot was that by the end of 1996 – at which time a number of other transition states, that had begun privatizing some time after the Poles, had worked well through the process – there remained in Polish state hands a surprisingly large number of firms, and a surprisingly large percentage of assets and initial value (see Table 1). Thus, only 22% of the starting stock of 8,441 SOEs was privatized after six years of transition. Even taking the smaller number ‘‘subject to ownership transformations,’’ the privatization percentage was just one-third. Table 1.

Numbers and Methods of Polish SOEs Privatized as of December 1996.

State Firms as of 31/12/90 Transformed to companies wholly owned by State Treasury Of these, some designated as of ‘‘special importance’’ Liquidated under 1990 Privatization Law (asset sales) Insolvent or liquidated under Bankruptcy Law Taken over by Agency for Agricultural Property

Turned over to local governments Total number of enterprises ‘‘subject to ownership transformation’’ Of which, privatization completed

Number of SOEs: 8,441

Comments

127

183 privatized; 12 to NIFs

160

Held out of privatization As of end 1996, 26 cases still pending

1,247

662 1,654

263

304 of these still in process Some sold, some subject to management contracts; figures vague Subsequent status not given

5,592

1,898

Source: Blaszczyk and Woodward, ibid., p. 11, citing the Central Statistical Office, 1997, and other official sources.

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Clearly, despite official statements and hopes, and despite considerable prodding and assistance from the international community, Poland turned out to be a very slow privatizer. Did it matter? Until 2000 Poland enjoyed just about the overall best growth record of all European and Central Asian transition countries. It returned to growth more rapidly and with more vigor than most other transition economies, and for a time in the mid-1990s had the highest GDP growth rate in Europe. By late 1999 its GDP was estimated at 125% that of GDP at the end of 1989, an excellent record of positive economic achievement. Did the Poles manage this accomplishment despite the slow pace of privatization, or because of it? In retrospect one can discern a ‘‘Polish model of transition’’ that succeeded without mass or rapid privatization. This consisted of complete liberalization of entry (January 1989); abolition of communist organizations in SOEs and formal endorsement of the power of workers’ councils (end/ 1989); liberalization of about 90% of prices (throughout 1989); stabilization through tight fiscal, monetary, and wage policies, including hard budgets for SOEs (January 1990); and near complete trade liberalization and current account convertibility (January 1990).18 Note, however, that all involved, from Balcerowicz onwards, readily admit that this winning policy package was initially regarded as incomplete. Many reformers, and most in the advisory community, felt at the time that the lack of rapid, mass privatization – consistently blocked by union power and a lack of political consensus among the many and vigorously competing non-Solidarity parties, evidenced in the frequent change of governments and ministers was a serious, probably crippling omission. Regarding privatization, one can see in hindsight that in the Polish context the introduction of free trade and free entry for new start-up businesses, combined with a tightened budget constraint on most remaining SOEs, and the introduction of a mechanism for spinning-off productive assets from SOEs without formally privatizing the parent firm, presented a viable alternative to mass and rapid divestiture. First, in conjunction with quick and extensive small-scale privatization, these policies encouraged the explosive growth of de novo private firms, which turn out to be the principal engine of recovery and growth in transition economies. In terms of restructuring they consistently outperform privatized firms, much less SOEs.19 Second, one also has to admit that the workers’ councils, so worrisome to both Bank staff and external advisors in 1990, ultimately proved to be a positive force in Polish SOEs. In other transition economies, for example, Bulgaria and Ukraine, where the old centralized state

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structures and sectoral ministries crumbled, where firm managers took over the control of assets, and where privatization was accepted in principle but not extensively carried out in practice, but where workers’ councils were weak or non-existent, the result was asset-stripping and deterioration of firm quality on a large scale. Poland avoided this outcome by good macroeconomic and financial policies, but also because in the firms the workers’ councils were keeping an eye on managers, and checking if not totally preventing them from asset-stripping and ‘‘spontaneous’’ privatization. The combination of good policy, vigorously applied, in-firm watchdogs, and small-scale privatization limited both output fall and criminal behavior in Polish SOEs – at least for a time.20 One might thus argue that the Poles, even if by default more than intent (i) did well not to privatize their medium and large firms rapidly; and that (ii) many other transition countries would have been better off had they followed the Polish approach and privatized larger firms more slowly. The first conclusion is conceivable but not proven. The problem is the counterfactual: the same good policy set that minimized production falls in the SOEs might have spurred privatized firms to even better efficiency and effectiveness levels. Some evidence for this was provided (later) by Blaszczyk and Woodward (1999), whose study on restructuring in Polish firms showed that ‘‘ownership status is the most important factor differentiating the sample y the best financial standing or the fastest growth rate was recorded by privatized enterprises.’’ They agree that ‘‘indicators for state treasury companies and firms from the Polish privatization group were similar through 1995 y .’’ But then the performance of privatized firms ‘‘y stabilized, while state-owned firms have been hit by a dramatic decline caused by the capital shortage barrier.’’21 Ownership matters, at least eventually. Overall, it is undeniable that Poland did well early on, but the feasibility and the benefits of the privatization path they followed were not at all clear at the outset. Given the sound macroeconomic policies quickly established and enforced in Poland, they might have been better off with more and earlier large-scale privatization – and certainly one can see serious problems now manifest due in part to the continuing, heavy financial demands of the unprivatized coal mines, steel mills, and utilities. The second assertion that other transition countries might have done well to adopt the Polish approach, does not hold up. One cannot easily borrow a single part of an integrated policy package applied elsewhere and expect it to replicate the full range of effects achieved in the original instance. In other words, it is illegitimate to concentrate on the pace and scope of privatization in Poland without taking into account the surrounding policy and institutional

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environment. Evolutionary and cautious large-scale privatization worked – for a time – in Poland because it was enmeshed in a setting of sound and well-applied economic and financial policies, vibrant new entry, robust political competition, and the rudiments of corporate governance in remaining SOEs provided (certainly) by the workers’ councils on the one hand, and (perhaps) by the professional and private NIF managers on the other. Had any one of these mechanisms been absent, the outcomes might have and probably would have been very different. Since few other countries, especially those to the east of Poland, possessed the macroeconomic frameworks and vigorously exercised internal political competition of Poland, it is not obvious that their adoption of slow privatization would have produced equivalent results.22 The limitations of the Polish privatization approach are now more evident, as the costs of maintaining the loss-making SOEs accumulate.

3. CZECHOSLOVAKIA The first World Bank mission to then Czechoslovakia took place in May 1990. For a variety of reasons, the Czechoslovaks borrowed hardly at all from the World Bank for real sector reform; this remained the case for all governments through the 1990s.23 But World Bank and OECD staff entered into an active dialogue with the privatization authorities, particularly in the Czech Republic, and kept up to date on the approach they followed. External staff were generally (not universally) persuaded as to the correctness and efficacy of the approach, often employed Czech privatizers to preach elsewhere the gospel and techniques of voucher privatization, and expended considerable effort in analyzing and understanding the method and its effects. Thus, the path followed in this country had a very significant influence on external advisors’ privatization efforts elsewhere in the region.

3.1. Different Starting Point Production in Czechoslovakia had been, along with that in the German Democratic Republic, organized and managed in a rigidly classic socialist manner almost up to the moment of the fall of the communist regime. Central planners and branch ministries had retained their dominance. There were no quasi-market mechanisms or small private firms along Hungarian lines, no powerful independent labor union or workers’ councils, or much

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decentralization to firm managers, or much private agricultural production, as in Poland, indeed, little experimentation with industrial cooperatives, leases, and non-quota production, as in the Soviet Union.24 The country, especially the ‘‘Czech lands’’ of Bohemia and Moravia – what would become after 1992 the separated Czech Republic – had a long manufacturing tradition and produced many comparatively high quality industrial goods for the COMECON countries and some non-COMECON markets. Living standards were about the highest in the socialist bloc and measured inequality about the lowest in the world. Official unemployment in May 1990 was 1,100 – in a country of 16 million. Part of this comparatively good performance was due to the solid economic base with which the country had entered the socialist period in 1948; part of it was due to the intelligence and industry of the Czechoslovak work and managerial force. As one Bank staff member said about the technocrats and plant managers encountered, ‘‘these guys are so good they almost made socialism work.’’ At the last moment some cracks had appeared in the Stalinist walls: officials in Prague in May 1990 noted that from late 1988 workers in large firms had been allowed to select their managers, from a list of three presented to them by the branch ministry. They said they had regarded this as a revolutionary change at the time. What was striking, however, was that the post-communist regime reversed this decision in April 1990, and reinstated managerial appointment solely by the branch ministries. Why? Because ‘‘the professors and researchers’’25 who made up the new administration accepted – unlike the Poles, with their longer history of struggle and suspicion, and the availability of alternatives – that it was the state that had to define and allocate property rights. Vaclav Klaus, at that time the Federal Minister of Finance, made this clear in May 1990, saying there was an acute need to introduce both a private and a public sector. At the moment, he said, there was neither, but only ‘‘a fuzzy sector in between.’’ Defining the division between the two was crucial for the future of the polity and the economy; and defining and allocating property rights was the principal task that would confront the newly constituted public sector.26 Privatization was the method by which property rights would be assigned.

3.2. Mass Privatization through Vouchers The body responsible for this process was the newly constituted Board for Temporary Administration and Privatization of State Property (later

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renamed the National Property Fund), headed by an economist, Dusan Triska – who would become the principal architect of the voucher scheme in the country, and a leading proponent of its application elsewhere. In his first meeting with the World Bank team he expounded his leitmotiv; that the overarching purpose of privatization in post-communist systems was to cut the link between the state and the productive firms. Though written later (in 1992), the following summarizes Triska’s position from the outset. Privatization y is not just one of the many items on the economic program. It is the transformation itself. Without a well-defined and feasible privatization strategy the program would become just another hopeless attempt to reform the unreformable. Privatization is the element that distinguishes transformation from reform. That is why privatization must be conceived of and viewed as an end in itself.27

Triska had previously written that ‘‘In the highly improbable case that privatization engenders, in the short run, declines in growth and efficiency, it would remain the Government’s policy to privatize.’’28 Speed, he consistently stated, was of the essence: ‘‘the faster the better.’’ How would this work? All SOEs would be transformed to joint stock companies. This ‘‘commercialization’’ process would entail some financial restructuring to clean or minimize debt and deal with eroded assets. This restructuring would be the ‘‘last task’’ of the sectoral ministries; following this they would be abolished (and they were). The only prerequisites for privatization were price liberalization, a bankruptcy law, and convertibility of the currency. He stated that macroeconomic changes, though necessary, would not be sufficient to alter or guarantee good SOE performance. Therefore, privatization had to be widespread and quick to extend and lock in the incentives coming from macroeconomic change. Immediate action on divestiture was required despite the imperfect policy and institutional foundation. Delay would simply allow those presently stealing the assets to complete the job. ‘‘If we wait too long, there will be nothing left to privatize.’’ There would be no attempt to reform those firms temporarily left in state hands; the solution was mass and rapid privatization. Use of the methods applied in the West would take too long, and place the mass of enterprises either in the hands of nomenklatura who had stolen money in the communist period, or foreigners; neither outcome would be acceptable. Rather, government would ‘‘give quite big portions of the state property to the people,’’29 for free, through vouchers. This program would, said Triska  reward the public,  help develop markets in general and capital markets in particular,

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 deal with the problem of insufficient local savings and capital, and  generate resources that would pay for the effort of producing information on the firms being privatized. ‘‘Everybody,’’ said Triska, would be given vouchers (booklets of ‘‘coupons’’ were eventually made available to all over the age of 18, for a fee equal to one week’s average wage), and then the many details of which firms would be brought into the process and how the vouchers will be exchanged for shares would be worked out. Still, he thought the process should be simple. He thought most people would probably use their vouchers to buy shares in firms they knew, in their neighborhoods, or in the immediate vicinity. The vouchers would not be convertible to currency, nor would they be tradable (in fact, unlike in many other countries, Czech vouchers were not denominated in currency units but in ‘‘points’’); they did not want those with ill-gotten gains to speculate and end up as major owners. Firms to enter the program would be lightly evaluated to determine general prospects and attractiveness for voucher-holders, but this and all other technical, preparatory processes would be, must be, simple and quick. They were aware of the problem of selling off the winners, leaving the state holding the losers. But, he said, who knows whether today’s loser could not be tomorrow’s winner, as changes occur in the macroeconomic framework, the trade regime, managers, etc.? Vouchers would be exchanged for shares in rounds of bidding in which prices would be expressed in points per share. The privatization authorities would set an arbitrary price in the first round; prices in the second and subsequent rounds would rise or fall according to the level of demand expressed in the previous round. Rounds would continue until the market cleared. Early bidders had a high likelihood of getting the amount of equity they wanted, but at a relatively high price (expressed in coupon points); later bidders might pay a lower price, but ran the risk of less-than-desired quantity. This scheme was designed to equate supply and demand in a situation of little information. The method was seen as fast, equitable, and a solution to two vexing problems: how to value firms and how to prevent ‘‘dirty money’’ from buying up the assets. The advisory group listening to this presentation was impressed, but not completely persuaded. A quotation from personal notes taken at the meeting reflects the group’s reactions and questions. The scheme ‘‘y strikes one as cumbersome administratively. It doesn’t guarantee revenues, either for the enterprise for restructuring or for the government for financing the social safety net. It places an enormous information burden on the public.

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People have to decide which enterprises to bid on. They may have to do so in a distorted price and macro environment which, when changed, will result in some seeming winners becoming dreadful losers (and vice versa). Perhaps most important, this scheme in general doesn’t solve the problem of putting good managers in charge of the resources.’’30 Triska dismissed all queries, especially those concerns about whether the public could make good choices and serve as good owners. Indeed, at one point he asked if the World Bank lacked faith in markets. You must realize, he said, that ‘‘the present system is more cumbersome, uninformed, unfinanced and unmanaged’’ than we could imagine; almost any alternative was preferable. Second, we did not understand the strength of the forces still existent in Czechoslovakia that were opposed to rapid change. These opponents were espousing a seemingly reasonable gradualism but this was a cover for their desire for no change, or even a reversal of transition.31 Delay would play into the hands of the anti-reformers. Third, getting good owners with capital and know-how was important, but it must be the second step. The imperative and essentially political, or indeed psychological, first step was to get the firms out of the hands and implicit responsibility of government and into the hands of private citizens. This crucial break with the communist past had to be sweeping and rapid; if it were not, the transition would falter and perhaps slide back. In an argument later repeated and refined by Russian reformers, Triska placed a lot of faith in the secondary market. He said that lack of capital and managerial know-how would force the new owners to open the equity in the firms obtained by vouchers to external investors having the needed skills and resources. In other words, natural, automatic market forces would eventually supply moneyed and experienced owners. Note that in this first, long and wide-ranging discussion, no mention was made of investment funds.

3.3. The Rise of Czech Voucher Privatization As usual, it took the reformers longer than anticipated to get started, but the privatization program was launched in 1991.32 From the outset it was a homegrown product; the role of outsiders generally and the World Bank in particular was limited to that of interested and then increasingly impressed observers and commentators. By 1995 some 1,800 medium and large firms had been privatized through two waves of a voucher process. Another 350 enterprises had been sold on a trade sale basis to strategic investors; and

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substantial assets had been transferred to local authorities or restituted to identifiable owners who had suffered expropriation by the communists. Public interest in vouchers was originally quite weak, but picked up dramatically after dozens of private investment funds came into being, claiming specialized information, promising to diversify risk, and in several cases guaranteeing positive returns on any investment.33 Citizens responded by buying vouchers, with 70% putting their vouchers into investment funds in the first round, and slightly less in the second. At the end of the voucher exchange most citizens thus held shares in an investment fund, and not in a specific firm; and the investment funds became the major holders of all privatized equity. The initial results were tremendously encouraging. Privatization contributed to the rapid growth of the private sector share of GDP, which reached a region – leading 74% by 1996. Exports shifted from Eastern to Western markets. Growth resumed, having spent but a brief time in low negative territory, and topped 6% in 1995. This transformation and growth were accompanied by single digit inflation and, most surprisingly, extremely low rates of unemployment. Compared to Poland and Hungary, with their initially high rates of unemployment and difficult to contain inflation, the Czech Republic looked good. Compared to Russia and many points east, it looked miraculous. By 1996 Prime Minister Klaus could state that the transition was more or less complete and henceforth the Czech Republic should be viewed as an ordinary European country undergoing ordinary political and economic problems. He characterized the voucher privatization program as ‘‘rapid and efficient.’’ Most observers and most World Bank staff working on the real sector in transition agreed.34 The early and apparently resounding success story influenced Bank staff in their recommendations on privatization in general and voucher use in particular in a number of other transition countries. Table 2, below, shows the principal and secondary methods of privatization employed in transition economies. In 9 of 26 reviewed countries vouchers were the prime divestiture method; in 10 they were the secondary method. In several instances, such as shall be shown for Russia, the World Bank did not initiate the voucher idea; but in many cases it pushed for the use of this method. Moreover, it was quite clear in this period that the World Bank generally approved of the method and was willing and able to aid in its implementation.35 In addition, in several cases, the Bank employed the dynamic and persuasive Dusan Triska to explain the Czech approach and techniques to seemingly reluctant or slow privatizers. Czech representatives featured prominently in Bank-sponsored and supported seminars and

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Table 2. Country Czech republic Hungary Slovakia Estonia Poland Russia Kyrgyzstan Lithuania Georgia Slovenia Bulgaria Croatia Kazakhstan Latvia Macedonia Moldova Armenia Romania Uzbekistan Ukraine Azerbaijan Albania Tajikistan Turkmenistan Belarus Bosnia

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Scope of Privatization and Method Used.

Large Scale Scorea 4 4 4 4 3.3 3.3 3 3 3.3 3.3 3 3 3 3 3 3 3 2.7 2.7 2.3 2 2 2 1.7 1 NA

Primary Method

Secondary Method

Voucher Direct Direct Direct Direct Voucher Voucher Voucher Voucher MEBO Direct MEBO Voucher Direct MEBO Voucher Voucher MEBO MEBO MEBO MEBO MEBO Direct MEBO MEBO Voucher

Direct MEBO Voucher Voucher MEBO Direct MEBO Direct Direct Voucher Voucher Voucher Direct Voucher Direct Direct MEBO Voucher Direct Direct Voucher Voucher Voucher Direct Voucher Direct

Source: For the scores and estimates of methods see: European Bank for Reconstruction and Development (1999). a The score is the numerical ranking of the EBRD; its classification system for assessing progress in large-scale privatization is: 1, minimal progress; 2, scheme ready for implementation; some firms divested; 3, more than 25% of assets privatized; 4, more than 50% of assets privatized, and substantial progress on corporate governance; 4+, more than 75% of assets in private hands; standards and performance comparable to advanced industrial countries.

conferences of the period, disseminating what they increasingly assumed to be ‘‘the’’ correct privatization method. The Bank’s 1996 World Development Report on transition noted some potential problems but concluded: ‘‘The Czech Republic’s mass privatization program has been the most successful to date.’’36 In 1997, two widely cited Bank research publications offered empirical data supporting the claim that the Czech privatization program was producing solid and positive results.37 The point is that, in the

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mid-1990s, when one looked to the World Bank for guidance on how to privatize in a transition setting, the Czech model was clearly the recommended approach.

3.4. y And the Fall While Poland and Hungary continued to enjoy 4 and 5% growth rates, the Czech GDP growth rate fell dramatically in 1996, sunk to 0.3% in 1997, turned negative in 1998, and did not recover markedly until 2000.38 Several factors account for the prolonged slide, aspects of privatization among them. First, the privatization investment funds were insufficiently regulated; this ‘‘opened the door to a variety of highly dubious and some overtly illegal actions that enriched fund managers at the expense of minority shareholders, and harmed the health of the firm y .’’ Second, some of the largest of these funds were owned by local banks, which themselves were only partially or not at all privatized. Investment funds owned by banks ‘‘tended not to treat aggressively poor performance in firms, since pulling the plug would force the fund’s bank owners to write down the resources lent to these firms.’’39 These banks, in turn, persisted in lending or rolling over loans to poorly performing firms privatized by vouchers. As late as the summer of 1998, the CEO of one of the largest (and still state-dominated) Czech banks stated that as ‘‘a national institution’’40 his bank could not ignore the needs of Czech industry, even in instances where the appraisal numbers were weak. The results were twofold: (i) the expropriation (called ‘‘tunneling’’) of firm assets by investment fund and firm managers41 defrauded many minority shareholders and led to widespread public dissatisfaction with privatization, and (ii) the tunneling, and deficiencies in the capital and financial markets, retarded needed restructuring in the privatized firms, leaving them overstaffed, undercapitalized, unable to raise investment funds, and poorly managed. The low unemployment rate, formerly seen as a sign of success, began to be interpreted as an indicator of lack of needed change in the firms. An additional factor causing problems was that a number of foreign portfolio and institutional investors had entered the Czech stock exchange, anticipating steady positive returns on the privatized firms’ and investment funds’ equities they obtained. As pervasive tunneling led to severe price drops in the minority shares of many firms and funds, these investors were burned. Unlike most Czechs, who could do little but grumble, the international investors could make a great deal of noise, on the street, in the

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financial press, and in meetings with officials. The international image of the Czech Republic suffered. Academic papers began to appear, asking whether the voucher approach to privatization was living up to its promises, or at least the implied promises. One of the first critiques was by Pavel Mertlik (later Minister of Finance), who in 1995 questioned both the extent of privatization – noting the large amount of assets retained, directly or indirectly, by the state – and whether the scheme was producing, or was even capable of producing, concrete, good owners.42 Criticism appeared of the investment funds, arguing that their very design made it unlikely that they could or would ‘‘enhance the value of their holdings.’’43 One study reviewed financial performance of a set of firms and argued that there was no evidence that funds were managing shares well; but the authors did find that ‘‘ownership concentration in hands other than funds had a major and positive effect on performance.’’44 That is, the set of Czech companies initially privatized to core investors (often foreign) were generally doing well, supporting Kornai’s argument that the key to good privatization was finding good owners. Subsequent research has largely confirmed that concentrated, core owners – of the type produced by trade or ‘‘case-by-case’’ sales, but not by voucher schemes that disburse ownership widely in a population – are associated with more, faster and better restructuring.45 But it is not just a simple matter of leaders recognizing the utility of concentrated owners and deciding to sell to them. Countries with good policy frameworks attract core investors, while poor policy countries do not; and it is the policy environment as much or more than the degree of ownership concentration that accounts for the progress seen. So, concentration of ownership is not the whole of the story. In the Czech Republic, secondary trading, led by privatization investment funds, did produce a high percentage of concentrated owners within two years of the voucher auctions.46 After the break-up of federal Czechoslovakia, the Meciar government in now independent Slovakia abandoned the second round of voucher privatization and turned over a mass of manufacturing firms, at very low prices and with long payment periods, to concentrated owners – the bulk of them politically connected to Mr. Meciar and his party. In both cases, and in others one could cite, the resulting concentrated owners were not associated, at least in the short term, with improvements in output, restructuring, or probity. The important point is while concentrated owners may be a necessary condition for successful enterprise transformation; they are not a sufficient condition. They have to be buttressed and guided by policy and regulatory

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frameworks in capital and financial markets that shed light on corporate decisions and actions, create and sustain proper procedures (e.g., regarding trading channels), and offer protection to minority shareholders and creditors. Indeed, one reason why direct foreign investment is so important is that the higher reputational risk of such investors may lead them to adhere to decent behavior standards, even in the absence of local regulations or enforcement capacity. The conclusion is that the nature of the new owner is important, but so is the legal and institutional climate into which the firm is divested. By 1998 the bloom was very much off the Czech privatization rose; to the point where an OECD country review could state bluntly that Czech voucher privatization produced ownership structures that ‘‘y impeded efficient corporate governance and restructuring.’’47 Since that time, government has addressed the deficiencies in the legislative and legal framework, particularly with regard to investment funds and capital markets, privatized fully or more completely most of the commercial banks, and started the last remaining large privatization projects, in electricity, energy, radio–television, and railways.

3.5. Implications The implications of this brief review are several: from the viewpoint of the Czech economy, one could argue that the application of the voucher approach resulted in substantial losses and missed opportunities. The approach turned over, whether planned or not, the bulk of the equity privatized by vouchers to investment funds. This was combined with the insufficiency of prudential regulation in capital and financial markets, the failure or inability to attend to corporate governance concerns, the continuing state ownership and influence in the banking sector, and the ownership of investment funds by banks. This mixture resulted in a small group of people benefiting while the mass of citizens received, directly at least, little or nothing from the transfer of former state property. Equally and perhaps more important, the approach failed to impose sufficient constraints and incentives on the new owners to restructure the firms. Kornai notes that labor productivity in Hungary in 1998 was 36% higher than in 1989; in Poland it was 29% higher. The Czech Republic registered a 6% increase.48 It is reasonable to assign some of the explanation for this to the mass privatization method.

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The average citizen’s utility was probably increased more by the trade sales than the voucher privatizations.49 Had the Czechs applied more widely this case-by-case approach (as did Hungary and Estonia) then one might have seen faster restructuring, a less severe recession, and a smaller and less costly problem of bad debts in the banks. The Czech architects of the program would not accept these criticisms of the voucher approach.50 They could note that the group of firms sold by means other than vouchers were arguably the ‘‘blue chip’’ enterprises, of high potential; and they could argue that many of the companies privatized through vouchers would not have attracted core, and certainly not foreign, investors. They might also argue that the option of leaving these firms in state hands was not open to them, since, unlike the Poles, they had no workers’ councils; that is, no countervailing mechanism in the firms to watch over the managers. They could note that concentrated owners did arise in fairly short order in many of the firms privatized through vouchers. The Czechs could also say, look around the region and note how very few countries have been able to mount good, extensive case-by-case programs. The countries that have applied case-by-case as their principal sales method – East Germany, Estonia, and Hungary – had different or superior, and in the case of Germany, unique starting conditions, or, in the case of Estonia, a situation where sales to foreign investors were welcome because of the fear of Russian domination. On the larger political front, the Czech reformers could state, correctly, that the near total collapse of communism was not predictable. One could not have known at the outset how weak the forces of reaction would prove to be, and how much time was thus available to experiment with ownership reform, and to attend first to the institutional and legal foundations of privatization. All these arguments have merit, though my conclusion is still that history and geography endowed the Czechs with many more chances for direct, case-by-case sales than they seized. The least that one can say is that opportunities were missed. From the point of view of outside advisors, the general infatuation with the Czech voucher approach51 reveals a number of interesting points  The primacy of the economic. Here, and even more so in Russia, most advisors tended to agree with those reformers who thought that ownership change was ‘‘y not just a necessary condition of capitalism, but a sufficient one.’’52 As several observers have noted, the primacy of the economic was almost Marxian in its intensity. This led to the belief that

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 The required legal/institutional framework would arise from demand by the new, private property owners. Many reformers and their external supporters did see the need, the urgent need, for legal, regulatory, and administrative mechanisms to channel and guide the acquisitive behavior of property owners. But they hoped and believed that this increasingly populous and powerful group would itself pressure government for, and support the creation of, the required institutional framework. World Bank staff generally agreed with this reasoning, and tended to downplay or reject alternative approaches because of  A strong bias towards concrete, substantial, and near-term action, as opposed to incremental, less dramatic actions laying the foundation for future developments. Voucher programs cut through the many and serious obstacles/questions posed by direct sales. How to attract investors? How to value the entities being sold? How to enforce contracts in the post-sale period? Use of vouchers made it relatively easy to meet donor conditionality targets on numbers of firms, or percentage of assets privatized; other methods53 were slower, more complicated, and more prone to delay. Donor organizations in general, and the World Bank in particular had – and have – a predilection for immediate and substantial action as opposed to longer term, ‘‘foundation laying’’ measures. Thus, the reformers’ arguments on the need for speedy and massive transfers fell on receptive ears.

4. RUSSIA From the beginning it was clear that Russia would be a special and more complex transition case, particularly with regard to privatization and enterprise reform. Poland and the Czech Republic were geographically and historically part of central Europe, with long-standing commercial, legal, and institutional ties with Western markets and cultures. Both were part of the communist bloc for about 40 years, meaning that there were plenty of citizens in both countries who either remembered the non-communist past, or had heard of it from their parents and relatives. Both could dust off old laws and memories and try to re-start a rusty but not completely forgotten system. This was not the case in Russia. Its socialist experience had endured for more than 70 years. In any event, despite considerable progressive strides in the 20 years prior to the Revolution, Russia was not a full-fledged

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capitalist system in 1917. This heritage resulted in much more uncertainty at the end of the socialist period than in countries farther to the west.

4.1. First Contact The first international mission – composed of representatives of the World Bank, the International Monetary Fund, the European Bank for Reconstruction and Development, and the Organization for Economic Cooperation and Development – to the then Soviet Union took place in September–October 1990. Regarding enterprises, it found confusion. There were, reportedly, 47,000 medium- and large-sized industrial firms in the Soviet Union as a whole; adding the energy, infrastructure, and large service-oriented firms brought the number to 55,000. Many of these were classed as ‘‘amalgamations,’’ ‘‘associations,’’ and ‘‘concerns,’’ that is, multidivisional entities containing subunits that could be regarded as selfstanding companies. This meant that the actual number of state-owned productive units was considerably higher than the official numbers indicated. As in Poland and Hungary, the way in which these enterprises functioned had been evolving, slowly in the 1960s and 1970s, and then much more rapidly in the mid-1980s with the advent of Gorbachev’s perestroika reforms. A 1987 Law on State Enterprises reduced the power of the branch ministries in favor of enterprise managers and workers. Firms were given an increased capacity to negotiate planned annual production, modify products to meet consumer demand, market their products abroad, contract with foreign partners, retain an increased amount of any foreign exchange earned, and allowed to look for credit outside the traditional funding sources. Some enterprises had won the privilege to sell some or all their production to any willing buyer, at a more or less ‘‘market’’ price; this privilege was to be expanded. ‘‘The goals of these changes were to decentralize some decision-making to the level of the firm, to widen the scope for personal and private initiatives, and to substitute (partially) indirect financial signals for direct planning as a means to guide enterprises.’’54 It was already clear in 1990 that the managers had gained most of the controlling power in this shift; other than make claims for wage increases, workers tended to defer to managerial decisions. The 1987 law also allowed increased latitude for non-state forms of enterprises; that is, joint ventures, leases, cooperatives, ‘‘collectively owned,’’ and ‘‘limited’’ firms. Data were

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scant on the exact organization, total number, and impact of non-state firms, but it was thought that these tended to be small in size, growing in number, and more productive than the larger enterprises out of which they had been spun. Spokespersons in the cooperative movement claimed 215,000 units in existence in October 1990, accounting for 5% of ‘‘net material product,’’ employing 5.2 million people, registering huge output and employment increases in the past two years, and growing rapidly. Another source stated that 12,500 leasing arrangements were officially registered, and estimated that many more were in informal existence. Enterprise interviews in 1990 revealed one or more leases or cooperatives in every firm visited, and the contrast was striking between the dynamism and enthusiasm shown by managers and workers in these units and the lethargy generally prevailing elsewhere – not surprising, given that employees in these non-state units escaped the wage caps that still were applied in the traditional firms. Some have argued that these promising developments should have been greatly encouraged and extended, and, had that been done, the non-state sector – operating somewhere in between private and public ownership – could have evolved and become, as it did in China, a major contributor to employment and growth.55 The implication is that the subsequent dismantlement of the real sector and the attempt to reconstruct it in largely privatized fashion was both unwise and unnecessary, and that a less revolutionary, less painful, more incremental and productive path had been available, and should have been chosen. That was not the way the mission of the international financial institutions (IFIs) saw it: A process of spontaneous privatization is taking place in large sectors of industry through the leasing of facilities to cooperatives consisting of the managers and workers of state enterprises. Given the uncertainty of ownership rights, including the right to sell enterprise assets, the incentives of the new managers tend towards short-term income maximization at the cost of enterprise decapitalization.56

The IFI mission assessed the non-state sector as an improvement, in incentive and productive terms, over SOEs, but as an inadequate and improper basis for long-term growth and transition. Inadequate because the lessees, and those in cooperatives, controlled the assets (liabilities remained in the parent firms) but did not own them; and it was apparent that the weakened state was in no position to monitor and enforce the obligations of the lessees to maintain the health of the assets. Improper because it seemed clear that managers in SOEs were using their newfound latitude to hive off the higher quality assets in their firms to leases and co-ops in which they

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personally had a stake. Non-state activities thus appeared to be thinly disguised expropriation of good assets by managers and favored groups of workers, and not a foundation on which one could base a policy of real sector reform. In view of the tremendous contribution to investment, production and growth made by non-state firms operating under what have been termed ‘‘fuzzy property rights’’ in China,57 it is possible that an opportunity was missed in not pushing harder for a general unleashing of these halfway measures to private industrial ownership. But the conditions prevailing in Russia were quite different from those in China, where fairly well functioning local governments were able to subject non-state firms to competition. Partly this was because the sub-national governments had the capacity and authority to step in and correct at least some of the most egregious self-enrichment by firm managers. Partly this was due to the central state’s ability to impose some discipline and penalties on the flagrantly corrupt. Perhaps the largest part of the explanation was that Chinese local governments were made financially dependent on the profitable activities of local firms. Since this was not the case in Russia,58 a recommendation to follow this approach (it probably would not have been adopted even if recommended; but that is another story) would likely have resulted in the further empowerment of managers. In the absence of competitive and institutional checks on their behavior, this probably would have produced neither production gains nor social benefits. One cannot say for sure, but it was not then thought (and I do not think now) that this approach would have worked in Russia. Thus, the real sector reform policy advanced by the 1990 IFI report was eventual full privatization of ‘‘almost all enterprises in the USSR.’’ Concluding that this was a long-term proposition, the report called for demonopolization and commercialization of the SOEs, the imposition of hard budgets, and efforts to approximate the effects of private sector management through state holding companies.59 The issue became moot: the impact of these recommendations was nil, as the political disintegration of the Soviet Union, and the rebirth of Russia, occupied center stage from the end of 1990 through to the fall of 1991.

4.2. The Mass Privatization Program As the political dust settled, the World Bank was called back to Russia, in November 1991, to assist the newly appointed Gaidar government in its

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privatization efforts. It found this government thoroughly committed to the concept of privatization. Leading officials in the Gaidar government entertained no hopes that one could reform state firms by means other than divestiture. There was thus no interest in state holding companies, performance improvement in SOEs, or any other halfway houses such as leasing and cooperatives. However, exactly how privatization should and could proceed was unclear. The government had recently appointed a new head and assistant head of the State Committee for Property Management (GKI, from its Russian initials; this later became a Ministry, or MKI), one of the bodies responsible for privatization. These were Anatoli Chubais and Dmitri Vasiliev, both from Leningrad (as it still was), the leading reform city in the country; they were producing a plan of action. As in Czechoslovakia, these officials had been ‘‘professors and researchers.’’ They had some legislative base to guide them. In July 1991 (before the final collapse of the USSR) the Russian Supreme Soviet had passed two relevant laws: one on Privatization of State and Municipal Enterprises in the Russian Federation, the second on Personal Privatization Accounts. Neither law was terribly detailed. The Privatization act established that government must submit to the legislature an annual program specifying what would, and what would not be divested, and in what manner. It assigned management responsibility for parts of the process to several different bodies, but there appeared to be considerable overlap in the responsibilities. It gave enterprise workers’ collectives the power to approve or reject, or at least delay, privatization proposals. It said very little about foreign investment and ownership. The second act vaguely indicated that ‘‘investment certificates’’ would be distributed to all citizens for use in the privatization process. In the troubled political situation after August 1991, nothing much had been done to implement these laws. In late October, Boris Yeltsin announced that privatization must now go forward. Debate intensified over how to proceed. The threat of a communist resurgence remained a possibility. The attempted coup had taken place in August 1991, and the only slightly reformed Communist Party, though much discredited by the failed coup, was still a major presence in the legislature and, for all one knew, in society at large. The reformers argued that speedy and decisive action was required, but as in Poland, the various key actors in the process had differing and often competing ideas. Workers, managers, branch ministries (rapidly transforming themselves into ‘‘industrial associations’’), and the sub-national governments were all putting forward claims. The November 1991 World Bank mission gravitated naturally towards dealing with and supporting the GKI. The July law assigned it (more or less)

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the prime responsibility for policy-making and program design. Its leaders were young, clear-headed, market-oriented reformers who saw their primary objective as advancing privatization rapidly and transparently. It was the only agency the mission encountered that was using high quality, obviously competent technical assistance; and the leaders had already established contact with supportive and enthusiastic Western academic advisors, who were marshalling financial and technical support for the organization. Thus, the GKI had the authority, the vision (what seemed the proper vision, one might add) and the capacity to act; and the World Bank and other donors such as USAID and the EBRD began at this time their long relationship with this agency and its ministerial successor. In November 1991 Dmitri Vasiliev had stated an aversion to vouchers, but by April 1992 a mass privatization program had been defined, cleared by the executive, and submitted to the legislature, with vouchers as the centerpiece. The now-familiar and overpowering logic was at work: sales for cash would be too slow, would exclude the bulk of the populace, and thus might stimulate political opposition to privatization in particular and reform in general. Giving away shares only to the workers in a particular firm was fine if the firm were a winner; otherwise not. Moreover, this policy would exclude the military, civil servants, and professionals from ownership. A mass program based on vouchers for all citizens seemed the only available way to deal with these concerns. This reasoning was accepted, and the reformers and their supporters swung into action. Between the spring of 1992 and the end of June 1994, the Russian authorities, actively supported by the Bank, the IFC, the EBRD, and USAID, with important smaller inputs from other donor organizations such as the British Know-How Fund, organized and implemented the largest and fastest privatization program ever seen, then or since. In just two years the Russian government was able to (1) corporatize and register over 24,000 medium and large state-owned enterprises as joint stock companies; (2) distribute vouchers to virtually the entire population in some 89 oblasts, territories, and autonomous republics; (3) privatize over 16,500 enterprises, most of which were in the tradable sector. Over forty-one million Russian citizens became shareholders through either direct ownership of shares in the newly privatized companies or share ownership in voucher investment funds. Moreover, private hands control more than fifty percent of Russia’s industrial production and twenty-two million workers are employed by private enterprises.60

These accomplishments came at a price. The need to reward the key stakeholders had led to firm managers and workers, ‘‘insiders’’ as they became known, ending up with a dominant 2/3 of the shares in about 2/3 of

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all firms divested.61 Nonetheless, at the end of the voucher privatization effort in 1994 almost all involved assessed the experience as positive. Dmitri Vasiliev summed up the ‘‘basic lessons’’ for those starting later: Privatization should be carried out in the y shortest possible period of time, using y the simplest and most standard procedures y . Restructuring should be postponed until the completion of privatization y . The maximum possible amount of property should be transferred to the population on a free basis y . Incentives should be provided to enlist the support of all important stakeholders, including workers, managers, population, officers of privatization bodies, local authorities.

He acknowledged the need to create ‘‘a securities market y to provide the reallocation of property rights to efficient owners following privatization,’’62 and that ‘‘deep institutional changes’’ were required for privatization to bear fruit. Still, the implication was that the required institutional changes were on the way and would appear in the foreseeable future. His central message was that Russia’s experience ‘‘proved that countries in transition y can make efficient use of voucher privatization methods.’’63 Privatization head Anatoli Chubais and his principal advisor, Maxim Boycko, agreed; they stated, in a June 1994 celebratory conference on Russian privatization held in Washington at the World Bank that the unprecedented Russian mass privatization program had successfully achieved its principal goals of removing firms from the control of politicians, and creating a constituency for a market economy. The summer of 1994 was the high water mark for mass and rapid privatization in Russia. The program had been carried out with remarkable speed and efficiency, in a fairly transparent manner (compared to what followed), and the contributions of the donor community had been important and acknowledged. The program seemed to justify the view of privatization as an end in itself, essential to severing the links between enterprises and the state. The characteristics of the optimal method of divestiture were speed, simplicity, and breadth of application. The risks – that neither corporate governance nor restructuring would initially be optimized – of privatizing to a set of diffused and inexperienced owners were recognized. Reformers and advisors called for legal and institutional measures to promote and regulate secondary trading. But as in the Czech Republic, the assumptions were that (i) the reformers in power could and would initiate this institutional change, and (ii) that the new group of private property owners created by mass privatization would constitute an active lobby, pressuring and assisting governments to both pass the required

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laws, and back the new legislation with the will and resources required to make the laws effective. And again, as in the Czech conception, financial need stemming from ‘‘depoliticization’’ and the demise of soft government money (what economists term the imposition of a hard budget constraint; constantly called for, rarely achieved) would force secondary trading among the capital short insider-owners, opening these firms to competent, concentrated ownership, and setting them on the path to restructuring and growth. The prevailing attitude among the advisory group generally matched the positive view of the Russian reform team, tempered by a realization that the bulk of equity had been transferred to insiders, and that there was a substantial amount of state assets that the program had not touched. This led to acknowledgment of the considerable ground still left to cover. Transfer to insiders was a striking step, but only a first step. It must now be followed by equally essential second steps opening ownership of privatized firms to external investors and owners. These y will complete the restructuring of firms begun by the transfer of ownership y . Such is the hope y much stands in the way in the achievement of this grand aspiration y . Insiders fear that the restructuring brought about by external investors will cost them their jobs; thus, they do their best to prevent or minimize sales of large blocks of share to external investors y 12,000–14,000 enterprises remain uncorporatized, unprivatized y what will happen to this important set of firms?64

4.3. Problems The optimism did not take long to fade. In July 1994 the Russian parliament rejected government’s proposed second phase privatization program. The program was promptly promulgated by presidential decree, and while this overcame the immediate obstacle, the subsequent and frequent use of such decrees gave ammunition to those who claimed privatization was being foisted upon an uncomprehending, unwilling polity. In 1995, production failed to recover, few external and even fewer foreign investors became involved in secondary trading in the privatized firms, and most importantly, signs appeared that the second ‘‘cash’’ phase of privatization was not proceeding in a rapid or transparent manner. Though many medium-sized firms were privatized for cash in the next few years, the methods were murky, and most of the remaining large firms and valuable assets were not brought to market, at least in anything resembling an open and competitive manner. Potential external investors, especially if foreign, complained of being blocked from participating in bids. Those few external investors who

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had obtained shares in the MPP often complained that their stake was being illegally diluted or eliminated, or that they were being ignored, misled, or actively cheated. Citizens began to grumble that the shares they had acquired for their vouchers were worth little if anything. Concern changed to serious alarm, in late 1995 – early 1996, over the ‘‘loans-for-shares’’ (LFS) transfers (ostensibly auctions) in which significant stakes in 13 high potential, natural resource-based firms were handed over, in a manner neither competitive nor lucrative to the selling state, to Russian commercial banks, all apparently owned by a group of financial ‘‘oligarchs’’ connected to the presidency. No Russian banks (foreign banks were completely excluded) other than those in a self-designated inner circle were allowed to bid, and the bids were rigged. The government did not repay the loans and the shares, and ownership of some of the best remaining Russian assets passed to the oligarchs.65 To give some idea of the results, the Uneximbank obtained 38% of the shares of Norilsk Nickel, a firm that in 1999 (reportedly) made annual profits of U.S. $2 billion, on the basis of a U.S. $170 million loan. The differing interpretations of the significance of the LFS auctions are instructive. The Russian managers, and some of their advisors, of the LFS were the very same, previously lauded reformers working under Anatoli Chubais. Their view, and that of their supporters, is essentially that of the exigencies of political economy: To succeed in the 1996 presidential elections Boris Yeltsin required financial support. Had those supporting Yeltsin not allied with the powerful bankers and managers, the Communist Party candidate might well have regained the presidency, and transition might have come to a halt or been reversed. LFS was thus an unpleasant but unexceptionable and necessary means to a critical end; alternatives were unavailable or worse, especially the alternative of leaving the firms in the hands of the state. The firms divested through LFS obtained the needed concentrated ownership, have generally performed well post-sale, and are now among the leading, most dynamic and profitable private firms in the country. The efficiency benefits of the transactions outweigh the equity costs. Shleifer and Treisman summarize the argument By 1995, the government had formed a political alliance with important bankers and enterprise managers, and the interests of small investors lost out in the political struggle. (Good laws had been passed but) y the implementation of these laws has been derailed by the new ‘‘oligarchs’’ whose fortunes were consolidated by the loans-for-shares program. Russia’s situation in this respect is troubling, but not exceptional. Many countries in the emerging world suffer from similar corporate governance failures y the limits of the achievable in Russian privatization were defined by the interests of the

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stakeholders already in place y privatization in Russia worked considerably better than its politically feasible alternative: doing nothing.66

A number of external advisors opposed and deplored LFS. I recall a 1995 memo drafted by several World Bank staff working on Russian privatization, including one particularly outraged Russian citizen, to World Bank management, calling attention to the deficiencies of the LFS proposals from the viewpoint of limiting competition and not producing revenues for government. I do not recall that this led to any official reaction, though it probably did add to the pressures that led to a change of tactics in the Bank’s support to Russian privatization (discussed below). Ira Lieberman, who had managed World Bank efforts to assist the mass privatization program, coauthored and published a blistering article on the shortcomings of LFS, depicting it as y non-transparent y involved clear conflicts of interest y created collusion y involved a nonlevel playing field excluding foreign investors and banks not favored by the government. In two years the Russian privatization program has moved from the outstanding accomplishments of the MPP to the point where its program is now widely regarded as collusive and corrupt, failing to meet any of its stated objectives.67

Most advisors distinguished between what they regarded as the generally decent and potentially positive MPP and the uncompetitive, corrupt LFS. The view was expressed in less pointed language in a later World Bank publication. ‘‘The lack of transparency in the way these latter privatizations (i.e., LFS) were carried out has raised serious concerns about equity, concentration of market power, and corporate governance. Moreover, because the processes utilized were insufficiently competitive, government revenues from the transactions were substantially reduced.’’68 Nonetheless, the conclusion on the part of the World Bank was not to withdraw from privatization, but to change the approach. Before discussing the revised approach it should be noted that a good number of Russian and external critics do not make any distinction between the MPP and LFS; indeed, some regard the LFS ‘‘as the logical and inevitable conclusion of the MPP.’’69 The reasoning appears to be that from the outset the so-called reformers had in mind the mass transfer of ownership to a particular group and set of people, and that the MPP and LFS were simply different tactics, applied at different times, to achieve that end. Observers who do not go so far as to regard the outcome as planned, and who make some quality distinction between the MPP and the LFS, are nonetheless severely critical of the end results

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Taken as a whole, Russian privatization led to several distinct outcomes. First, a new kleptocracy emerged. A small number of individuals, who mostly achieved initial wealth through favorable deals with or outright theft from the government, ended up controlling most of Russia’s major firms and, to a nontrivial extent, the government itself.70

In response to internal concern and external criticism, over the next three years the World Bank and other donors scaled back on privatization efforts and shifted to building within Russia an acceptance of, and a capacity to execute, case-by-case transactions. The premise was very different from that which had underpinned support to the MPP. Instead of emphasizing speed of ownership change and quantity of privatizations these efforts would concentrate on the transparency and quality of a small number of transactions, carried out in accord with accepted international sales standards. The objective was to produce a demonstration effect; ‘‘y to send a signal to both domestic and foreign investors that Russia’s business environment is open, competitive, and investor-friendly, and that private sector development is market-driven.’’71 Raising revenues for the cash-strapped government, and promoting domestic support for the transition to the market also featured among the goals of the attempt to promote case-by-case divestiture. Through 1996 and into 1997, World Bank teams negotiated with Russian officials to create a case-by-case sales framework that would be transparent and competitive, open to all interested bidders, foreign as well as domestic, rely heavily on reputable and experienced financial advisors, value the firm to be sold by methods consistent with international standards, and allow all bidders and the public at large access to all needed and available information concerning the firm to be privatized. The government eventually (in April 1998) passed a resolution endorsing this approach, but referred to it, before and after, as ‘‘the World Bank resolution’’ and mostly ignored it. The time-consuming focus of RussianWorld Bank privatization discussions in this period concerned the list of firms that would be sold according to the case-by-case rules. Despite a major educational effort on the part of the Bank to expose Russian officials to best practice on privatization of medium and large, high-potential firms using private sector financial advisors, and repeated explanations of the benefits that could and should accrue were the process correctly handled, the Russian authorities were unwilling or unable to place good companies in the case-by-case program. In several instances seemingly good firms, placed in the program after lengthy and contentious debate, were without notice to advisors removed from the list, and other firms of lesser or dubious potential substituted.

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At the end of the day, and given the client’s resistance to the concept, the privatization component in several World Bank loans was scaled back considerably, to the point where conditions concerning transactions were modest in the extreme. Achievements, either in terms of inculcating within the Russian government a commitment and capacity to carry out case-bycase sales, or in terms of completing a fair number of well-managed ‘‘open and competitive’’ transactions, were very slight. Advisors recall that at the most two, or perhaps just a single firm was ever sold according to this method. One reason for the lack of enthusiasm (to put it mildly) for case-bycase sales was the apparent and widespread concern within Russia, even among privatization officials, of foreign takeover of key assets. A less charitable interpretation is that privatization officials were either involved in or powerless to stop the corrupt and non-transparent transfer of these assets to the well connected. For whatever reason, the World Bank was never able to find much of a constituency for open and competitive transactions.

4.4. Interpretation Critiques of the Russian approach to transition, of its privatization program, and of World Bank and other donors’ support of the program, began to appear in 1995, and multiplied thereafter. Nobel laureate Kenneth Arrow termed Russian privatization ‘‘a predictable economic disaster.’’ Jeffrey Sachs – formerly an advocate of mass and rapid privatization – stated that the Russian government should renationalize the particularly valuable firms mis-privatized in the LFS, with a view to re-privatizing them, the second time correctly,72 and Joseph Stiglitz (1999), at that time Chief Economist of the World Bank (and now Nobel laureate), wrote and presented – at World Bank development economics conferences in Washington and Paris – two influential critiques of the approaches applied in transition. With regard to privatization, the thrust of Stiglitz’s argument was that privatizing in the absence of a sufficient, market-supporting ‘‘institutional infrastructure’’ was a serious mistake that could and did ‘‘lead more to asset stripping than wealth creation.’’73 In essence, Stiglitz’s view was the reverse of the ‘‘realist’’ position outlined above; the equity costs of the path followed outweighed the efficiency gains. Stiglitz argued that this should readily have been foreseen, if not by the first generation of transition reformers, than at least by their Western economic advisors and presumably by the involved World Bank staff (there was a strong ‘‘they should have known better’’ tone to the papers). Again, the implication was that the

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headlong rush to privatization was a basic, obvious mistake; that much of the decline and pain associated with transition in general and privatization in particular was avoidable; and that much more attention could have and should have been paid to building the institutional/legal/administrative foundation on which properly functioning capitalism is based. The upshot of Stiglitz’s reasoning was: if only one had followed a more evolutionary, more decentralized and participatory approach to ownership reform the costs might have been much lower, and the benefits more substantial, and faster in coming. In their more focused and detailed study Black et al. specifically asked the question, ‘‘what might have happened with staged privatization and more institution building?’’ They regard as inadequate the reformers’ argument that the same amount and type of theft would likely have occurred under continued state ownership. They acknowledge that theft was and is present in SOEs, but argued that in Russia  theft often became worse in privatized firms;  while weak, some control mechanisms did exist in SOEs;  in SOEs, one might steal the flow of income, but in privatized firms one could steal the entire stock; thus,  government would have been better off financially had it retained the control of the major natural resource producing firms; and politically,  theft in newly privatized firms harms attempts to move to a market system, while theft in SOEs adds to the political case for transition; ergo,  retention of SOEs would have been the wiser course of action.74 Black et al. speak from personal, practical, and extensive involvement in the Russian privatization process. Being aware of the deficiencies of the Russian governmental and administrative systems, they expend considerable effort to keep their suggested policy alternatives realistic and feasible; ‘‘attainable,’’ in their word. They conclude that Russia should have effected a slower, staged privatization of the larger firms, through more case-by-case sales to strategic investors and foreigners, expanded leasing, and cash auctions. They reason that had the reformers and their supporters put the level of energy they expended on mass and rapid privatization into selective divestiture, accompanied by efforts to build the basic foundations of a market economy to control self-dealing, attack corruption, and reform the tax regime the results could have been, would have been, considerably different and better.75 It is possible they are correct. But the problem with these recommendations, as with the Stiglitz critique; indeed, the problem with all of the

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alternative policy constructions suggested for Russia, is that they assume (i) a certain amount of freedom, or neutrality, on the part of the existing Russian government to choose from a menu and select the optimal policy (in terms of enhancing efficiency or welfare), and (ii) a modicum amount of capacity in government that would have allowed it to implement the chosen policy.76 It is not clear that either the will or the ability was ever there, or could easily have been put there. It is this inability to construct a persuasive political/administrative counterfactual that gives weight to the realpolitik argument of the reformers and their close supporters, that is, the mix of political forces in early transition Russia led almost inevitably to the privatization outcomes one saw, and what the reformers were able to achieve was, in the circumstances, justifiable and as good as one could expect (the argument advanced by Shleifer and Treisman; see above).77 Thus, the Black et al. counterfactual is appealing but not convincing. I do not see sufficient signs that a set of policies along these lines could have or would have been adopted at any point in the 1990s in Russia. Had they been adopted it is unlikely they would have been implemented or enforced. Had it been possible for the Russians to move slowly on privatization while freeing entry and imposing hard budgets (along the lines of the Polish approach), then slow or no large-scale privatization might have been acceptable, but one did not see until very recently any indications of either freer entry or hard budgets. One can thus make a case that the likely alternative to mass and rapid privatization to insiders in Russia was not some close approximation of the Polish or Hungarian approaches, but rather what one sees in Ukraine: very slow privatization of larger firms, rampant and rapacious bureaucratic interference in firms (this exists in Russia as well, perhaps not quite so acutely), and, in the absence of a powerful set of insider-owners, political stagnation as the various factions fight over the still initial division of the spoils. Overall, despite the dismay caused by the poor results of Russian privatization (so far), and despite a reluctance to accept the somewhat mechanistic inevitability, the aura of predestination, of the realpolitik interpretation of Russian events, I conclude that interpretation is superior to the alternatives proposed so far. Even if one accepts this line of thought, a second, and important – at least for the World Bank and the other involved donors and financial institutions – question remains to be answered: Did the efforts undertaken by the external agents in aid of Russian privatization best fulfill their mission? On the basis of their experience, technical expertise, and what they could perceive as the process unfolded, should these agents have advocated

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(or advocated earlier) a different approach or a different set of techniques and tactics? Specifically, should the advisors have pushed harder for the break-up of large firms prior to sale? Should they have resisted the exclusion from the voucher program of the natural resource firms, advocated earlier a track parallel to the MPP for case-by-case sales of some high-potential companies, denounced more forcefully the LFS scheme? Most importantly, should they have perceived earlier that the transfer of ownership to insiders and the general public would in the absence of enforceable contracts, capital and financial market regulation, a willingness and capacity on the part of government(s) to impose hard budgets, and a modicum of probity in the public administration, result in weak corporate governance in the privatized firms and produce sub-optimal results, at least in equity terms? Should the involved external community, in sum, have pushed harder for SOE control and reform, and less for privatization? Even if the political dynamics were such as to lead to the likely rejection of this advice, was it not incumbent upon the World Bank and the others to at least give it? There is merit in this view; one can make a good case that all the questions posed above should be answered in the affirmative. Recall (see footnote 59) that concerns over the corporate governance effects of a voucher approach had surfaced as early as 1990, in the IFI report on The Economy of the USSR. Recall as well that there were, persistently, at least a few voices within the World Bank pointing out the dangers of privatizing unbundled conglomerates and transferring ownership to insiders and investment funds; that from an early date a number of World Bank staff with experience in China were critical of the approach to privatization in Russia; and that many involved World Bank staff expressed concern, at various points, that too much was being promised of privatization. It was not that nobody in the external advisory community saw the potential problems. But once again, the seeming primacy of the economic (summed up in the idea that if we could just get ownership ‘‘right’’ much else would follow), the conclusion that the differing initial conditions of Russia did not allow it to take the Chinese path, and especially the strong sentiment that persisted up to and through 1995 – that one had to seize the perhaps fleeting moment, and support forcefully the one clear center of liberalizing reform in the country – overcame doubts and concerns, and led the vast majority of IFI staff and management, officials of the bilateral donor agencies, and most involved academic advisors, to support rapid privatization in general, and the MPP in particular. Finally, bear in mind that while the ‘‘yes’’ answer to the questions posed above seems reasonably evident now, those answers were not at all clear in

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1991 or indeed much before the late 1990s, by which time the donor approach to privatization in Russia (and elsewhere in transition) was changing, and becoming more cautious and long-term. In a sense this says that as the outsiders learned the complexity of the issue, they adjusted their advice to suit the circumstances, exactly as one would wish. But it also raises the important question of why, in the far less clear days of 1991–1994, was the World Bank, the EBRD, USAID and others so willing to push for a major reform, the outcomes of which were so highly dependent on a series of additional and supportive reforms, the likelihood of enactment of which was so uncertain? A good part of the answer, as this chapter shows, lies in the mindset and incentives of IFI staff and management, with their emphasis on action, indeed on ‘‘action this day.’’ Another important, but undocumented and thus less analyzable part of the answer, particularly with regard to Russia, was the external political pressure that influenced all donor policy on assistance in general and privatization in particular. There is no piece of supporting paper to point to; one can only assert that many World Bank staff working on Russia throughout the 1990s concluded that senior management was often being pressured by the G-7 to take rapid and largescale action to relieve Russian economic distress and speed its reform, and that this pressure subtracted greatly from the amount of scrutiny and credulity applied to loan packages.

5. PRIVATIZATION AND INSTITUTIONS A general view requires a summary statement on the economic and financial results of privatization in this set of countries. Such a review exists; in 2000, Simeon Djankov (of the World Bank) and Peter Murrell (of the University of Maryland) produced a comprehensive and rigorous assessment of the empirical results of privatization in transition economies.78 They conclude that in the aggregate, the microeconomic effects – that is, performance at the level of the firm – of privatization in post-communist states are positive and significant; that in most countries and sectors, any and all forms of privately owned firms achieve better performance, as measured by the amount of restructuring undertaken, than do firms left in the hands of the state. Even in those cases where the differences in restructuring between privatized and state-owned firms are slight and not statistically significant, they are nonetheless almost always positive, meaning that there is little

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evidence that privatization has harmed firm performance; with the very important possible exception of Russia, where firms privatized to workers appear to be doing even worse than SOEs.79 Moreover, the study reveals both better restructuring outcomes when the new owners are ‘‘concentrated,’’ that is, when ownership or a controlling stake is transferred to an individual investor, or small group of investors. Geography matters as well; privatization’s positive effect on restructuring is more evident in East and Central Europe (which includes the Baltic states and Southern Europe) than in the former Soviet Union (excluding the Baltic states).80 Djankov and Murrell calculate how different types of new private owners perform, relative to one another and to traditional state ownership, in terms of restructuring. They find that traditional state ownership is, in most cases, the worst performing category. Concentrated owners, specifically foreign owners, investment funds, ‘‘blockholders’’ (domestic core investors), and managers, far outperform diffused owners. Diffused individual owners, of the sort produced in Mongolia, Lithuania, Russia, and elsewhere through voucher privatization, produce about a tenth as much restructuring as the top ranked, concentrated categories. Institutional factors – the competence, honesty, and accessibility of the legal system, particularly with regard to the enforceability of contracts; the scope and transparency of regulatory mechanisms in financial and utility/ infrastructure markets; the existence of competence and probity in public administration in general interacting with methods of sales – all these account for much of the difference in restructuring outcomes between concentrated and diffused owners. Privatization methods employed in the former Soviet Union more often favored owners who subsequently performed weakly: diffused individuals, insiders, and workers. (Recall from Table 2 above that six of the nine countries, seven if one counts Lithuania, that relied on vouchers as their primary privatization method were formerly part of the Soviet Union. The countries in Central and Eastern Europe that did rely on vouchers as their principal transfer method [the Czech Republic, Slovakia, and Lithuania] experienced more problems with their privatization programs than did countries relying on non-voucher methods; e.g., Poland, Slovenia, Hungary, Estonia.) These ‘‘y types of owners that need institutional help have received less assistance from institutions in the former Soviet Union than elsewhere.’’81 Thus, former Soviet countries relied mainly on privatization methods dependent on institutional capacity – which they lacked – to make firms function well post-sale. Conversely, even though East and Central

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European transition economies were better endowed with institutional capacity, they tended more to rely on the direct sales methods that produce concentrated, less institutionally reliant owners. The point of all this is that Russia would probably have been better off had it applied privatization methods resulting immediately in concentrated owners. While easy to recommend this course of action would have been hard to carry out as the narrative above makes clear. To hammer the point home: it is unrealistic to think that much would have been accomplished, even if policy makers had opted for this path; the fact is that institutional weaknesses in Russia and the former Soviet Union made these countries unattractive to medium-sized domestic core investors, and any sort of foreign investors. Thus, in scrapping early efforts at a case-by-case program, Russia missed a good bet – but it was still a bet. The realistic choice for Russia, as Shleifer and others imply, was not between voucher privatization or extensive case-by-case sales, but rather between voucher privatization or continued state ownership of the mass of productive firms. The case for and against an evolutionary approach turns on the assessment of the Russian state’s ability to at least halt the erosion of assets in SOEs, if not to manage them decently. The one country that was formerly part of the Soviet Union that succeeded in applying, rapidly, direct sales methods was Estonia. The Estonian case is important and interesting, since it shows that investors domestic and foreign could be found to pay cash for generally run down and highly dubious assets and generally make a go of them. True, the prices paid were low, as the privatization authorities consciously sought to encourage employment maintenance and creation and future investments as much or more than sales price. True, the proximity of Estonia to Scandinavian markets and the significant Estonian diaspora in Scandinavia helped greatly, as did the country’s history of independence prior to World War II, its previous relatively advanced integration into the Western European commercial system, and the extraordinary dedication to market principles of its post-communist governments. True, as noted, the distrust of foreign investors was muted in Estonia, as most considered Western investors of any sort or nationality preferable to Russians, or resident ethnic Russians, as owners. One must also note the extensive and excellent aid on privatization given to Estonia by the German government, which provided substantial technical assistance and helped the Estonians apply the sales methods and techniques first devised by the Treuhandanstalt. This all adds up to a special, very difficult-to-duplicate set of circumstances. But none of this should detract from the fact that this was a well-conceived, bold, very well executed program.82

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Djankov and Murrell confirm the view that the farther East one travels, the more difficult it has proven for firms – state or privatized – to restructure. They quantify what many have long thought; the superiority of concentrated vs. diffused owners. They posit a trade-off between speed and quality of privatization, and suggest that transition countries with a large remaining portfolio of firms and assets to divest would do better to proceed more slowly, and try to create the good and stable working conditions needed to attract and retain concentrated owners of quality. (They do not answer the question of how to prevent asset-stripping in the interim, or how to prevent opponents of reform from using the delay in privatization to militate for continued state ownership.) It is now commonplace to note that institutions matter, but Djankov and Murrell show the paucity of empirical work about the way in which institutions work, how they are brought into being, or which ones a reforming government should try to build first or indeed whether government action to create and sustain institutions is at all efficacious or desirable. World Bank staff that have struggled with these issues for years have devised a list of institutional/accompanying policy areas that require priority attention:  elimination of barriers to entry, especially for foreign investors, and more emphasis on the enhancement and strengthening of competitive forces;  privatization of banks, paralleled by the establishment of prudent regulatory and supervisory frameworks to guide capital market activities;  strengthening of creditor rights and eliminating barriers to exit, both in law and in the mechanisms that apply and enforce the law;  enforcing contracts, and building a range of mechanisms through the courts and less formal mechanisms to settle business disputes in a transparent, rule-based manner. This is a reasonable list, and there is now some analytical basis for it. Sachs, Zinnes, and Eilat (2000) examined the relation between privatization, institutional reforms, and overall economic performance in transition and produced a study that is complementary to the Djankov–Murrell paper. They distinguished between what they termed ‘‘change-of-title’’ privatization reforms, and ‘‘agency-related’’ changes. The former is a shift of ownership. The latter involves incentive and contracting reforms, that is, policy and institutional measures aimed at hardening budget constraints, improving management and the performance and regulation of capital markets, promoting prudential regulation, and laying the foundations for decent corporate governance, along the lines of the list given above.

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They found that: privatization involving ‘change-of-title’ alone is not enough to generate economic performance improvements y the real gains to privatization come from complementing (combining) [sic] change-of-title reforms with ‘agency-related’ reforms y it is only when the legal and regulatory institutions supporting ownership are in place and functioning that owners can exercise their prerogatives conferred by a change-of-title to pressure firms to improve their productivity and profitability.83

A threshold level of agency-related reforms is required if privatization is to positively affect economic performance. If this modicum level of contracting and incentive reforms is not present, then change-of-title privatization may produce no or even negative effects. But note that they find the obverse is also true: improvement in agency-related matters ‘‘does not guarantee economic performance improvements unless enough change of title privatization has already occurred.’’ Thus, institutional advancement matters as much as ownership, and one must avoid a simple, blanket approach to privatization: ‘‘y privatization policies must be tailored to y (the) level of complementary reforms in place.’’84

6. CONCLUDING OBSERVATIONS A unifying thread in the cases is that all three show the importance of establishing control over managers, the group that emerged from the wreckage of central planning best placed to further their interests. Methods and policies that established rules and surveillance, that opened the doors to foreign investors (who are subject to some extra-national reviews of and limits on their behavior), that pushed competition and freer entry and exit alongside change of ownership, proved better, both in terms of promoting restructuring in the firms, and in gaining public acceptance of the process. The faith in the voucher approach was misplaced, or at least heavily overemphasized. Stiglitz and others are correct to admonish the external advisory community; it – we – should have been searching earlier for ways to introduce concentrated owners; we should have paid more attention (earlier than we did) to prudential regulations in capital and financial markets and other institutional development matters. Note that these were not ignored; but the relative effort devoted to these activities was small in comparison to the push for mass privatization. Specifically, it might have been better to advocate more widely the approach used by the Estonians; that is, limiting the exchange of vouchers

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to minority stakes in firms in which a controlling majority share had already been sold to a core investor. This increases the chances of turning over the firm to a good owner, possessing the incentives to look after and develop the health of the assets, and it also increases the chances that voucher-holders will obtain a share that will maintain or increase its value. Indeed, the Estonians applied this procedure in a small number of the higher potential firms, further increasing the prospects for the new minority shareholders. The counter argument is that Estonia was a special case (see the discussion above) with conditions that could not easily be replicated, and that elsewhere core investors could not so readily have been found – but this use of vouchers would have been worth a try, particularly in Russia, at least for a set of firms. Many of us succumbed to the temptations of ‘‘the primacy of the economic’’ argument. The speedy, astonishing collapse of communism demonstrated that one had entered into a period of ‘‘extraordinary politics;’’ it was easy to conclude that this was as well a period of ‘‘extraordinary economics,’’ in which one could  privatize conglomerates without breaking them up, and assume that import competition would prevent the abuse of market power (without thinking too much about structural barriers to imports from exchange rate issues, poor transportation systems, and activist and often corrupt sub-national governments that moved to protect ‘‘their’’ firms from competition of any sort);  assign the primary restructuring and corporate governance responsibilities to second phase private owners (and downplay the absent or very weak mechanisms that would make it feasible and worthwhile for this secondary trading to take place); and  depend on a mass of brand new and often bewildered and suspicious private shareholders to lobby for further liberalizing reforms and supporting institutions (without noting that there was not much historical evidence of a ‘‘demand-pull’’ causation sequence for institutions). The temperament and outlook of external advisors (they want to act, they want to do, they want to bring about substantial change, in as short a time as possible), in conjunction with the internal incentives and financial frameworks of the IFIs (claims to the contrary, the pressure to lend is still substantial), explains much of this state of affairs. The alternative to large quick programs is advice, technical assistance, educational efforts, and consensus building; all of acknowledged importance, and all small in scale, slow in pace, and not involving large-scale resource transfers. Eventually,

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some means must be found to pay for all this staff time, and the loan or credit remains at the heart of the resource system, particularly in real sector activities. Ultimately, despite all the criticism of privatization in many transition countries, the counterfactual remains elusive. The dubious foundations of the arguments of those who recommended that an activist government should have pursued a different, more gradual and statist set of policies in Russia, for example, have already been pointed out. Let us simplify the issue by ignoring the egregious LFS program: Would Russia be better off today had it not undertaken the MPP? Black et al. and many others appear to think yes; I think not. I think that with all the faults of privatization, early and late, Russia is better off having these firms in private hands. The evidence and proper comparison for this assertion is not found in China, but rather in Ukraine, which has not privatized nearly as much as has Russia, and is in much worse shape. Still, one must acknowledge the political implications of poor privatization. Corrupt and non-productive privatization has contributed to the continuing importance of Communist parties in Russia and Ukraine. The failure of privatization to fulfill quickly its promises helped Communists return to power in Moldova, and helped defeat center-right governments in both Romania and Bulgaria. In many countries where Communists do not pose a serious electoral threat, disappointment with privatization is such as to erode faith and confidence in market reforms generally.85 Governments cannot affect good policies if they are not in power. Concerning the question of major firms ‘‘mis-privatized’’ in nontransparent ways, many observers in and outside transition countries have argued that they be re-nationalized, cleaned up, and re-sold in a proper manner. But an equal number, including some highly critical of past privatizations, believe that ‘‘re-nationalization for re-privatization’’ is a poor idea. The Putin administration in Russia, while strongly (at least publicly) disapproving of many past privatizations, has nonetheless announced that it will not advocate a mass of re-nationalizations (though it has reasserted state control in the all-important energy sector). Mongolian officials acknowledge that many of their privatized firms perform worse, on average, than those retained by the state and at the same time insist that renationalization would do more harm than good.86 A former Minister of Privatization in Armenia argued in 1999 that even though a high percentage of privatized firms in his country appear to be on the verge of collapse, their privatization was still the right thing to have done, and he would oppose any effort at re-nationalization and re-privatization. What is the reasoning

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behind such views? The concerns are several: first, re-nationalization would alarm and antagonize the already scarce and wary investors these economies so clearly need. In a few rare cases in Russia and Slovakia, for example, when government prosecutors suggested seizing the assets of firms that were privatized in a manner that was formally legal, but morally odious, the bulk of the investor community protested loudly.87 Investors want laws to be fairly and efficiently applied, and contracts to be enforced, but they are reluctant to upset any commercial status quo. Second, governmental capacity in the former Soviet Union has not improved so markedly in the past few years to allow one to think that a second effort at privatization would produce results superior to the first. Why should the people who misprivatized the first time round be given a chance to repeat their errors? Third, even discounting the first two concerns, and under the best of conditions, it is reasonable to think that many re-nationalized firms would remain for some time in the public fold, being prepared for re-sale. How would they be managed and financed during this period; what would prevent them, in the words of the Armenian Minister, from ‘‘making irresistible demands on non-existent public resources?’’88 On balance, rather than indulge in problematic re-nationalization and a second effort at divestiture, government efforts in the former Soviet Union are better devoted to transferring remaining assets to ‘‘serious investors with long-term prospects,’’ to assisting the private owners they do possess to acquire new management skills and fresh capital, and to developing the ‘‘mechanisms of the marketplace y to spur y formally privatized enterprises’’ into positive change.89 The overall conclusion is that in many cases privatization could have and probably should have been better managed; opportunities were missed. But it is inaccurate and unfair to hold privatization accountable for all the problems of transition. First, the evidence shows that in East and Central Europe, privatization has proven its worth. Second, even in the former Soviet Union, most early reformers were careful to state that the first objective of privatization was to depoliticize the links between enterprises and the state; they accepted that efficiency and equity considerations had to come later. They were, as noted, especially convinced there was a need for speed; one had to act quickly to forestall the return of the communists. It turns out that a change of ownership was by itself not sufficient to cut the political financial links, but that was not clear at the outset and it still looks like a necessary if not a sufficient condition. It also is now clear that far more time was available than had been thought. ‘‘It might have been possible to approach privatization in a more deliberate manner; the results

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might have been less insider ownership and domination, less resistance to external investors, more protection for minority shareholders y .’’90 This may be the case. But again, counter to this speculation is the fact that those countries in the former Soviet Union that pursued an alternate path of trying to transit without much change of ownership, have not had any great success.

NOTES 1. The term comes from Leszek Balcerowicz, Minister of Finance and Deputy Prime Minister in the first non-communist government in Poland, established in September 1989; and applier, if not inventor, of the ‘‘Big Bang’’ approach to transition. The idea was that the euphoria created by the escape from the communist system (and Russian domination) resulted, for a time, in a suppression of normal political competition and gave, again for a time, remarkable policy latitude to the replacement regime. 2. Due to sectoral and size classification problems, there was some confusion as to the number of SOEs to be dealt with. For example, Sachs and Lipton (1991, p. 29) stated that as of 1988 Poland possessed a precise 3,177 ‘‘state enterprises in the industrial sector y .’’ 3. Personal mission notes, January 1990. 4. Save for an early and excellent study by Earle, Frydman, Rapaczynski, and Turkewitz (1994). 5. Reunited Germany had managed to sell off some 10,000 plus business units in an incredibly short time, without resorting to either IPOs or give-away schemes. But the process had been managed, staffed, and bankrolled, at a cost of more than 240 billion DM and some give much larger figures, in the realm of U.S. $200 billion, by the Federal Republic of Germany. The process was not replicable; ‘‘there is, unfortunately, no West Poland’’ as someone put it. 6. For Poles this was not an abstract possibility. Recall that as recently as December 1981 the Polish army, with the approval of Soviet authorities, had declared martial law, suspended civilian rule, interned 10,000 members of Solidarity, sent tanks into the Gdansk shipyards, shot dozens of demonstrators, and tried to resurrect ‘‘traditional’’ socialist production methods. Recall as well that in late 1989 and for some time to come there were still substantial numbers of Soviet troops stationed in East Germany, Poland, Hungary, Czechoslovakia and, of course, Lithuania, Latvia, and Estonia. Recall further the August 1991 attempt by hard liners to reinstate more traditional rule in Russia. The threat seemed real enough. 7. Kornai (1990) and Kornai (2000, pp. 6–20) revisited the subject; see the section on ‘‘Ownership reform and the development of the private sector,’’ in ‘‘Ten Years After ‘The Road to a Free Economy:’ The Author’s Self-Evaluation,’’ paper delivered to the Annual Bank Conference on Development Economics, Washington, DC April, in which he makes a good case that his diagnosis and prescription was superior to the alternatives pursued. Murrell (1992b, pp. 35–53) of the University of

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Maryland was another early skeptic regarding the need for and utility of massive and rapid ownership changes; and also see Murrell (1992a, pp. 3–16). 8. This view was strongly presented in a widely read, very influential Bank paper of the time. See Hinds (1990). 9. Thus Sachs and Lipton argued in mid-1990: ‘‘Workers’ desires to block privatization may also increase rapidly in the near future if, as expected, unemployment rates rise sharply in Eastern Europe. Workers may assume, with some justification, that their job tenure will be undercut by the privatization of their firms. Even if workers in a particular enterprise do not actually block privatization, they may attempt to bargain with the government, demanding, for example, a cut in the enterprises’ debts or various guarantees on employment levels, as their ‘‘price’’ for letting the privatization go forward. If the government becomes enmeshed in case-by-case bargaining, there will be no end in sight, given that hundreds of large enterprises must be privatized.’’ They feared the outcome would be ‘‘paralysis.’’ (op. cit., p. 28). 10. See the excellent study by Dabrowski, Gomulka, and Rostowski (2000, p. 21). 11. Ministry of Finance, Warsaw, ‘‘Holding Companies as a Means of Accelerating Privatization in Poland,’’ March 7, 1990, p. 1. 12. On reading the MoF note, in May 1990 I wrote and distributed in the World Bank a memo saying this was a generally good idea, and added: ‘‘But why not go one crucial step further; why not think about the free distribution y of say 20 percent of the shares in each holding company, to a portion of the general public? The idea here is to assign y to a group of citizens a minority of shares in each holding created y . In this way self-interested citizens, and not just disinterested bureaucrats, would at least begin to have a direct personal stake in the holding’s performance y . A share given away to all citizens would mute the need to award concessions to workers in the privatized firms.’’ That this approach would probably cause large ‘‘technical, administrative and political problems’’ was acknowledged ‘‘y but I think the potential benefits of widespread private ownership, even in this partial, preliminary and indirect fashion, outweigh the evident costs’’ (Nellis, 1990). Others in Poland and among the advisory community were thinking along the same lines and advocating similar schemes. 13. The idea had first been put forward in Poland by Lewandowski and Szomburg (1989, pp. 257–268). Lewandowski later became Minister for Privatization. Anders Aslund notes that the voucher idea had surfaced in Russia even earlier, and may originally have been conceived by Milton Friedman. The first recorded free transfer of equity in government-owned firms to the public was in the Canadian province of British Columbia at the end of the 1970s; see Guy Heywood (1990). 14. Gregory T. Jedrzejczak, ‘‘Privatization in Poland,’’ in Bohm and Kreacic (1991, op. cit., p. 85). 15. Construction, pulp and paper, glass, cement/limestone, rubber and tires, cables and wires, furniture, breweries, and confectionery goods. 16. Thieme, Bukowski, Mrozek, and Pinski (1993, p. 192). 17. Blaszczyk and Woodward (1999, p. 11). 18. Dabrowski, Gomulka, and Rostowski (2000, op. cit., p. 12). 19. A finding confirmed by many, including Havrylyshyn and McGettigan (2000, pp. 257–286).

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20. Some, including some at the World Bank, saw this earlier than others. See Pinto, Belka, and Krajewski (1993), which showed no or insignificant differences in performance between the SOEs and privatized firms in their sample. See also Pinto and Wijnbergen (1994), which details the policy and financial measures that contributed to good SOE performance, and explains why privatization was, nonetheless, still necessary. In light of the findings later reported by Blaszczyk and Woodward, this conclusion holds up pretty well. 21. Blaszczyk and Woodward (op. cit., pp. 45–46). They also note that as of late 1999 there was not yet much information on performance on the firms in the NIFs. 22. As Anders Aslund points out (personal communication), Poland was unique in its retention of a private sector of size in both the rural and urban sectors. It thus possessed, at the outset of transition, a more complete and appropriate legal structure, including a bankruptcy regime, than most other transition countries. 23. Vaclav Klaus, Minister of Finance of Czechoslovakia from 1990 to 1992, and Prime Minister of the Czech Republic from 1992 to 1997, doubted the utility of World Bank involvement in the economy. When asked if he needed international technical assistance, he famously replied, ‘‘Why pay hard money for soft advice?’’ 24. Bokros (2000, p. 1) portrays pre-transition Czechoslovakia as ‘‘a truly neostalinist stronghold until the very last minute before the Velvet Revolution.’’ For an excellent discussion of the importance of initial conditions and much else, see Bokros (2000). 25. Bokros (op. cit., p. 2). 26. Personal notes taken at mission meeting with Minister Klaus and his team, Prague, May 7, 1990. 27. Triska (1992, op. cit., p. 104). 28. Triska and Jelinek-Francis (1991, op. cit., p. 119), . 29. Personal mission notes, Prague, May 7, 1990. 30. Personal mission notes, Prague, May 7, 1990. 31. Some opponents of rapid change advocated a ‘‘third way’’ to transition, somewhere between socialism and rampant capitalism; this gave Mr. Klaus the chance to declaim: ‘‘The ‘third way’ is the shortest route to the Third World’’ (Mission notes, May 1990). 32. As in Poland and Hungary, the mass of small firms and business units were auctioned off at an early date, with generally positive results. 33. As noted, citizens had to pay about a week’s wage to obtain the coupon booklet; the guarantee offered by the investment funds was a multiple on that original purchase price. 34. Not all, for example, David Ellerman (1998) had long expressed doubts as to the utility of the approach, and later wrote a strong critique of the approach. 35. The World Bank was far from alone in this; most other donors, including the EBRD, the EU, USAID, and several other bilaterals, endorsed, advanced, and supported this approach. 36. World Bank, (1996, p. 56). 37. Frydman et al. (1997) and Pohl et al. (1997). Note that both of these studies used firm level data dating from the first few years of transition. The data set analyzed by Frydman et al. ran through 1994; Pohl and his team reviewed data through 1995 or 1996.

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38. At the beginning of 2002, GDP growth rate for three quarters of 2001 in Czech Republic was 3.9%; versus 0.9% in Poland, and 4.0% in Hungary. 39. Nellis (2001, p. 170). 40. At the time of the interview this particular bank was, in theory, privatized. But government retained 45% of the equity and another 15% was in the hands of local governments, and not normally voted. Government thus remained the largest single and dominant shareholder; and this was the case for the other major banks up to 1998, and beyond in some cases. 41. Given weaknesses in the legal framework, many of these acts were formally legal; thus, one cannot strictly use the term ‘‘theft.’’ 42. See Mertlik (1996, pp. 117–121). 43. Pistor and Spicer (1997). 44. Weiss and Nikitin (1997, p. 21). 45. The most recent and rigorous analysis confirms the general (though not total) superiority of private over state ownership, and among private owners, the superiority of concentrated over diffused owners. Note that the data also reveal a large variation in results by subregion, with privatizations in East and Central Europe and the Baltics yielding generally positive results, while those in Russia and the other parts of the former Soviet Union yielding much poorer, and in a very few cases, negative results. See Djankov and Murrell (2000). ‘‘Restructuring’’ refers to the cost cutting, efficiency- and competitiveness-enhancing steps required to position a firm to survive and thrive in a market environment. 46. Claessens and Djankov (1999, p. 503); see Table 1B in that article. 47. OECD (1998, p. 49). 48. Kornai (2000, op. cit., pp. 10–11). 49. In the sense that these privatized firms are among the most profitable, dynamic firms in the economy, and, in contrast to most voucher-privatized firms, they have increased their workforces, improved conditions of work, and generated growth among local suppliers. At least the Czechs did sell a set of firms in this manner; the Russians did not and are still paying the price for this. 50. In Warsaw in late 1999 to review 10 years of transition, Vaclav Klaus was asked to account for the relative poor performance of the Czech economy vis-a`-vis those of Poland and Hungary in the past several years. He said first that the differences were quite minor and would be invisible and unremembered in a few year’s time, and second, that what economic problems existed in the Czech economy were attributable solely to the excessively tight interest rate and monetary actions of the independent Czech Central Bank, and not at all to the policies of his government, prior to his stepping down from the Prime Ministership in November 1997. At a seminar (in Ljubljana) several years earlier, when asked what he might change in his policies and approach in the light of experience, Mr. Klaus had answered, ‘‘nothing whatsoever.’’ 51. This author was among the infatuated. 52. Kornai (2000, op. cit., p. 15). 53. Management–employee buy outs (MEBOs) were also relatively simple and fast, especially when installment purchases were allowed or encouraged, as they were in Romania, Slovenia, Croatia, and elsewhere; see Table 2. There is little evidence that this divestiture method is associated with extensive post-sale restructuring. 54. Nellis (1991a, b, p. 3).

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55. This is the general argument of Peter Nolan (1995, p. 311). ‘‘Tragically, the Soviet economic system had a large potential for improvement under a suitable set of incremental reforms. It was not necessary for there to be a period of ‘surgery’ and steep decline of output and living standards before improvement set in.’’ See Nolan (1995). He adds, however, that ‘‘y successful implementation of such policies required the maintenance of a strong and effective state apparatus y’’ without indicating just how that last, crucial political condition could have been fulfilled. Specifically with regard to unleashing the Russian lease-holders and cooperatives, Joseph Stiglitz later argued that ‘‘(R)eformers who recognize that real transformation requires participation and involvement would have welcomed this reform movement and would have pushed it all the way to full privatization y . In Russia, the leasing movement was stopped dead in its tracks in favor of voucher privatization.’’ ‘‘Whither Reform? Ten Years of the Transition,’’ Paper delivered at the Annual Bank Conference. 56. The Economy of the USSR (op. cit., p. 26). 57. The extent and nature of the Chinese non-state sector’s contribution was not fully documented in 1990, but enough was known much of it from World Bank research and reports to make it plausible that one might have made a recommendation to follow this path. 58. Peter Murrell characterizes the distinction in approach at the end of the 1980s in the two countries as follows: ‘‘The Chinese were given a license to compete and a death sentence for stealing; the Russians were given a license to steal and punishments for competing.’’ (Personal communication, July 2001). This lends weight to the interpretation of the situation in the IFI report. 59. The Economy of the USSR (op. cit., pp. 26–28). In light of later events, it is worthwhile to quote the report’s statement on mass privatization through vouchers. While acknowledging that their use could speed up ownership transfer, ‘‘y such giveaways have a number of disadvantages. Most importantly a voucher system would result in widely scattered ownership which would be unlikely to result in effective monitoring of enterprise managers’’ (p. 26). 60. Lieberman and Veimetra (1996, p. 739). 61. For a discussion of the politics of the process see Shleifer and Treisman (2000). Shleifer was a key participant in the process; see Shleifer, Boycko, and Vishny (1995). For data on the outcomes of voucher privatization see Joseph Blasi et al. (1997). Kremlin capitalism: Privatizing the Russian economy. Ithaca: Cornell University Press. Note that the reformers had taken some steps to prevent insider dominance, but the high rate of inflation wiped out the financial barriers they had tried to erect against insider control. 62. Vasiliev (1995, pp. 372–373). 63. Ibid., p. 372. 64. Nellis (1994a, b). 65. See Freedland (2000) for an analysis of the details of these transactions. 66. Shleifer and Treisman (op. cit., p. 38). 67. Lieberman and Veimetra (op. cit., p. 738). 68. Broadman (1998, p. 23). 69. Personal communication from a Russian economist who asked that a name not be used.

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70. Black, Kraakman, and Tarassova (2000, pp. 1746–1747). Regarding their distinction between the MPP and the LFS, in an earlier (and much shorter, May 1999) draft of this paper they concluded that small-scale privatization was entirely positive, that ‘‘y mass privatization of medium-sized enterprises was probably a positive step on balance, but that the rigged sales of the largest enterprises was a major error’’ (p. 35). On the other hand, they seemed to contradict this distinction in the last paragraph of the draft paper where they wrote: ‘‘Mass privatization of large firms in an otherwise badly run country is no panacea. In the case of Russia, and perhaps more generally, it might be worse than no privatization at all’’ (p. 41). I could not find these words in the published version of the paper. 71. Broadman (op. cit., p. 25). Building a capacity to execute good case-by-case privatizations was not a new idea; Bank staff had from the beginning stressed the importance of this approach but given the press of the MPP and the demands on the small Russian reform team, it had received insufficient attention. 72. Arrow and Sachs made these statements in 1998; they are cited in Nellis (2001, op. cit., p. 168). 73. Stiglitz (1999a, p. 7). See also his somewhat different paper Stiglitz (1999b, op. cit.). 74. Black et al. (2000, op. cit., pp. 1777–1782). 75. Black et al. (2000, ibid., p. 1778). 76. Another illustration: in 1995 a group of concerned U.S. economists (Michael Intriligator, Robert McIntyre, Marshall Pomer, Dorothy Rosenberg and Lance Taylor), appalled by Russia’s plight and the outcomes of privatization (and this was before LFS), wrote and distributed ‘‘A Checklist for Action in the Russian Economy’’ (summary published in the World Bank’s Transition Quarterly (Intriligator, 1995)). Almost all the corrective measures proposed began with ‘‘the government should y .’’ They advocated price and wage regulation, restrictions on capital movements, protection of domestic fledgling industries, expansionary fiscal policy, state-owned development banks, financial support to enterprises, limiting food imports, and subsidizing fuel and fertilizer purchases. Institutionally, they called for efforts to modernize the legal system, eliminate the criminal underworld, set right the banks, the tax code and collection procedures, the sub-national governments, and the health and education systems. Note once again that these views were printed in a Bank publication, and Professor Intriligator was invited to Washington to present his views in a Bank seminar. To most of us working on Russia, this set of prescriptions seemed not to be in touch with Russian political and administrative realities: We saw no evidence that the Russian administrative mechanisms possessed either the altruism or the competence required to put these policies into effect. 77. A few transition countries Belarus and Uzbekistan most prominently have neither privatized nor fully liberalized, and yet have, so far, avoided the massive growth and production declines seen elsewhere. But their approaches are not examples of an alternative, gradualist route to transition, but rather as an avoidance of transition and a continued reliance on state-ordered production, of largely unsellable products. This course is unsustainable. 78. Djankov and Murrell (2000, op. cit.).

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79. But see their Table 1 (row 6, columns 1 and 2); one set of studies indicates a probability that in the former Soviet Union state-owned firms have more effectively restructured than privatized firms (p. 7). 80. However, if one looks at qualitative rather than quantitative indicators of restructuring, the studies reviewed suggest a high likelihood of privatized firms outperforming state-owned firms, even and perhaps particularly in the former Soviet Union. Djankov and Murrell place more weight on quantitative than qualitative studies, and that is reasonable. But it may be that good qualitative indicators (e.g., the addition of a marketing department, whether or not the firm has a business plan) are a harbinger of good quantitative performance to come? 81. Djankov and Murrell (op. cit., pp. 13–14). 82. For details of the Estonian approach see Schmidt (1997, pp. 523–557). 83. Sachs et al. (2000, p. 54). 84. Ibid. 85. In Moscow in mid-1998, just before the August crash, the current joke was: ‘‘Everything the Communists told us about socialism was a complete and utter lie. But unfortunately, everything they told us about capitalism turns out to have been true.’’ 86. Views expressed during the author’s interview with three officials of the Mongolian Ministry of Justice, seminar on privatization at the International Law Institute, Washington, DC, July 2000. 87. On the other hand, there have been a number of cases where purchasers failed to remain current on their installment payments, or broke other contractual stipulations, with the result that privatization authorities repossessed the assets for re-sale. This has happened a few times in Estonia, for example. The point is that repossession is much easier when the law or contract has clearly been broken; and even then it is viewed as a measure of last resort. 88. Cited in Nellis (2001, op. cit., p. 188). 89. The terms are from Sondhoff (1999, pp. 238, 240). 90. Nellis (2001, op. cit., p. 188).

REFERENCES Black, B., Kraakman, R., & Tarassova, A. (2000). Russian privatization and corporate governance: What went wrong. Stanford Law Review, 52, 1746–1747. Blaszczyk, B., & Woodward, R. (Eds). (1999). Privatization and company restructuring in Poland. Case Report No. 18. Center for Social and Economic Research, Warsaw. Bokros, L. (2000). Visegrad twins’ diverging paths to relative prosperity: Comparing the transition experience of the Czech Republic and Hungary. Lecture presented at the Czech National Bank, Unpublished World Bank paper, September, Washington, DC. Broadman, H. (1998). The emergence of case-by-case privatization in Russia: Principles and institutions. In: Broadman, H. (Ed.), Case-by-case privatization in the Russian federation. World Bank Discussion Paper No. 385. Claessens, S., & Djankov, S. (1999). Ownership concentration and corporate performance in the Czech Republic. Journal of Comparative Economics, 27, 498–513.

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Dabrowski, M., Gomulka, S., & Rostowski, J. (2000). Whence reform? A critique of the Stiglitz perspective (5th draft, March). Warsaw: Center for Social and Economic Research. Djankov, S., & Murrell, P. (2000). The determinants of enterprise restructuring in transition: An assessment of the evidence (September). Washington: World Bank. Earle, J., Frydman, R., Rapaczynski, A., & Turkewitz, J. (1994). Small privatization: Transformation of retail trade and service sectors in Poland, Hungary and the Czech Republic. New York: Central European University Press. Ellerman, D. (1998). Voucher privatization and investment funds: An institutional analysis. Working Paper No. 1924, World Bank. European Bank for Reconstruction and Development. (1999). Transition report 1999. London: EBRD. Freedland, C. (2000). Sale of the century: Russia’s wild ride from communism to capitalism. New York: Crown Business. Frydman, R., Gray, C. W., Hessel, M. & Rapaczynski, A. (1997). Private ownership and corporate performance: Some lessons from transition economies. World Bank Technical Paper No. 1830. Washington, DC. Havrylyshyn, O., & McGettigan, D. (2000). Privatisation in transition countries. Post-Soviet Affairs, 16(July–September), 257–286. Heywood, G. (1990). Giving it away: Case study of the British Columbia Resources Investment Corporation. Unpublished paper presented to a World Bank Conference on Privatization in Less Developed Countries, Washington, DC, June 12. Hinds, M. (1990). Issues in the introduction of market forces in eastern European socialist economies. World Bank Europe-Middle East-North Africa Region Discussion Paper IDP-0057, April. International Monetary Fund, The World Bank, Organisation for Economic Co-operation and Development, European Bank for Reconstruction and Development (1990). The economy of the USSR: Summary and recommendations. Washington: The World Bank. Intriligator, M. (1995). A checklist for action in the Russian economy. Transition Quarterly, 6(September–October), 10–11. Jedrzejczak, G. T. (1991). Privatization in Poland. In: A. Bohm & V.G. Kreacic (Eds), Privatization in eastern Europe: Current implementation issues. Ljubljana: International Center for Public Enterprises in Developing Countries. Kornai, J. (1990). The road to a free economy: Shifting from a socialist system – The example of Hungary. New York: Norton. Kornai, J. (2000). Ownership reform and the development of the private sector. In: Ten years after ‘The road to a Free Economy’: The author’s self-evaluation. Paper delivered to the Annual Bank Conference on Development Economics, April, Washington, DC. Lewandowski, J., & Szomburg, J. (1989). Property reform as a basis for social and economic reform. Communist Economies, 3, 257–268. Lieberman, I., & Veimetra, R. (1996). The rush for state shares in the ‘klondyke’ of wild east capitalism: Loans-for-shares transactions in Russia. George Washington Journal of International Law and Economics, 29(3), 739. Mertlik, P. (1996). Czech privatization: From public ownership to public ownership in five years? In: B. Blaszcyck & R. Woodward (Eds), Privatization in post-communist countries. Warsaw: Center for Social and Economic Research. Murrell, P. (1992a). Conservative political philosophy and the strategy of economic transition. East European Politics and Societies, 61(1).

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Murrell, P. (1992b). Evolution in economics and in the economic reform of the centrally planned economies. In: C. Clague & G. Rausser (Eds), The emergence of market economies in Eastern Europe. Cambridge, MA: Blackwell. Nellis, J. (1990). Poland: Proposal to form state holding companies for public enterprises. World Bank Office Memorandum of May 3. Nellis, J. (1991a). Improving the performance of Soviet enterprises. World Bank Discussion Paper 118, March. Washington, DC. Nellis, J. (1991b). Privatization in reforming socialist economies. In: A. Bohm & V. Kreacic (Eds), Privatization in eastern Europe (pp. 15–23). Ljubljana: International Center for Public Enterprises in Developing Countries. Nellis, J. (1994a). Introduction. In: I. Lieberman & J. Nellis (Eds), Russia: Creating private enterprises and efficient markets. Presented at the World Bank conference on Russian Privatization, June. Nellis, J. (1994b). Is privatization necessary? Viewpoint, FPD Note No. 7, May. World Bank. Nellis, J. (2001). Time to rethink privatization in transition economies? In: Havrylyshyn & S. Nsouli (Eds), A decade of transition: achievements and challenges. Washington: IMF. Nolan, P. (1995). China’s rise, Russia’s fall. New York: St. Martin’s Press. OECD. (1998). The Czech Republic. Paris: OECD. Pinto, B., Belka, M., & Krajewski, S. (1993). Transforming state enterprises in Poland: Microeconomic evidence on adjustment. World Bank Policy Research Working Paper, WPS 1101. Pinto, B., & Wijnbergen, S. (1994). Ownership and corporate control in Poland: Why state firms defied the odds. Working Paper 1308, June. World Bank Policy Research. Pistor, K., & Spicer, A. (1997). Investment funds and mass privatization: Lessons from Russia and the Czech Republic. World Bank Viewpoint No. 110. Pohl, G., Anderson, R. E., Claessens, S., & Djankov, S. (1997). Privatization and restructuring in central and eastern Europe evidence and policy options. World Bank Technical Paper No. 368. Washington, DC. Sachs, J., & Lipton, D. (1991). Privatization in eastern Europe: The case of Poland. In: A. Bohm & V. Kreacic (Eds), Privatization in eastern Europe: Current implementation issues. Ljubljana: International Center for Public Enterprises in Developing Countries. Sachs, J., Zinnes, C., & Eilat, Y. (2000). The gains from privatization in transition economies: Is ‘Change of Ownership’ enough? Unpublished paper, HIID, Cambridge, MA. February, 2000. Schmidt, H. (1997). Methodenfragen der Privatisierung, dargestellt am Beispeil Estland. In: Soziale Marktwirtschaft als historische Weichenstellung-Festschrift zum 100.sten Geburststag von Ludwig Erhard (pp. 523–557). Shleifer, A., Boycko, M., & Vishny, R. (1995). Privatizing Russia. Cambridge: MIT Press. Shleifer, A., & Treisman, D. (2000). Without a map: Political tactics and economic reform in Russia. Cambridge: MIT Press. Sondhoff, H. (1999). Privatisation policy in Russia: From ineffective denationalisation to the creation of effective ownership structures. Intereconomics, 2(September/October), 238, 240. Stiglitz, J. (1999a). Quis Custodiet Ipsos Custodes? Corporate governance failures in the transition. Annual Bank Conference on Development Economics – Europe, Paris, June. Stiglitz, J. (1999b). Whither reform? Ten years of the transition. Paper delivered at the Annual Bank Conference on Development Economics, Washington, April.

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Thieme, J., Bukowski, J., Mrozek, M., & Pinski, T. (1993). Privatization in Poland: 1992. In: A. Bohm & M. Simoneti (Eds), Privatization in central and eastern Europe: 1992. Ljubljana: Central and Eastern European Privatization Network. Triska, D. (1992). Voucher Privatization in Czechoslovakia – 1992. In: A. Bohm & M. Simoneti (Eds), Privatization in central and eastern Europe. Ljubljana: Central and Eastern European Privatization Network. Triska, D., & Jelinek-Francis, C. (1991). A study of privatization in the Czech and Slovak federal republic. In: A. Bohm & V. Kreacic (Eds), Privatization in eastern Europe: Current implementation issues. Ljubljana: International Center for Public Enterprises in Developing Countries. Vasiliev, D. (1995). Privatization in Russia – 1994. In: A. Bohm (Ed.), Privatization in central and eastern Europe 1994. Ljubljana: Central and Eastern European Privatization Network. Weiss, A., & Nikitin, G. (1997). Performance of Czech companies by ownership structure. Unpublished paper delivered to World Bank seminar. World Bank. (1996). From plan to market: World development report, 1996. Washington: The World Bank.

CHAPTER 3 MASS PRIVATIZATION IN TRANSITION ECONOMIES$ Daniel Kopf, Ira W. Lieberman and Raj M. Desai The success of privatization, and therefore of the whole transformation crucially depends on a clear understanding of its nature, goals and strategies. It is not realized in a vacuum; in our case it is part of a very complicated transformation process – from communism to free markets, to a free society. –Former Czech Prime Minister Vaclav Klaus (1993)

1. INTRODUCTION The distribution of state property to the private sector has always been and will continue to be intensely political. Relinquishing hiring, production, investment, and other enterprise decisions constitute a significant loss of potential rents to those who exercise control rights in state-owned enterprises. Additionally, the large transfer of wealth that privatization on a large-scale entails, combined with the potential for unemployment, loss of access to enterprise-based social services (which were substantial in statesocialist economies) threatens to undermine public support for privatization and reform in general. $

Portions of this chapter are largely drawn from previously published works by Ira Lieberman. The two main sources are the following: Lieberman, Nestor, and Desai (1997) and Lieberman, Ewing, Mejstrik, Mukherjee, and Fidler (1995).

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 137–172 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00003-4

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In the late 1980s, the communist countries of Eastern Europe and the Soviet Union lacked private ownership in a way that is almost incomprehensible to those who are accustomed to Western style capitalism. Reformers in these countries faced the seemingly insurmountable task of quickly privatizing these economies. The major tasks were corporatizing (in the region, this normally meant converting state-owned enterprises to joint stock companies) enterprises and giving away or selling ownership of these new companies. Contrary to much popular thought, each country employed very different strategies to meet these ends, which depended on the history and current political situation of the country. Following an introduction to the basics of mass privatization, this chapter will attempt to describe and evaluate mass privatizations in the Czech and Slovak Republics, Poland, and Russia in the context of the political circumstances reformers faced. These countries were chosen because of the wealth of literature scrutinizing them and the diverse nature of their privatizations.

2. MASS PRIVATIZATION DEFINED Mass privatization is the process of quickly transferring a substantial portion of publicly or state-owned assets to a diverse group of private owners, usually the majority of the population or citizens 18 years and older, who participate in share ownership directly or through financial intermediaries. Mass privatization usually involves the distribution of vouchers or coupons to the population for free or for a nominal charge. These vouchers can then be used to bid on or exchanged for shares in either the joint stock companies created from the former state-owned enterprises or in investment funds (quasi mutual funds) that intermediate ownership between citizens and the newly privatized enterprises. Thereafter, shares in stateowned enterprises are usually sold at auctions.

3. MASS PRIVATIZATION VERSUS CASE-BY-CASE PRIVATIZATION The goal of mass privatization was to privatize hundreds or even thousands of enterprises in a relatively short period, while the window of opportunity for reform remained open. It is often assumed that transition countries had a choice between case-by-case and mass privatization, but this supposition was

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not held by many involved in privatization at the time. David Lipton and Jeffrey Sachs wrote in 1990, ‘‘The potential costs of rapid privatization must be traded off with the high cost of maintaining the present systemy the real risk in Eastern Europe is not that the privatization process will be less than optimal, it is that will be paralyzed entirelyy [This is likely to happen] unless hundreds of large firms in each country are brought quickly into the privatization process.’’1 Lipton and Sachs preceded this statement with a roll call of those who supported a ‘‘free distribution of shares’’ (essentially mass privatization), which included many leading economists and businessman.2 Among the countries that attempted mass privatization in the early 1990s, the number of privatized enterprises ranged from 250 in Albania to some 16,000 in Russia.3 Such efforts stand in contrast to the one enterprise at a time approach implied by ‘‘classical’’ or case-by-case privatization. Mass privatization was largely a systems approach to privatization. The programs usually started with a selection process. For example, all medium-sized and large enterprises in the tradables sector except very large or ‘‘strategic’’ enterprises (as in the Czech Republic, Kazakhstan, Lithuania, Moldova, Russia, and Ukraine), or a specific subset of enterprises nominated for the program (as in Albania, Poland, and Uzbekistan). By contrast, case-by-case privatization selects one or a few enterprises to be privatized and was used in the region for the large or strategic enterprises left out of mass privatization, such as banks and infrastructure companies. Mass privatizations generally require ‘‘mass corporatization,’’ that is, a standardized approach to providing state-owned enterprises with a clear legal status and ownership structure. This allows a pipeline of state-owned enterprises to be legally converted, usually as open joint stock companies, and made ready for privatization. Features of mass corporatization may include standard corporate charters, an equal nominal share value for all the shares of the corporations included in the program, the use of adjusted book value as a starting point for initial valuation of the newly formed company (at least for opening balance sheet purposes), and the initial nomination of boards of directors. Many countries in the region adopted the German-style dual board of directors system, in which independent directors form a supervisory board and managers form an executive board. Mass privatizations generally avoided restructuring prior to privatization, even in cases where substantial liabilities encumbered an enterprise. The objective was to decentralize the restructuring process, placing this responsibility on the new private owners and removing it from the state. The logic being that if a government is incapable of efficiently running the entity, it is unlikely to be able to restructure it.

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By contrast, in case-by-case privatization corporatization was normally tailored to the entity being privatized. Substantial passive or defensive restructuring usually occurs, such as financial engineering leading to debt and balance sheet restructuring, as well as laying off excess workers. Valuation goes to the core of case-by-case privatization. Financial advisers spend considerable effort trying to estimate the value of an enterprise using valuation approaches such as discounted cash flow or comparable sales comparison to the enterprise being sold. Subsequent marketing of the company and the sales process were geared toward reaching as close to the projected or estimated value as possible. Mass privatization, on the other hand, has generally relied on open, highly transparent, auction processes to value enterprises based on bids by the public, using vouchers or voucher investment funds as financial intermediaries. The Czech Republic operated the most complex bidding (and hence, valuation) process, allowing each stage of privatization to go through five bidding rounds. Other countries, such as Armenia and Russia, relied on simpler, one-round clearing mechanisms to allocate shares to bidders. Poland, which did not use open auctions, allowed only prequalified and selected investment funds to bid for enterprise shares in a ‘‘football pool’’ allocation process. Attempts by countries such as the Krgyz Republic to establish minimum valuations prior to auction, usually based on some inflation adjustment of book value, generally did not work well in mass privatization programs (MPPs). Adequate financial and accounting information on state-owned enterprises, essential for such valuation, generally was not available, and in any case would have little bearing on the performance and valuation of these enterprises operating in a market economy.4 Finally, MPPs created market demand through vouchers and voucher investment funds. Governments used public information campaigns to explain these processes to the public. But voucher investment funds often drove demand, generating substantial interest on the part of the investing public through aggressive marketing programs and distorted promises of large returns on the vouchers placed with a particular fund. MPPs emphasized the characteristics of the vouchers (who qualifies for them, how to distribute them) to ensure that demand was created and the public supported the program.5 The basic objective of mass privatization was to create millions of new shareholders, hopefully making privatization and other pro-market reforms irreversible. Mass privatization invariably created a critical mass of private enterprises. In case-by-case privatization, by contrast, demand creation is selective and targeted. When shares are sold to strategic investors, a prequalified subset of qualified buyers is usually targeted. In the event of an initial public

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offering, employees or the public may be targeted, but such sales generally involve a discount from the share price, which may reflect a discounting from the entire share offering as initially valued (as in the sales of British Telecom and British Gas).6 Mass privatization, conceived in 1990–1991 in Czechoslovakia, Lithuania, and Poland, was substantially different than privatization as originally developed in the United Kingdom and as practiced in other industrial countries and much of the developing world. It was born out of the unique circumstances of transition in Central and Eastern Europe and the Commonwealth of Independent States (CIS), where the state owned almost all property – from the smallest retail bakery to the largest utility. Another factor that made transition countries differ from other privatizing economies was the level of politicization. Although separating politicians from the economy is always an important argument for privatization, this was even truer for transition countries where many generations of complete government direction had led to extremely deep-rooted relationships between enterprise managers and politicians, relationships that were often inefficient or corrupt. Russian reformers even claimed that it would have been absurd to let the ministries manage a case-by-case privatization program considering that they were so inefficient and lacking in knowledge of business practices.7 The high level of politicization also made it important for reformers in transition countries to gain support from the general population. While case-by-case privatizations would enrich politicians, reformers could argue to the public that mass privatization would distribute assets more equally. This helped reformers gain support from the population against entrenched politicians and gave momentum to depoliticization. In their book Privatizing Russia, Russian privatization inside experts Maxim Boycko, Andre Shleifer, and Roberty Vishny, write that ‘‘the way to make the public an ally in privatization is to distribute free shares to all citizens.’’8

4. SPONTANEOUS PRIVATIZATION For impermissibly long, we have discussed whether private property is necessary. In the meantime, the party-state elite have actively engaged in their personal privatization. The scale, the enterprise, and the hypocrisy are staggering. The privatization of Russia has gone on [for a long time], but wildly, spontaneously and often on a criminal basis. Boris Yeltsin (October 21, 1991, from Kremlin Capitalism)

When considering mass privatization, it is important to weigh the alternatives for Eastern European countries and former Soviet Republics

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had they not undertook this process. Although this likely would have been disastrous, one obvious alternative was continued state direction over the economy. This option was clearly unappealing because of the dire economic state that government direction had led to. Transition countries had also incurred a great deal of debt and the starved governments badly needed revenue from their assets. Another alternative was spontaneous privatization. In many ways, the need for immediate mass privatization was a reaction against the perceived evils of enterprises spontaneously privatizing. In the years prior to mass privatization, as the communist parties in transition countries lost their grip on power, managers diverted assets and profits both legally and illegally through leaseholds and cooperatives. Managers of large factories, whose power had been checked by the communist party, were now able to strip their organization of assets because politicians on the national level were no longer able to keep a close eye on their subordinates. Managers were able to privatize gains while socializing losses. Relying on subsidies to support under-performing parts of the organization, managers and other insiders were able to pocket extra profits. This was far from an optimal situation. The winners from this kind of privatization were a small group of nomenklatura, and others connected to managers. The citizenry loses badly when enterprises spontaneously privatize, particularly those with valuable assets. New owners had low incentives to restructure and were likely to rely on their political connections (see Russia). Possibly more important than the negative economic consequences of spontaneous privatization were the political ones. When average citizens see managers expropriating what was once considered public property it causes them to associate privatization with corruption and exploitation of the masses.9 Mass privatization’s achievements should be evaluated in the context of the threat of spontaneous privatization. Critics of MPPs often overlook the urgency of the situation that many transition countries confronted. Former Chief Economist of the World Bank Joseph Stiglitz disparaged the speed of the Czech–Slovak MPP, ‘‘y no country has succeeded in privatizing everything, overnight, well, and it is likely that were a government to try to do instantaneous privatization, there would be a mess y . The failures of the rapid privatization strategies were predictable and predicted.’’ In this quote and in other critics writing, it often sounds as though these observers were unaware of the ‘‘mess’’ that would have resulted from working slowly or doing nothing at all.10 To a certain degree, the experience of spontaneous privatization in the USSR in the late 1980s may have influenced the shift towards rapid

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privatization in the post-Soviet Russia. Well before the collapse of the Soviet Union, state-enterprise directors often profited from many of the rights associated with ‘‘ownership’’ following the 1989 Law on State Enterprises. The law gave enterprise directors (and employees) in an enterprise the right to lease its assets; ultimately, these leased assets could be purchased at once or in installments through the cooperative or collective. Although leases were meant to be awarded on a competitive basis, no competitions were held in practice, and nearly all leases were awarded by enterprise insiders to themselves. The intent of the law, of course, was to decentralize the elaboration of annual plans. Indeed, at the time lease buy-outs were viewed by some as an embryonic form of privatization – one that might avoid unemployment or social unrest. They were, however, little more than profit-sharing arrangements for the management and employees. Buy-outs were often set up for arbitrage purposes – to secure inputs at subsidized prices, sell goods at uncontrolled prices, and pocket the difference. Directors thus reaped the benefits of their control rights while the costs and liabilities associated with ownership remained socialized.

5. THE CZECH AND SLOVAK MPP In any analysis of mass privatization, it is certainly appropriate to begin with an analysis of the Czech–Slovak MPP. Before the 1992 breakup of Czechoslovakia, the two Republics privatized as one, and continued to be inextricably linked. The Czech–Slovak approach to mass privatization was an innovative and influential model that would effect all future privatizations, specifically for its emphasis on the use of vouchers and investment privatization funds (IPFs). Prior to their separation, the two republics engaged in the first stage of mass privatization together. The first stage of privatization was a success for both Republics in that they were able to divest a great deal of business into private hands and create capital markets that had laid dormant for their many years as satellite states. At first, both the Slovaks and Czechs emphasized vouchers, but in later stages of privatization the Slovakian government became disenchanted with the MPP and began focusing on alternative methods, specifically direct sales and public auctions. The Czech–Slovak mass privatization was focused on the creation of a market environment. Whereas the Polish (discussed later in this chapter) were more concerned about assuring restructuring in firms that already

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existed, the Czech–Slovak’s were focused on rapid institutional change and the spillover effects that would result from that change.11 Unlike in Poland, the communists had held firmly on to power in Czechoslovakia until 1989. Following the Velvet Revolution, there was a great deal of power vested in the top of the federal government and in line ministries. With centralized power the reformers were able to organically create a privatization program that could be executed very quickly. Those in government, especially Prime Minister Vaclav Klaus, were fervent supporters of a swift transition.12 Bernard Black points out that while powerful Russian firm managers had to be appeased, in the Czech Republic, ‘‘Privatization proceeded whether management liked it or not.’’13 The Czech–Slovak MPP was both a top-down and a bottom-up approach. It was top-down because the privatization law required that all large firms be privatized. It was bottom-up because management of state enterprises or bidders prepared their own privatization plans, which were reviewed by the relevant ministry and by the ministries of privatization in each republic. The MPP was divided into two waves based on the readiness of a given state enterprise for privatization. A percentage of shares (varying between 3 and 100%) were reserved for distribution through vouchers (Box 1).14 Vouchers were emphasized in the first wave of privatization for large and medium-sized state enterprises. Other methods of sale, such as direct negotiated sales, public auctions and tenders, and transfers to municipalities, emerged during the first wave through competing privatization plans. An important element of this process was that privatization plans presented by enterprise management had to compete with plans submitted by outsiders. Of the 2,744 enterprises privatized in the first wave, about 1,490 (representing US$10.7 billion in assets) were sold through the voucher system.15 Each adult citizen was eligible to purchase a book of vouchers. For the first wave, 8.5 million Czech and Slovak citizens paid a nominal subscription fee of 1,000 koruna (Kcs.) (US$35) to obtain vouchers. The initial price was set at 3 shares per 100 voucher points. Voucher holders had a choice of directly converting their vouchers into shares through auctions or placing them with IPFs, which would bid for blocks of enterprise shares through the same auctions. Roughly 434 legally registered IPFs in the two republics attracted 72% of all vouchers placed. In the first wave, however, 40% of these vouchers went to just 10 funds, mainly subsidiaries or affiliates of large commercial banks, savings banks, and insurance companies (the Harvard Fund was one notable exception). The funds played a major role in

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Box 1. Basic Characteristics of Mass Privatization in the Czech and Slovak Republics.  Emphasized speed and the early involvement of the public as investors.  Bottom-up, company, or competitive bidder directed privatization.  Emphasized free market bidding for firms being privatized through the voucher process.  Early emphasis on voucher privatization, with other privatization methods evolving from company – prepared or competing privatization plans.  Foreign and domestic investors competed on a level playing field.  Alternative privatization proposals sought to foster competition; avoided preferences for insiders (workers and managers).  Little initial concern with prudential regulation, particularly with financial intermediaries, which accumulated large concentrated holdings of state enterprises.  Little attention given to the problem of ‘‘orphaned enterprises’’ resulting from dispersed ownership and the absence of a major shareholder to provide corporate governance.  Restructuring viewed as the responsibility of new private owners.  MPP was explicitly linked to capital market development.

promoting voucher privatization by promising substantial returns on investments to voucher holders.16 Companies were privatized through a complex, centralized auction process. Unlike Russia, the Czech Republic was a small country, so it was unnecessary to have regional auctions. The auctions proceeded in a series of rounds lasting almost six months. It took five rounds of investing to complete the first wave of voucher privatizations. The government put shares at auction for an estimated value. If too many investors attempted to buy shares in a company, the share price was re-adjusted for the next round by a price-setting committee in the Ministry of Finance.17 Many officials had feared that investors would hold back in the first rounds, but in fact almost 90% of all points were invested in the first round, revealing a high participation rate. While many of these attempted investments had to be returned due to over subscription, 30% of the shares were sold in the first round of bidding.18

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By the end of the second round 56% of all shares had been sold and, almost three-quarters of investment points had been successfully invested. Share prices were adjusted once again and by the end of the third round 67% of all shares had been sold and more than 85% of all voucher points invested. At the end of the fourth round in November 1992, 79% of all shares had been sold and 93% of all available voucher points had been used. By the fifth round, it was clear that some equilibrium between supply and demand had been reached with 92.8% of shares sold (the residual was left with the National Property Funds) and 98.8% of voucher points used.19

6. OUTCOMES OF CZECH–SLOVAK MPP By December 1992 the first wave of privatization was complete. About 1,500 state enterprises employing 1.3 million workers were privatized through the voucher process. Of these, 943 were in the Czech Republic, 487 were in Slovakia, and 62 were federal property. In addition, 323 enterprises in the Czech Republic were sold through public auction, 244 through public tender, and 794 through direct sale. Projects that were approved too late for the first wave of voucher privatization were included in the second wave.20 Foreign investors responded enthusiastically. During the first wave, negotiations were under way with about 220 potential foreign investors, involving a total book value of Kcs. 50 billion (US$17 billion). Incredibly, 7.5% of the total country’s capital assets were included in the first wave of voucher privatization, and a subsequent 4.5% in the second wave.21 The completion of the MPP was expected to open up the Czech Republic to a significant inflow of foreign investment negotiated directly through the new private enterprises. The MPP was meant to encourage passive investors, as emerging market funds surged into the Czech capital market in early 1994. As Prime Minister Vaclav Klaus (1993) noted, ‘‘It has become one of our fundamental theses that foreign capital will finally enter the country at a massive scale after privatization because the relevant decisions must ultimately depend on private initiative of real owners.’’22 After new governments were formed following elections in June 1992, new ministers of privatization were appointed in each republic. Both ministers promised to address the ‘‘lack of definition’’ that had plagued the privatization process. In each republic, this involved prioritizing privatization methods, allowing for more transparency in choosing between projects, loosening bureaucratic entanglements, and further restricting the use of personal contacts in getting proposals approved.23

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One of the major questions hovering over the break-up of Czechoslovakia was how its separation would influence the course of privatization. The two privatization ministers agreed that – the first wave should be completed and its results upheld, and that the second wave should be carried out separately by the individual republics. The decision to honor the results of the first wave resulted from several factors, the most important of which was the recognition that altering the first wave would delay the transfer of enterprise ownership into private hands. Another factor contributing to the decision was a sympathetic sentiment toward the property rights of shareholders. After the federation broke up, Czechs and Slovaks began owning significant numbers of shares in firms in the other nation, therefore, both republics went to great lengths to uphold the rights of existing shareholders.24 The pronouncement that the two republics should conduct the second wave of voucher privatization separately was made possible by the existing privatization mechanism. It was not difficult to undertake the second wave on a republican, rather than on a federal level. Moreover, voucher privatization was viewed as a means of transferring something of significant value from the state to the general population. After the separation of Czechoslovakia, there was no reason why either republic’s government would want to make such a transfer to foreign citizens. The second wave of voucher auctions took place only in the Czech Republic. Roughly 861 companies were included in the second wave and approximately 6.2 million Czech citizens, or about 80% of the eligible population subscribed for vouchers. Investment funds again played the dominant role in the process, with 350 funds attracting 64% of all vouchers. Again, there was a concentrated placement of vouchers in the largest funds with the largest 15 funds attracting just over 40% of voucher points versus 40% for the top 10 funds in the first wave. The wave was completed in November of 1994 after six iterative rounds of auctions, leaving just 3.7% of offered shares unsold and 0.6% of available points unused.25 The Slovakian government was less keen on their experience with voucher privatization, particularly with IPFs. Many in the government believed that more standard methods of privatization would lead to more concentrated governance and a higher likelihood of restructuring. Nonetheless, another round of voucher privatization was announced in early 1995. It was later cancelled due to political difficulties. Most importantly, the government was unable to come to a decision about which enterprises should be privatized. It has been suggested that one of the reasons the Slovaks lacked this political will was because of the importance of military industry in the nation. So

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much power was held buy these stakeholders that they were able to block depoliticization of the economy.26 Slovakian politicians who did not want depoliticization and believed that most citizens were incapable of participating in the capital markets due to information asymmetry and exploitative tactics by the IPFs won the day. Following the cancellation of the second phase of voucher privatization, the 3.3 million coupon books, which had already been given out by the government were exchanged for privatization bonds. The bonds were not popular with the populace who were skeptical that the government would pay off these bonds when they matured.27 A natural outcome of the MPP has been the creation of capital markets. As mentioned earlier, mass privatization provided a ‘‘critical mass’’ in the supply of shares, and the distribution of vouchers among the population created a demand. While initial public reaction was less than enthusiastic, the spontaneous emergence of more than 400 voucher funds boosted public interest through extensive advertising and promises of big returns.28 The first wave of privatization brought nearly 1,000 companies into the secondary share market with a total book value of US$7 billion. After being closed for 50 years, the Prague Stock Exchange was reopened in April 1993. Share trading, however, did not begin until June. In dollar terms, the Prague Stock Exchange index grew by 288% in 1993. By the end of 1993, market capitalization reached US$14 billion and the total trading volume was about US$300 million. During 1994, market capitalization in the Czech Republic, as a percentage of GDP, reached above 50%, a level equivalent to those characteristic of advanced industrial economies.29 Seventy-five percent of total trading, however, occurred in just 1% of the firms on the stock exchange. Foreign investors showed interest in the Czech Republic, and estimates on the level of foreign capital in the Prague Stock Exchange ranged between 50 and 90%.30 At the same time the Prague Stock Exchange was reopened, another exchange, RM-S (an over-the-counter system), was brought into operation. Its primary objective was to provide greater capital market accessibility. Four hundred RM-S outlets were established where individuals could trade directly or through professional brokers. The RM-S exchange cleared its buying and selling orders in trading rounds that occurred every two or three weeks. By January 1994, the total trading volume for all 10 rounds was Kcs. 3.2 billion (about US$110 million).31 Capital markets in the Czech Republic deepened and increased their level of activity throughout 1994. However, paralleling the course of most

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emerging markets, 1994 also proved to be quite a volatile year for the Czech capital markets. The Prague Stock Exchange index fell from a peak of 1,245 in March to around 500 in December. Part of the reason for the plunge was the large volume of trading that took place off the market. It is estimated that as much as 80% of all transactions in 1994 took place outside of the stock exchange.32 Moreover, a weak banking system, and a lack of transparency further slowed exchange activity near the end of 1994. The Ministry of Finance was the primary regulator for the securities industry, and all sales had to be registered at the Securities Registration Center. Both the Prague Stock Exchange and the RM-S exchange were required to submit trading rules to the Ministry of Finance and to make these rules available to clients. Although a number of regulations had been passed, such as the Law on Investment Companies and Funds, the Law on Securities, the Law on Bonds, and the Law on Stock Exchange, capital markets in the Czech Republic operated largely on the basis of selfregulation.33 Vaclav Klaus, the Czech finance minister at the time, felt the country had suffered enough regulation for the last 40 years, and largely took a laissez-faire approach.34 Nevertheless, the emerging capital markets in the Czech Republic did encounter a number of startup problems and the pain of inadequate regulation. It is estimated that 80% of all trades were performed outside of the exchange due to lack of infrastructure. Most of these off-market transactions were not reported for several days, and consequently, the market was deprived of information on prices and volumes. The absence of a securities exchange commission fueled speculation about collusion and insider trading.35 The Czech government eventually recognized the need to implement more stringent regulation and supervision procedures to prevent collusion and insider trading. In May 1996, the Czech government adopted a series of regulations, which included the Securities Act and the Stock Exchange Act. These new regulations mandated several protections for investors including stricter disclosure rules, supermajorities for altering corporate form, and mandatory buy-out offers. The government hoped that these changes would improve the Republic’s reputation and eliminate or severely reduce financial collusions and poor accountability.36 The main risk the Czech MPP faced was tied to the post-privatization restructuring of recently privatized companies. A second important risk was the concentrated ownership structure that emerged from the MPP with investment funds owning the vast majority of shares of firms privatized through the voucher process. This raised a fundamental issue of abuse of

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market power, as well as several secondary but important governance issues discussed below.37 The complex process of evaluating privatization projects, the time consuming nature of the centralized auction process, and the delays caused by external political events, stretched to four years what was initially conceptualized as a very fast method for privatizing state-owned enterprises. During this period the enterprises were left with little governance and mounting problems of indebtedness, obsolescence, and an acute need for restructuring. In some cases enterprise managers took advantage of the governance vacuum and spontaneously acquired some of the best assets of these firms through mechanisms such as leasing out, as in other Central and Eastern European countries.38 The delays in the program left Czech enterprises more vulnerable and in substantial need for restructuring. As a result of the mass privatization process, investment funds became the primary owners of the vast majority of Czech enterprises. Of greater note, a small number of investment funds managed to achieve concentrated ownership of the recently privatized enterprises. The 13 largest IPFs received over 100 million voucher points, accounting for more than 56% of all points owned by IPFs.39 With a few notable exceptions, these funds were managed and owned by financial institutions, primarily in the banking sector. There was cross or inter-locking share ownership between the banks (as fund managers and often owners) and the funds. Moreover, the Harvard Fund took a substantial ownership stake in a few of the major banks. As one analyst has noted, ‘‘there is the unplanned appearance of a concentrated system of cross-ownership under which the leading Czech financial institutions (i.e., banks and insurance companies) indirectly hold substantial and potentially controlling blocks in each other.’’40 Such tangled ownership raised many problems. First, it was not clear whether the investment funds had the managerial competence to govern the enterprises under their control. Second, since under law, a single fund could acquire only 20% of any enterprise’s shares, it was unknown how well funds, presumably with different investment strategies, would be able to cooperate in addressing the sticky problems of enterprise restructuring.41 Third, there was the question of how enterprises would raise funds for restructuring. There was a potential conflict of interest between the role of banks as fund managers (or owners of investment funds) and as creditors. Fourth, investment funds as purchasers and sellers of enterprise shares could become tangled up in insider and self-dealing. There was also the potential for further consolidation of fund ownership though the acquisition of smaller funds by larger funds. Funds’ shares traded at a substantial

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discount in the market and despite regulatory obstacles, it was still quite tempting for larger funds to consolidate their ownership. Fifth, the regulatory framework for the funds, which was initially minimal and consistent with the market-driven structure of the MPP process needed to address the confluence of events which made investment funds so important as both as enterprise owners and as capital market institutions in their own right. The governance provided by the funds in the Czech Republic and the regulation of the funds themselves, was the critical issue for successful longterm restructuring and reform of the real sector in the Czech Republic. The question of ‘‘Who Will Guard the Guardians?’’ applied more at the investment fund level in the Czech Republic, than it did at the enterprise level.42 The rearranging of IPF portfolios following the first two waves of privatization is often referred to as ‘‘third-wave privatization.’’ Following the third wave, IPFs often controlled more than the 20% of a company they were legally allowed, leading some of these funds to become holding companies. In an environment of trivial legal restrictions, mergers and acquisitions happened at a rapid pace. There was concern that there might be a rising ‘‘financial oligarchy.’’ The national Securities and Exchange Commission was created to assuage that fear. Barabara Blascyck, a Polish privatization expert and advisor to the Polish Government from 1989 to 1996, writes, ‘‘The essence of the problem [in the Czech Republic] was that insufficiently regulated privatization investment funds ended up owning large and controlling stakes in many firms privatized by vouchers, as citizens diversified risk by investing their coupon points in these funds. But most of the large funds were owned by state banks, in which the Czech state retained a controlling or even majority stake.’’43 It was expected that depoliticization through mass privatization would lead to restructuring of former SOEs, but since these companies were ‘‘repoliticized’’ by IPFs, this intended restructuring often did not take place. In 2001, the Polish research group, the Center for Social and Economic Research (CASE), conducted some exhaustive research on the process of secondary privatization. Secondary privatization refers to the ownership that takes over from the owners that received a firm when it was initially privatized. One of their findings is that ownership concentration steadily increased from 1996 through 1999, which was a desired outcome by the government. By 1999, about half the firms in the Czech Republic had a dominant owner with over 50% of equity (see Table 1). The Case studies also contend that when the ownership of a privatized firm is concentrated in an investor other than an IPF, it had a positive impact on performance,

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Table 1. The Average Share of the Largest Shareholder Companies Privatized through the Voucher Scheme.

Mean Median Standard deviation Number of firms

1996

1997

1998

1999

38.8 36.3 19.3 652

42.8 42.0 20.4 652

48.6 47.5 21.5 652

51.9 49.7 21.8 652

while there is no evidence to indicate that this is true for firms whose ownership was concentrated in an IPF.44 The Case studies also come to the conclusion that as a result of the emphasis on speed in Czech privatization, there was a failure to create adequate legal institutions, which might have stopped ‘‘tunneling’’ and other illicit practices.45 In the argument between speed versus institutional readiness, it often seems like your damned if you do and your damned if you don’t. If there was no emphasis on speed, than companies’ values would have depreciated even more than they did in reality, but this comes at the cost of the unpredictability that comes with weak legal institutions. There was an incredibly complex set of variables for reformers to deal with without the benefit of hindsight. Despite these concerns, the MPP was in many ways a great success. In the Czech Republic alone it led to the privatization of 70–80% of state-owned enterprises in a variety of sectors – industry, construction, agro-processing, and banking.46 The transformation was rapid by any measure, except perhaps by the initial expectations of the Czech planners. It created capital markets that over time induced further structural change in the economy. It decentralized the problem of restructuring Czech industry and placed it in the hands of new private owners, rather than the hands of government. It was sequenced well into an overall program of reforms, so that today the Czech economy has been largely reformed and liberalized. After 2000, the process of European Union (EU) accession drove most reforms in the accession states such as the Czech Republic and Slovakia.

7. POLAND With its caution and focus on National Investment Funds (NIFs), the Polish MPP in many ways represents a counterpoint to the Czech–Slovak MPP.

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The Polish model was more top-down, dirigiste and wary of the risks of a market-driven privatization process than the Czech and Slovak model. Mass privatization played a less central role in overall privatization for the Poles than for the Czech’s. The Poles concentrated their energy on a ‘‘shock therapy’’ program starting in 1989, which focused on halting hyperinflation, macroeconomic stability, and direct sales of SOEs.47 Critics often discuss privatization in transition countries as if there was groupthink across the region when it came to policy. In fact, countries differed greatly on the emphasis that they put on regulation versus rapid change. The Polish reformers were more conservative than other reformers in transition countries about institutional change. They were also more concerned than the Czechs about devising a voucher scheme that would create corporate governance arrangements most likely to lead to restructuring. In fact, if some of Poland’s reformers had had their way, there would have been many more cash sales to foreigners because this was the most predictable path to restructuring. Yet following direct sales of some Polish SOEs to Germans, the population was quite displeased with what they perceived as an auction of the family jewels to outsiders. After this it became clear that a privatization program including free distribution of shares to the public would be necessary.48 With the end goal of proper corporate governance in mind, the reformers methodically created a program that they believed would prevent minority shareholders and other vulnerable participants in the market from having their share ownership diluted out or expropriated. In 1991, the Polish government passed the Privatization Act. The Act called for capital privatization, direct privatization of small enterprises, and liquidation of failed enterprises, their assets being apportioned to other more profitable enterprises. It was also expected that there would later be some form of voucher privatization. Though the Polish MPP was largely designed by the end of 1991, the Polish process of voucher privatization was much slower than most of there transition counterparts. This was in great part due to the political turnover in Poland and the nature of their government, and the need for coalitions. There was concern in Government with the close relations between workers and managers that existed in the country in resisting outside ownership and aggressive restructuring, a legacy of Solidarity, and the fear of politicians of upsetting unions by too aggressively pursuing the MPP.49 There were six different governments in Poland between 1989 and 1995, ratcheting back and forth between governments that were pro-reform and those that were more conservative. This lack of continuity made any substantial progress towards executing the MPP very difficult.50

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The basic parameters of the future voucher privatization existed as early as 1992, but the program was delayed until 1995. This delay would end up costing a great deal, as enterprises that were dormant, unable to restructure or make any other important changes, for this period, lost significant value. The delay was a consequence of the inability of the government to come to a consensus on which companies would be a part of the scheme and the particulars of how corporate governance would be regulated.51 Many of the best companies on offer were taken off the list because the government deemed them too essential to be privatized, especially in what they considered a risky MPP program.52 An advantage of the delay was that Polish reformers were able to observe some of the problems associated with the Czech and Russian programs and then design their program to avoid repeating these other nations’ mistakes. For the first stage of Poland’s MPP, the Ministry of Privatization chose an initial group of 460 medium-sized to large state enterprises. Although the Ministry emphasized voluntary commitment of the state enterprises to the program, in reality there was initial selection or culling by ministry staff to ensure success.53 In order to avoid the problems of excessively dispersed ownership and to limit the scope for expropriation, scandal, etc., the Polish authorities engineered a top-down approach to privatization relying on NIFs instead of the type of investment funds that appeared in other transition countries (Box 2). The National Investment Funds Act, passed into law in June 1994, provided the basis for the privatization of state-owned Polish companies through the distribution of share certificates to adult Polish citizens for a nominal fee. The NIF Program was designed to promote the development of profitable companies and to permit the public to participate by enabling them to acquire share certificates and, ultimately, shares in individual NIFs. In December 1994, 15 NIFs were established as joint stock, limitedliability companies by the Ministry of the Treasury. From 1995 through 1996, the Ministry of Treasury, in four tranches, transferred shareholdings in the privatized companies to the NIFs. Each fund assumed lead management of about 30 state enterprises, through a bidding process that resembled a ‘‘football pool.’’ The funds managed their portfolio of firms as closed-end mutual funds for an initial period and had the option to subsequently convert to open-ended funds. The Government sought to attract high quality or ‘‘brand name’’ investment managers, who would operate on the basis of a management contract offering substantial rewards for increasing the value of the portfolio by restructuring its underlying assets.54

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Box 2. Basic Characteristics of Mass Privatization in Poland.  Mass privatization was one option in a menu of privatization methods employed in Poland.  The selection of firms was top-down, and the use of external consultants and accountants was emphasized to prepare firms for privatization. This made the process inherently slower than the Russian or Czech and Slovak approach.  Financial intermediaries (consortia of Western and Polish investment firms) were used to initially manage the funds and prepare them for subsequent market flotation.  Financial intermediaries also were used to diversify the risk of Polish citizens and to reduce the potential for inequity.  The process involved little early involvement or choice by Polish citizens and, therefore, there was less opportunity to educate them about the benefits and risks of a market economy.  Prudential ownership limits were established because of concern about excessive concentration of ownership by the funds.  The MPP sought to deepen capital markets by floating the investment funds’ shares on the Warsaw Stock Exchange.

Each investment fund initially took a lead share holding of 33% of equity in 30 state enterprises, as well as a smaller, highly diversified holdings in a number of the other state enterprises to be privatized under the MPP. Polish workers received 15% of equity, and the government treasury retained 25% for later sale. The government’s ownership interest was effectively represented by a lead fund. The fund manager would have discretion over the primary assets it managed.55 The boards of directors of these funds followed the German model of a dual board. The supervisory boards were composed of Polish citizens, initially appointed by the government, and included members appointed by labor. The privatization ministry, with the assistance of the Open Society Institute (Soros Foundation), trained approximately 1,000 Poles to become directors through a certification process. Citizen involvement was important because the Ministry of Privatization did not want the funds to be perceived as a foreign takeover of Polish firms. The fund manager appointed the majority of the management board.56

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After their first year of operation and an annual audit, Polish citizens were allocated shares in these funds through the conversion of master share certificates (a form of voucher) into shares in the NIFs. Each Polish citizen over the age of 18 was eligible to receive a master share certificate for a nominal fee, representing a share in all of the NIFs. The certificates were in bearer form and were immediately tradable. Stockbrokers and foreign exchange dealers were expected to intermediate and to create a secondary market in these certificates.57 The Polish approach differed from the Czech and Slovak approach in emphasizing financial intermediaries created through state intervention, and risk diversification for its citizens. Again, more dirigiste than the Czech or Russian models, Polish citizens initially held shares in funds, rather than directly in state enterprises. The Polish program was designed to maximize fairness and avoid the potential for initial losses by citizens as a result of direct investment in the former state enterprises.58 The creation and deepening of capital markets was an important part of both approaches to mass privatization. The Czech funds developed spontaneously, without government intervention, and became the major players in the Czech and Slovak MPPs. Czech and Slovak citizens placed 72% of their vouchers through funds in their first wave of privatization and 64% in the second wave. Although a large number of funds were initially established, vouchers were highly concentrated in the 10 most popular ones. The Polish MPP initially operated exclusively through 15 state-sponsored NIFs.59 Both processes relied on investment funds to provide governance and restructuring support for the newly privatized enterprises. Thus, while starting from a different perspective, these approaches appear to converge with respect to the integral role of investment funds in enterprise governance. Both countries believed the concentration of ownership to be paramount to the likelihood of restructuring. The NIFs were created in part to ensure that there would be effective ownership with power and influence over management, while at the same time not allowing the ‘‘wild west’’ type of investment that went on following the Czech–Slovak MPP. The Polish reformers even invited foreign financial institutions to be a part of the process and possibly manage NIFs in an effort to seek the most competent leadership possible. On the other hand, the Polish model lacked the market qualities or dynamics of the Czech and Slovak or Russian approaches, and had more difficult winning support and enthusiasm from citizens. The government tried to overcome this problem by distributing share certificates to the

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population soon after establishing investment funds and selecting enterprises for their portfolios.60 The Polish MPP was completed in 1995. By June 1997, the NIFs were floated on the Warsaw Stock Exchange. The certificates that Polish citizens received in 1995, which entitled them to 1 share in each of the 15 funds, were converted by the end of 1998. The direct role of the state in NIFs concluded by 2001. In the five years prior to 2001, the government’s role in the funds decreased dramatically and in the end the private sector took total control.61 While the governments role declined, the role of large investors greatly increased. At the genesis of the NIF program, small institutional and individual investors (those who owned less than 5% of a fund) accounted for 85% of all shares owned. By 2001, this number had dwindled to 41%. Large institutional investors held no shares in NIFs at the beginning, but by 2001, this kind of investor held over 46% of shares. Most of this rise was due to increased interest from foreigners (Fig. 3.4 from Case Report no. 48).62 The NIF program was created in part to lead to ownership concentration and in turn good corporate governance. In just two and a half years from 1998 to 2000, the average share of the largest shareholder went from 5.4% to 24%, and the average share of the largest three shareholders went from 7% to 42%.63 Like the Czechs, it is clear that the Polish reformers were successful in achieving ownership concentration, but it is unclear whether this led to the ultimate goal of good governance or restructuring. One of the reasons that the funds did not provide proper corporate governance was the political pressure applied by the government on the managers of the funds. The government and trade unions were opposed to any major restructuring that would cause downsizing or bankruptcy. As evidence of the effects of political pressure, the Case Reports give as an example the several million dollar investment that one of the NIFs put into a meat factory even though it was clear that the factory’s ‘‘liabilities exceeded it assets.’’64 This investment was apparently done only under the influence of politics and social pressure. Higher concentration of ownership could not make up for the lack of depoliticization of the process. Furthermore, the aforementioned Case Studies conclude that the managerial staff of most NIFs was ill-equipped and often lacking know-how in restructuring.65 The Case Studies also assert that the NIF program was at its best when privatizing companies ‘‘quickly and efficiently.’’ Their statistics indicate that the later a company left the NIF system, the worse the performance of that enterprise. Another important conclusion from their data was that the enterprises that saw the least depreciation were those which were sold to foreign investors or

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domestic corporations. The pace of secondary privatization and the type of investor, not the concentration of ownership, seem to be the most important causes of a successful privatization.66 The reports also show that when mass privatization leads to non-insiders receiving companies, these companies undergo secondary privatization very quickly.67 In the conclusion to their study of secondary privatization, the authors of the Case Reports claim that ‘‘Poorly designed privatization institutions do not fulfill the roles assigned to them, but rather take on lives of their own and begin to create new problems.’’68 Nevertheless, throughout the course of privatization in Poland, expropriation of investors occurred rarely and in relatively modest proportions compared to other transition economies. Although large-scale privatization began relatively slowly, protection of investors significantly improved perceptions of the Polish market, allowed firms to obtain external finance, promoted the development of more liquid secondary markets, and contributed to a positive investment climate – despite the weaknesses of the Polish legal system.

8. RUSSIA The Russian MPP was characterized by a sense of urgency. Among reformers, there was a general recognition of the dire state of the Russian economy and a need to privatize before the assets of major enterprises were expropriated by their managers and workers. Andre Shleifer, an advisor to Privatization Minister Anatoly Chubais in the reform process in Russia, points out that the general population did not recognize this reality. A majority of the population polled in 1996 opposed the private ownership of large industrial enterprises. This political environment made Russia’s success in implementing an MPP all the more remarkable.69 The Russian State Property Committee (GKI) and the Regional State Property Agency (MKls) were responsible for the overall program. However, the Duma established a competing institution, The Federal Property Fund, which ultimately became responsible for executing final share sales. At the regional level, local state property committees reported to governors of specific regions, and regional property funds reported to the local soviets. Ultimately these two institutions cooperated at the regional level to make the MPP work.70 Perhaps the most famous and controversial figure associated with privatization in a transition economy is Anatoly Chubais, who remains an important political figure in Russia. Chubais was the first head of the GKI

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and the greatest advocate of Russia’s privatization program. In early 1992, with a backdrop of macroeconomic instability and a country in disarray, Chubais managed to pass through Parliament the basis for what would become the Russian MPP. In retrospect, Chubais’s ability to force the program he helped devise through the treacherous terrain of Russian politics seems inconceivable.71 Russian reformers were able to examine ongoing privatizations in Poland and the Czech Republic and choose particular tactics based on their success in these countries. Chubais badly needed public support for his mass privatization scheme, and looked towards these examples to see how he could garner approval. While many politicians in Moscow supported giving ownership of enterprises directly to workers and managers, Chubais believed that a successful privatization must include all members of the population (retirees, students, professionals, etc. y). A privatization giving complete control to managers and workers would have made restructuring unlikely and allowed continued reliance on political connections to persist.72 Chubais and his reformers concluded that a voucher privatization similar to the Czech Program would be suitable. The Polish privatization based on investment funds although more conservative and likelier to provide appropriate corporate governance, was too centralized, too dirigiste, to be acceptable to Russian reformers. The Czech program allowed the public a choice in how to use their vouchers, and inspired the interest and excitement Russian reformers believed was necessary for success.73 However, the Czech auction process was far too complex and centralized for Russia with 81 regions (oblasts) covering 8 time zones. Consequently, the Russian program focused on gaining broad-based support by issuing vouchers at a nominal cost to all 145 million citizens. Unlike the Czech and Slovak program, in which vouchers were denominated in points and were non-tradable, Russia vouchers were denominated in rubles (R10,000 per voucher) and were immediately tradable, leading to the emergence of a large secondary trading market for vouchers. Vouchers quickly became the most important and most actively traded financial instrument in the country. By early 1993, 97% of the population had claimed vouchers.74 Of these voucher holders, 34% of them immediately sold their voucher because of their urgent need for money. The vouchers sold for between 5 and 20 dollars depending on the location and time of the sale. Remarkably, 11% of the population gave away their vouchers as presents.75 Even though the GKI made a significant attempt to educate people about the voucher process, this gift giving was probably a reflection of the bewilderment people felt when trying to figure out how to use this piece of paper.

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The Russian MPP, like its Czech and Slovak counterpart, supported the spontaneous creation of voucher investment funds. Learning from the Czech and Slovak program, these funds were registered as joint stock companies from the start and were licensed and regulated as closed-end mutual funds. About 650 regional and NIFs were licensed, but few funds emerged with substantial market power. By the end of the MPP in June 1994, five national voucher funds had collected between 1 and 3 million vouchers, 40–60 important inter-regional funds had emerged, and about 50 regionally focused funds possessed a substantial shareholder base.76 The funds were initially limited by a regulation that restricted ownership to a maximum of 10% of any enterprise’s shares (later amended to 25%). Although a number of Russian funds had concentrated regional importance, the Russian funds did not have nearly the same kind of ownership influence as the Polish or Czech and Slovak funds. The funds had great difficulty competing with Russian managers for governance rights over the newly privatized firms77 (Box 3). The Russian voucher funds were highly criticized. Svetlana Glinkina, a Russian academic focused on transition economies, writes that although those who sold there vouchers immediately were not very well compensated, ‘‘Even less fortunate were the 25% of Russians who invested their property certificates in unregulated privatization or voucher investment funds.’’ She goes on to claim the far majority who put their vouchers into these funds lost everything.78 Fifteen percent of voucher holders invested in firms directly. It was unusual for the firms that average citizens chose to be profitable ones. Those firms with optimistic profit projections were protected against outsiders by their managers, who wanted only other insiders as shareholders.79 Unlike the former Czechoslovakia or Poland, where SOE reform laws enabled the Communist Party to remove under-performing managers as late as 1989, the USSR had no such opportunity. Here, enterprise insiders – managers and employees – had both the incentive and the power to defend themselves against Yeltsin’s attempts to reallocate property rights through rapid privatization. Workers, due to a paternalistic relationship under managers, the absence of labor markets, the lack of sectorally based trade unions, and the direct provision of social services by enterprises, did not constitute a distinctive group with interests opposed to management. On the contrary workers and managers were traditionally more or less united in their common struggle to bargain for lower production quotas. Consequently workers made no claims against property rights distinct from managers. Together, workers and managers constituted a pressure group,

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Box 3. Basic Characteristics of Mass Privatization in Russia.  A bottom-up process was emphasized, with state enterprise employees choosing one of three options for privatization.  Option 2, the most popular option, allowed workers and managers to own up to 51% of the shares in the enterprise through closed subscription. Workers and managers were able to utilize vouchers to acquire their shares.  Rapid corporatization was emphasized to create a pipeline of privatized firms, and the valuation of assets was based on book value.  Vouchers, valued in rubles, were distributed to 145 million Russian citizens and were immediately tradable.  Investment funds, licensed regionally or nationally, developed spontaneously. Funds had an important effect in promoting privatization within Russia, but had less influence in enterprise governance than their Polish or Czech and Slovak counterparts.  Initially, regional voucher auctions were relied on as the only way to sell shares to the public. Later, a national auction center was established for the sale of large, federally controlled properties such as Zil and Uralmash.  Voucher depositories were also established to allow inter-regional bidding for shares. The process spawned an active, but informal, secondary market in share trading. The development of regional capital markets in Moscow, St. Petersburg, and Vladivostok, is an important outcome of mass privatization.  Mass privatization was virtually the only way to privatize mediumsized and large enterprises. In August 1994, cash auctions and tenders began for the residual shares of privatized enterprises owned by the Federal Property Fund and for enterprises that stayed outside the MPP.

which dedicated itself towards ensuring that enterprise insiders received the numerous privileges that ultimately made their way into the Russian program. As Gaidar himself later conceded, ‘‘Beginning in May and June [of 1992] it was impossible to stand up to the pressure of the industrial lobby.’’80 Thus, it is that the designers of the Russian program confronted

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the following political reality: pre-existing institutional arrangements that distort free markets cannot be wiped clean by governmental fiat. The Russian MPP, consequently, was unique in the benefits and power it offered to managers and workers through the three different privatization options the government gave enterprises. Through Options 2 and 3 (the third option was rarely used due to the lack of clarity of regulations governing this option) of the Russian MPP, managers and workers became the majority shareholders in most medium-sized and large privatized enterprises. This had severe implications for restructuring prospects as firms moved into the post-privatization stage.81 By March 1993, roughly 8,700 medium-sized enterprises and 2,300 large enterprises had been corporatized. This process created an important pipeline for privatization auctions to proceed without disruption. As part of the corporatization process, the enterprise’s privatization commission had to develop a privatization plan and elect a privatization option among three available options. Option 2, offering immediate control of the enterprise to employees, was the most popular option – 74% of all corporatized firms chose this option. By offering 51% of shares to employees at a price 1.7 times book value, it protected management and workers against outsiders gaining control of the enterprise.82 Twenty-one percent of all enterprises (33% of large enterprises) chose Option 1, whereby 40% of shares were offered to employees. Twenty-five percent of shares were given to workers for free and another 10% was optional at a 30% discount, and 5% of shares were given to managers for a small sum.83 This usually happened when the company was too capital-intensive to buy outright or when managers feared giving workers voting shares. Option 3, a complicated scheme requiring worker approval in which a management group was given a year to create their own privatization plan, was chosen by only 1% of all corporatized enterprises.84 The speed with which firms were corporatized varied widely across the country. This is a reflection of the significant divergence in local attitudes toward privatization. It is important to note that the Chubais led reformers had originally only presented Option 1 to President Yeltsin and subsequently the Duma. The reformers preferred Option 1 because it would lead to majority outside ownership and thus was more likely to lead to enterprise restructuring. As major stakeholders with significant political power, managers and workers were able to halt Option 1 from passing through the Duma as the only choice. The reformers were left with the option of either letting the MPP arrest or coming up with other options that would pacify managers and workers. Chubais fought against Option 2 but it was a losing battle. The Duma added Option 2 to the MPP. One small victory was that Chubais was

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able to maintain that if an enterprise chose Option 2, the 51% stake could not be owned as a collective but by each individual worker with the right to sell shares at any time of their choosing.85 Option 2 was politically necessary but economically quite inefficient. Allowing workers and managers to retain a majority stake entrenched inside managers and blocked restructuring. This was an example of what Shleifer refers to as the creation of new distortions to replace the old ones. Critics assail the Russian MPP based on this aspect of the program, but this ignores the fact that without a certain amount of unwanted compromise privatization most likely would have completely stalled.86

9. RUSSIAN MPP OUTCOMES The voucher auction process in Russia differed greatly from those in Czechoslovakia. In Czechoslovakia, the voucher auctions were centralized, with all companies auctioned at one time. This would have been administratively impossible in Russia because of its geographic size, the decentralization of political control to the oblast (state) governors, and the lack of power in the central government. Moreover, during the Gorbachev reform era, Perestroika, power was vested in the enterprise managers with the dissolution of most line ministries and the Communist Party. These were the traditional institutions that controlled enterprise activities. In Russia, auctions were for the most part held by local governments. Another major difference is that the Russians held single round auctions, in which the number of voucher bids determined the number of shares each bidder received, whereas the Czechs held several rounds of auctions so that each company was given an appropriate valuation. Russia’s choices in auction strategy were determined by simplicity and speed above all else.87 Bernard Black criticizes the structure of the Russian auction by suggesting that giving shares out depending on the number of vouchers bid led to corrupt auctions. Black claims that many auctions were compromised by the exclusion of bidders who were unwanted by managers or others who were trying to concentrate ownership in their own hands. Some of the tactics he asserts tainted auctions were last minute announcements of auction location, airport closings, and armed guards paid to intimidate bidders.88 (Most analysts of the MPP see the process as largely transparent. Black seems to confuse the MPP with loans-for-shares auctions for some of Russia’s largest companies that occurred in 1995 and discussed in Chapter 7 of this book on Russian Privatization.)

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Voucher auctions began in Moscow in December 1992. The Bolshevik Biscuit Company was chosen, after hurried negotiations with its management, as the first company to go through the voucher auction process. The company was taken through the process at breakneck speed in December 1992, amid a blaze of publicity and considerable Western technical assistance. During that month 18 enterprises from 8 oblasts/cities (including Moscow, Vladimir, Yaroslval, and Perm) and a variety of industries (including trucking, cement, arid microchip production) went through the voucher auction process.89 From this modest start, the pace of regional auctions accelerated such that 70 regions (oblasts) were involved in auctions by mid-1993. In June 1993, shares in 859 enterprises in 60 regions were sold at voucher auctions. By March 1994, about 9,500 enterprises, employing 10.8 million workers, had sold shares in the voucher auction process. Seventy-nine percent of the enterprises that had been privatized through voucher auctions were medium-sized. By the close of the MPP in July 1994, about 16,000 enterprises had been privatized, employing nearly 22 million workers. Forty-one percent of medium and large state firms were privatized in less than two years.90 Furthermore, about 40 million Russian citizens had become shareholders.91 Though rapid progress, was made on voucher auctions, initially there was much less emphasis on post-auction capital market development. During 1994 the Russian State Property Committee assisted in the development of private registrars (required for all firms over a certain size), custodians, and transfer agents, and in establishing preconditions for secondary share trading. In order to perfect shareholders’ property rights and to change existing ownership structures largely dominated by insiders, a liquid and transparent secondary equity market with the entire required institutional infrastructure was necessary. The existence of large numbers of regional commodity exchanges and the rapid, spread of voucher trading demonstrated that a vital secondary market could be created.92 An informal securities market developed in Russia during 1994, with roughly 40 companies shares regularly quoted by an active network of brokers. The Moscow Times had its own index of 30 leading privatized or partially privatized companies and a listing of about 20 stocks not included in the index. Share holdings were focused on energy and oil issues (Gazprom, United Energy Systems, and Lukoil), and a few telecommunications, and auto and truck assembly companies, (Rostelekom, AutoVAZ, KamAZ, and Zil). Market activity was estimated at an average of US$500 million a month in early 1994. Much of this activity was by external

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investors, such as Credit Suisse First Boston, Flemings and Salomon Brothers, who fueled a large speculative run-up in Russian equities; By fall 1994, however, market activity fell to an average of US$30–US$50 million a month due to eroding investor confidence caused by high inflation, the rise of anti-reformist political figures, and the events in Chechnya.93 Unlike the centralized and more classical Warsaw and Prague stock exchanges, capital markets in Russia developed on a regional basis, with Moscow, St. Petersburg, and Vladivostok serving as the most important regional exchanges.94 Most trading, however, was off-market, fueled by the fight for control of Russian enterprises that arose between managers as insiders, individual investors, and a few of the large investment funds. Also, large financial industrial groups (FIGs) developed, with banks at their core. These FIGs contested managerial control by purchasing shares at cash auctions through tenders, buying workers shares, and gaining control of the governments residual shares (see Chapter 7, in this book on Russian Privatization and the loans-for-shares auctions). The creation of a regulatory agency with sufficient authority to prevent trading abuses was essential to the success of secondary markets. While the Russian MPP was the clear responsibility of GKI, responsibility for capital market development was less transparent. Initially it was thought that the Ministry of Finance would be granted jurisdiction in addition to its responsibility for the regulation of financial institutions, banks, and investment funds (excluding voucher investment funds under GKI). A 1995 Presidential Decree established the Russian Securities and Exchange Commission with clear capital market development and regulatory responsibilities.95 Dmitri Vassiliev, Chubais’ first Deputy Minister for Privatization, became the first head of the Russian SEC. The risks of the Russian MPP were largely tied to the problems of insider ownership. Although on average senior management acquired a relatively low percentage of insider shares, there was little doubt that in most privatized enterprises the managers were in control.96 Most analysts believed that excessive insider control would prevent active restructuring of enterprises for several reasons. First, managers would need to appease workers who had become important shareholders. Second, most managers were experienced in implementing state plans, and lacked the ability to restructure within an economic environment that was market driven. Another risk of insider ownership was that insiders, particularly the managers, would ignore outside shareholder rights and eliminate any potential influence such shareholders had over enterprise governance. Some analysts directly attributed the low values at voucher auctions for Russian enterprises to

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the degree of insider control and the risks that this entailed for minority shareholders.97 Some of these fears seem to have been warranted. Glinkina writes that workers were passive in their interaction with manager/owners. She attributes this passivity to management calculatingly instilling fear into ‘‘rank-and-file’’ workers/owners and ‘‘Russian workers’ traditional apathy and distrust in their ability to influence events.’’98 Counter intuitively, 40% of workers felt less able to influence firm decisions after they had become a shareholder. Also, 46% of workers also felt that they had had less information about firm performance after becoming an owner.99 There seemed to a general miscalculation on the values of workers. It seems that above all else, workers were concerned with stability and retaining their job in a shrinking job market. If workers thought that manager dominated ownership made downsizing less likely, than workers were eager to sell their shares to managers rather than outsiders. Whether or not it should have been, ownership concentration was certainly not a major worry for lower level workers. Through intimidation and a variety of other mechanisms, owners were able to obtain the shares of workers for small fees, and within two years of privatization usually became owners of the ‘‘largest package of group shares.’’100 The data shows that although privatized enterprises did not restructure at the same pace as their counterparts in the Czech Republic and Poland, they clearly did a great deal more restructuring than those that remained under the governments control. Shleifer and Treisman claim that they were unable to find a single study that did not show the positive effects of privatization on restructuring. A World Bank study on the efficiency of firms in Russia showed that the greater the amount of private ownership the better the firm is able to function.101 Finally, achieving social equity has also been somewhat of a problem. Although, protecting the interests of enterprise insiders has been a primary characteristic of the Russian MPP, it is clear that the distribution of benefits among insiders was unequal. Workers and managers that happened to work for profitable enterprises were rewarded under the corporatization options while those who worked for inefficient SOEs have suffered.102 This chapter purposefully does not discuss the Russian loans-for-shares program that began in 1995 (discussed in Chapter 7). Loans-for-shares has been fairly criticized for inefficient and corrupt practices, making it even more of an imperative that critics do not confuse it with mass privatization. Evaluations of mass privatization are often colored by future failures. For example, Bernard Black’s article, Russian Privatization and Corporate

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Governance: What Went Wrong?, often mixes-up the MPP and loans-forshares in deeming the process corrupt.103 It is clear that the combination of loans-for-shares, mass instability, rampant inflation, the failure of the MPP to deliver gains to voucher holders, and the Russian financial crisis of 1998 discredited Russian privatization in the West, and in Russia, despite the real achievements of the MPP.104

10. CONCLUSION The MPP programs in various countries, but above all Russia, were highly criticized by the academic community and in time by the development community. Criticisms focused on the dispersion of ownership, the degree of inside ownership and the fact that the MPP would produce neither real owners nor managers capable of restructuring the companies privatized under these programs. Virtually all of the reformers and their advisors involved in designing and implementing these MPPs, understood that they were second or even third best solutions, especially when compared to caseby-case privatization as practiced in the UK, New Zealand, and eventually in Latin America. It is easy to criticize in retrospect, but at the time, starting in 1990, no one could imagine privatizing thousands of firms, 25,000 in the case of Russia, employing previously utilized methods of privatization in any reasonable period of time. For the Czechs, the Poles, and the Russians speed was considered an essential issue, as was some form of distributive equity to get the entire population involved. There was a perceived ‘‘window of opportunity’’ and progress under privatization had to be achieved before that window shut. There was a need to create a critical mass of private firms for a market economy to work, and privatization one firm at a time, would have led to crowding out by the state-owned sector. Other issues include that called for more radical solutions than a case-bycase approach were the lack of interest of foreign investors, and the absence of a capital market. Foreign investors were largely interested in a select number of companies in telecoms, natural resource areas or large companies in the tradables sector in sectors such as cement. There were no capital markets in any of these countries at the time, nor any private source of equity capital. The banks had not been privatized and commercial lending to private companies did not yet exist. Also, many of the companies included in the MPP were in the tradables sector and it was far from clear that they could survive in a market economy. Reformers believed that it was

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better to get them in the hands of new owners, out of the hands of the State, and let those firms that could restructure do so and those that could not exit the market. Finally the external criticism that privatization required so-called ‘‘real’’ owners and ‘‘real’’ managers who could operate in a market economy, was hard to understand for the mass of firms that needed to be privatized. Aside, from the lack of sources of capital, there was only one set of managers in the country. Some of these managers, highly experienced and usually engineers by background, could be re-trained over time and in other cases it was a generational issue. New managers would need to emerge who had worked for some time in a market economy. The idea that you could overnight put in new managers, except in a limited number of cases, was not realistic. So MPPs were implemented in a number of countries in the region and while they certainly did not represent the optimal solution, they were perhaps the only viable way to move forward considering both politics and economics.

NOTES 1. Lipton and Sachs (1990). 2. Those on this list include Janusz Lewandowski, Vaclav Klaus, Tibor Liska, Roman Frydman, Andzej Rapaczynski, The Economist, and others. 3. Lieberman, Nestor, and Desai (1997, p. 2). 4. Lieberman et al. (1997, p. 3). 5. Lieberman, Ewing, Mejstrik, Mukherjee, and Fidler (1995). 6. Lieberman et al. (1997, p. 3). 7. Boycko, Shleifer, and Vishny (1995, p. 12). 8. Boycko et al. (1995, p. 72). 9. Boycko et al. (1995, p. 60). 10. Stiglitz (2002, p. 159). 11. Grosfeld and Hashi (2001). 12. Lieberman et al. (1995, p. 7). 13. Black, Kraakman, and Tarassova (2000, p. 10). 14. Lieberman et al. (1995, p. 5). 15. Lieberman et al. (1995, p. 5). 16. Shafik (1993). 17. Boycko et al. (1995, p. 89). 18. Lieberman et al. (1995, p. 6). 19. Shafik (1993). 20. Lieberman et al. (1995, p. 6). 21. Blaszczyk and Woodward (2001). 22. Lieberman et al. (1995, p. 6). 23. Lieberman et al. (1995, p. 6).

Mass Privatization in Transition Economies 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70.

Lieberman et al. (1995, p. 7) Coffee (1994). Boycko et al. (1995, p. 43). Dado (1998, p. 239). Shafik (1993). Pohl, Jedrzejczak, and Anderson (1994). Business Central Europe, ‘‘Bulled Over,’’ March 1994. Lieberman et al. (1995, p. 8). Oxford Analytica East Europe Brief, February 20, 1995. Lieberman et al. (1995, p. 8) Desai and Plockova (1997, p. 191). Lieberman et al. (1995, p. 8). Desai and Plockova (1997, p. 191–196). Anderson (1994). Mejstrik and Burger (1992). Blaszczyk and Woodward (2001, p. 11). Coffee (1994). Anderson (1994). Coffee (1994). Blaszczyk and Woodward (2001, p. 12). Blaszczyk and Woodward (2001, p. 13). Blaszczyk and Woodward (2001, p. 13). Lieberman et al. (1995, p. 10). Duvivier (1997, p. 219). Boycko et al. (1995, p. 72). Grosfeld and Hashi (2001, p. 15). Duvivier (1997, p. 219). Grosfeld and Hashi (2001, p. 22). Duvivier (1997, p. 220). Lieberman et al. (1995, p. 10). Lieberman et al. (1995, p. 10). Lieberman et al. (1995, p. 11). Lieberman et al. (1995, p. 11). Lieberman et al. (1995, p. 12). Lieberman et al. (1995, p. 12). Lieberman et al. (1995, p. 12). Duvivier (1997, p. 221). Grosfeld and Hashi (2001, p. 15). Blaszczyk and Woodward (2001, p. 19). Blaszczyk and Woodward (2001, p. 19). Blaszczyk, Gorzynski, Kaminski, and Paczoski (2001, p. 26). Blaszczyk and Woodward (2001, p. 22). Blaszczyk and Woodward (2001, p. 23). Blaszczyk and Woodward (2001, p. 25). Blaszczyk and Woodward (2001, p. 26). Shleiffer and Treisman (2000, p. 22). Lieberman et al. (1995, p. 14).

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71. Boycko et al. (1995, p. 2). 72. Boycko et al. (1995, p. 82). 73. Boycko et al. (1995, p. 82). 74. Shleiffer and Treisman (2000, p. 23). 75. Glinkina (2005, p. 298). 76. Volgin and Milner (1994). 77. Lieberman et al. (1995, p. 15). 78. Glinkina (2005, p. 298). 79. Glinkina (2005, p. 298). 80. Gaidar (1999). 81. Lieberman et al. (1995, p. 15). 82. Book value was a measure of the original costs of the building, equipment, and assets. 83. Lieberman et al. (1995, p. 15). 84. Blasi, Kroumova, and Kruse (1997, p. 42). 85. Boycko et al. (1995, p. 79). 86. Shleiffer and Treisman (2000, p. 32). 87. Boycko et al. (1995, pp. 90–92). 88. Black et al. (2000, pp. 11–12). 89. Lieberman et al. (1995, p. 16). 90. Glinkina (2005, p. 299). 91. Lieberman et al. (1995, p. 16). 92. Morgenstern (1994). 93. Lieberman et al. (1995, p. 16). 94. Morgenstern (1994). 95. Lieberman et al. (1995, pp. 16–17). 96. Blasi (1994); Webster (1994). 97. Boycko, Shleifer, and Vishny (1995). 98. Glinkina (2005, p. 301). 99. Gurkov and Maital (1996). 100. Glinkina (2005, p. 302). 101. Shleiffer and Treisman (2000, p. 37). 102. Lieberman et al. (1995, p. 17). 103. Black et al. (2000, p. 11). 104. Inflation wiped out much of the savings of the middle class.

REFERENCES Anderson, R. (1994). Voucher funds in transitional economies: The Czech and Slovak experience. Policy Research Paper 1324. World Bank: Washington, DC. Black, B., Kraakman, R., & Tarassova (2000). Russian privatization and corporate governance: What went wrong? Stanford Law Review, 52, 1731–1808. Blasi, J. (1994). Russian privatization: Ownership, governance and restructuring. In: I. Lieberman & J. Nellis (Eds), Russia: Creating private enterprises and efficient markets. Washington, DC: World Bank.

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Blasi, J., Kroumova, M., & Kruse, D. (1997). Kremlin capitalism: Privatizing the Russian economy. Ithaca, NY: Cornell University Press. Blaszczyk, B., Gorzynski, M., Kaminski, T., & Paczoski, B. (2001). Secondary privatization in Poland (part II): Evolution of ownership structure and performance in national investment funds and their portfolio companies. Case Report No. 48. Center for Economic Research: Warsaw. Blaszczyk, B., & Woodward. R. (2001). Secondary privatization: The evolution of ownership structures of privatized enterprises. Case Report No. 50. Center for Economic Research: Warsaw. Boycko, M., Shleifer, A., & Vishny, R. (1995). Privatizing Russia. Cambridge: MIT Press. Coffee, J. (1994). Investment privatization funds: The Czech experience. Corporate Governance in Central and Eastern Europe: A Joint Conference of the World Bank and the Central European University Privatization Project, December 15–16, Washington, DC. Dado, M. (1998). The Slovak republic. In: I. Lieberman, S. Nestor & R. Desai (Eds). (1997). Between state and market: Mass privatization in transition economies (pp. 236–241). Washington, DC: World Bank. Desai, R., & Plockova, V. (1997). The Czech republic. In: I. Lieberman, S. Nestor & R. Desai (Eds), Between state and market: Mass privatization in transition economies. Washington, DC: World Bank. Duvivier, Y. (1997). Poland. In: I. Lieberman, S. Nestor & R. Desai (Eds), Between state and market: Mass privatization in transition economies. Washington, DC: World Bank. Gaidar, Y. (1999). Days of defeat and victory. University of Washington Press. Glinkina, S. (2005). Outcomes of the Russian model. In: J. Nellis & N. Birdsall (Eds), Reality check: The distributional impact of privatization in developing countries (pp. 297–324). Washington, DC: Center for Global Development. Grosfeld, I., & Hashi, I. (2001). The evolution of ownership structure in firms privatized through wholesale schemes in Czech republic and Poland. Case Report No. 49. Center for Economic Research: Warsaw. Gurkov, I., & Maital, S. (1996). Perceived control and performance in Russian privatized enterprises: Western implications. European Management Journal, 14(2), 166–166. Lieberman, I., Ewing, A., Mejstrik, M., Mukherjee, M., & Fidler, P. (1995). Mass privatization in central and eastern Europe and the former Soviet Union: A comparative analysis. Washington, DC: The World Bank. Lieberman, I., Nestor, S., & Desai, R. (1997). Between state and market: Mass privatization in transition economies. Washington, DC: World Bank. Lipton, D., & Sachs, J. (1990). Privatization in Eastern Europe: The case of Poland. Brookings Papers on Economic Activity, 1990(2), 293–341. Mejstrik, M., & Burger, J. (1992). The Czechoslovak large privatization. Working Paper 10. CERGE, Charles University, Prague. Morgenstern, C. (1994). Capital markets development and financing Russia’s transformation. In: I. Lieberman & J. Nellis (Eds), Russia: Creating private enterprises and efficient markets. Washington, DC: World Bank. Pohl, G., Jedrzejczak, G., & Anderson, R. (1994). Creating capital markets in eastern Europe: Lessons from market economies. Background Paper, Workshop on Creating Capital Markets in Central and Eastern Europe, Prague. Shafik, N. (1993). Making a market: Coupon privatization in the Czech and Slovak republics. Policy Research Working Paper 1231. World Bank: Washington, DC.

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Shleiffer, A., & Treisman, D. (2000). Without a map. Cambridge: The MIT Press. Stiglitz, J. (2002). Globalization and its discontents. New York: W.W. Norton & Company. Volgin, A., & Milner, Y. (1994). Investment funds and privatization. In: I. Lieberman & J. Nellis (Eds), Russia: Creating private enterprises and efficient markets. Washington, DC: World Bank. Webster, L. (1994). Newly privatized Russian enterprises: A survey. Working Paper. World Bank: Washington, DC.

CHAPTER 4 WHY IS CHINA SO DIFFERENT FROM OTHER TRANSITION ECONOMIES?$ William P. Mako and Chunlin Zhang China differs from most other transition countries in that its transition was not accompanied by a change in its political system. This basic difference has had wide-ranging effects on the methods adopted for the restructuring and privatization of state-owned enterprises (SOEs), corporate governance, and capital market development. The eventual resolution of contradictions in the initial transition in China’s SOEs will profoundly affect the future competitiveness of China’s enterprise sector.

1. DIRECTIONS In the mid-1970s, China’s economy had only two forms of public ownership: state ownership and collective ownership. In the agricultural sector, virtually all production was organized into collectively owned Production Brigades (villages) and People’s Communes (townships or groups). In industry, SOEs accounted for 80% of total industrial output, with the remaining 20% $

Views expressed in this chapter are those of the authors and should in no way be attributed to the World Bank, its Executive Directors, or the countries they represent.

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 173–203 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00004-6

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shared by urban and rural collectives. By the late 1990s, SOEs and collectives accounted for less than 50% of GDP (International Finance Corporation, 2000; p. 18). Transformation of the ownership of production has undoubtedly been one of the key components of China’s successful reform program. This has been achieved through combined efforts: privatization of agricultural production on collectively owned land; new entry of collectively owned industrial enterprises, especially township and village enterprises (TVEs), and their subsequent privatization; new entry of foreign-invested and domestic private enterprises; and ownership transformation of existing SOEs (Mako & Zhang, 2003). A typical pre-reform SOE was a stand-alone factory, wholly owned by the state. It had no corporate form, holding company or group affiliation, or shareholders. China initially divided responsibility for exercising stateownership rights in SOEs. First, ownership rights were exercised at every level of government. Depending upon an SOE’s size and location, national, provincial, municipal, or county officials exercise the state’s ownership rights. Second, at least until the establishment of state-owned assets supervision and administration committees (SASACs) since 2003, stateownership rights were shared by a wide range of government and party agencies. Thus, for instance, key actors would typically be a Communist Party working group on the hiring or firing of senior management; a Ministry of Finance (MOF) entity (e.g., a municipal finance bureau) on monitoring financial results and claiming profits; a planning entity on capital investment plans; and an economic commission on technological progress, product quality, and management improvements. Power was decentralized during the 1980s, both to SOEs and to local governments. Between the government and SOEs, SOE insiders (managers and employees) were increasingly granted managerial autonomy and allowed to share net earnings with the government in the form of explicit profit retention and bonuses. This system of managerial autonomy and profit sharing subsequently had significant effects on ownership transformation for several reasons. First, given typically inadequate monitoring of enterprises by Party and government officials, incumbent managers were often able to exercise effective control over their firms even prior to obtaining any legal ownership rights. Second, flexible sharing of enterprise earnings between the government and SOE insiders enabled SOE managers and employees to accumulate sometimes significant wealth, either as a result of good performance or government finance, including bank loans.

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Government decentralization was encouraged by implementation of a ‘‘fiscal contracting system’’ in the 1980s that made local governments residual claimants and delegated more decision-making power to local governments.1 Local governments entered into long-term fiscal contracts with higher-level governments. The nature of contracts varied across regions and over time. Typically, however, local governments were responsible for the revenue consequence of their economic policies – similar to the managerial autonomy and profit-sharing approach taken with SOEs. Fiscal decentralization strengthened local governments’ incentives and hardened their budget constraints, as also happened with SOEs. Competition among local government jurisdictions, a by-product of fiscal decentralization, had some heavy costs, notably local protectionism. Meanwhile, the Central Committee of the Communist Party of China (CPC) and the central government remained in a strong position to act as referee and to reward or punish local governments for their performance. All top local officials are de facto appointed by the central authority. All this has two somewhat contrary implications for the ownership transformation of enterprises. On the one hand, local governments are sensitive to the direct fiscal and social costs and to economic development opportunity costs from insufficient ownership transformation. While local governments must also be sensitive to the possibility that ownership transformation may hasten the recognition of hidden SOE losses (e.g., NPLs, unpaid worker pensions), inter-jurisdictional competition tends to strengthen the motivation of local governments in encouraging SOE ownership transformation. On the other hand, political centralization has meant that no government official can ignore ideological and political barriers and sensitivities regarding SOE ownership transformation. Government policies on ownership transformation have distinguished between large SOEs and small or medium SOEs. As early as 1987, the CPC permitted ‘‘some’’ small SOEs to be sold to employees or contracted out to private management. Around 1995, the CPC questioned the role of state ownership in the ‘‘socialist market economy’’ that had been identified as the objective of reform. As it had become increasingly clear that the government could not control every sector and all SOEs, it would have to decide which sectors and which SOEs to control. The formulation announced in 1995 was simple: ‘‘grasp the large and let-go the small’’ (zhua da fang xiao). Approved methods for ‘‘letting go’’ of small SOEs included the use of employee buyouts, sale to outsiders, reorganization, combination, leasing, contracting out, and joint venture (JV). In 1999,

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Table 1. Year

Overview of China’s SOEs, 1997–2003 (Assets in RMB Millions). SOEs

Central

Local

Assets Combined

1997 26,000 236,000 262,000 2003 19,000 127,000 146,000 Change (7,000) (109,000) (116,000)

Central

Local

Average Assets Combined Central

4,862,440 7,635,080 12,497,520 9,833,860 11,630,090 21,463,950 4,971,420 3,995,010 8,966,430

187 518 331

Local 32 92 59

Source: Finance Yearbook of China.

the CPC Central Committee reiterated this ‘‘let-go small’’ policy and extended it to medium-sized SOEs. These policies appear in changes in China’s SOE portfolio. Between end1997 and end-2003, the number of SOEs decreased by almost half, from 262,000 to 146,000 – a reduction of 116,000 (Table 1). Consistent with a policy to ‘‘grasp the large,’’ centrally administered SOEs decreased only from 26,000 to 19,000. By contrast, the reduction of 109,000 locally administered SOEs illustrates a widespread commitment to ‘‘let go’’ small and medium SOEs. Notably, average asset size for both centrally administered and locally administered SOEs nearly tripled during this period. This appears to reflect a combination of both intensive investment in fixed assets and policy-driven mergers and acquisitions (M&A) whereby healthier SOEs would take over distressed SOEs. For large SOEs, ownership transformation started with corporatization. In the late 1980s, while the contracting responsibility system was still China’s main enterprise reform strategy, China started experimenting with a ‘‘shareholding system’’ in a few large SOEs. In 1993, the Party’s Central Committee formally adopted corporatization (referred to a ‘‘building modern enterprise system’’) as China’s main SOE reform strategy. In 1997, the National Congress of the CPC called for a ‘‘strategic adjustment of the layout of the state-owned sector’’ and for ‘‘exploring multiple forms of public ownership.’’ In 1999, the Central Committee further decided to implement the following: (i) ‘‘withdrawal of the state’’ from certain sectors and enterprises, to be defined; (ii) ‘‘diversification of the ownership structure’’ of most SOEs; and (iii) sales of state-owned shares in listed companies to finance reform of China’s social security system. In late 2002, the Party’s national congress launched a major reform of China’s state assets management system. A centerpiece was the decision to

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concentrate state shareholder rights and responsibilities in (as appropriate) a new state-owned assets supervision and administration commission (SASACs) for centrally administered SOEs and local-level SASACs for locally administered SOEs. During the 1990s and beyond, the Party and government have consistently ruled out ‘‘privatization’’ as an option for SOE reform, preferring instead to speak in terms of ‘‘ownership transformation’’ and ‘‘ownership diversification.’’ A clear distinction can be made between insider-led and outsider-led ownership transformation.

2. METHODS Most of the issues with which the government is now grappling have arisen from management buyouts and initial public offerings (IPOs). While focusing on these two methods, this section also summarizes China’s innovative approach to administrative bankruptcy of SOEs.

2.1. Insider-Led Ownership Transformation Despite a lack of nationwide statistics or survey data, it does appear that insiders dominated ownership transformation before 2003. There are several possible reasons. First, compared with private ownership by outsiders, an enterprise jointly owned by its managers and employees is ideologically much closer to the notion of public ownership. Hence, insider-led transformation has carried lower political risk for officials who implement enterprise reform. Second, as indicated earlier, insiders (especially managers) had gained control in many SOEs prior to the start of ownership transformation. Hence, transformations that tended to legalize the de facto control of insiders more readily gained the support of enterprise insiders, which made implementation politically easier. Third, insider-led transformation has often been used as an opportunity to settle explicit and implicit obligations of the state toward SOE employees. Given the risk of larger employee layoffs in outsider-led transformations, insider-led may be easier to implement. Fourth, especially in the late 1990s, many SOEs were in such poor financial condition that it was difficult to attract outside investors. At the same time, these SOEs did not want to be liquidated. As a local government official noted, insider-led ownership transformation was designed to address the fears of three main constituencies: government

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officials’ fear of making political mistakes, managers’ fear of losing power, and workers’ fear of losing jobs. Insider-led ownership transformation of small/medium SOEs has typically resulted in a limited liability company with managers and employees as shareholders. Sometimes, small fractions of shares have been distributed to outsiders (e.g., retired employees, local officials) who have a close link to the firm or insiders. In the so-called first round transformation, which was very common during 1995–1998, shares were often distributed more evenly among managers and employees. This was later found undesirable. In the subsequent ‘‘second round transformation,’’ the concentration of shares owned by top management was often increased, for instance, through management’s purchase of existing shares from workers or of new shares. SOEs that underwent ownership transformation after 1998 typically went directly toward concentrated management ownership. In medium and large SOEs, the limited wealth of insiders has often been a binding constraint. Insiders may be able to afford only a minority stake in many transformed SOEs. Allocations of minority shares to insiders have often occurred at the time of corporatization. In addition, shares have sometimes been given to managers and employees as part of their bonus. For example, a large SOE was allowed (by the municipal government administering it) to distribute up to 25% of increases in the book value of the state’s ownership share to managers and employees in the form of shares. Through this method, insider ownership grew from zero in 1996 to 42% by 2001. A variety of other methods have been used as well to get around wealth constraints. E.g.,  Leasing. Large-value assets (e.g., land use rights, buildings) are sometimes excluded from the balance sheet in cases of SOE share sales to insiders. The transformed firm then leases the assets from the government. In some cases, the SOE’s entire assets are leased to the firm’s management or insiders, who become the assets’ owners after making specified lease payments.  Installments. The full purchase price of the SOE may be paid in installments, which are often based on projected profits from the transformed SOE.  Asset spin-off. In many cases, some SOE assets have been retained by the state shareholder in order to finance the state’s social obligations to SOE employees. For example, in one industrial city, the government commonly retained SOE assets (while reducing the SOE’s book value) to cover three obligations: RMB 8,000 for each redundant worker; RMB

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6,000 for each ‘‘senior’’ retiree; and RMB 12,000 for other retirees. Given flexibility in estimating social obligations, this method has sometimes been used to reduce SOE sales prices to fit the purchasing capacity of insiders.  Assets evaluation. To safeguard against the ‘‘loss of state assets,’’ SOE sales prices are supposed to be based on a formal assets evaluation authorized by the local authorities. Anecdotal evidence suggests, however, that local governments are often able to influence assets evaluations.  Liabilities assumption. In some cases of highly indebted SOEs, buyers have obtained ownership of firms simply by assuming existing liabilities, the so-called zero-price purchase.  Special credit. In more recent MBOs, since 2002–2003, insiders have overcome their own wealth constraints by borrowing from private – often informal – trust funds that lend money collected from individuals or institutions, perhaps including banks (Box 1).

Box 1. Trust Fund Financing. The Suzhou Fine Chemical Group was privatized through an MBO in May 2003. The Chairman and CEO acquired 90% and 10% of the group, respectively, from the Suzhou Financial Bureau for a total of RMB 125 million. The purchase was fully financed by a loan from a ‘‘trust fund,’’ with all shares pledged as collateral. A local accounting firm performed an assets evaluation prior to the sale. From a starting group book value of RMB 308 million, RMB 189 million was ‘‘spun off’’ (reduced) as compensation for non-performing assets and settlement of the status of employees. The final price resulted from application of an MBO discount, as stipulated by municipal government regulation. The Chairman and CEO were expected to repay the trust fund in three years from company profits, which need to reach RMB 72 million per year. In 2002, the year before the MBO, the group earned just RMB 38 million. Extra income was expected in 2005 from a piece of real estate that the group had just acquired with support from the municipal government. Employees participated in the transaction by subscribing to interest-bearing trust fund ‘‘units.’’ From five alternative ways to participate in the transaction, 90% of the group’s employees chose this trust fund option.

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Table 2.

Main Alternatives for Outsider-Led Ownership Transformation. Existing Shares

Majority shareholding Minority shareholding

Sale to domestic private firms and/or individuals Not common

New Shares Some join ventures Some joint ventures; IPOs

2.2. Outsider-Led Ownership Transformation Table 2 illustrates the main options for outsider-led ownership transformation. Sales of majority shareholdings to outside individuals or firms, JVs, and initial public offerings of minority shareholdings have been the most common. Sale to domestic private firms/individuals. In the simplest cases, small SOEs were sold to private firms or individuals. Despite the perceived dominance of insider-led transformation, this kind of sale probably accounted for a large portion of all ownership transformation cases. Some evidence indicates that sales to outsiders have become increasingly more important in recent years. A survey in six cities found that while sales to outsiders accounted for only 7.7% of all ownership transformation cases, such sales accounted for 23.5% of ownership transformations in 2002 (Garnaut et al., 2005). In many cases, relatively healthy SOEs or private investors have taken over distressed SOEs (through merger or acquisition) for restructuring. Such restructurings have had mixed results (Box 2). SASAC has said that any central SOE not ranked in the top three of its sector in 2009 will be ‘‘phased out.’’ Joint venture. China opened its SOEs to JV foreign investment at the very beginning of enterprise reform and ‘‘opening up.’’ During the period 1979–1994, 140,899 JVs were created in China, representing 53% of actual FDI (Li, 1995, p. 89). China has gradually come to accept foreign control in JVs. During the 1980s, JVs were typically controlled by the Chinese parent SOE, while wholly foreign-owned firms were less important in terms of total FDI. This changed in the 1990s, as new JVs were more often controlled by foreign investors and wholly foreign-owned firms became the biggest component of FDI.2 When a Chinese SOE invests most of its performing assets into a JV controlled by foreign investors, fundamental

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Box 2. Restructuring of Distressed SOEs. The Haier consumer durables group had taken over about 15 lossmaking SOEs in various provinces by the late 1990s. Despite central and local administration pressures to take over moribund companies, Haier was able to select companies that made good products, possessed good technology, and had a market – despite bad management. Haier was in a strong position to negotiate favorable terms to take over the debts and workforce of acquired SOEs. Sinopec was forced at the end of 1997 to take over two big petrochemical SOEs in Shandong province. The two SOEs, Zibo Chemical Fiber and Zibo Petrochemical – with 50,000 employees – had accumulated RMB 3 billion in debts, with assets of only RMB 1 billion. Sinopec estimated that the two companies needed at least RMB 1 billion in new investment in order to modernize obsolete production facilities. Part of the proceeds from Sinopec’s IPO was used for this purpose. To promote steel sector consolidation, market-leader Baosteel was forced (in 1998) to take over Shanghai Metallurgical Holding – a group with 10 times as many employees (120,000 workers, of whom 90,000 were employed in various non-steel subsidiaries and social services) and excessive debt. More recently, to promote consolidation of 200 steel producers in Hebei province, the provincial SASAC and the National Development Investment Company (under central SASAC) created a Southern Hebei Steel Industry Investment Fund, to be owned by existing steel company owners, that will become the largest shareholder in a New Handan Steel Group, itself to be charged with restructuring much of Hebei’s steel sector. Huanyuan Group, a relatively new SOE group created in Shanghai in 1992, became well known for acquiring and restructuring distressed SOEs. Its first wave of takeovers, which focused on textile SOEs along the Yangtze River, resulted in two IPOs. Around 1996, the group’s expansion turned to farm machinery, which resulted in a third IPO. Post-1999 failures in farm machinery, however, led Huanyuan to withdraw from that sector. Huanyuan’s acquisition of a large number of ailing pharmaceutical companies in 2002 had similarly disappointing results. All this was done with extensive bank borrowing. As of 2005, the Group reported RMB 43 billion in debt and returns on assets a disappointing 0.8%. In late 2005, central SASAC began discussions with two centrally administered ‘‘asset operations companies’’ (China Chengtong or China Resources) to take over and restructure Huanyuan.

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Delong Group, a well-known financial conglomerate, collapsed in May 2004. Starting from a film processing and ketchup business in Xinjiang province, two brothers acquired control in 6 listed companies and 170 non-listed firms. In August 2004, the asset management company (AMC) associated with Industrial and Commercial Bank of China was assigned to restructure Delong’s assets and to work out debts reportedly totaling RMB 20–30 billion. As of early 2005, media reports suggested that losses from Delong’s financial holdings could amount to RMB 7–10 billion, a reduction from initial estimates. In Chongqing, the local SASAC created an AMC (Yufu) in March 2004 to settle debts owed by local SOEs to banks. With a loan of RMB 2.2 billion from China Development Bank, Yufu acquired the debts with a book value of RMB 10.7 billion owed by 667 local SOEs to one of China’s four big banks. Debtor SOEs then settled their debts by transferring their land use rights to Yufu. Having become one of the largest land owners in Chongqing, Yufu diversified by acquiring shares in several listed companies. In Jilin province, as of mid-2006, it was estimated that the resolution of remaining distressed SOEs would cost RMB 10 billion. The provincial government put together a financing plan involving: (i) a state assets management company to manage the land occupied by these SOEs (similar to Chongqing’s Yufu land-for-debt model); (ii) purchases of SOE debts from banks and AMCs by the local government; (iii) bank financing; and (iv) a government budget allocation of RMB 0.2 billion. Source: OECD (2002), and press reports.

ownership transformation and operational changes take place. In legal terms, however, the old SOE (shell) remains an SOE, usually with poorly performing assets, redundant workers, and bad debts. In the more successful cases, the old SOE uses its earnings from the JV to finance restructuring of the old ‘‘shell.’’ For instance, China’s automobile industry is now dominated by JVs with global carmakers. In the case of Shanghai Automobile Group, its second-tier operating companies include about 60 JVs, which were mostly created by carving out the better-performing assets from old SOEs. Since 1995, the group has resolved about 20 SOE shells left over from JV transformations, with about 10 shells remaining as of 2003.

Why is China So Different from Other Transition Economies?

Table 3. Share Type

State

Typical Holder

SASACs

Legal persons Enterprises, domestic institutions ‘‘A’’ Individuals; investment funds ‘‘B’’ Foreigners; investment funds

183

Types of SOE Shares. Payment

Transferability

Average Allocation for Shanghai-Listed Companies 26%

Same as above

Not traded; sometimes transferred to legal persons at book value Same as above

43%

RMB cash

Tradable

28%

Foreign currency Tradable

3%

Buildings, equipment, technology, land, cash

Source: Based on Walter and Howie (2003, pp. 73–81, 104–105); Tenev and Zhang (2002, p. 84, 107); and authors’ estimates.

IPOs. While JVs have been the favored vehicle for attracting foreign equity investment, IPOs have served the same role vis-a`-vis domestic investors. The basic approach has been essentially the same. An old-style SOE would carve out its better-performing assets, ‘‘package’’ these into a public offering, and invite private investors to buy shares in the publicly listed subsidiary (package). But there have been two key differences. First, while JVs have mostly involved (foreign) firms, IPO buyers have mostly been (domestic) individuals. While private capital entered the publicly listed subsidiary, corporate control of the subsidiary typically remained with the state-owned old SOE i.e., the group, or ‘‘shell.’’ Second, to ensure continued state control, the creation of new shares for public sale and trading was accompanied by the creation of ‘‘non-tradable shares’’ to be retained by state-owned or controlled institutions. The variety of share types (Table 3) allowed under a 1992 ‘‘standard opinion’’ from the State Committee for Restructuring of the Economic System (SCRES) has subsequently complicated corporate governance.3 During the period 1990–2002, about 1,100 SOEs participated in initial public offerings (IPOs). This IPO activity peaked in 1994–1997 (Table 4). As also indicated in the following table, IPOs typically offered multiple types of shares. For instance, while non-tradable shares remained with the statedesignated shareholder and other legal persons, a public offering of tradable

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Table 4.

Overseas Shanghai ‘‘A’’ Shanghai ‘‘B: Shenzhen ‘‘A’’ Shenzhen ‘‘B’’ Total

Initial Public Offerings, 1990–2002.

1990–1993

1994–1997

1998–2002

Total

19 101 22 76 19 237

63 271 28 272 32 666

46 332 5 152 8 543

128 704 55 500 59 1,446

Source: Walter and Howie (2003, p. 121).

shares might include offerings of overseas shares (e.g., ‘‘H’’ shares in Hong Kong), and both ‘‘A’’ shares for locals and ‘‘B’’ shares for foreigners on the Shanghai or Shenzhen exchange. The key aforementioned features of SOE IPOs – heavy buying mainly by domestic retail investors and retention of state control, largely through the blocks of non-tradable shares – gave rise to numerous problems (see Sections 3.4 & 3.5) from which China is only now emerging.

2.3. Administered Bankruptcies To deal with troubled SOEs, the government created the ‘‘capital structure optimization program’’ (CSOP) in 1994 to administer SOE bankruptcies. SOE land use rights were to be used to satisfy obligations to laid-off workers and retirees. Thus, CSOP ‘‘linked the main off-balance liabilities of enterprises (pensions and severance, as well as other labor ‘rehabilitation’ entitlements stemming from the SOE employee status) to the main under-valued or offbalance assets (land use rights)’’ (World Bank, 2000, p. 2). During the period 1994–2004, CSOP resulted in 3,484 SOE bankruptcies, involving RMB 237 billion in bank debt write-offs and 6.7 million worker layoffs. In August 2006, after 12 years of drafting and discussion, the National People’s Congress adopted a new enterprise bankruptcy law. After intense debate on the sensitive issue of worker claims, it was agreed that secured creditors would have a priority claim to their collateral, except for worker claims incurred before August 2006 that could not be satisfied by other (i.e., non-collateral) assets. As for other distributions, this market-oriented law sets the following priorities: bankruptcy administrative costs; employees’ claims; all other social insurance and tax arrears; and other unsecured claims. As this new law takes effect on June 1, 2007, the CSOP program will

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phase out (with a final 2,116 SOE cases approved by the State Council in February 2006) and SOE bankruptcies will be governed by this new law and the same set of rules as for all enterprises.

3. CONTRADICTIONS The main methods for insider-led and outsider-led ownership transformation do seem to have done a lot to turn around an enterprise sector that was highly distressed as recently as 1998. Reliance on management/employee buyouts, reticence about consolidating power in a single state shareholder, and the practice of ‘‘packaging assets’’ for public share sales, however, gave rise to some serious contradictions – ‘‘loss of state assets,’’ fragmented responsibility, lags in SOE performance, shareholder expropriation and mistrust, poor corporate governance, and major distortions in China’s stock markets. 3.1. Loss of Assets In discussing privatization irregularities resulting in a ‘‘loss of state assets,’’ it is important to distinguish between hype and realty. There may be a tendency in China’s popular press to imply that reasonable post-privatization gains reflect shady dealings.4 That said, anecdotal evidence suggests that many SOEs have been acquired for less than fair value and subjected to asset stripping by insiders. Popular methods seem to have included sell-low-buy-high transactions with captive vendors, transfers of assets to new (captive) subsidiaries with remaining obligations stranded in the parent company, unwarranted management bonuses, interdiction of government compensation intended for settlement of worker claims, disguised MBOs via mysterious asset outflows to nominee acquirers, irregular loans to outsiders, parking of assets, and collusion with asset appraisers. One retrospective review of 60,000 privatization transactions involving RMB 200 billion in state assets found, as of end-2002, 1,035 fraud cases for which almost 1,200 people were punished.5 A public backlash against insider transactions and the ‘‘loss of state assets’’ erupted when a Hong Kong-based professor questioned acquisitions by a Guangdong-based private company of a number of SOEs. In an August 2004 speech, he claimed that ongoing privatizations (especially MBOs) had resulted in large losses of state assets to a small number of ‘‘capitalists’’ and SOE managers; that the current direction of privatization

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must be stopped; that SOEs can be run as efficiently as private firms, so long as the government hires professional managers and imposes fiduciary duties upon them; and that China’s SOE reform had suffered from ‘‘neo-liberal’’ thinking. These accusations met with overwhelming popular support. The few mainstream economists who disagreed were widely condemned and cursed in unanimous comments directed to internet chat rooms, while many other mainstream economists remained silent. SASAC eventually reaffirmed the government’s stance toward privatization ‘‘and pushing forward ownership transformation in a regulated way.’’

3.2. Fragmented Responsibility Prior to 2003, the governance of both centrally administered and locally administered SOEs was highly fragmented. For centrally administered SOEs, an ‘‘enterprise working committee’’ of the CPC central committee handled the appointment or dismissal of senior SOE management – the CEO, the chairman, and the firm’s party secretary. The MOF provided financial oversight. SOE accounts were audited by supervisory councils that reported to the state council. Decisions on technical upgrades and capital investments by SOEs required approval from the State Economic and Trade Commission (SETC), while the State Development and Planning Commission (SDPC) had to approve any financing of such capital investments. For locally administered SOEs, pre-2003 governance was sometimes more centralized in such major cities as Beijing, Shanghai, and Shenzhen. There might be some separation of regulation and ownership, and of governance and management. In some cases, a state asset management company would act as equity managers for locally owned SOEs on behalf of state asset management commissions designated as the official state owner authorized to exercise governance. In practice, state asset management commissions were often ‘‘virtual’’ and ceremonial, rather than professional. This created an ownership vacuum that encouraged ad hoc interventions by local government and party officials into the management of local SOEs. In practice, as a result of such fragmentation of authority and responsibility for SOE governance, SOE managers ended up having a lot of autonomy over SOE operations. As long as SOE managers avoided gross mistakes and preserved employment, they had wide latitude to run SOEs for the benefit of workers and management. While this was not necessarily the planned or intended result, the governance and management of China’s

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SOEs evolved into a style more akin to Yugoslavia’s ‘‘socially owned’’ enterprises. 3.3. Lagging Performance From a macro perspective, China’s SOE sector has seen a dramatic turnaround in the past decade. About 100,000 unprofitable SOEs have disappeared (merged, acquired, or bankrupted) since 1997 and the proportion of loss-makers has decreased from about two-thirds in 1997 to about half in 2002 (Table 5). Total losses from unprofitable SOEs still hovered around RMB 280 billion ($34 billion) in 2003. The financial position of SOEs has also improved overall, as indicated by lower liabilities/equity ratios and better working capital management – as indicated by steady overall reductions in inventories and receivables relative to sales. But pockets of SOE distress remain. When SOE equity is adjusted for ‘‘unhealthy assets’’ (e.g., uncollectible receivables, un-saleable inventory), it appears that provincial portfolios of locally administered SOEs are actually insolvent in China’s three northeast provinces and some interior provinces (World Bank, 2006). Problems of lagging SOE performance are highlighted by survey data on 8,332 firms – including a mix of small, medium, and large; private, stateowned, and foreign-invested; and high-tech, medium-tech, low-tech, and basic materials producers. Looking at net profits relative to fixed assets,6 the correlation between ownership and profitability is striking. For instance, among medium and large high-tech firms, returns on net fixed assets averaged 59–66% for foreign-invested enterprises (FIEs), 31–40% for private Table 5.

Profitability of China’s SOEs, 1997–2003 (Currency in RMB 100 Millions).

Year

Total Profit

Loss-Makers

Total Profit of Profit-Making

Total Loss of Loss-Making

1997 1998 1999 2000 2001 2002 2003

791.2 213.7 1,145.8 2,833.8 2,811.1 3,786.3 4,769.3

65.9% 68.7% 53.5% 50.7% 51.2% 49.9% na

na 3,280.2 3,290.7 4,679.8 4,804.7 5,588.8 7,589.1

na (3,066.5) (2,144.9) (1,846.0) (1,993.6) (1,802.5) (2,819.8)

Source: Finance Yearbook of China.

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Table 6. Firm Size/ Ownership Small Private SOE Foreign Medium Private SOE Foreign Large Private SOE Foreign

Relative to Net Fixed Assets, 2004.

High-Tech (%)

Mid-Tech (%)

Low-Tech (%)

Basic Materials (%)

36 17 55

39 15 58

29 8 16

37 9 44

40 4 66

31 1 70

22 26 14

29 19 46

31 8 59

29 5 49

17 6 18

25 9 31

Source: Mako and Shi (2007). This sample includes 1,084 manufacturers of medical and pharmaceutical products, electronic or telecommunications equipment, or instruments, meters, or office machinery (characterized as ‘‘high-tech’’); 3,416 makers of general machinery, special equipment, transportation equipment, or electrical equipment (medium-tech); 1,158 textiles or garments firms (low-tech); and 2,674 producers of raw chemicals or chemical products, chemical fibers, rubber or plastic products, metal products, or smelters or processors of ferrous or non-ferrous metals (basic materials). Medium-sized firms are defined as those with 100–500 workers. Of the firms surveyed, 70% are private, 22% are foreign-invested enterprises (FIEs), and 8% are state-owned enterprises (SOEs).

domestic firms, and from negative 4% to 8% for SOEs. Except for mediumsized low-tech firms, this pattern tends to prevail among the medium/large firms in the other sectors as well as among small firms (Table 6). While China’s basic materials producers (e.g., oil, steel, aggregates) have benefited in recent years from intense investment in fixed assets, other SOE manufacturers can find it difficult to make a profit. China’s manufacturers have excelled at providing the low-cost manufacturing capabilities for multinational firms’ global supply chains. SOEs have tended, however, to under-invest in the ‘‘soft’’ assets needed to enhance profitability. These include proprietary research and development, brand development, aftersales service, industry standard-setting, and supply chain integration (Steinfeld, 2004). The financial performance of SOEs is clouded, however, by continuing obligations to provide various social services and by ongoing government subsidies. For instance, in northeast China as of end-2002, SOEs ran 7,183 social service units (e.g., child care centers, primary and middle schools,

Why is China So Different from Other Transition Economies?

Table 7. Year

1998 2001

189

Compensation of Senior Management. RMB 60,000–200,000

WRMB 200,000

SOEs

Private

SOEs

Private

4% 8%

19% 28%

0.3% 0.9%

7% 12%

Source: Study cited by Watson Wyatt (2005, p. 7).

hospitals, recreational facilities, public security, and judicial organs), employing 140,000, and annually costing RMB 15.4 billion.7 While being reduced to meet WTO rules, subsidies to SOEs remain substantial. Budgeted subsidies to SOEs in 2003 totaled RMB 63 billion, down from RMB 104 billion in 2000. SOE performance is further clouded by inadequate financial disclosure. Reports of poor financial reporting are legion. A MOF audit of 320 SOEs in 2000 found that 57% misreported profits by more than 10%. A 2003 government audit of 152 firms (including 12 private firms) found that 82 had misreported profits by more than 10%. The most serious cases were almost evenly split between over- and under-statements of profits. Private firms were found to be weaker than SOEs in accounting and financial management. An audit of the State Power Group found that the group had under-reported its 1998–2002 profit by RMB 7.8 billion. Motives can be as varied as the misstatements themselves and may include efforts to manipulate performance-based compensation, to qualify the firm for an IPO or a debt/equity swap, to make local officials look good, or to reduce taxes. The ability of SOEs to attract top-quality graduates and managers has been hampered by constraints on the ability of SOEs to provide marketcompetitive compensation. For instance, surveys indicate that less than 5% of senior managers at SOEs earned at least RMB 60,000 in 1998 versus 26% of senior managers at private firms in China (Table 7). The situation has improved such that just 19% of senior managers at SOEs earned at least RMB 60,000 in 2001. But compensation still lagged behind that at private firms, where 40% of senior management achieved that level in 2001.

3.4. Expropriation of Minority Shareholders China’s initial approach to SOE IPOs created numerous opportunities for expropriating minority public shareholders. The previously described

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process of ‘‘packaging for listing’’ created as many as 1,100 situations where good-performing publicly listed companies were controlled by SOE groups suffering from bad assets, redundant workers, social service burdens, excess debt, unfunded pension liabilities, and – in at least some cases – unscrupulous management. In theory, many different types of related party transactions (e.g., rents, trademark fees, consulting fees, purchases or sales of materials) could have been used to suck cash out of listed companies to fund group or individual needs. In practice, groups found a simple and straightforward way to get the cash out of good-performing listed subsidiaries – they just borrowed it. A 2002 analysis of 115 listed companies found that 83% had made loans to state-controlled parent (group) companies. These borrowings by statecontrolled groups amounted to RMB 42.6 billion. In nine cases (e.g., Shougang (Capital Steel), Kelong Electric Appliances, Shenzhen Petrochemical), ‘‘loans’’ from the listed company exceeded RMB 1 billion. In most cases, the group had no plan – or only a leisurely 2–4-year plan – to repay its publicly listed subsidiary.8

3.5. Distortion of Equity Markets As noted earlier, state shares and legal person shares represented a large block of equity – accounting, on average, for about 70% of the shares of companies listed on the Shanghai Stock Exchange. These shares might occasionally be transferred to another legal person at book value (BV), but could not be traded. Opportunities for enthusiastic local investors to bid up prices for tradable shares resulted in large divergences in share pricing. For instance, November 2003 ‘‘A’’ share prices for China Eastern Airlines were 385% of the BV of non-tradable shares and 313% of the price of ‘‘H’’ shares set by moreskeptical Hong Kong traders (Table 8). In the case of China Eastern, nontradable state shares accounted for 62% of all shares outstanding, a reasonably typical (large) percentage. Poor corporate governance, expropriation of minority public shareholders, and a large overhang of non-tradable shares (which, if dumped, could expose retail investors to huge losses) combined to depress share prices for a prolonged period. From mid-2001 until mid-2005, when substantial corporate governance and equity market reforms began to take hold, the Shanghai Stock Exchange (SSE) index declined 60% (Fig. 1). The SSE’s decline continued even after the S&P500 bottomed in 2002–2003.

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Table 8. Segmentation of Share Ownership and Share Prices: Case of China Eastern Airlines, November 25, 2003.

Number shares (100 million) Ownership Share price US$ price

‘‘A’’ Shares

‘‘H’’ Shares

State Shares

3.00

15.67

30.00

6% RMB 4.17 $0.50

32% HK$ 1.28 $0.16

62% RMB 1.07 $0.13

Source: Walter and Howie (2003, p. 189).

SSE Composite Index

as of 15-Feb-2007

+150% 000001.SS

+100% +50%

^GSPC

0%

Billions

-50% 6.0 4.0

2002

2004

2006

Volume

2.0

0.0 Copyright 2007 Yahoo ! Inc.

Fig. 1.

http://finance.yahoo.com/

Shanghai Stock Exchange (SSE) Index Versus S&P500 (GSPC), 2000–2007.

4. RESOLUTIONS Since 2002, initial reforms by a new state shareholder have gone a long way toward addressing contradictions arising from the partial transition of China’s enterprise sector. Questions remain, however, as to whether these initial reforms will be sufficient, or whether there remains a need for a more fundamental change in the balance of power between the state and capital markets in providing financing, governance, and discipline to China’s large enterprises.

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Following decisions taken at the party congress in November 2002, the central government’s SASAC was formed from components of the tobe-disbanded SETC; the enterprise working group of the CPC central committee, and monitoring units from the MOF. Local counterpart SASACs were to be formed at the municipal and provincial government levels. Central SASAC was mandated to exercise the state’s shareholder rights, according to China’s company law and other regulations; to promote and guide the reform of SOEs and holding companies (groups); to designate boards of supervisors at SOEs; to appoint, dismiss, and set pay for the senior management of SOEs in its portfolio; to monitor and audit the value of state assets (equity); and to handle other ownership tasks, as directed by the government. The newly formed central SASAC initially focused on several priorities: A. Consolidating its portfolio of large SOEs; B. Adopting a more open approach to SOE ownership transformation; C. Gaining authority over the hiring and firing of management at large SOEs; D. Linking management compensation to performance, at large SOEs; E. Making SOE financial reporting more accurate; and F. Improving corporate governance.

4.1. Portfolio Consolidation When it was organized in early 2003, central SASAC’s staff of about 800 was to oversee 196 SOE groups, with about 11,600 subsidiaries and assets of about RMB 7,000 billion. As a result of mergers, central SASAC’s portfolio was reduced to 169 SOE groups as of August 2005. Various reports indicate that central SASAC would like to reduce its portfolio to 80–100 SOE groups. To consolidate its portfolio, central SASAC may make greater use of ‘‘asset operation companies’’ (i.e., holding companies) to manage smaller non-core SOEs and restructure distressed SOEs. Press reports indicate, for instance, that central SASAC had wanted its Chengtong Group to take over and restructure the ailing Huanyuan Group in late 2005, but that Chengtong was unable to arrange financing by China Development Bank. Efforts continue to spin off the social assets of centrally administered SOEs. In July 2005, the government moved to clarify policies regarding subsidies and transfers of social assets. Initially, 74 central SASAC SOE groups were involved and spin-offs of social assets were to be completed by end-2005.

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4.2. Privatization Reform In December 2003, SASAC issued two regulations on SOE privatization. These marked a shift in attitude from a passive stance to a more directive role in shaping privatization transactions, as well as a determination to lessen the advantages of insiders vis-a`-vis outsiders. Key points were the following:  An ownership transformation plan that contemplates the loss of state control must be approved by the relevant (e.g., municipal) government, not just by its SASAC.  Managers are prohibited from participating in decision-making on an MBO in which they are involved, borrowing from their own or any other SOE, or borrowing from banks using their SOE’s assets as collateral.  Any transfer of state ownership rights in a non-listed SOE must be conducted at a public property rights transaction center (PRTC). Many cities have one or more PRTCs. Any PRTC will do, not necessarily in the same region.  All transactions must be advertised and provide specified information in qualified newspapers and on the website of the relevant PRTC for at least 20 days ahead of the transaction.  Sales may be carried out through auction, bidding, or negotiated (sole source) sale, depending in part on the number of potential bidders. Since then, efforts have continued to fine-tune rules on MBOs. An October 2004 investigation into implementation of the December 2003 regulations in several provinces reportedly found weak enforcement, with many local governments still selling SOEs through a ‘‘black box process’’ rather than through open bidding at a PRTC. In November 2004, central SASAC made clear that large SOEs are not suitable for MBO. In December 2004, SASAC indicated that a manager found responsible for decline of an SOE’s performance would not be allowed to buy its shares. All sales of ownership stakes were to take place at a PRTC, with prices determined by competitive bidding and managers paying the same price as other buyers. In valuations, no deductions beyond those authorized by explicit government policies could be made to reduce an SOE’s book value. An April 2005 regulation by SASAC and the MOF banned MBOs for large SOEs and set more explicit rules for small/medium MBOs. ‘‘Management’’ was defined to include managers at the SOE in question as well as

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those of any parent firm. Managers bidding for an SOE would be required to explain the source of their funding, and acquisition through a trust or other intermediary would not be allowed. By February 2006, it appeared that small/medium MBO activity had significantly dropped off since the April 2005 regulation. Some suggested that SOE managers were ‘‘boycotting’’ MBOs until the latest ‘‘regulatory storm’’ had passed. Thus, SASAC seemed caught between responding to public concerns about losses of state assets and ‘‘letting go’’ small and medium SOEs. In Beijing, for instance, a proposed transformation of RMB 29 billion in state assets launched in September 2005 had found no takers as of January 2006. To avoid exposure to ‘‘MBO risk,’’ the Beijing SASAC relied on its own holding companies to formulate ownership transformation plans. The Beijing PRTC was entrusted to search for and negotiate with potential buyers. Frozen out of the process, incumbent managers reportedly became non-cooperative. Nationwide, however, SASAC’s initiatives appear to have had some effect. During the first half of 2006, 60 PRTCs all across China were reported to have transacted sales of state ownership stakes amounting to RMB 76.3 billion. According to one credible source, 80% of sales of state ownership stakes were now occurring via PRTCs.

4.3. Hiring and Firing As noted earlier, the hiring and firing of senior management at SOEs had traditionally been the prerogative of a designated party organ.9 Hence, it was a major departure when central SASAC began publicly advertising to fill some top management jobs at its large SOEs.  In September 2003, central SASAC advertised for six reasonably senior jobs (e.g., deputy CEO, chief accountant) at six of its large SOEs.  In June 2004, central SASAC again advertised for 23 openings, including for 11 deputy CEOs, at its large SOE groups. Press reports indicate that it received over 900 applications and that 22 of the openings were filled. Most of the new managers were from other SOEs. But a few came from non-state firms.  In May 2005, central SASAC advertised for 25 senior management jobs. Two of these were for CEO, which was a first for SASAC. Thus, it appears that central SASAC has gained more leverage over top management at its SOE groups. Reportedly, however, for the 50 largest of

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SASAC’s 170 SOE groups, the CPC Central Committee’s personnel department still grants final approval for the 3 top jobs: chairman, CEO, and party secretary – as these mostly hold ministerial rank. It is noteworthy that only 4 of the 22 hired in the June 2004 cohort came from non-state firms. This may indicate that positions at SOEs are not attractive to China’s top-flight managerial talent, which could raise longterm questions about the talent mix at SOEs and SOE competitiveness.

4.4. Management Performance and Compensation In mid-2003, SASAC set up rules for performance evaluation and compensation for senior managers at large SOEs in its portfolio. SOE managers (i.e., chairman, vice chairman, directors, CEO, deputy CEO, and CFO) are required to sign performance contracts with SASAC, establishing annual and 3-year performance targets for total profit, ROE, and growth in book value among other items. Each manager will be rated from A to E, with each rating carrying a 0–3 coefficient to determine total salary (with bonus) relative to a pre-determined base salary. At a February 2004 working conference, central SASAC indicated that senior managers of large SOEs would be subject to a new pay scale ranging from RMB 100,000 to RMB 1 million. Various reports suggested that average salaries would range from RMB 250,000–350,000. As of end-2004, central SASAC had signed performance contracts with the managements of 30 SOE groups. These groups reportedly promised to deliver gains of 10.5% appreciation in net assets (book value) and 8.4 annual revenue gains over the next two years. In August 2005, central SASAC announced annual performance evaluation results for its 179 SOE groups. On the above-mentioned A–E scale, 25 were rated as A, 141 as B, and 13 as D or E. D or E ratings indicated that the SOE’s management had failed to fulfill their performance targets and that management would receive no bonus. Managers at A-rated SOEs could receive bonuses up to three times the amount of their base ‘‘performance salary.’’ Management contracts are not a new idea. Past efforts in China to use management contracts to improve SOE performance have encountered various issues (Shirley & Xu, 2001). Among other issues, a near-term emphasis on growth in profits and net assets may discourage investment in soft or intangible assets (e.g., brand development, after-sales service, proprietary R&D, supply chain development, and management capacity)

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needed to increase profitability and sustain competitiveness over the long term. Thus, it may make sense for SOE performance contracts to include some firm-specific qualitative performance indicators as well as quantitative financial performance indicators. In apparent recognition of such considerations, central SASAC indicated in mid-2006 that it had added technological innovation as an additional metric by which SOE management performance would be evaluated.10 By mid-2006, statistics indicated that 72 centrally administered SOEs had managed to increase labor costs faster than sales revenue. Central SASAC’s 12 most profitable SOE groups, which accounted for 79% of the total profit of central SASAC SOE groups in 2005, showed the highest labor cost increases as well. In the case of China Mobile, for instance, its 2005 average labor cost was RMB 123,600 – 5–6 times higher than the national average. This partly reflected central SASAC policies allowing for higher pay increases in cases of profit growth or profitability gains.

4.5. Financial Reporting Soon after its establishment, central SASAC launched a program to clarify and verify financial data of its portfolio companies. This program was expected to be completed in late 2004 and pave the way for implementation of new accounting rules. In another noteworthy development, China Chengtong Group became – in June 2005 – the first non-listed SOE to publish its annual report, in this case its 2003 annual report. In announcing this, the group’s chairman explained that ‘‘SOEs are ultimately owned by the people, and therefore higher transparency and more disclosure of SOEs are important for people to monitor SOEs.’’ He also suggested that SASAC require all SOEs to do the same thing gradually.

4.6. Corporate Governance Both central SASAC and the China Securities Regulatory Commission have made various efforts to improve corporate governance at SOEs, both wholly state-owned and publicly listed. Apparently reflecting its desire to develop a more ‘‘normal’’ model of SOE governance and transition from active involvement to corporate overseer, central SASAC mandated in February 2004 that all centrally

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administered SOEs – including those that are 100% state-owned – should be governed by boards of directors as of early 2007, later extended to end-2007. An experiment was started in June 2004 to establish boards of directors at seven 100% SOEs (including China Chengtong Group) by end-2004 and at 20–30 SOEs by end-2005 was delayed as a result of difficulties in selecting independent directors.11 It may indeed be a challenge to find, hire, and train several hundred independent (and non-conflicted) directors with the requisite expertise in marketing, production/operations, and finance. The central SASAC chairman has promised to transfer more power to SOE boards of directors as they set up and operate according to modern corporate governance standards. Meanwhile, the CSRC made notable gains in 2004/2005 toward protecting minority public shareholders and reforming China’s equity markets. Earlier, the CSRC had established rules that one-third of the directors on the board of a listed company should be independent and that independent directors would be required to approve any connected transaction before a motion for approval could be submitted to the full board. A corporate governance code promulgated by the CSRC (about 2002) mandated the disclosure of directors and supervisors for listed companies, of their performance, attendance by independent directors and their votes on proposed connected transactions, as well as the establishment of board committees (e.g., audit, compensation). To protect minority holders of tradable shares, the CSRC published a draft regulation ‘‘Some Rules Concerning Strengthening Protection of Rights of Social Public Shareholders’’ in September 2004. The key innovation was a proposed new voting mechanism giving greater clout to the holders of tradable shares over a number of issues recognized as important: (i) issuance of additional shares or convertible debt; (ii) acquisition of assets exceeding 20% of a company’s book value; (iii) use of a shareholder’s shares to repay debts owed to the listed company; (iv) an IPO in a foreign jurisdiction by a subsidiary of the listed company; or (v) other important issues impacting the interests of ‘‘social public shareholders.’’ Approval of such important issues requires a majority of both all shares represented at a shareholders’ assembly and all tradable shares represented at a shareholders’ assembly. The initial implementation of this rule for minority shareholder protection produced some startling results. In December 2004, a proposal to issue additional shares in a department store in Chongqing was defeated by public shareholders representing just 2% of the total votes (shares) in attendance at a shareholders meeting. In April 2005, another connected

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transaction supported by the large shareholders of Tianjin-based Baili Electronics was defeated by just one shareholder representing less than 1% of total shares. Despite the increased importance for independent directors and controls on connected (related party) transactions, a residue of mistrust from past expropriations remains. In several cases, corporate restructuring transactions have been undertaken to eliminate one corporate party – either the parent or the sub – and thereby eliminate the possibility of any related party transactions between the two. Such corporate restructuring transactions have variously involved IPOs, shares-for-debt swaps, and ‘‘going private’’ transactions (Box 3). At a February 2004 working conference with local officials, central SASAC encouraged the parent companies of SOE groups to prepare for IPOs whenever possible, to eliminate the risk of parent-sub connected transactions that might harm public shareholders. As for shares-for-debt swaps, some believed that this model could be applied to other listed companies. Others worried, however, that such transactions might create a new path for controlling shareholders to siphon cash from their listed subsidiaries. As noted earlier, the continuing large overhang of non-tradable shares and an aborted attempt in 2002 to eliminate or reduce this overhang exerted a prolonged dampening effect on China’s stock markets. In October 2005, the National People’s Congress approved numerous amendments to China’s Company Law. Amendments to allow a ‘‘piercing of the corporate veil,’’ cumulative voting for directors, and derivative suits responded to past governance issues. In April 2005, the CSRC promulgated a plan to encourage conversions of non-tradable (NT) shares into tradable shares. Basically, holders of tradable shares would have to be compensated for the dilution resulting from the conversion of NT shares into tradable shares. Conversion plans put forth by boards of directors would have to be approved both by 2/3 of all shares present at a shareholders meeting and by 2/3 of the tradable shares present at the shareholders meeting. The CSRC suggested a minimum ‘‘lock up’’ period for the (major) holders of newly issued tradable shares. None of the new tradable shares could be sold during the first 12 months after conversion. During the period 13–24 months after conversion, holders of new tradable shares could sell a maximum of 5% of these shares. At most, another 10% could be sold during months 25–36. The boards of several companies immediately made proposals to convert NT shares. Several were rejected by tradable shareholders for lacking

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Box 3. Corporate Restructuring Transactions to Eliminate Related Parties. IPO. In early 2003, the Guangdong-based consumer electronics manufacturer TCL completed an IPO in which it absorbed its listed subsidiary. TCL is probably the first SOE-turned listed company that does not have a non-listed SOE ‘‘shell.’’ Shares-for-debt swap. In July 2004, China Securities Regulation Commission (CSRC) and SASAC approved an experiment to be implemented in selected companies known as the ‘‘shares-for-debt’’ experiment. In cases where controlling shareholders had borrowed heavily from listed companies, shares in the parent could be exchanged for debt owed to the listed subsidiary  The first ‘‘shares-for-debt’’ swap was concluded in September 2004. Prior to that, the Hunan Broadcast and Television Center controlled 50.3% of its listed company. The parent also owed the listed company RMB 539.2 million. To repay that debt, the parent agreed to reduce its holding in the listed subsidiary to 35.9%. Shares in the listed company were priced at a 0.4% premium to their book value. At the shareholders’ assembly, 12 shareholders representing 56.1% of total outstanding shares attended, of which 5 shareholders represented tradable shares accounting for just 1.85% of the total shares outstanding. Representatives of 98% of ‘‘non-related’’ shares and 94% of tradable shares voted in favor of the debt for shares proposal. The deal was later approved by the CSRC and SASAC.  In November 2004, Northern China Pharmaceutical (NCP) announced a transaction whereby controlling shareholders would give up their shares to repay group debts to listed subsidiaries. In a change from the Hunan TV deal, NCP Group shareholders sold some of their shares to a Dutch strategic investor and used the sales proceeds for cash payments to listed subs. Following this transaction, shareholdings in NCP were about 30% with insiders and 8% with the strategic investor, with the remainder hold by small retail investors. ‘‘Going private.’’ Sinopec surprised the market in February 2006 when it announced a share buy-back program, instead of paying public shareholders to support conversions of non-tradable shares into tradable. Sinopec instead moved to spend RMB 14.3 billion to buy back shares in four of its listed subsidiaries, from other shareholders, at

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10–14% premiums on the 52-week high. The stated objectives included integrating the subs better into Sinopec’s overall business structure and eliminating related-party transactions and competition between Sinopec and the four subsidiaries. Shares to be bought back represented 18, 15, 29, and 74% of the four subsidiaries’ shares.

sufficient protections and/or inducements. The first conversion plan to be approved by holders of tradable shares (on April 10, 2005) was put forth by the board of Sanyi Heavy Machinery Group. This conversion plan offered additional free shares to holders of tradable shares; set a minimum price for eventual sales of newly converted tradable shares by majority shareholders; and provided for a longer lock-up period. In June 2005, the CSRC had authorized an additional 42 companies to propose plans for converting NT shares into tradable shares. Shortly thereafter, the CSRC chairman announced that there would be no third batch of NT share conversions.12 Rather, lessons learned in the previous pilots would be quickly implemented at all listed companies. As of May 2006, over 70% of listed companies had completed their ‘‘share reform’’ – the conversion of non-tradable state shares into tradable shares. Thus, a market-based solution was found for a policy-based problem. This resolution of the NT share overhang may have some far-reaching benefits. By creating at least the theoretical possibility of a hostile takeover, the managements of listed SOEs may become more responsive to capital market discipline, desires for transparency, and corporate governance best practices. Indeed, in a media interview in fall 2006, the SASAC vice chairman supported more international IPOs (on the A+H shares model) on the basis that international equity markets would help encourage SOE adoption of international best practices in corporate governance and help SASAC to monitor the performance of its SOEs. In August 2006, the CSRC issued a regulation on the takeover of listed companies. This new regulation revised rules to reflect widespread conversions of non-tradable shares into tradable. By making a general call to tender shares optional rather than mandatory, it appeared that the regulation was intended to encourage takeovers. Meanwhile, more transparent stock market pricing of SOE shares (after NT share conversions) will make it easier for central SASAC to rely on the judgment of equity investors (and resulting share prices) – rather than on easily fallible management contracts – for evaluating management performance at its large SOEs.

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As 2006 drew to a close, the State Council General Office distributed a set of ‘‘guiding opinions’’ prepared by central SASAC. Intended to inform the ‘‘layout’’ of state ownership among sectors and enterprises, this document suggested that state capital is still scattered in too many sectors and enterprises. State capital should be concentrated in sectors crucial to national security and the national economy.13 This is the first time over the past two decades that an officially accepted boundary for state control of industrial sectors has been specified. The document also sets other targets for transition of China’s SOE sector. These include accelerating the emergence of some large conglomerates that are internationally competitive, with self-owned IPR and established brand names; making joint stock companies the ‘‘main form of public ownership;’’ liberalizing most small and medium SOEs; completing ‘‘policy oriented’’ SOE bankruptcies by 2008; and reducing the number of SOE groups under central SASAC’s control to 80–100 by 2010. China’s wide ranging use of experiments, pilots, and expediencies to promote SOE reform since the late 1980s calls to mind two aphorisms by Deng Xiaoping. The first is that feeling for stones with one’s feet can be the best way to cross the river. The second is that a cat’s color does not matter, so long as it catches mice. Over the coming years, we may expect China’s remaining SOEs to become increasingly agile at crossing rivers and – while neither fully capitalist nor fully socialist – to become more adept at catching mice.

NOTES 1. This is close to ‘‘federalism with political centralization’’ described in Blanchard and Schleifer (2000). 2. The share of wholly owned foreign-invested enterprises (WOFIEs) in actual FDI inflow increased from 3.5% in 1984 to 37% in 1990 and to 62% in 2001 according to official statistics. 3. For an insightful discussion of the 1992 standard opinion and its conceptual origins, see Walter and Howie (2003, pp. 73–81). 4. One city in Shandong province began privatization to insiders relatively early, in 1992. According to a recent newspaper account, privatization had been successful in that most privatized firms subsequently experienced ‘‘rapid development,’’ with annual growth rates in excess of 10%. The Shandong newspaper goes on to suggest that there are believed to be more than a dozen people in one small city worth more than $12 million and several hundred worth more than $125,000. From a crosscountry perspective, however, experience from Central and Eastern Europe suggests

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that such growth rates are entirely natural and one of the main ex ante rationales for privatization. 5. In one case, a group of managers who had bought out an SOE for RMB 6 million was found guilty of hiding almost RMB 11 million in state assets during the valuation process. 6. This measure is intended to provide a clearer focus on efficiency of innovation. For instance, according to this measure, it does not matter whether a firm does a good job or a bad job at managing its accounts receivable, inventory, and accounts payable. 7. Shao Ning, Vice Chairman of the State-Owned Assets Supervision and Administration Commission (SASAC), International Conference on Revitalizing Northeast China, Dalian, 25 September 2004. 8. The largest shareholder: Easy to borrow but difficult to pay back. undated, mimeo. 9. This, however, has not precluded the appointment of some foreigners as directors on the boards of some large state-majority enterprises listed on the Hong Kong Stock Exchange. 10. It was pointed out that over 40% of SOEs lack registered trademarks for their main products. SASAC described the weaknesses of centrally administered SOEs as ‘‘manufacturing without innovation, innovation without IPR, IPR without application, and application without protection.’’ 11. According to press reports in mid-2006, difficulties in finding and recruiting appropriate external directors led central SASAC to make most appointments from among the cadre of retired SOE managers and to appoint chairmen who would also serve as full-time executive directors – rather than splitting the chairman and CEO functions, as had originally been contemplated. 12. He also indicated that future IPOs should not include non-tradable shares. 13. In other forums, these have been identified as military industry, power grid and generation, oil and petrochemical, telecoms, coal, civil aviation, and shipping.

REFERENCES Blanchard, O., & Schleifer, A. (2000). Federalism with and without political centralization: China versus Russia. Working paper 00-15. MIT, Cambridge, MA. Garnaut, R., Song, L., Tenev, S., & Yao, Y. (2005). China’s ownership transformation: Process, outcomes, prospects. Washington, DC: International Finance Corporation. International Finance Corporation. (2000). China’s emerging private enterprises: Prospects for the new century. Washington, DC: International Finance Corporation. Li, L. (Ed.) (1995). Basic knowledge of China’s utilization of foreign capital. Beijing: Foreign Trade Press. Mako, W., & Shi, A. (2007). Innovation behavior of firms in China. Mimeo. Mako, W., & Zhang, C. (2003). Management of China’s state-owned enterprises portfolio: Lessons from international experience. Beijing: World Bank, www.worldbank.org/cn Organization for Economic Cooperation and Development (OECD). (2002). China and the world economy: The domestic policy challenges (Vol. I). Paris: OECD.

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Shirley, M., & Xu, L. (2001). Empirical effects of performance contracts: Evidence from China. Journal of Law, Economics and Organization, 17(1), 168–200. Steinfeld, E. (2004). Chinese enterprise development and the challenge of global integration. In: S. Yusuf, M. A. Altaf & K. Nabeshima (Eds), Global production networking and technological change in East Asia. Washington, DC: World Bank and Oxford University Press. Tenev, S., & Zhang, C. (2002). Corporate governance and enterprise reform in China: Building the institutions of modern markets. Washington, DC: World Bank & International Finance Corporation. Walter, C., & Howie, F. (2003). Privatizing China: The stock markets and their role in corporate reform. Singapore, Asia: Wiley. Watson Wyatt. (2005). Study on SOEs performance management and compensation. Beijing, processed. World Bank. (2000). Bankruptcy of state enterprises in China: A case and agenda for reforming the insolvency system. Washington, DC: World Bank Publication. World Bank. (2006). China: Facilitating investment and innovation: A market-oriented approach to Northeast revitalization. Report No. 34943-CN. World Bank, Beijing, www.worldbank. org/cn

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CHAPTER 5 PRIVATIZATION IN ROMANIA FROM 1989 TO 2007 Dick Welch In the decade before the collapse of communism, Romania was poor though industrialized with many firms that could not survive in a modern market economy. It had also passed the post-war years under an unusually repressive communist regime that was brought to an end on Christmas day in 1989 when the dictator Ceausescu was executed. The transition to democracy in Romania, however, was slowed by the presence of many excommunist politicians and functionaries in the early governments of the 1990s. As will be seen, the road to economic reform and to a successful privatization was a rocky one and it was not until the end of the 1990s that the economy began to recover and privatization moved forward successfully. In the early years of privatization in Romania, that is, between 1991 and 1998, a number of inefficient privatization techniques were tried, e.g., joint ventures, management buyouts, investment funds, vouchers in these funds, an inefficient tender program, and all were either unsuccessful or produced modest results. Not only were privatization techniques found wanting but also government commitment was lacking. It was not until the end of the 1990s that the government, under heavy pressure from a faltering economy, a looming foreign exchange crisis and a critical IMF, World Bank and E.U., agreed to an effective economic program, with a substantial and transparent privatization program for banks and industrial firms. The privatization

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 205–220 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00005-8

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initiative proved successful, the major failing bank was closed and further bank privatization and major sales of large state industrial firms were successfully undertaken in the early years of this century. By 2005 significant progress had been made in privatizing the major utilities (gas and electricity), as well. By then, the privatization of the industrial sector was drawing to a close, although significant numbers of firms, to far gone to successfully privatize, were still on the government’s books. All but one state bank had been sold. There is little question that Romania’s successful attempt to enter the European Common Market, with the E.U.’s insistence on deep reforms, was a major factor in the success of the privatization program. In the last two years, the privatization program has slowed and it will be interesting to see whether the privatization of the remaining utilities continues now that Romania is in the E.U. The structure of this chapter is to follow the progress of privatization in Romania using the activity of the World Bank through its structural adjustment lending in the country as a guide. The World Bank’s lending program was closely tied to structural reform in Romania, particularly to reform through privatization in the series of private sector adjustment loan (PSAL) loans in the late 1990s and early 2000s. These loans and the pressure for reform from the international agencies and the E.U. were key to the privatization program.

1. ECONOMIC BACKGROUND, 1990–1996 The first step in the reform of the Romanian enterprise sector after the collapse of communism was the commercialization of state enterprises. This was completed by 1991. Two types of enterprises were established: regies autonomes and commercial companies. The regies autonomes were legal entities with the social capital owned by the state. This legal status was restricted to enterprises that were ‘‘natural monopolies or of public interest or essential for national defense and security.’’ The governance of regies autonomes of national importance was the responsibility of the ministries, while the governance of regional regies autonomes was devolved to local authorities. The commercial companies were mainly joint stock corporations and about 6,300 of them were incorporated between 1990 and 1991. Their social capital was split between the state-ownership fund (SOF) and five private-ownership funds (POFs, latter called PIFs). Table 1 presents the structure of state holdings at the beginning of privatization in 1992.

Privatization in Romania from 1989 to 2007

Table 1. Legal Form Regies autonomes Other state companies Corporatized companies Of which: 100% state Mixed Cooperatives Communal services Total

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State Ownership in 1992, by Legal Form. Percent of Firms

Percent of Employment

4.8 2.0 83.9 75.7 8.2 8.8 0.7 100.0

20.7 1.0 72.2 69.6 2.6 5.9 0.1 100.0

Source: Romanian Enterprise Registry, 1992.

As can be seen from the table, corporatized state companies, which were in principle those companies deemed to be commercial, represented just over 70% of state companies, based on employment, and the regies about 20%. By 1995, state enterprises still accounted for about 69% of employment and output in Romania. This figure had dropped to less than 40% by June 1998. Industrial sector output fell by half between 1989 and 1992 due to the collapse of the Council for Mutual Economic Assistance (CMEA) and the drop in trade with the former Soviet Union. Industrial production increased by an average of about 2% per annum in 1993–1994, and grew faster during 1995–1996. However, due to the lack of significant economic reform, industrial production fell by 6% in 1997 and 17% in 1998.1 The profitability of state enterprises declined from 15% of revenues in 1990 to 5% in 1993 and to 0.6% in 1994. The real financial situation of the state-owned enterprises (SOE) sector was substantially worse. On a cash flow basis, the state enterprise sector generated an aggregate negative operating cash flow of around 6% of GDP. To continue operating, loss-makers financed operations through arrears to suppliers, the state, the banks and, sometimes, workers. The government’s first reaction to the accumulation of arrears was to net out the stock of arrears with a Global Compensation Scheme (Law 80 of December 1991). Credit was injected into the economy in early 1992 by bank financing extended to debtors who used the proceeds to pay down arrears. However, arrears continued to accumulate in spite of the government’s commitment not to undertake further compensation schemes. In 1994–1995 payment arrears amounted to an astounding 23.3 and 24.4% of GDP, respectively, increasing to 28.3% by 1997.

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Measures were taken throughout the period to improve financial discipline in the enterprise sector. A new bankruptcy law was passed in May 1995, which included a stay on collection actions against a debtor on the initiation of proceedings. Yet the main factors in preventing the reduction of losses from state corporations were (i) the lack of progress on privatization, workout, and liquidation of state commercial corporations; (ii) the continued presence of state banks that would finance their losses; and (iii) the ongoing presence of governments that tolerated and financed losses in both the regies and commercial state sector.

2. PRIVATIZATION, 1990–1996 To undertake privatization, the government established an institutional framework under Law No. 58/1991. The National Agency for Privatization was created to develop privatization strategy and monitor and control its implementation. Initially, the agency played an active role in launching the privatization process by starting the first pilot privatizations and organized the early auctioning of small assets. By 1994, however, the role of the agency had been limited to its supervisory and regulatory roles. The SOF was established in June 1992 and started its operations in October. It was the majority shareholder of all commercial companies, with a 70% stake in each of them. The SOF’s initial objective was to divest itself of its holdings over the course of seven years. POFs were established in 1992, although the state retained some control over them. Each POF was given 30% of the commercial companies’ shares, either on a sector or on a regional basis, on behalf of the population, and 15.5 million certificates of ownership vouchers in them were distributed to Romanians. The POFs performed like closedend stock funds with limited liability and, at the end of five years, were expected to convert themselves into mutual funds, although this did not happen. The mandate of the funds contained the conflicting objectives of portfolio maximization and rapid divestiture. This contradiction, coupled with the political nature of their leadership, resulted in their excessive concentration on portfolio management at the expense of privatization. The main methods used for privatization between 1990 and 1994 were joint ventures, pilot privatization of selected companies, and management employee buyouts (MEBOs). Later, all methods of privatization were used, but the results were still not encouraging. By the end of 1996, about 2,716 commercial companies were privatized of which only 69 were large enterprises.

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There were several reasons for this poor performance. First, the statemanaged, top-down approach to privatization was inadequate, considering the sheer number of commercial companies involved. However, privatization proceeded fairly quickly with small commercial companies, thanks to the bottom-up, demand-oriented, standardized approach that was subsequently adopted. Second, the maintenance of close ties between medium and large commercial companies and branch ministries (despite the loss of their ownership function), the insistence on considering privatization within the framework of comprehensive industrial policies, and the desire to restructure commercial companies prior to privatization slowed the program. The SOF was also slowed by the misgivings and nostalgia of branch ministries. Third, the SOF management was too preoccupied with maximization of the proceeds of sales of commercial companies and by the belief that restructuring should be done before privatization. Moreover, the SOF did not use best practices, resulting in botched and lost sales. Finally, there was a lack of leadership and political will to implement privatization. In response to the disappointing privatization performance, the government decided to issue and distribute a new type of privatization voucher (called privatization coupons) under a mass privatization program. These coupons, together with the existing certificates of ownership, represented 30% equity in state-owned companies. However, this rearrangement of holdings in state enterprises not only did not accelerate privatization or improve the management of state companies but rather made case-by-case privatization needlessly complex. By October 1997, only 11% of the capital stock of Romania’s enterprise sector had been privatized, a shocking record for over six years’ work. The scope, pace, and accomplishments of Romania’s privatization compared unfavorably with many of other countries in transition. Thus, earlier legislation governing privatization was extensively revised. All legal provisions were consolidated into a single law, Emergency Ordinance 88/ 1997. However, between May 1997 and June 1999 the authorities modified the legal framework governing privatization at least 15 times. While each new amendment was superior to the one it superseded, it further slowed privatization. In 1997, the World Bank worked with the government and other institutions to help get the economic program and privatization back on track. One of the results of this was the Bank’s 1997 Financial Enterprise Structural Adjustment Loan’s (FESAL) program and its conditionalities.2 Romanian pricing and trade was liberalized. Against a target of 3,600 SOEs, more than 4,000 were privatized.3 The corporatization of utilities was

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started and companies prepared for privatization. A minority equity share of the telecommunications company was sold in early 1999. Obstacles to new enterprise creation were removed and more than 300,000 were registered. The entry of ‘‘greenfield’’ firms was an important signal in all transition economies that the business environment had improved. There was significant downsizing of loss-making enterprises and a reduction in their labor force, particularly in mines. The government enacted legal regulations to strengthen the prudential, supervisory, and enforcement capabilities of the national bank (NBR). Other important components of banking infrastructure were created, i.e., a payments system, deposit insurance, banks’ chart of accounts, and a credit-risk information bureau. All of these developments had a salutary effect on subsequent reform efforts, although their earlier absence complicated the ability to effectively implement reforms under the FESAL. Belatedly, privatization of state banks began in late 1998 and early 1999 (Romanian Bank for Development and Bancpost). However, the overall objectives of the enterprise-restructuring program were not achieved, in particular with respect to components of privatization, utility restructuring, and the closure of loss-making state corporations. This was due to the resistance of labor unions and other vested interests, as well as the lack of a political commitment to achieve program objectives. The legal framework and the judicial system also proved inadequate, in particular with regard to expediting the liquidation of non-viable firms. The bankruptcy law proved hopelessly cumbersome and slow to apply. Most of the state corporations eventually liquidated were closed by order of the SOF. Restoration of financial discipline in enterprises was not successful. To impose a hard budget constraint on enterprises placed under surveillance, the initial program placed a cap on the financial support available from the state, the SOF, and the banks. The caps were too generous, and enterprises were able to renegotiate their debts with their creditors without undertaking cost-cutting measures. Table 2 shows privatization from 1993 to 1998 in Romania by company size. The number of large company privatizations appears more impressive than it is. The SOF classified large companies as those with a social capital of over about US$2 million and, thus, many firms classified as large are really medium in size. There were still a significant number of large, important firms that had not been privatized, including large firms in the steel, aluminum, oil, transportation, and all the network industries, except for the partial privatization of telephone. While not shown in the table, foreign participation was very low, averaging 1% and never exceeding 2%

Privatization in Romania from 1989 to 2007

Table 2.

211

Privatization Results: 1993–1998a.

Company Size

1993

1994

1995

1996

1997

1998

Total

Small Medium Large Total

239 24 2 265

771 134 15 860

1,031 404 44 1,479

2,010 640 69 2,719

2,930 797 105 3,832

3,823 4,066 784 8,073

10,804 6,065 419 17,288

a

SOF and government sources.

of privatizations in any year. This was particularly troublesome as one would have expected a higher level of foreign interest in Romanian firms, and the lack of foreign participation led to a lack of strategic buyers with modern technology and ready access to capital and markets. In the World Bank’s recent study of the Bank’s program in Romania, the report states, ‘‘Despite the large volume of Bank assistance in the 1990s, progress in market reforms was slow, and development outcomes were unsatisfactory during this period. The government’s unwillingness or inability to implement reforms is the main reason.’’4 By the end of 1998, the economic situation of the government reached a crisis point and the World Bank and the IMF intervened with significant lending programs with tough conditions on privatization, including bank restructuring and privatization, as well as other economic reforms. The existing government made a serious and successful effort to implement these reform conditions and this was continued by the succeeding government that took power in 2000. The following sections outline the successes of the new policy thrust and political commitment on privatization in Romania.

3. WORLD BANK PSAL LOAN, 1999–2000 In the fall of 1998, partly in response to the crisis economic conditions, the World Bank started planning a PSAL5 to replace the FESAL. Its private sector development and financial components focused on bank restructuring and privatization and the sale of large, important state-owned companies in aluminum, steel, and air transport, as well as the workout and liquidation of significant loss-makers. Because of the indifferent performance of the SOF in these fields in the FESAL, steps were taken to link better the privatization process to government (cabinet) and to provide adequate financing for the retainer fees of investment banks and workout firms through allocation of

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part of the $25 million PIBL (technical assistance loan) that accompanied the PSAL. The latter was particularly important, as adequate financing would allow the SOF to hire internationally reputed investment banks to undertake the important privatizations and would both attract foreign strategic buyers and, add more clarity, competition, and transparency to the process. The government realized that the success of reform depended on the progress of privatization and the elimination of financial support to nonviable, loss-making firms and the development of a sound banking system. The persistent decline in the economy was recognized as a consequence of delays in structural reform. The reform program was expected to have a broader base of support in recognition of the insufficiency of past structural reforms. Important objectives of the PSAL program were to provide $300 million in balance-of-payments support and facilitate and accelerate the privatization, workout, and liquidation of large firms. Sixty-nine large enterprises were to be privatized or worked out by investment banks and other financial agents, 200 privatizations done using the RASDAQ (stock exchange), 850 privatizations of large, medium, and small firms undertaken from the SOF portfolio, and two large state banks privatized and one closed. These actions were designed to enhance the private sector’s role in the economy and put public finances on a more sustainable path. By pursuing accelerated enterprise privatization and reform, the PSAL put corporate restructuring at the top of the political agenda in recognition of performance weaknesses under the FESAL. These reforms were considered necessary for financial sector reforms to be effective, and for macroeconomic stability to be restored. To help accelerate privatization, parliament passed a new privatization law in agreement with the World Bank. The government adopted new norms, in consultation with the bank, to implement this law which permitted the use of sales agents, forbade setting minimum sales prices, required the provision of adequate warranties, improved administrative liquidations, and contained provisions for debt workout and forgiveness of state debt. Between January 1, 1999 and May 31, 1999 another 30 large companies and 250 medium-size enterprises were privatized. These measures, which included politically sensitive companies and sectors, sent a clear signal that the government was committed to changing ownership, management, and governance. For large SOEs, a program of case-by-case privatization, liquidation, and workout was initiated. The goals of this program included: (i) reducing

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payment arrears to utilities and the budget; (ii) supporting financial sector restructuring by reducing arrears; (iii) eliminating of the fiscal and quasifiscal costs of supporting loss-makers; (iv) enforcing hard budget constraints; (v) increasing industrial efficiency by attracting new investment and new owners; and (vi) providing a credible signal to the market that reforms were being pursued in Romania. Using international tenders, the government hired investment banks to privatize the national airline (TAROM) and two significant aluminum companies (ALRO and ALPROM). Investment banks and workout firms were also hired to privatize five other large companies and to work out five more. The government agreed to the privatization of at least 30 large companies through the use of five pools of companies each tendered by international sales agents. Because of the poor condition of many of the large firms and the low value of many of the smaller ones, firms were offered in pools to attract sales agents. About $10 million was allocated from the $25 million PIBL to support the overall program. In addition, the government selected an international investment bank to privatize at least 35% of the total capital of SNP Petrom, including new shares. Unfortunately, the sale was a failure largely because the government did not offer a control block of shares. (Petrom was successfully privatized in 2003.) Under PSAL, the SOF undertook more privatizations and liquidations for small- and medium-sized firms and sale of shares on the stock exchange. These were successful in privatization of a significant number of small and medium enterprises. In the second tranche of the PSAL, the government continued with the privatization of an additional 600 small- and medium-sized firms, representing 14.5% of the number of remaining enterprise in SOF portfolio. By the end of the program, 850 small- and medium-size companies had been privatized. Box 1 presents some thoughts arising from a study of the effects of several sorts of privatization opposed to no privatization at all on Romanian labor productivity from 1992 to 1999.

4. WORLD BANK PSAL II LOAN, 2001–2003 After significant and accelerated progress in 1999, during which nearly 1,500 SOEs were privatized, Romania still had more than 2,150 SOEs remaining in state hands at the beginning of 2000. This high degree of state ownership in the economy, combined with continued state ownership of the largest

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Box 1. Some Thoughts on the Efficiency of Privatization in Romania. A study published in 2002 laid out the results of an econometric analysis of firm data regarding the effects of privatization versus continued state ownership on firms in Romania. The study was undertaken using a large database of company data from Romania covering the period 1992–1999. The findings of the analysis showed strong evidence that privatization has had positive and substantial effects on the growth of firm labor productivity in Romania. The most effective owners were outside owners, that is, private sector buyers, who have purchased state firms in privatization. Inside owners, e.g., MEBOs and voucher participants, who obtained state firms, have had a much weaker effect on labor productivity, although the effect was positive. Continued state ownership has had a negative effect. Source: Earle, J.S., & Telegdy, A. (April 2002). Privatization methods and productivity effects in Romanian industrial enterprises. Working Paper No. 02-81.

banks, continued to perpetuate an ineffective incentive structure that undermined economic competitiveness and hindered growth. PSAL conditions had helped reverse these weaknesses and putting the enterprise sector on the path to recovery and competitiveness. Privatization under PSAL II was aimed at the divestiture of the largest public sector industrial and commercial loss-makers from the government portfolio and improvement in the regulatory framework and capacity in key energy and power sectors. It also focused on the privatization of public utilities. While significant progress in privatization had been made under PSAL, and a number of major privatizations had been begun with the hiring of international investment banks and financial advisors, a number of key privatizations had not been completed. It was then decided to continue the completions of the PSAL privatizations under the new PSAL II, while adding more large-firm privatizations and continuing the rapid progress that had been made on medium and smaller firms. While the extent of privatization and restructuring of SOEs under PSAL had been impressive, nonetheless, there were still about 600 SOEs yet to be privatized. Therefore, under PSAL II6, the government proposed to finish the privatization program begun under PSAL, namely the large enterprise privatization. It signed a privatization deal for its steel mill, SIDEX, in July

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2001 with a strategic investor and focused on the privatization of the remaining large companies, such as ALRO and ALPROM aluminum producer and fabricators. It also committed to the privatization of TAROM, the state airline, although this later failed. Furthermore, it committed to the privatization of eight more large firms and the workout of another five. Finishing earlier privatization of pools of companies and starting new pools, carrying out privatizations and liquidations of small and medium firms was also given priority. A further element was the government’s commitment to reform in the banking system. Bancorex, the county’s largest, and insolvent, bank had been closed while Banca Agricola was to be put up for sale and the biggest government-owned bank, Banca Comerciala Romana (BCR) considered for subsequent sale.7 Finally, the government had committed to make significant privatizations in the energy sector and the privatization of gas and electrical distribution was to be started. The PSAL II was in the amount of 339.8 million Euros with two tranches: the first, to be disbursed at the time of loan effectiveness; and the second floating, to be released after the conditions in the loan agreement were completed. PSAL II had, in line with the government’s commitment to privatization, a number of objectives. First was the elimination of state ownership of banks for full privatization of the banking sector (i.e., BCR, CEC), although this would not be fully completed under PSAL II, and strengthening financial intermediations and financial sector modernization. The second was the divestiture of the large industrial and commercial firms for the government’s portfolio with continued stress on privatization transactions undertaken under competitive and transparent conditions along the lines proposed by the government above. The third was the continued sale of the small and medium companies left in the privatization portfolio. The fourth, and last, was the reduction of the quasi-fiscal situation in the field of energy utilities. The successful sale of Petrom to strategic international buyers was planned, with the introduction of modern legal, regulatory, and institutional framework to encourage private sector competition of network industries and undertaking reform of the power sector for efficiency, reliable service, fair pricing, and proper regulatory oversight. Some components of the PSAL programs were finished more quickly than expected and a few could only be fully completed under the programmatic adjustment loan (PAL) series of loans that followed the two PSALs. The privatization sales of Petrom took longer than expected and BCR was not sold until 2005. The sales agreement for Petrom was signed in July 2004 and

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was the principal reason for the delay in the closure of PSAL II. Other energy sector privatizations also took longer than anticipated.8 Overall, however, the privatization progress under the two PSALs was impressive. By 2004, the major government firms in the industrial sector had been privatized, e.g., steel, aluminum, automobiles, petroleum to strong, international strategic buyers, and in a wide range of other industrial sectors, significant progress had been made in banking with the biggest bankrupt closed and the rest of state banks either privatized or on the road to privatization. And, finally, significant steps were being taken to privatize utilities. Specifically, the two gas distribution companies had been put to tender and international strategic buyers found and the first two of the total of eight electrical distribution companies, too, had found international strategic buyers.

5. PAL ADJUSTMENT LOANS: 2004–2007 PAL 1 was the first of a series of three PALs designed to support the government’s reform program over the period to 2007 and came after the two PSALs. The World Bank documentation describes the loan as follows:9 The current privatization program focuses on manufacturing and infrastructure SOEs. The privatization focus of the two previous structural adjustment loans (PSAL and PSAL II) was on reducing the role of the state in manufacturing and banking and in the second adjustment loan, PSAL II, a program of infrastructure privatization was launched. The government plans to complete privatizing SOEs in manufacturing and the energy sector (electricity and gas) to privatize the last two commercial state banks and has closed the state privatization agency, APAPS. Residual firms that are to be liquidated or that are under court procedures have been transferred to a new agency AVAS. This transfer consolidates the portfolios of the old asset management company AVAB with that of APAPS in a manner that streamlines the privatization and liquidation processes. Best practices for transparent and competitive privatization procedures will be followed for these privatization sales.

Specifically relating to the energy sector in Romania, the World Bank documentation stated the following:10 In July 2003 the government approved and published a strategy – The Road Map for the Energy Field – or the development of the energy sector with the focus on gas and electricity sectors. The strategy has short-term (2003–2004), medium-term (2005–2007) and long-term (2008–2015) dimensions. One of the means for implementing the strategy is the privatization of state-owned oil, and gas and power enterprises. The privatization of the national oil and gas company Petrom as well as the gas and power distribution companies was launched under PSAL II. Over the course of the PAL program the other

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gas producer, Romgas, the remaining distribution companies as well as three large power generation companies will be privatized.

The approval of PAL 1 took place in the fall of 2004 and upon the completion of a number of conditions laid out in the loan. For privatization, the conditions had been:  The offering for sale by the AVAS (privatization agent) a number of companies in their portfolio and the sale of holdings on the Bucharest Stock Exchange; and  The hiring of an investment bank to privatize the last state bank, CEC. (The BCR bank already had an investment bank to sell it dating from a previous unsuccessful sale.) The plan in the proposed three PAL loans was to start working with the government on fulfilling the conditions of the next proposed loan, PAL 2, once the first loan was in place with the target of assuring the second loan targets were on track the following year. The PAL 2 privatization targets were ambitious, specifically:  Selling of liquidation the bulk of the remaining privatization portfolio for industrial firms. Most of these firms were of small or medium size and were generally in poor condition and difficult to sell;  Privatizing the remaining two large state banks, BCR and CEC;  Continuing with the privatization of the electrical distribution companies and selling three more, for a total of five of the eight companies. And, as well, hiring investment banks to sell the last three;  Offering for sale three electricity-generating complexes; and  Hiring an investment bank to sell Romgas, the second gas producer in Romania. The proposed privatization component for PAL 3 was largely concerned with finishing the privatization proposed in the earlier two PALs and bringing to a close the majority of the privatization in Romania. The sale of the electrical distribution companies and the three generation complexes would be completed. Hidroelectrica would be sold, all or in parts and the sale of Romgas completed. Thus, at the end of PAL, the industrial sector of Romania would be in private hands, as well as the energy sector. The sale of the remaining shares in the fixed-line telephone company was under way in 2006 (although the sale has been put on hold in a dispute with the investment bank hired to do this sale), and the only important sectors of

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saleable infrastructure still in government hands would be in the transport sector. While the second PAL has not been put in place as of the end of 2006, BCR bank was sold in 2006. CEC bank was brought to market in 2006 and received a number of offers. Negotiations with and a second offer by the leading bidder was not accepted by the government and it announced shortly thereafter that the government would keep CEC in state ownership and make further investments in it as a state bank. Two more electrical distribution companies were sold but no sales of the three generation complexes have taken place and Romgas remains in state hands. Sales and liquidations in the AVAS portfolio continue as part of its ongoing mandate. It now seems clear that the second and third PALs will not be made nor will the parts of the privatization program foreseen in them unless the government moves forward on its own initiative. The government has announced in the press at various times that it will move forward on Romgas and the remaining distribution and generating companies in the electricity sector but little progress has been made and we note the volt face in the banking sector with the commitment to keep CEC as a state bank.

6. CONCLUSION In spite of the slowing of privatization in the last two years, Romania has made good privatization progress since 1998. Almost its entire state-owned industrial sector has been privatized and the companies that are left are largely in such a poor condition that they cannot be sold and are destined for liquidation. In infrastructure, a promising start was made on the privatization of the electricity industry, at least so far as electricity distribution goes. Gas distribution has been privatized and part of the gas production industry was sold when Petrom (a producer of oil and gas) was privatized. The state telephone company has been sold although the government still has a large minority holding. The state banks have been sold or closed with the exception of the savings bank, CEC. No privatization has been done on rail and ports or post office activities. The national airline has not been sold (although there was a try several years ago) and airports are still in state hands. While there has recently been an initiative to sell smallholdings in important state companies in the infrastructure sector through IPOs, such a program is aimed at strengthening the local stock exchange and is not a serious privatization program.

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Table 3 shows the rise in GDP growth from 1997 to 2006 and the growth of the private sector as an increasing percentage of GDP. Foreign direct investment (FDI) is also shown and the low levels of FDI can be noted until 2003 when it started to take off, in part due to good privatization receipts and in part due to Romania’s growing attractiveness as it approached membership in the E.U. (January 1, 2007). Romania’s figure for the private sector share of GDP is in the mid range of formerly communist transition countries, as can be seen in the Table 4 below. Its modest performance is probably a result of two factors: low FDI up until recently and an unfinished privatization program. Privatization then can be seen as a positive success story. After a particularly slow and troubled start, Romania was able to regain lost time near the end of the 1990s and undertake a substantial privatization effort over the following decade. The role of foreign institutions, particularly the IMF, the World Bank, and the E.U., in encouraging, assisting, and financing the program is clear. What is not so clear now is the future of privatization in Romania over the coming decade. Romania and the IMF

Table 3.

GDP Growth and Private Sector Share of GDP.

Measure

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

GDP% %Private sector FDI (B Euro)

6.1 60 1.3

4.8 60 2.1

1.1 60 1.0

2.1 60 1.1

5.7 65 1.2

5.1 65 1.1

5.2 65 2.2

8.4 70 6.4

4.1 70 6.6

6.5 70 8.7

Source: EBRD Statistics.

Table 4. Transition Country Czech Republic Hungary Estonia Slovakia Latvia Lithuania Poland Romania Russia Serbia

Selected Transition Countries, 2006. Private Sector as a % of GDP 80 80 80 80 75 75 75 70 65 55

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have had serious disagreements over the IMF’s advice to Romania. The latest World Bank country strategies for Romania show a considerable diminution in privatization as an economic tool. With its accession to the E.U., Romania may be under less pressure from this institution to reform. Government commitment may have waned. While the progress of the European Common Market with its emphasis on deregulation and opening markets will put competitive pressures on Romanian industry, including state industries, it is an open question whether Romania will continue on the successful privatization path of the last few years.

NOTES 1. The data in these sections come from government and World Bank sources. 2. Material in this section comes from World Bank sources. 3. Most these were small- and medium-sized firms. 4. World Bank (2005a). 5. Material in this section comes from World Bank sources. PSAL and PSAL II were structural adjustment loans focused on privatization and bank reform. 6. World Bank (2005b). 7. This and the following paragraphs are based on material in the April 2002 World Bank MOP. 8. World Bank (2005a). 9. PAD, August 15, 2004, The World Bank. 10. Ibid.

REFERENCES World Bank. (2005a). Romania – Country assistance evaluation. Report Number 32452, May 25, Washington, DC. World Bank. (2005b). Romania – Second private sector adjustment project. Report Number 32653, June 16, Washington, DC.

CHAPTER 6 BALKAN LATECOMER: THE CASE OF SERBIAN PRIVATIZATION Mirko Cvetkovic, Alexander Pankov and Andrej Popovic 1. INTRODUCTION Two factors explain why the Serbian privatization experience deserves close attention from outside world. First, Serbia’s starting conditions for privatization, with a historical tradition of workers’ management, strong trade unions, and an ambivalent initial attitude toward privatization, have as much in common with circumstances surrounding privatization in the developing countries as with those in the so-called economies in transition. Second, Serbia embarked on a resolute privatization path only in 2001, following more than 10 years of diverse privatization efforts in other post-socialist economies of the region. This makes Serbia a perfect case study of how a country can learn from the experience (both positive and negative) of other reformers. This chapter is comprised of two main parts. The first half is meant to give the reader a factual background, including the conditions at the start of privatization process, legal and institutional framework, and the short chronological outline covering past six years. The second half examines in more depth Serbia’s efforts to resolve the large, loss-making industrial conglomerates that presented the largest challenge to the government. As authors hope to show, Serbia’s experience with problems of financial discipline, debt restructuring, labor shedding, and the use of bankruptcy Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 221–260 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00006-X

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instrument all present important lessons for policy makers and students of privatization around the world. Throughout the chapter, the authors make a special effort to demonstrate the complex workings of the political economy underlying the privatization process.

2. STARTING CONDITIONS FOR PRIVATIZATION IN SERBIA Privatization in Serbia formally started in 1989 with the adoption of the Privatization Law in the Parliament of Socialist Federal Republic of Yugoslavia (SFRY). The law was prepared and supported by the reformist Federal Government led by then Prime Minister Ante Markovic. General reformist atmosphere and the privatization law itself were the evidence that the authorities officially recognized and accepted the fact that the concept of private ownership was superior to that of any other type of collective ownership. However, the population did not share the same enthusiasm and perceptions. During the previous decades, Yugoslavia was able to provide a relatively high standard of living to its citizens by utilizing its non-aligned policy. Therefore, the public perceived the proposed privatization as an undesired process done under international pressure, rather than the real need of the economy. The law was designed to produce a massive and rapid insider privatization by offering capital at a book value, partly free of charge and partly at a huge discounts and repayment in installments. This approach was more or less in line with voucher privatization, widely recommended to transition economies at that time. Unfortunately, in the early 1990s SFRY entered into the period of great political instability, resulting in armed conflicts and ultimately its disintegration. Serbia’s attempts to preserve the federation brought it political and economic isolation, including UN-imposed economic sanctions. The Kosovo conflict and subsequent NATO bombing in 1999 meant continued disruption to economic activity and resulted in significant damage to country’s capital infrastructure. The last decade of the twentieth century was marked by continued and considerable decline of Serbian economy, mainly as a result of political disintegration, wars, loss of internal and external markets, isolation from technological advances, and continued dominance of socially owned enterprises. Strangely enough, the privatization process officially never stopped, while privatization models were changed in line with political needs and popular

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expectations. The 1990s were marked with three major changes related to privatization process: (i)

First, after the country had formally disintegrated the Serbian Parliament adopted the new (Serbian) privatization law to replace the one adopted by SFRY Parliament. In its nature, the new law was very similar to the previous one, but was less favorable to citizens. Namely, the discounts and the number of installments were reduced. The signal was that privatization was not strongly supported by the government, while the new law was being implemented in the period of great macroeconomic instability. The inflation was growing at an increasingly high rate, resulting in one of the highest inflation rates ever recorded in the world economic history in 1993. At the end of the period, the daily inflation rate was at some 100%. Since the law provided that revaluation and adjustment of installments were made on annual basis, many people opted for last-minute premature repayment just before the mandatory revaluation. It was, therefore, possible to acquire an enormous value of capital for a handful of dollars. (ii) As a result, in 1994 the Serbian Parliament adopted new privatization regulation aimed at nullifying the inflation gains. This was not a new privatization law, but rather a new approach to revaluing the installments. The peculiar feature of the new regulation was that it was applicable not only to the future but also to the past installments. The consequences of the regulation with retroactive clauses included virtual nullification of nearly the entire previous privatization program conducted under the Serbian Law. At the same time, the citizens were given a strong signal that privatization was not on the agenda of the economic policy. (iii) Finally, in 1997 the Serbian Parliament adopted a brand new privatization law, changing the previous model. The new law was offering a majority stake of 60% to employees and general population free of charge. Further, 10% was earmarked to be transferred to the retirement fund, and 30% was offered for sale to insiders under a discount and in installments. The important feature of the new law was a five-year ban on secondary trading of the acquired shares. The effect of the new law was much more diffused ownership structure with no possibilities for concentration of capital in the short run. Therefore, management was given huge rights while it was subject to very little control. There were no incentives for improving corporate governance, or introducing strategic partners and fresh investments to the companies.

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The government appointed after democratic changes in 2000, inherited enormous problems in the enterprise sector. Main characteristics and sources of the problems included: (a) the legacy of social ownership; (b) destructed and devastated economy; and (c) huge expectations by the population from the new democratic authorities. Social ownership is an ownership management system quite different from central planning. Essentially, the problem is in its peculiar feature granting the workers and managers of socially owned enterprises the benefits of ownership, entitling them to the residual income as wages, but also shielding them from many of the risks faced by owners in the market-based systems, including any potential liabilities and losses, which tended to be socialized. Social ownership has also led to under-investment as workers tried to maximize the funds available for distribution of wages. There was a widespread attitude that the workers alone should be credited for their companies’ good financial performance, but if the performance was poor, then the society, or more precisely the government, was expected to take responsibility for the failure and cover the losses. In a way, each socially owned enterprise was too big to fail. Therefore, the popular perception of social ownership has been, and to a degree still is, positive. Once one of the most prosperous countries in the region, a leader in industrial production, productivity, living standards, and GDP growth, Serbia has in only one decade (1990–2000) become economically devastated and a poor country. As opposed to social, educational, health, cultural, and other aspects of life, the economic performance is much easier to quantify. Economic indicators demonstrate disastrous effects of the legacy of the 1990s. For example, GDP level in 1999 was only 46.9% of that in 1990, while industrial production and wages and salaries were at 39.5% and 33% for the same period, respectively.1 It would be fair to conclude that Serbia has entered the new century as a devastated country, both economically and socially. Immediately after the democratic changes of 2000, the population was very supportive of the idea of comprehensive reforms and European integration. In the first elections after a decade of authoritarian rule by Slobodan Milosevic, the democratic coalition won more than two-thirds of seats in the parliament. The new government was initially endowed with considerable popular support necessary to start with necessary reforms. The support, however, was tightly connected with unrealistic expectations of immediate and huge improvements in living standards. Temporarily

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defeated, the members of the former regime laid low, waiting for their chance to come back.

3. THE FACTS – STORY LINE OF SERBIAN PRIVATIZATION IN 2001–2006 After the establishment of a broad coalition government in early 2001, Serbia’s pursuit of desperately needed reforms could commence. The new government was a coalition of 19 parties, led by Prime Minister Zoran Djindjic, with a broadly accepted reform mandate, but inherently fragile given a large number of parties with very diverse interests. Among countless issues the new government had to deal with, privatization was one of the most pressing priorities as it was widely perceived as necessary for releasing assets held by inefficient and politically driven state and socially owned enterprises into productive use, thus strengthening the foundations of the emerging market economy. Therefore, after over half a century of socialist rule and absence of market-based economy, the Government of Serbia had in 2001 embarked on an ambitious and competitive privatization program. The goal of Serbian privatization was to transfer ownership from state-owned and socially owned companies to the private sector, which would ensure new corporate governance and contribute to real sector efficiency, thus fueling Serbia’s economic growth. Additionally, privatization also served as a key instrument for attracting foreign capital necessary for revitalization of Serbian economy. While designing the privatization framework, the Government of Serbia has taken into account the vast privatization experiences of other East European countries in transition during the 1990s. This was the major factor playing to the government’s advantage, allowing it to learn from their mistakes and focus on implementing best practices. Based on that experience, the government has opted for a politically unpopular method of direct sale of majority stakes in state-owned and socially owned companies to the highest bidders and strategic investors in a transparent competition through auctions and tenders, over widely used voucher system implemented in most other transition countries in Eastern Europe in which the shares would get distributed to citizens free of charge or for a nominal fee (Box 1). The chosen method meant that the privatization process would last longer, given the longer preparation periods necessary to make the companies fit to face the market.2 Finally, the government has also envisaged that the portion of

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Box 1. Direct Sale vs. Voucher Privatization. Despite the fact that direct sale was lengthier and more complicated process than voucher system, in the longer run it would ensure better recovery of Serbian economy, and this was a good decision for at least four reasons: first, voucher privatization would merely transfer ownership to citizens without ensuring substantial change in management practices, which was needed to ensure efficiency and profitability; second, there would be no, or very limited, inflow of desperately needed capital to repair the dilapidated infrastructure, revive production processes, and ultimately increase productivity; third, the absence of developed capital markets would inhibit voucher holders ability to sell their securities to individuals/entities who could use them most productively; and fourth, there would be no or very limited revenue impact to the state budget. At the end of the day, voucher system would only formally change the ownership structure, without really transforming these entities into productive and market-oriented enterprises. Ultimately, this has proven to be a good strategy. According to a report from 2005 financed by European Agency for Reconstruction titled ‘‘Impact Assessment of Privatization in Serbia’’24 companies privatized under 2001 Law have generally improved their financial performance and have invested in modernizing their production process, while companies privatized to employees based on 1997 Law showed on average poorer financial results and lacked significant investments in modernization. Additionally, the cases where the employee shares were later bought by major shareholders (i.e., investment funds or strategic investors) showed much better performance than those with employee ownership, thus demonstrating the inferiority of the employee ownership privatization.

the capital subject to privatization does get transferred to both employees and other citizens through distribution of free shares.

3.1. Legal and Institutional Basis for Serbian Privatization The Privatization Law of 2001 created a legal and institutional framework for disposal of state-owned and socially owned capital. The law stipulated

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three methods of privatization: (1) Public tenders for large enterprises, offering to a strategic investor 70% of the capital. Employees had the right to receive up to 15% of the capital through free shares, whose total nominal value amounted to 200 euros per year of service, for a maximum of 35 years of service. After this initial distribution is completed, the remaining shares (15%) were to be registered with the privatization registry for eventual distribution to other citizens. The goal of this process was to offer more attractive companies to reputable strategic investors, and thus spark the inflow of foreign direct investments (FDI) and subsequent technology transfers. (2) Public auctions of majority ownership of small- and medium-size enterprises, with up to 30% of shares being distributed to employees, with the same total nominal value threshold of 200 euros per year of service. All remaining shares not distributed to employees under this scheme were to be transferred to the share fund for eventual sale. Auctions were foreseen as an efficient instrument for disposal of the bulk of small and medium enterprises, bringing simplicity, transparency, and speed to the process, as well as maximizing potential revenues. The law also provided for some flexibility in the process aimed at encouraging, or at least not discriminating against the local investors with limited resources, by allowing that in addition to cash, individuals (Serbian citizens only) were entitled to finance their acquisition in up to six annual installment rates. Additionally, investors could purchase companies/assets with either cash or frozen foreign currency savings bonds3 with a maturity date matching the date of selling (i.e., cash equivalent). Further, only in case the sale was not made for cash, or previously mentioned cash equivalent, investors could then purchase this capital/assets with frozen foreign currency savings bonds regardless of their maturity date, and in a single installment only. (3) Restructuring and subsequent tenders/auctions of large, presently lossmaking but potentially viable enterprises, or parts thereof. Employees in enterprises subject to pre-privatization restructuring were not entitled to free shares, because of negative capital structure. It is important to note that restructuring was clearly defined as measures undertaken in order to exclusively increase the privatization potential of individual companies, and not to rescue them so that they may continue to operate as state or socially owned. This principle of preparing the firm for privatization or partial privatization through the sale of its parts or assets was the essence of the Serbian restructuring concept.

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In addition to the above-stated core methods, and due to the fact that under pre-2001 privatization laws many enterprises were partially privatized by distribution of shares, as well as transferring them to the workers/managers in the companies, a certain percentage of shares were neither distributed nor taken up by insiders and were retained by the state. A special purpose vehicle – Share Fund (SF) – was created in 2001 with a goal of disposing all of these residual state-owned holdings from previous privatizations, as well as any new residual holdings arising from privatizations under the new law (i.e., from auction procedures and cancelled contracts). The goal of the SF is to eventually dispose of all shares via the capital market, public auction, or tender. The law established three institutions responsible for implementing the privatization process, namely Privatization Agency (PA), SF, and Central Registry for Securities (CRS); additionally, it provided for maintaining of privatization registry (PR).  PA is a legal entity responsible for initiating, implementing, and monitoring the sale of capital/assets of state-owned and socially owned enterprises.4 The PA was set up with generous donor support which allowed it to offer competitive salaries and recruit qualified professionals, as well as to outsource advisory work to private consulting firms. Since the PA was entrusted with doing all the preparatory work, including restructuring where necessary, as well as designing and negotiating the terms of sale and post-sale monitoring, its ability to rely on qualified staff and private sector advice was crucial for its success.  As previously mentioned the SF is a legal entity receiving all residual shares from all previously privatized enterprises, both under old and new laws. SF initially administered some 900 packages of shares, while today this number has been reduced to around 600.  CRS was established in early 2004, after which all databases from the PA’s temporary registry were transferred to CRS. The CRS essentially represents a unified database recording all shares issued throughout Serbia. Finally, the PR was intended to record a portion of the capital (at least 15%) of each enterprise sold through public tender, which is then supposed to be distributed to all citizens, who did not receive any shares under any previous scheme, within two years after the completion of privatization process in Serbia. The law allows socially owned enterprises to initiate their own privatization, notifying the PA of their decision. Additionally, the ministry in

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charge of privatization could initiate privatization process. While employee and/or management consent was not a necessary pre-condition for initiating the privatization process, the PA has always tried to secure their consent prior to proceeding with it. Additionally, the potential buyers could express their interest in particular enterprise, thus initiating its privatization. In practice, in most cases the relevant ministry initiated the privatization process. When it comes to state-owned enterprises (SOEs) only the government could approve its privatization. In cases where the PA estimated that the capital/assets of enterprises being privatized could not be sold without prior restructuring, it could initiate the restructuring process. Restructuring refers to any organizational and/or financial changes, which could increase companies’ potential for successful sale, upon which they would be offered for sale through public tender or auction. Finally, enterprises undergoing privatization cannot, in accordance with the law, make any major management decisions without PA approval. The reason for this is to prevent any potential negative impact on the privatization process. It is also important to note that the PA, which is in charge of managing the privatization transaction, has in addition to cash offers also used investment and social programs as important criteria for selecting the winning bidders in tender privatizations. This was largely due to the political economy in Serbia and strong union organizations with considerable demands.

3.2. First Steps – Focus on Early Wins Following the formation of the democratic government in early 2001, most of the year was devoted to the development of the necessary regulatory framework, institutional capacity building, and preparation for offering the first batch of companies for the market test. In particular, the government has, with generous donor support, made significant efforts in building the institutional capacity of the PA, which was supposed to play the principal operational role in the process. The initial focus of Serbian privatization was on ‘‘early wins’’ – the divestment of larger and potentially more viable socially owned enterprises which could be prepared for market test relatively fast and which could attract strategic investors. The goal was to spark the interest of reputable foreign investors, ensure recovery of important industries which were at the same time some of the largest employers, as well as to maximize potential

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Box 2. Impol-Seval Aluminum Rolling Mill. An Example of a Successful Tender Privatization Aluminum Rolling Mills Sevojno was sold in 2002 in a tender procedure in which 70% of shares were acquired by Impol d.d. from Slovenia. The remaining 30% of the shares were, in accordance with the privatization law, evenly distributed between the current and former employees (15%) and the PR (15%). The new owner initially took over the entire workforce of 1,129 employees, which was subsequently decreased to the current level of 743 workers. It is important to note that the layoffs were conducted entirely on voluntary basis, and each volunteer received an appropriate severance package. After privatization the company changed its name to Impol-Seval Aluminum Rolling Mill, a.d. Sevojno, but the name, however, was not the only thing that changed. In fact, privatization brought a spectacular revival to the company prospects. In the period of 2002– 2006, the new owner invested over 31 million euros in the revival of the production capacities, resulting in the productivity increase of 7.2 times, while the production output in 2006 was 3.5 times higher than in 2002, and the highest ever recorded. Additionally, in 2006 the company’s exports have reached 94% of its output, securing revenues of some 49 million euros, making Impol Seval a.d. one of the top five exporters in Serbia. Further, the salaries and wages have increased by 120.6% in the post-privatization period (2002–2006). Impol-Seval Aluminum Rolling Mill, a.d. Sevojno, serves as an excellent illustration how a successful privatization, with subsequent changes in corporate governance and significant investments in reviving the dilapidated facilities, could transform once an inefficient socially owned enterprise into a champion of Serbian economy.

revenues. Very importantly, securing success stories early on would contribute to public support for implementing these painful reforms, while rapid divestment of inefficient socially owned enterprises would reduce losses and generate economic benefits sooner (Box 2). In 2001–2003, with generous support of the World Bank and other donors, the PA contracted a group of competitively selected investment banks to work on preparing a group of some 50 larger and potentially more viable companies for sale through an open and competitive international

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tender process. In parallel, given government’s intention to expand the preparation process to a larger number of firms than initially supported by donor programs, and its willingness to secure invaluable private sector advice, the PA was able to hire another set of advisors for preparing additional companies using government’s funds. As a direct result of these activities, in January 2002 the agency successfully tendered three cement plants, realizing nearly $140 million from the sales. Relying on the assistance of directly hired investment banks, the PA during 2003 has prepared and sold the country’s second-largest gasoline and petroleum products network Beopetrol to Russian Lukoil for 117 million euros, and two tobacco companies, Duvanska Industrija Nis to Philip Morris and Duvanska Industrija Vranje to British American Tobacco realizing 387 and 50 million euros, respectively, not only securing considerable revenue, but also attracting large and reputable foreign investors. Additionally, during the same period the PA has also sold five sugar refineries, two tourist agencies, and the country’s main producer of frozen foods.

3.3. Auction Program The government was determined to conduct a swift and effective privatization process, and the largest number of privatized enterprises was to come from the companies selected to be privatized through public auctions, given that most enterprises fit into this method due to their size. However, there were several hurdles related to quick disposal of socially owned companies through auction procedure. First, there were hundreds of enterprises awaiting privatization, each of which had to go through a lengthy preparation period in order to get ready for auction. A major component of the preparation included lengthy valuation process in which teams of people were literally counting and valuing company assets. In addition to this, two auction methods were used initially, English5 (ascending) and Dutch6 (descending) with starting prices at 80% and 120% of the estimated valuation, respectively. Auction would initially start with the ascending method, and in case the result was not satisfactory (i.e., nobody offered more than the initial price) the descending method would be immediately employed to ensure that the best price is achieved. Essentially the problem with this approach was that the market perceived the initial prices as too high. The auctions were supposed to be the engine of privatization, deemed appropriate for most enterprises, but the process was off to a very slow start,

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with only five companies privatized via auctions by the end of second quarter of 2002, primarily due to the mentioned constraints. The reformist government was extremely dissatisfied with the dynamics of privatization through public auctions, and viewing privatization as one of his priorities the prime minister stepped in personally, instructing the Ministry of Economy to take the necessary measures to make the process swifter and more efficient. The necessary efficiency of the auction process was achieved primarily by change of regulation, as well as by strengthening the human resource capacity of the PA by hiring more of the skilled staff. The prime minister’s intervention and a subsequent change of regulation in June 2002 simplified the preparation, and allowed more flexible auctioning of the majority of small- and medium-sized companies. This included streamlining and simplifying the valuation procedure, as well as lowering the initial auction prices. The essence of the changes included a new valuation methodology, which called for companies’ and PA’s estimate of company value by using a book value method, instead of valuing particular assets or estimating capital. This model was used as a basis for the so-called accelerated auction procedure. However, auctions for a certain number of companies with potentially more valuable assets remained under the old system. Additionally, the Dutch auction method was dropped, and the initial price in the auction was set at 20% of the estimated value. In case the first round was unsuccessful, the second round would start immediately after in which the bidders could pay with frozen foreign currency savings bonds whose maturity was still pending. In case the auction was unsuccessful, the company was offered in the second auction at a starting price which was half the price in the first auction, with the rest of the auction structure unchanged. This change proved to be an ingenious move, since it immediately translated into tremendous improvement in the sale record. After only 5 companies had been sold through public auctions in the first two quarters of 2002, the implementation of this novel approach has increased the pace of auction sales tremendously, increasing the number of sold companies to an incredible 140 in the last quarter. In other words, nearly 85% of the total auction sales in 2002 were recorded in the fourth quarter, and almost 53% in the month of December alone.7

3.4. Restructuring – The Measure of Last Resort In order to deal with some large and potentially viable companies, which could initially find no buyers, the government in 2002 selected a group of 28

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large loss-making companies with numerous subsidiaries and significant workforce, with a goal of increasing their sale potential. The idea was to subject these firms to a restructuring process, under a premise that after necessary financial and/or organizational changes, the company in whole or in part, or even just its assets could be attractive to potential investors even if initially this was not the case. In less than two years, the so-called restructuring list has grown to more than 70 SOEs. While in certain cases it was evident that the probable outcome for certain companies would be shutdown and asset sale, the necessity of the restructuring approach was grounded in a political reality of Serbia. The government had to demonstrate that it was doing everything in its power to ‘‘rescue’’ these companies, thus meeting the expectations of the employees, their unions, management, as well as wider public whose perceived value of these enterprises was much higher than in reality.

3.5. Temporary Slowdown In early March 2003, reformist Prime Minister Zoran Djindjic was assassinated, which resulted in a serious shock to Serbian politics, with serious consequences extending even to present days. Amazingly, this horrendous crime did not stop the enterprise sector reforms he championed so much, and in fact 2003 ended as the most successful year of Serbian privatization, with privatization of approximately 41% of all companies sold in the period 2002–2006, as well as nearly 48% of all revenues recorded in the same period.8 Interestingly enough, the slowdown of privatization process did not come during this most challenging period, but rather the following year coinciding with the advent of the new government, after early elections were called due to significant political instability caused by the prime minister’s murder. At the end of 2003 parliamentary elections, the opposition parties who ended up leading the new government, among other things, ran on the agenda of questioning the privatization process, making corruption accusations, promising to re-examine the entire privatization approach, and even change or rescind certain transactions. The quarterly comparison of companies privatized in both tender and auction procedures in 2003 and 2004 clearly indicates the major slowdown in 2004 coinciding with the change of government, and resulting in an effective privatization achievement of less than 40% (in terms of companies sold) of the previous year’s result (Table 1).

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Quarterly Breakdown of Companies Sold (2003 and 2004).

Companies Sold (T+A)

IQ

IIQ

IIIQ

IVQ

Total

2003 2004

189 66

139 43

113 31

135 82

576 222

Source: Privatization Agency (2007).

The slowdown could to a degree be contributed to a less attractive PA portfolio in 2004, given that a pool of more viable companies in the pipeline had shrunk. As a direct result of politics, the PA suffered from inertia on policy decisions during the prolonged election campaign and its aftermath, and an additional reason included the change of the PA management, and departure of a number of senior professional staff. The downward privatization trend continued until the new government realized its mistake after several lost months, deciding to change the PA management again and renew the privatization push. The improved results in the last quarter of 2004 were a direct result of this decision. Despite the fact that the privatization process was eventually revived, the dynamics of this activity has never reached the same level of intensity as in the initial years. The fact that political decisions have speeded up and slowed down the privatization process in 2002 and 2004, respectively, clearly demonstrates that the political will to implement this painful and unpopular reform is crucial for its success.

3.6. Renewed Privatization Push While the new government deserves the blame for initially slowing down the privatization process, it should be given credit for getting it back on track. Recognizing that high indebtedness of many companies in restructuring was a deal breaker for their privatization, the government introduced amendments to the privatization law in 2005 which ensured that all state creditors (i.e., tax authority, pension and disability fund, health fund, etc.) were obliged to write-off their receivables (as of December 31, 2004) to companies in restructuring, and get compensated from the proceeds of sale. The direct result of this policy decision has been a successful privatization of a number of large and troubled companies which were subject to restructuring process. The restructuring center’s portfolio consisted of 78 large and troubled companies, with state creditors’ claims of over 4 billion euros. Although only a handful of them had been resolved in the first three years of

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privatization, largely due to their poor condition and huge debts, the process accelerated following the enactment of the amendments to the privatization law in 2005. In 2006 alone, at least 15 SOEs from the restructuring list were sold, not to include a greater number of subsidiaries and non-core assets. Some of the companies in restructuring have been able to attract reputable foreign investors with significant investment commitments, such as the Magnohrom which was acquired by Global Steel Holdings Ltd. for slightly over 1.2 million euros, and with investment commitments of over 23 million euros. Further, other companies were able to record more significant revenues from the sale proceeds, such as HIP Azotara, which was sold to a consortium of Serbian and Lithuanian companies for 13.1 million euros, and investment commitments of 30 million euros. Finally, in late 2005 the government began the preparations for the sale of assets of the Mining and Smelting Complex Bor (RTB Bor), with the tender expected to be completed in first quarter 2008. The investor is required to reach agreement on a social program with the company’s unions. After an initial restructuring process the core mining and smelting activities were packaged for sale, while non-core assets were excluded and will be offered separately. In case this transaction is closed successfully, it will become one of the biggest successes, not only of the restructuring process, but also of Serbian privatization in general. In this case, the World Bank worked with the government and the PA to fund and provide technical expertise and guidance on all phases of the process. In addition to this, the government, in mid-2004, adopted a new law on bankruptcy, which became effective early in 2005, considerably reinforcing both the privatization process and facilitating general reallocation of unproductive and/or underutilized assets of insolvent companies back into productive use, thus contributing to private sector development. The new law replaced the previous obsolete and inefficient legal framework, significantly improving the process in numerous ways, such as introducing specific rules for resolving the status of insolvent enterprises, clarifying the role of bankruptcy administrators, and giving more say to the creditors in the process. Along with the new law, two new institutions were established with a goal to facilitate implementation of the new law, namely Privatization Agency Bankruptcy Unit (PABU) and Bankruptcy Supervision Agency (BSA). The PABU is a part of the PA, and as the PA it has also benefited from generous donor assistance related to its capacity building. The PABU was designed to administer the bankruptcy process for the majority of stateowned and socially owned enterprises, either by appointing its own staff, all of which need to be licensed administrators as specified by law, or by

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engaging outside licensed bankruptcy administrators and providing clear instructions for their work. The BSA is in charge of licensing bankruptcy administrators, and supervising their work, as well ensuring swift, efficient, and lawful bankruptcy procedure. Despite the introduction of the new and improved bankruptcy framework in Serbia, very few companies from restructuring were sent to bankruptcy, even though there were numerous candidates which have not been able to find buyers even after two offerings in the market. The reason for this was lack of political will to proceed with this, given that the public in Serbia perceives bankruptcy as a procedure that destroys companies. In this respect, Serbia is not alone; in virtually all countries in the region bankruptcy was strongly resisted and politicians lacked either the will or the power to initiate mass bankruptcies of insolvent SOEs.

3.7. Privatization Results After more than five years of privatization, 1,407 enterprises have been privatized through competitive public tender and auction procedures, with privatization proceeds reaching nearly 1.7 billion euros, with social and investment program commitments of almost 1.4 billion euros, and preserving jobs for 193,489 workers. The fact that 74% of all offered companies were actually sold is quite impressive, having in mind numerous challenges resulting from the legacy of social ownership (Table 2). Table 2.

Key Privatization Results (2002–2006).

2002 x Sold Companies/Success Tenders 11 Auctions 165 Total 176

2003

2004

2005

2006

2002–2006

Ratea 39% 16 41% 8 67% 15 58% 25 64% 75 52% 78% 560 78% 214 70% 185 74% 208 76% 1,332 76% 73% 576 76% 222 70% 200 72% 233 74% 1,407 74%

Revenues (in 000s Euro) Tenders 200,691 Auctions 42,214 Total 242,905

594,748 205,070 799,818

11,395 109,157 120,552

96,516 164,100 260,616

101,202 160,888 262,090

1,004,552 681,429 1,685,981

S. Fund Revenues (000s Euro) Share Fund Total 82,968

67,778

52,219

125,190

70,103

398,258

Source: Privatization Agency (2007). Offered/sold.

a

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It is important to note that the real revenue impact of privatization was nearly 2.1 billion euros given the proceeds from sale of residual shares after privatization both under old and new laws, as well as shares of privatized companies in cases where sales contracts were cancelled due to various contract violations, which were sold through the SF. Additionally, the SF sales also ensured jobs for additional 94,962 workers, thus increasing a total number of preserved jobs to 288,451. Further, the share of cancelled sales contracts was steadily decreasing as the privatization progressed, finally resulting in a relatively minor total share of cancelled contracts over the five-year period of some 13%. The fact was that the PA could not control in advance whether the buyer would actually fulfill the contractual obligations, but what was important was that safeguards were built in the system, including performance and bid bonds, allowing the PA to keep all or partial revenues from the sale of company in cases where the buyer failed to meet the specified obligations. Shares of those enterprises were offered again through the SF, thus multiplying the financial effects of privatization, and more importantly discouraging potential harmful intentions. With over 1,400 enterprises privatized through auctions and tenders, and subsequent revenues of nearly 2.1 billion euros in the five-year period, investment and social program commitments of nearly 1.4 billion euros, and preserving jobs for nearly 290,000 people, all in light of great political instability caused by the assassination of Serbian Prime Minister in 2003, it could be said that Serbian privatization was a considerable success. While some would say that roughly 2 billion euros of revenues is not an impressive amount considering the number of privatized entities, it is important to note that privatization was not envisaged as a revenue-generating activity. The primary goal of privatization was a transfer of ownership from inefficient state-owned and socially owned enterprises to the private sector. Further, it was designed to attract reputable investors and FDI through an open competition, thus ensuring allocation of assets to most productive use. In fact, nearly all FDI inflows to Serbia in the period 2001–2003 were related to privatization, also improving the investment reputation of Serbia for other potential investors. Finally, its purpose was to ensure subsequent change in corporate governance with positive impact on long-term growth.

3.8. Remaining Privatization Agenda Despite the considerable progress, the process of ownership transformation is far from complete. At the end of 2005, 13.1% and 16.5%, respectively, of

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the total labor force were still employed in socially and state-owned sector, respectively, with further 15.1% employed in enterprises with mixed ownership9. As of end 2006, between 700 and 800 socially owned enterprises still remain in the PA database, although many of them proved unable to find buyers after one or two offerings through tenders or auctions. This number includes some 40 loss-making, heavily indebted enterprises, which have been selected by the authorities to undergo organizational and/or financial restructuring prior to privatization. Additionally, the state retains, directly and through the development and pension funds, substantial holdings in some 600 enterprises currently in the SF portfolio, with over 30% stake in half of them (so-called mixed ownership).10 Further, most of the state-owned and municipally owned utility companies remain inefficiently organized and in dire need of investment financing. Finally, in contrast to the profit-making private enterprise sector, the socially owned, state-owned, and mixed enterprises reported in 2005 the consolidated net losses of Euro 393, 158, and 458 million, respectively.11 Despite their heavy indebtedness and operating losses, many state-owned and socially owned enterprises continue to survive largely because they benefit from both direct and indirect subsidies. The direct subsidies include cash payments allocated by the Ministry of Economy, while indirect ones include arrears from other state-controlled entities such as tax authority, public utility companies, health and pension funds, and so forth. Accumulation of arrears by state-owned and socially owned enterprises will continue to undermine the solvency of the named public institutions, and ultimately the tax payers will have to finance those unpaid liabilities through their contributions to state coffers. A more detailed account of direct and indirect subsidies will be provided later on in this chapter. Even though the new Serbian Constitution, adopted at the end of 2006, does not feature the category of social ownership, this will initially only formally change the ownership structure. Some of the remaining socially owned companies will end up being privatized, some will undergo bankruptcy, while some may be transferred to some form of state ownership, but the substantial change can only be achieved through privatization, either through direct sale or bankruptcy. Even after the socially owned sector is divested, in addition to a still large state-owned sector personified in several giant utilities and a number of smaller holdings, there will also be a large number of municipal public utilities in need of privatization. For this next step to develop favorably, it would be important that the privatization decision for each category of utility companies is preceded by a thorough assessment of local market

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conditions, reorganization, and restructuring requirements of the sector, and an independent regulatory regime, in order to prevent the emergence of any private monopolies. Finally, the existing capacity of the PA, built in the last five years, could serve as an advantage to conduct privatization of public utilities and municipal property in a transparent and competitive manner. These facts clearly indicate the lingering negative impact that the remaining state-owned and socially owned enterprises have on the Serbian economy. The safest way to prevent the continuation of the cited inefficiencies is to accelerate and finalize their privatization. For the benefit to the Serbian economy, the PA should continue to vigorously pursue clearing its portfolio while the existing bankruptcy mechanism should be improved to complement the PA efforts to resolve the status of unsellable companies. Finally, the divestiture of residual state holdings held by the SF should be accelerated as well.

4. ANALYSIS – RESTRUCTURING OF SOCIALLY OWNED ENTERPRISES 4.1. Struggle for Hard Budget Constraints Soft budget constraints represent one of the most problematic legacies of socialist economy. The term soft budget constraint was coined by Janos Kornai12 to describe how SOEs could rely on increased subsidies from the state when they increase their losses. The former SFRY (inclusive of Serbia) shared the problem of soft budget constraints similar to other socialist countries. The softness of budget constraints comes in various ways, but often there is something that could be interpreted as an implicit contractual relationship. In Serbia, the most important channels of soft budget constraints included: (a) soft loans (almost never repaid) from the development fund or other source; (b) tolerance of arrears in regards to taxes, health care and pension contributions, utility bills, custom duties, and so forth; and (c) tolerance for not complying with environmental regulations, licenses, permits, etc. In reality, soft budget constraints were reserved only for the state-owned and socially owned companies, while private sector was generally operating in a free market environment. Gradually, as the sources for financing soft budget constraints (such as inflation and transfers from private sector) were exhausted, the budget constraints started to harden for small- and medium-size socially owned

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companies. The rationale was that due to their size, there was no political risk associated with their failure. However, the private sector never received the same treatment. After democratic changes of 2000, the new government inherited devastated public revenue system, as well as huge expectations on the part of management and employees of big socially and state-owned companies, which were completely opposite to the government’s reform agenda. While the government wanted to recover public finances and create a competitive market environment and merit-based incentives, the unions, whose strength and influence was proportional to the size of the enterprise, such as those at car-maker Zastava and RTB Bor, were fighting to preserve the prerogatives they received under the social ownership. A set of policy reforms introduced from the very beginning was aimed at tackling the problem of financial discipline, and despite the fact that financial discipline is still a pending issue and an utmost priority, certain positive results have been achieved. Hardening budget constraints is all about cutting off subsidies, which could be either direct and visible, or indirect and usually harder to recognize and measure. Further, cutting off subsidies always includes a twofold approach: one directed at cutting off channels for direct transfers, and the other directed at reducing the number of recipients. With the commencement of a wide range of economic reforms, as well as with some specific actions, the government was able to slow down the flow of subsidies. This was specifically achieved by disabling two important subsidy channels:  Cutting off banking channels with the bankruptcy of some of the stateowned banks, and introduction of new development fund regulations; and  Cutting off transfers through state-owned utility companies with the introduction of value-added tax (VAT). In 2001, the four largest, and subsequently several smaller state banks, went bankrupt, which ended the era of using the commercial banking system for transferring subsidies to non-performing companies. The new banking system, which gradually started to develop afterward, was based on private and primarily foreign ownership. Additionally, the government changed the operational regulations of the state-owned development fund. The policy of the fund was changed, preventing any majority socially owned company to apply for development fund loans. Additionally, although adopted earlier, the law on VAT became effective on January 1, 2005. Given the very nature

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of VAT system, tolerating utility bill arrears became quite painful for the utility companies. One of the more important results of Serbian enterprise sector reform was reduction in the number of subsidy recipients. This was largely achieved with the implementation of an ambitious privatization program which was at the core of Serbia’s enterprise sector reform over the past five years. It is envisaged that the privatization of socially owned companies will get completed by the end of 2008. In principle, the reform policy aimed at hardening budget constraints was sound. However, it should be clearly stated that this problem still remains an utmost policy priority in relations to enterprise sector reforms. From the very beginning it was obvious that the introduction of financial discipline would be a long process and that success would come gradually. Once the development fund was given instructions to stop issuing new loans to socially owned companies, the government created the so-called subsidy fund. This was not a real institution but rather an annual budgetary item aimed at supporting the survival of socially owned enterprises prior to their privatization. The idea was to increase the attractiveness of a certain number of companies and make them more appealing to potential buyers. The idea was also to constrain the subsidies with the proposed budgets, as well as to make them more transparent. In addition, the target of this policy was a group of companies in the restructuring program, which was administrated by the PA. The number of companies in restructuring varied over time, but the number of active cases never exceeded 80. Several larger groups were broken up into the core company and the subsidiaries, such as Zastava where the component companies, the trucking company (a joint venture with Fiat), and the marketing subsidiaries, were all separated from the primary auto assembly company and privatized on their own. The idea was to create a cluster of viable auto parts and other auto companies, not just a giant assembly operation. In 2002, the government decided to use the development fund as a financial vehicle when deciding if the subsidy would be directly transferred to the companies from the budget. Moreover, the transfer was formally presented as a soft loan, only this time the Ministry of Economy made this decision and not the development fund. There were pros and cons to this approach, but the outcome was probably more negative than positive. The development fund was again administrating soft, never repaid loans, thus confusing private entrepreneurs of what its true role was. At the same time, the distribution of funds did not include clear justifications and there was no control over the effects it produced. The evidence of direct subsidies to

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Table 3.

Direct Subsidy Channeled through Development Fund – Socially Owned Companies (Euros in 000s).

Description Restructuring companies Other companies Total

2003

2004

2005

2006a

81.690 22.223 103.913

56.946 19.481 76.428

42.264 9.626 51.890

26.444 9.502 35.945

Source: Ministry of Economy. a Data for three quarters of 2006.

socially owned companies shows that despite the fact that the number of restructuring companies was limited, the number of subsidy recipients was 3–5 times bigger. In that sense, hundreds of companies receiving small subsidies reduced the total amount earmarked for a group of companies in restructuring by 20–25%. Table 3 shows the disbursement of direct subsidies. The table indicates a decrease in total direct subsidies, which is in line with the reduction of the number of recipients through privatization. Additionally, the table shows that 20–25% of the funds were disbursed to recipients other than companies in restructuring. Finally, since the figures refer only to socially owned companies, the amount spent in three quarters of 2006 (the last year before the resolution of socially owned sector) could be considered significant. Indirect subsidies are transferred to enterprises through a number of different channels. The fact that introduction of VAT made it more difficult for utility companies to extend these indirect subsidies did not explain the entire picture. In order to shed more light on the issue of indirect subsidies granted by the state-owned utility companies and tax authorities (including health and pension contributions, and VAT), an analysis13 was conducted for a group of 20 companies which were the most significant offenders within (socially owned) companies in restructuring. Indirect subsidy was calculated as the amount of increased arrears within the specific period. The result, based on data collected from creditors, is shown in Table 4. This analysis confirmed an overall decline in indirect subsidies. At the same time, the subsidy structure shows that unpaid utility bills constituted the major source of indirect subsidies. Compared to the direct subsidy figures, a rough estimate is that for the economy as a whole, the indirect subsidies were at least 2–3 times higher than the direct ones. Two major state-owned utility companies in Serbia are Electric Power Company (EPS), and Oil and Gas Company (NIS). These companies are

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Table 4. Indirect Subsidies for 20 Selected Socially Owned Companies in Restructuring – The Most Significant Offenders (Euros in 000s). Description

Tax administration Utility companies Total a

2006a

2005 Amount

%

Amount

%

34.123 89.239 115.362

29.58 70.42 100.0

23.670 23.368 47.038

50.00 50.00 100.0

Data for three quarters only.

Table 5.

Collection Rate of the Utility Companies in 2005 (in %).

Description Restructuring (non-performing) companies Other companies Average (all customers)

EPS

NIS

61.68% 97.17% 91.80%

83.94% 92.47% 91.48%

Source: EPS, NIS.

often used to channel indirect subsidies to non-performing socially owned companies. Table 5 shows the collection rates of these two companies. The figures confirm that the state-owned companies are widely used as the vehicle for indirect subsidy transfers to non-performing companies. Finally, biased treatment of socially and state-owned companies could be considered as an additional type of indirect subsidy. This refers to the tolerating violation of a number of regulations. Typically, socially owned companies are tolerated when not complying with environmental regulations, while the probability that they would get punished if certain permits and licenses (mining, construction, etc.) are not fully in line with legal requirements is very low. The inspections verifying these numerous issues are rare, while fines (if any) are low. These types of indirect subsidies are sophisticated, they are not officially recorded and are very effective. Even though these are not real subsidies in terms of cash inflows, they grant these companies substantial competitive advantage over the private sector, not to mention that these policies are completely opposite to the philosophy of market economy. They are also damaging to country’s investment reputation, and discourage new foreign investments. Finally, political will rather than additional financing is a decisive factor for fostering competition and halting this type of indirect subsidies. Perhaps the best example, again, is the aforementioned case of RTB

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Bor, a large copper mining complex in Eastern Serbia. This company violated a host of Serbian environmental regulations, and survived thanks to direct and indirect subsidies for years before the government, with support from the World Bank, finally decided to put it to the market test. Even though financial discipline in Serbian economy is improving, the flow of public funds to persistently loss-making enterprises is still very high. Therefore, despite the considerable achievements in the last five to six years, further hardening of budget constraint is still a priority task which will facilitate restructuring, bankruptcy, and eventually dissolve non-performing firms, thus releasing the assets, including real estate, of loss-making firms back into productive use. This is especially helpful to the important SME sector, where entrepreneurs are in particular need of land and storefronts, as well as other assets, so often controlled by large non-productive firms. Finally, hard budget constraints are also a prerequisite for trade unions’ cooperation in the restructuring process, since as long as employees in socially owned firms do not feel the pressure of facing layoffs prior to privatization, they will keep opposing restructuring since they fear it will result in increased redundancies.

4.2. Debt Workout in Serbia – A Long and Winding Road As shown in the preceding section, the chronic lack of hard budget constraints characteristic of Serbia’s SOE sector has resulted in massive levels of indebtedness. Larger SOEs, in particular, carried a disproportionate share of debt, representing both liabilities for investment finance dating back to the Yugoslav period, as well as the liabilities accumulated by those enterprises in the 1990s in order to keep afloat despite sanctions and loss of traditional markets. Recognizing that these former giants of socialist industry were unsellable in their present state, while at the same time being ‘‘too big to fail,’’ authorities provided in the 2001 privatization law for the possibility of pre-privatization restructuring under the guidance of PA. Besides the need to deal with excess employment, heavy indebtedness was the main criteria for putting companies on the so-called restructuring list that grew from 28 SOEs in 2002 to some 80 SOEs by end-2004. Very importantly, companies in restructuring enjoyed temporary protection from creditors as bankruptcy procedure could not be opened against them. Achieving the pre-sale settlement with creditors was meant to be the key objective of restructuring exercise. The privatization law and accompanying regulations stipulated detailed procedures to be followed by the PA for

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collecting creditors’ claims and negotiating with creditors. The PA had secured large volumes of donor assistance to help it deal with the problem of identification and verification of claims, many of which dated back many years if not decades. In each case, the restructuring program, including the debt workout section, was to be approved by the creditors’ committee, before putting the company, or saleable parts thereof, on sale through tender or auction. The basic assumption underlying the model was that the creditors would be more willing to agree to a partial reduction in their claims toward the troubled SOE to increase the likelihood of successful and rapid privatization with multiple bids, rather than postponing the settlement until the lengthy and complicated bankruptcy process is completed. Another reason for initial optimism was the fact about 3/4 of the total debt of the companies in restructuring was owed, directly or indirectly, to the state. The state was by far the largest creditor for practically all SOEs on the restructuring list, in some case reaching 80% share. Besides the direct liabilities to the state in the form of arrears to tax authorities, pension fund, and unemployment fund, the main creditors of the companies in restructuring were state-owned public utilities and banks. As shown in Table 6, the Bank Rehabilitation Agency (BRA) alone was responsible for a quarter of liabilities for SOEs on the end-2003 restructuring list, thanks to its role as a receiver of four large ex-Yugoslav banks that were put into bankruptcy in early 2002.14 Moreover, the share of state and statecontrolled debt among the overall package of liabilities kept rising in the early 2000s as large SOEs were increasingly relying on direct and indirect subsidies for cash flow and investment finance. Since the government was the driving force behind resolution of SOEs, it could be assumed that the prominence of the state creditors would give the Table 6.

Debt Structure (44 Companies in Restructuring Program; in Euros 000s).

Creditor Bank Rehabilitation Agency State (directly) Public companies (infrastructure and utilities) Banks Suppliers Workers (unpaid salaries and other claims) Total Source: PA.

12/31/2002 12/31/2003 Structure 12/31/2003 277,990 167,543 75,757 142,484 95,721 43,578 803,073

238,237 233,904 89,406 221,896 115,295 51,537 950,276

25% 25% 9% 23% 12% 5% 100%

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state the ability to play a proactive role in restructuring, and, in fact, to be the dominant decision maker in most cases. However, soon enough the PA and the donor realized that the opposite was the case – indeed, the lack of cooperation of state creditors proved to be a key bottleneck in the preprivatization restructuring process. Despite the generous technical assistance funding provided by the World Bank and other donors, only a handful of companies from the PA’s restructuring list of over 70, had completed the preparation of the restructuring program, only to get bogged down in the endless negotiations with creditors who were supposed to approve it. A particularly glaring example was presented by a large chemical industry holding of Zorka, which had been selected by the PA and donors in early 2002 to serve as a pilot case of fast and successful privatization through restructuring. In reality the preparation of the restructuring program and securing its approval by creditors required more than two years of work from the PA and its advisors. Interestingly enough, private and even socially owned creditors generally proved supportive of a creditors’ settlement, showing a willingness to accept a partial write-down in exchange for a fast settlement through privatization of saleable assets. In fact, by accepting the average haircut, they were virtually accepting the market price for their claim. In contrast, the statecontrolled creditors were reluctant to accept any write-down. The situation was particularly exacerbated in cases where more than one state agency was involved in the negotiations, as was the case for practically all SOEs on the restructuring list. Risk aversion of the officials representing state creditors explains their reluctance. To put it in simple terms, representatives of state creditors on the creditors’ committee were concerned that if they agreed to receive less than the nominal book amount, they might later on be questioned or investigated by superiors or auditors to explain why they had agreed to a haircut. They believed that the future auditors would not accept the argument that in the absence of the haircut, the whole debt would have to be written off because such argument about the counterfactual could not be formally proven.15 Each state creditor had its own specific circumstances that made a decision on pre-privatization debt haircut difficult to accept. In the case of the debt held by bankrupt banks, for instance, the BRA management rightly believed that their primary obligation was to secure the best settlements with the banks’ numerous creditors. Similarly, the MOF and BRA were reluctant to accept the workout of SOE debt to the functioning state-owned banks, as the latter themselves were in the process of privatization. State-owned utility companies such as the national electricity generation and distribution entity

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(EPS) perceived any reduction of historic SOE liabilities as jeopardizing their financial stability at the time when they themselves were in the process of deep restructuring. A common concern for the state creditors was moral hazard presented by write-off – would not this amnesty, even a partial one, encourage continued irresponsible borrowing and non-payment of current liabilities by the SOEs? An interesting case was presented by the historic liabilities to the tax authority. In order to facilitate the tender and auction privatization the government had decided early on to clear the company books from the tax arrears accumulated by SOEs in the period before a certain cut off date. Very importantly, this was a conditional write-off, since it only took effect at the moment of sale of the SOE in question in an auction. The impact of this measure on the speed of restructuring of larger SOEs should not be exaggerated, as tax arrears represented only 4.1% of the historic liabilities of 44 companies present on the restructuring list in 2003. Moreover, the Ministry of Finance at that time proved extremely reluctant to extend the cut off date for writing off the tax arrears, citing the moral hazard problem. By mid-2003, it had become obvious to the PA and key donors that the restructuring process would not move forward unless some mechanism was found to ensure cooperation from creditors, particularly the state ones.16 In an attempt to cut through the extremely complex and slow process of creditor negotiations, by end-2003 a ‘‘conditional tender’’ instrument was developed by the PA with help from the World Bank. In a conditional tender, investors were invited to submit offers to purchase the company without accepting debts to state-controlled or state-owned creditors, while debts to private creditors (mainly, suppliers) must be assumed. In other words, bidders were advised in the tender documents to assume that all state debts will be written off at the settlement of the transaction. Investors submit bids stating the cash they will pay.17 A market value of the firm was thus determined.18 Perhaps the main feature of this mechanism was that the write-off was to become effective only at the moment of sale, in order to avoid the moral hazard problem. The privatization proceeds from the sale of the debtor company were to be distributed among the creditors proportionally to the written off debt, up to the nominal amount of their debts. The underlying assumption is, of course, that government’s interest is not merely to collect its claims. Where there is a strategic investor of some potential, government’s longer-term interest should be to support the emergence of a flourishing, healthy company. Even in case where the sales proceeds prove to be insufficient to cover the full amount of creditors’ claims, the net financial position of the state can be expected to be positive

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because privatization also means the irrevocable ending of subsidies to lossmaking firms. The government also wants to preserve and create jobs through successful privatization. Finally, important medium- and longerterm result is the emergence of a solid and reliable taxpayer. Following the successful testing of this approach by the PA in several large privatizations, the newly formed Serbian Government decided in mid-2004 to create clear legal grounds for conditional debt write-off through promulgating relevant amendments to the privatization law. It helped a great deal that the new minister of economy came into office straight from the director’s position at a large SOE in restructuring that had been sold to a Slovenian investor through a conditional tender procedure. In May 2005, the Serbian Parliament approved amendments to the privatization law that made it possible for the state and state-controlled creditors to write-off their receivables (as of December 31, 2004) to companies in the restructuring process, with the write-off becoming effective at the moment of sale. Other creditors (private creditors and other SOEs) could join in the write-off in order to get compensated from the sale proceeds, or they could choose to wait for a bilateral settlement with the new owner. Very importantly, the central coordination and control of state entities responsible for the claims was improved, with the Ministry of Finance given the key role for authorizing the conditional write-off. The amendments gave clear powers to the representatives of state creditors to approve the conditional write-off, at the same time providing for penalties to those officials who did not act accordingly. The introduction of conditional write-off mechanism, albeit happening after four-year period of trial and error, has proven to be one of the most successful measures of Serbian privatization, on a par with the accelerated auction program. As of March 2007, more than 20 large SOEs from the restructuring list had been sold, many of them to international strategic investors – a remarkable result considering the extremely distressed condition of these companies.

4.3. Dealing with the Social Costs of Restructuring Regional and global experience indicates that paying adequate attention to the social consequences of restructuring is a prerequisite for its success.19 The labor factor acquired particular prominence in the case of Serbia, given the legacy of social ownership and workers’ self-management, described earlier in this chapter. On the one hand the Serbian SOE sector, above all the large industrial conglomerates put on the restructuring list, displayed

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heavy levels of overstaffing, which, along with heavy indebtedness, greatly reduced their chances for successful and competitive privatization. On the other hand, mass redundancy was a completely new concept both for the workers, who in many cases had spent all their lives working for this enterprise, and for the management, whose political weight still depended on the size of the labor force, even though there might not be enough work for all employees. While the level of overstaffing varied from company to company, the World Bank analysis estimated that between one-third and one-half of the workforce in companies under restructuring were redundant as of early 2002. As was to be expected, it was the older employees, with relatively low levels of qualifications and limited capacity for retraining, who were most at risk from the privatization. Furthermore, a number of companies in restructuring were located in towns and regions they traditionally generated a dominant portion of local employment, with Zastava and RTB Bor being the most prominent examples. Not surprisingly, the fragile coalition governments have been very conscious of the possible political fallout from the unpopular restructuring. The labor dimension, more than any other factor, explains the slow and sometimes uncertain course of Serbian restructuring process. Early on in the process the government included provisions in the privatization legislation aimed at buying social peace and (reluctant) support for privatization from the company management and employees. Besides providing for free distribution of some shares to workers of companies sold through the regular tender and auction procedure, the government required that the buyers commit to a generous social package for the employees.20 At the beginning of privatization process, the PA made it a rule that all bidders should commit to a minimum three-year period in which no involuntary layoffs could happen without workers receiving generous compensation package to be negotiated between the new owner and trade unions. Since the management and unions were actively involved in the decision on launching privatization, and in the end had to sign the privatization contract, this approach clearly put the burden of social costs on the shoulders of the private investor. This model, however, could only work for relatively attractive companies, of which there were precious few on the PA books to start with. Generous social packages negotiated by employees of cement factories or tobacco firms were sought after by workers in all other SOEs, but the reality was that the deeply insolvent, distressed firms on the restructuring list risked having no interested bidders at all unless serious labor shedding was undertaken

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before the tender. Similar to other privatizations in transition economies and worldwide, in Serbia investors have proven to be generally averse to having to resolve social issues, particularly redundancies. Investors would heavily discount the risk of implementing social conditions after privatization (i.e., disruptions, strikes, political interference) in their offer price. By mid-2003, the government had to change the term for its mandatory retention policy from three to one year even for presumably more attractive firms outside the restructuring list, in an attempt to attract more bidders and raise the privatization revenues. Another instrument for dealing with the massive level of redundancies in large SOEs has been the government’s ‘‘Social Program’’ (SP), adopted in 2002 for employees declared redundant during pre-privatization restructuring process. The SP was financed from a separate annual allocation in the state budget (so-called transition fund), and provided a menu of compensation and redeployment options to redundant workers in order to facilitate their voluntary separation from the company before putting it up for sale. Under the initial SP terms, a typical redundant worker could choose between: (i) a lump-sum payment of around Euro 1,000 or around Euro 100 per year of service (whichever is higher); and (ii) payment for up to two years, depending on length of service, at 40–80% of the average wage in Serbia. The worker could apply a portion of severance pay toward retraining programs to help him find an alternative employment or open a business. While the initial objective of the SP seems to have been to buy the consent of the employees of recalcitrant SOEs for initiating the privatization process, and to avoid the negative political fallout, over the past five years, it has proven to be a critical instrument for resolution of the large industrial conglomerates. As shown in Table 7, more than 178,000 workers have Table 7.

Amount disbursed (Euro) Number of beneficiary workers Number of beneficiary enterprises

Use of Government’s Social Program (2002–2006).

2002

2003

98,678,902.86

83,437,485.95

51,787

36,899

17,596

34,997

37,397

178,676

29

80

28

87

162

386

Source: Ministry of Labor.

2004

2005

2006

Total

29,125,665.33 74,282,412 99,463,441.14 384,987,907.07

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voluntarily left their companies over this period in exchange for receiving the SP benefits. Given the age and skills profile of redundant workers, it is hardly surprising that more than 90% of them opted for a straightforward severance payment in cash, leaving the company with 2,000 euros per person on average. This package was quite generous relative to the packages given to workers in companies outside the SP – workers of eligible SOEs could get on average three times more than the minimum severance pay specified in the labor law. However, it was less generous than packages offered to facilitate large-scale restructuring in other transition economies such as Poland or Croatia. As can be seen from the table, the Serbian Government spent almost 400 million euros on its SP over the past five years. While this represents a substantial burden on the state budget, the long-term impact of the program is expected to outweigh the immediate costs. With regards to the net budget revenue, the government should be neutral to whether a SP is financed by the investor or by the state, because investors will reduce their offer price for a company according to the size of the SP they are required to finance. Moreover, in many cases there would have been no bidders for badly overstaffed companies. The experience has shown that pre-privatization labor shedding is a sine qua non condition for successful resolution of companies on the restructuring list as strategic investors would not want to carry the financial and political costs of dealing with redundant workers. The best example, again, is RTB Bor, which could attract potential investors only after the government sent home with severance pay more than three quarters of its historical 22,000 strong workforce. In the longer run, the successful privatization facilitated by the pre-sale labor shedding is expected to produce a reliable taxpayer and employer in lieu of the current subsidy recipient. From economic point of view, the use of budget resources to finance one-time severance payments for redundant workers is clearly more justified than using the same (or greater) resources to subsidize continued existence of inefficient and loss-making SOEs (including salaries of excess workers) for an indefinite period of time. The Serbian authorities firmly grasped that point by the end of 2004, when they started decreasing the direct subsidies to SOE sector, while at the same time raising the allocation for transition fund in order to expedite the labor shedding. Although the initially strict enterprise eligibility criteria for government’s SP payments have been somewhat diluted in the process (162 SOEs benefited from the program in 2006, compared to 28 and 87 in 2004 and 2005, respectively),21 few would argue that the major recent progress with resolution of SOEs on the restructuring list would have been possible without the SP.

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4.4. Bankruptcy as an Instrument of Divesture From the very beginning of the reforms the Serbian Government was aware that, in addition to privatization, the bankruptcy should also be used as an efficient and needed instrument of divesture. Also, it was clear that the existing Law on Compulsory Settlement, Bankruptcy and Liquidation could not produce the required result. It was because the law was designed and used to protect the debtors rather than creditors and to provide the continuation of the operations in disturbed companies preserving the jobs and consequently maintaining losses. It was normal that the cases, once opened, would last for years with virtually no incentives for their completion. In line with the nature of the existing law, on one hand, and requirements of free market economy, on the other, it was obvious that the new bankruptcy law was urgently needed. However, at that time in Federal Republic of Yugoslavia (FRY), the responsibilities were split between state and federal authorities in a manner that state authorities were responsible for privatization, while the bankruptcy was within federal domain. The political position of Serbian authorities was that sustainability of the federation should be supported at all costs. As a result, the Serbian Government was focused on privatization. Bankruptcy remained out of the main stream of the reforms at the state level, with the expectations that the federal level would take care of it. After approximately two years, the privatization started to produce its first tangible results. At the same time, the restructuring was facing serious problems without any signs of improvement in the future, if some actions were not undertaken. The expectations that the federal authorities would work on bankruptcy proved to be a mistake. As a consequence, bankruptcy law could not be used as a mechanism to foster restructuring. That proved very difficult for restructuring cases in Serbia. In almost all restructuring cases, there is the need for a ‘‘stick.’’ That stick is the threat of putting the company into bankruptcy. In order to overcome this problem the Government of Serbia initiated actions in two directions. First, the restructuring regulations (changes in privatization legislations including laws and bylaws) were produced. And second, the team of experts supported by international donors was appointed in order to produce draft brand new bankruptcy regulations. The idea was to prepare the bankruptcy law that later would be submitted to the Federal Parliament for formal approval. The draft law was prepared in 2003. After the elections and creation of the new government in 2004 the adoption of the bankruptcy law became the responsibility of a new cabinet. Problems with federal domain were, in the

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meantime, resolved as the new Constitutional Agreement between Serbia and Montenegro transferred the bankruptcy from federal to state level. Finally, the new Bankruptcy Law was approved by Parliament in July 2004, and came in force half a year later. By its philosophy it is one of a set of important legislative acts underpinning a market-based economy. The bankruptcy law provides a much-needed collective mechanism for unsecured creditors to collect their receivables, when the debtor is unable to settle its debts under the original contractual terms. As such, it is important for protection of creditor rights, without which you cannot operate a sound banking system or have open commercial exchange between companies on standard credit terms, rather than on a cash basis. One way to view bankruptcy is in terms of control rights. When a firm defaults, some control rights pass to the creditors and (in most countries) the legal system represented by a bankruptcy courts or judges. Debtor-oriented bankruptcy schemes (such as Chapter 11 – United States Code, Title 11 – Bankruptcy in the US) preserve a large measure of control rights in the hands of the incumbent management, while creditor-oriented frameworks (such as the UK system) give more control to creditors. Furthermore, systems vary depending on the powers and roles of the judges. The merits of debtor- vs. creditor-oriented schemes is a matter of debate, but there is a considerable consensus that extending substantial discretionary powers to judges is a bad idea, especially in countries like Serbia where the courts have yet to be reformed. The new bankruptcy law in Serbia replaced the Law on Compulsory Settlement, Bankruptcy and Liquidation, enacted in 1989 and was amended several times thereafter. The law represented a major improvement over its predecessor. Assessments undertaken on behalf of the European Bank for Reconstruction and Development rated it as one of the best bankruptcy laws in the region. The law was supplemented with a series of regulations issued by the Ministry of Economy, establishing a code of ethics and reporting requirements for bankruptcy administrators, and providing a more detailed regulation on how administrators conduct bankruptcy procedure. In general, the law provided for easier initiation of cases and increased the authority of the bankruptcy administrator, as well as the creditors. While the new law continued the practice of having a three-judge panel presiding over a bankruptcy case, the role of the judges in administering the estates of debtors was significantly refined. Instead, the judges took on a more traditional role of resolving disputes among the parties and ensuring that the procedural requirements in the law were met.

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With respect to SOEs in financial difficulty, the law requires the bankruptcy panel to appoint a state agency to serve as an administrator in cases where majority state-owned and socially owned companies undergo bankruptcy proceedings. The PABU has assumed this role. For SOEs and other companies, there are now greater possibilities for reorganization. The new law gives the debtor more breathing room by temporarily restraining secured creditors from seizing encumbered property that is necessary for reorganization. It also allows for greater flexibility in how a reorganization plan may be formulated, while at the same time clarifying the procedures on how the plan would be reviewed and voted on. The law provides a shift from debtor to creditor-friendly provisions. For example, unlike the previous law, it has no concept of a ‘‘debtor in possession.’’ Creditors can now initiate a reorganization plan early on in the proceeding, and such plan could be prepared by the bankruptcy administrator or defined groups of creditors, and not solely by the debtor. The law also redefines the relative powers of the participants in a proceeding, giving much more power to creditors, primarily through administrator’s reporting requirements, and the ability of any creditor to object to the court over the actions of the administrator or the bankruptcy judge, and most importantly, through the creation of a representative creditors’ committee. The key principles of the new law include the following: (i)

(ii)

(iii)

(iv) (v) (vi)

Unless the creditors indicate early in the proceedings that they will not support any form of reorganization, the debtor, the administrator, or others can file a reorganization plan within 90 days of the opening of the proceedings. Some powers previously held by the bankruptcy judge are transferred to a creditors committee representing all unsecured creditors. This is important as for the first-time creditors have a degree of direct control over the actions of the administrator. Preliminary proceedings must be concluded within 30 days. Other strict deadlines are imposed, all designed to speed the process and reach a conclusion as to whether a debtor should be reorganized or liquidated within 120 days from the opening of the proceedings. Any and all sales of assets must be through widely advertised auction or tender sales, unless the creditors indicate differently. The duties of the administrator are expanded and clarified, and basic minimal professional standards are set. Henceforth, bankruptcy administrators will be licensed. A new agency under the Ministry of Economy ensures the application of the

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standards, and has the power to suspend or remove the license of the administrator. The law on the BSA became effective on August 1, 2004. This law creates the legal framework for an agency under the Ministry of Economy responsible for examining licensing and supervision of bankruptcy administrators appointed according to the terms of the bankruptcy law. Generally, cases opened but not completed under the previous Law on Compulsory Settlement, Bankruptcy and Liquidation are to be administered in accordance with the terms of the 2004 Bankruptcy Law.22 A number of existing bankruptcies of socially and state-owned companies thus became the responsibility of the PA bankruptcy unit. Although enacted in July 2004, the bankruptcy law became effective on February 1, 2005, allowing time to develop the capacity of both the PA bankruptcy unit and the BSA. In its operations up until now, the BSA has predominantly focused on the examination and licensing of the initial group of bankruptcy administrators. However, as the cadre of licensed administrators levels off, the BSA must shift its focus to competent performance of the regulatory function. PABU operates under the PA and administrates bankruptcies of socially owned enterprises, and its institutional capacity is gradually developing. However, there will be a large number of state-owned and socially owned enterprises which cannot be privatized by tender or auction. Their resolution through bankruptcy is an important element in the government’s program to complete the divestiture of all socially owned enterprises by the end of 2007. Therefore, the PABU has to be prepared to further strengthen its capacities and accept new challenges. As of June 30, 2006,23 commercial courts in Serbia had 1,345 open bankruptcy cases. It is important to note that this refers to all bankruptcy cases including both private and socially owned enterprises. As indicated in Table 8, approximately a third of the cases have only been opened for a few months, while one-fifth of these cases are more than five years old. Of the cases that are still pending, 770 were initiated before and 575 after the new procedures came into effect. Total filings of cases under the new law up through June 30, 2006 are presented in Table 9. Up until the end of 2006, bankruptcy filings varied between 40 and 60 per month. However, since the government is committed to complete the divestiture of all socially owned enterprises by the end of 2008, unless some specific strategy and approach is introduced, it is to be expected that the last quarter of 2008 might experience a huge number of bankruptcy filings.

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Table 8.

Pending Bankruptcy Cases Mid-2006.

Litigation Period Less than 6 months 6–12 months 1–3 years 3–5 years 5–10 years More than 10 years Total

Number of Cases

%

440 73 282 265 230 55 1,345

32.71 5.43 20.97 19.70 17.10 4.09 100.00

Source: CCASA APP Database.

Table 9.

Filings under The New Law (February 1, 2005 through June 30, 2006).

Item Resolved cases Pending cases Total

Number of Cases

%

542 575 1,117

48.52 51.48 100.00

Source: CCASA APP Database.

Very few of resolved cases saw the resolution through full completion. The high proportion of petitions was dismissed very early on in the proceedings. The grounds for such dismissal vary. Two of the most common grounds include the petitioner’s failure to pay the required advanced payment, and the determination that the debtor lacks sufficient funds to cover the costs of the proceedings. The PABU responsible for bankruptcies of socially owned enterprises is administrating the majority of all cases. Table 10 shows the PABU case load at the beginning of 2007. The current case load of PABU appears to be at the higher level than its current institutional capacity, as the PABU is still facing significant challenges in terms of planning, staffing, and case load management. The law on bankruptcy is fundamentally sound in policy and direction and in substance it is being implemented successfully. Two years after enactment, legislative ‘‘fine tuning’’ would be appropriate to remedy some of implementation issues identified in practice.

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Table 10. Item Old law cases New law cases Total Dismissed Total pending

257

PABU Case Load (Beginning of 2007). Number of Cases

%

222 139 361 49 286

61.50 38.50 100.00

Source: PABU.

However, the main results achieved still refer to the small- and mediumsize companies whose assets are successfully sold and brought back to the productive use. Unfortunately, there is still no example of a single big complicated case resolved. Just the opposite – there is reluctance by the courts to verify petitions and formally open the bankruptcy for big cases. At the same time all big cases opened in accordance to the former law are still pending. In the absence of clear political support for bankruptcy, the unions have started to organize and ask for the active role in the process. We are witnessing strikes of the workers in the companies in bankruptcy, as well as all kinds of different requests to the courts and to the government. The executive authorities (government, ministries, BSA, etc.) are not firm in their reactions. In fact, in their public statements they stress their responsibilities are limited since the courts should not be influenced by the executive authorities. In fact, they are only passing the responsibilities to the courts. Demonstration that the process is politically supported is missing. It is fair to say that, in addition to executive authorities, the courts are also significantly contributing to the existing situation. There is still no clear understanding of the requirements of free market economy. A number of judges are still hostages of the self-management system and they give huge weight to the social consequences that individual actions may have. Of course, social consequences are considered from the stand point of the social ownership, rather than market economy. Lack of political will and legacy of old industrial culture are the most important contributors to the slow speed in resolution of big bankruptcy cases, as well as to the implementation of the bankruptcy on companies in restructuring. Political will is also required to strengthen the BSA and PABU capacities including to provide adequate and devoted professionals.

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5. CONCLUSIONS Over the past six years, the Serbian government has achieved impressive progress with ownership transformation process, despite having to act within constraints imposed by specific legacy of social ownership and political instability. Building on the experience of other transition economies, the PA has utilized a variety of privatization instruments – tenders, auctions, pre-sale restructuring, and bankruptcy. The common denominator in all these methods was a competitive and transparent sale, preceded by a thorough preparation of each entity for a successful transaction. As noted above, the guiding principle was to ensure a permanent change in corporate governance and transformation of privatized entities into productive units of the economy, attracting reputable investors, and ensuring inflow of capital and know-how.

NOTES 1. Source: Bosnjak (2001). 2. At the same time, given the fact the so-called secondary privatization follows voucher privatization in order to achieve a concentrated majority ownership, the direct sale method is then not necessarily longer since it achieves this objective immediately. 3. Frozen foreign currency savings bonds were used as a reimbursement to citizens for lost foreign currency savings due to fact that the state-run banks have defaulted on this debt during the 1990s. 4. Following the enactment of a new bankruptcy law in early 2005, the PA (bankruptcy unit) could also serve as a bankruptcy administrator, in cases of state and socially owned companies, where it has been appointed in such capacity. 5. English auction refers to an auction starting at the lowest acceptable price inviting ascending bids until the highest bid is reached. 6. Dutch auction refers to auction method in which the price is continuously lowered until a bidder responds favorably. 7. Ibid. 8. Data Source: Privatization Agency (2007). 9. Data Source: Solvency Center (2006). 10. Ibid. 11. Ibid. 12. Rodden, Eskeland and Litvack (2003). Full text online: http://www1.worldbank. org/publicsector/decentralization/hardbudget.htm 13. Liebermen and Cvetkovic (Various dates 2005–2007). 14. Substantial portion of this debt is attributed to the guarantees issued by Yugoslav banks for external borrowing by SOEs in the socialist period. Although most of this debt was written off as part of Serbia’s settlement with Paris and

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London Club creditors in 2001–2002, the enterprise liabilities to the banks, which by then had been put in bankruptcy, were not adjusted accordingly. In other words, a reduction of the state’s liabilities to foreign creditors did not result in a corresponding reduction of government’s claims on debtors in the real sector. 15. Begovic and Paunovic (2005), Real sector restructuring. In Four years of transition in Serbia. Belgrade: Center for Liberal Democratic Studies. 16. Private Sector Note (2004). 17. Another option (used less commonly) is that the requested bid is for a cash price (if any) and the amount of state debt to be assumed. The winning bid is the best combination of the two factors. 18. If no offers are received, it means that the market is not willing to pay any price for the company, neither in cash nor in the form of debt assumption. In this way the market signals that the company cannot be sold even with debt workout, and that it should be liquidated or put into bankruptcy. 19. Posusney and Cook (2002). 20. In tender privatizations, the buyer’s social program is one of the three basic criteria used for bid evaluation purposes (in addition to the cash price and investment program). Similar attention to treatment of workers is given to companies sold through auctions. 21. In theory, the government’s SP should only be open to companies that cannot attract any positive cash bid without pre-sale labor shedding and to ‘‘marginal companies’’ for which the expected sales price is positive, but where the difference between investment value and the costs of implementing a social program are not high enough to mitigate implementation risks from an investor perspective. In practice, political factors have inevitably influenced the eligibility decisions for individual SOEs. 22. For cases initiated before February 1, 2005, the procedures under the new law may apply depending on the extent that the assets of the debtor have been sold. If more than half of the property of the debtor, as defined by book value of its assets, has been sold the old law applies. Otherwise, the case continues under the new law. 23. According to the data collected by Booz Allen and Hamilton team under USAID (United States Agency for International Development) as well as CCASA (Commercial Court Administration Strengthening Activity) Project CCASA. 24. ‘‘Impact Assessment of Privatization in Serbia’’ – Report prepared by the IDOM/SEECAP consultant team (Cordet-Dupuoy & Temse, 2005) as a part of the ‘‘Preparation of Companies for Privatization’’ project, EuropeAid/116898/D/SV/YU.

REFERENCES Begovic, B., & Paunovic, M. (2005). Four years of transition in Serbia. Belgrade: Center for Liberal Democratic Studies. Bosnjak, M. (2001). Analytical basis for macroeconomic stability and development policy of SR Yugoslavia. Belgrade: Federal Secretariat for Development and Science. Cordet-Dupuoy, A., & Temse, J. (2005). Impact assessment of privatization in Serbia. Part of the ‘‘Preparation of Companies for Privatization’’ project prepared by IDOM/SEECAP.

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Lieberman, I., & Cvetkovic, M. (Various dates 2005–2007). Direct and indirect subsidies and transition fund payments. Belgrade: Briefing Notes for the Government of Serbia and Privatization Agency. Posusney, M., & Cook, L. (Eds). (2002). Privatization and labor: Responses and consequences in global perspective. Northampton, MA: Edward Elgar. Private Sector Note. (2004). Hard budget constraints, restructuring and privatization in Serbia: A strategy for growth of the enterprise sector. The World Bank (mimeo). Privatization Agency. (2007). Republic of Serbia (numbers represent data provided by the privatization Agency (PA) or calculations based on the data provided by the PA). Rodden, J., Eskeland, G., & Litvack, J. (Eds). (2003). Fiscal decentralization and the challenge of hard budget constraints. Cambridge, MA: The MIT press. Solvency Center. (2006). National Bank of Serbia (numbers represent data provided by NBS’ Solvency Center or calculations based on those data).

CHAPTER 7 THE RISE AND FALL OF RUSSIAN PRIVATIZATION Ira W. Lieberman 1. INTRODUCTION Russia’s size – both in terms of population and geography, spanning 11 time zones, 89 oblasts (states or regions) and autonomous republics and its privatization program, encompassing some 100,000 small-scale enterprises, 25,000 medium to large firms, and 300 or so of its largest firms, made its privatization program the largest sale/transfer of assets conducted among the transition economies, with the possible exception of China. Comparisons by many of the program’s critics, and there are many, to Poland, Hungary, or the Czech republic are invidious, especially the latter two countries whose populations are similar to just that of greater Moscow. The Russian Privatization Program went though a number of phases. During the period of the Gorbachev Reforms, 1986–1990, Perestroika, privatization was dominated by spontaneous privatization and leasing out that also included lease purchase agreements. But the Gorbachev reforms were an attempt to reform socialism and not to move Russia towards becoming a market economy. The next phase of the program under the Yeltsin Administration, from 1992 to 1994 was the privatization of some 75,000–100,000 small-scale enterprises and the mass (voucher) privatization (MPP) of some 16,000 medium to large enterprises. From September 1994

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 261–343 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00007-1

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through 1995, the program focused on the sale of residual shares left over from the MPP for both cash and through so-called tenders (Fig. 1). In September 1995 the Government carried out the loans-for-share auctions and attempted to partially privatize Svyazinvest, the national telecommunications company, on a stand alone basis, using the more classical case-by-case methodology. During 1997–2000, most privatization cases either confirmed the loans-for-share auctions or were a matter of the Government selecting suitable owners for a state-owned company. By contrast, one of the real success stories in Russian privatization, little known and little commented upon, was the restructuring and privatization of the Russian coal sector. Finally, in recent years, there has been no privatization, rather an effort by the Putin Administration to reduce the power of specific oligarchs and to break-up their conglomerates, in some cases large financial industrial groups (FIGs). FIGs and other large industrial holding groups are an important outcome of the privatization program and these are discussed briefly in this chapter. Also, the Putin Administration has sought to increase state control over certain strategic sectors of the economy and has done so by reacquiring or nationalizing a portion of the joint-venture ownership of foreign investors, the oil majors, in Russian oil and gas properties. The nationalization is increasing the size and holdings of the two state-owned giants, Rostneft, an integrated oil producer, and Gazprom, now an oil and gas giant. In a postscript to this chapter on Russian Privatization, we will briefly examine the Putin administration’s policies with respect to the nationalization, the oligarchs, foreign direct investment, and the oil and gas sector.

2. PRIVATIZATION UNDER THE GORBACHEV REFORMS 2.1. The Industrial Legacy1 Until the Gorbachev reforms of 1985, the USSR followed a classic centralplanning system. The state played an overwhelming role in the economy. In all Eastern bloc countries, the state was the dominant economic player, but there was a notable variation between the USSR and Eastern bloc countries. In the Soviet Union it has been estimated that in 1985, 96% of the net material product (NMP) was produced by the state sector.2 In 1984 in China, the figure was 82% and in Hungary, 74%. Only the former Czechoslovakia and East Germany had higher figures – 97% (1986) and

1987-1990 Power devolves from center and branch ministries to regions and enterprise managers. Spontaneous privatization.

1987-1989 Law on Socialist Enterprise Law on Cooperatives Law on Enterprise Leasing by Workers

Nov. 1991 Y. Gaidar appointed deputy pm for economic reform July 1991 Basic law on privatization

December 1994 Begin cash and tender sales of residual shares

Jan. 1992 Price liberalization

August 1991 Coup attempt by Communist hardliners. Breakup of USSR

Dec. 1992 First voucher auction

June 1994 Completion of MPP

July 1992 Vouchers introduced October 1993 Yeltsin vs. Parliament stand-off

November 1995 New law promoting FIGs passed

July 1995 Duma passes land reform bill permitting lease, but prohibiting sale, of land

Nov.-Dec. 1995 Loans for Shares auctions

Sept.-Dec. 1995 Unsuccessful Svyazinfest I attempt

Feb.-Nov. 1992 Design and preparation of MPP

Fig. 1.

May-June 1996 Oligarch finance Yeltsin’s presidential campaign, compete in privatizations of large companies

August 1998 Government default, ruble devaluation. Collapse of commercial banking sector

Sale of LFS pledged shares postponed to Sept. 1996

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Privatization Timeline

1997 New privatization law; Sale of Svyazinfest II, oil companies

1998 Failure of large privatizations: Rosneft, Gazprom, Svyazinfest III

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96.5% (1982) respectively. It has been estimated that there were 47,000 state enterprises in the USSR industrial sector.3 If energy and large service firms are included, the total rises to 55,000. Soviet state enterprises were large and monopolistic. Of the 7,664 product groups distributed by the former Soviet Gossnab (Committee of Deliveries and Supplies), 77% were produced by just one firm. The high degree of industrial concentration and the size of the Soviet market meant that the average Soviet enterprise was far larger than its counterpart in either the Western or Eastern bloc.4 The average number of employees for the largest 952 firms in manufacturing and energy was over 8,500; the average for all 25,000 enterprises in these sectors was 821, ten times the equivalent figure for a range of Western countries. The largest enterprises in the former USSR (AVTOVAZ, which produced cars, and KAMAZ, which made trucks and tractors) each employed 100,000 employees. This industrial legacy of a high degree of both state ownership and industrial concentration dramatically increased the scope and complexity of the privatization program, as well as the need for an effective post-privatization corporate governance system.

2.2. Gorbachev’s Reforms Gorbachev’s reforms, from 1985 to 1990, were the first systematic attempt to dismantle the central planning apparatus. The reforms had considerable impact on the privatization program. The broad aims of the reforms were to transfer decision making power from the branch ministries (branch ministries controlled sectors of the economy such as fertilizers, mining, telecommunications, oil and gas, light industry, etc.) and the central agencies to enterprise managers, and to allow (and encourage the formation of) non-state forms of enterprises. Enterprise managers’ new rights were laid out in the 1988 Law on State Enterprises. Managers were given leeway to retain and allocate internally generated funds (particularly for wages and bonuses), change product design, expand into foreign markets, seek foreign joint venture partners, and borrow from outside the official funding sources. Most important, mandatory production targets were replaced with ‘‘state orders.’’ Enterprises were now free, after fulfilling state orders, to produce and sell as much output as they could. Initially, this meant little, since state orders covered 90% of industrial output. State orders, however, were progressively curtailed and managers were given real power over output decisions. From 1989 on, branch ministries were reduced and reorganized, considerably

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restricting their power over state enterprises. During the Yeltsin Administration, these ministries sought to reassert themselves (as holding companies, joint stock companies, trade associations, and so on), forcing the privatization program to require corporatization of SOEs at the lowest institutional level. That had an important impact on the structure of Russian industry post privatization. Cooperatives and leaseholds were permitted from 1988, and small private companies, limited-liability companies, and joint stock companies were permitted from 1990. Cooperatives were frequently sub-contractors or spinoffs from state enterprises and were often set up to exploit privileged access to scarce goods. Likewise, lease holdings were usually subunits of large state enterprises. Groups of workers would lease space and equipment from their state enterprise. Leaseholders were free to accumulate new assets through retained earnings or bank loans, with these assets becoming the property of the leaseholders. Agreements to buyout the leased assets were also common. It was estimated that some 2,000–2,500 firms privatized under the MPP, was a recognition of the managers and workers lease–purchase rights. As intended, Gorbachev’s reforms transferred power from planners to workers, managers, and regional authorities. What was not anticipated was the manner in which these groups began to exploit their new found freedoms. State enterprises began rapidly increasing workers’ wages, bonuses, and welfare expenditures. This led to a sharp decline in after-tax profits remitted to the state and contributed to a federal budget crisis. Spontaneous privatization was prevalent as managers began to divert profits and assets both legally (through cooperatives and leaseholds) and illegally. The demise of the Communist Party and its associated organs of control made this possible. This process accelerated in 1991 as employees used the purchase option in lease agreements with a new right to set up joint stock companies, often buying leased assets at book values – a fraction of their true value. Similarly, local authorities took control of infrastructure in their region or municipality (water, electricity, and so on) and demanded control over enterprises within their jurisdiction. Governments at all levels lost many of their ownership rights to enterprises, which had been ceded to workers, managers, and local authorities. Russia’s MPP, by necessity, had to recognize and incorporate these new and competing ownership claims.5 Above all, the so-called red managers increased their control over the enterprises and in time their power over their workers. The traditional checks and balances through the branch ministries and the Communist part, were largely dissolved. In fact, a new power emerged out of this process, that was to play a powerful, behind the scenes role during the Yeltsin

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Administration, the Union of Industrialists and Entrepreneurs, whose managing director, was Arkady Volski. The Union initially represented the military industrial complex, not subject to privatization, and in time much of Russian large industry.6

3. LEGISLATIVE AND INSTITUTIONAL FRAMEWORK The first steps towards privatization were taken by the Gorbachev government in July 1991, when the former Soviet Union Supreme Soviet passed a law on ‘‘The Basic Foundations of Denationalization and Privatization of Enterprises.’’ An equivalent law was passed by the Russian Supreme Soviet a few days later. Previous reform packages, such as the ‘‘500 days’’ program put forward by Grigory Yavlinsky and Stanislav Shatalin in mid-1990, had mentioned privatization but had never contained a detailed program. These packages were ultimately abandoned. Although the 1991 law was later amended, it remained a blueprint for privatization. It laid down procedures, outlined the organizational infrastructure for implementation, and mandated a detailed annual privatization program. Even at this early stage, the law foresaw workers receiving discounted shares in the enterprise in which they worked, state enterprises converting into joint stock companies, and vouchers being distributed. But given the political turbulence and uncertainty generated by the coup in August 1991, the break-up of the Soviet federation, and Yeltsin’s initial focus on macroeconomic stability, little was done to establish the necessary legal and institutional framework required for privatization. Not surprisingly, by January 1992 the number of enterprises transferred to private and collective ownership had reached only 70 and 922, respectively.7 The privatization program as it unfolded in 1992 and 1993 was heavily influenced by the differences between the Yeltsin presidency and the Russian parliament (the Duma). The parliament acted as a remnant of the communist past and an obstacle to smooth passage of the program. Quarrels over the form and speed of the 1992 privatization program erupted throughout the first half of the year. Significant compromises were made to the anti-reform camp in the passage of privatization legislation through Parliament. The 1992 annual privatization program itself was not passed until mid1992.8 A large number of other enabling decrees and laws covering details were issued from 1991 onward. Topics covered delineation of ownership between federal and local authorities, the corporatization

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process, vouchers, investment funds, auctions, tenders, and other sales procedures. Along with progress on the legislative front, an institutional infrastructure was also established. The State Committee of the Russian Federation for the Management of State Property (1992a, 1992b) (known as the GKI) was reoriented to drive forward the privatization program. The GKI was responsible for formulating and implementing privatization policy. It was also responsible for preparing annual privatization estimates, data on the number of large and medium-size enterprises in the privatization programs, drafting privatization laws and decrees, distributing vouchers, licensing investment funds and enforcing privatization during the course of the privatization process. The GKI was supported by regional (oblast) and municipal sub-independent units. GKI’s subsidiaries (KIs) were attached to local or municipal governments in all of Russia’s regions. The head of the KI was nominated by the governor of the oblast and approved by the central GKI. The director of each municipal KI was appointed by the local mayor. The enterprises were required to prepare a privatization plan to be approved by the KIs. Small-scale privatization was decentralized to the municipal level from the start. While designed on a highly centralized basis, the MPP was implemented on a decentralized basis. This was only way that the program could have achieved its objectives, given the politics of Russia with power devolving to the regions, in particular the Oblast Governors. The Russian Parliament, in an effort to exercise greater control over the privatization program, created a rival agency to GKI, the Federal Property Fund, which reported directly to the Parliament. In addition to the central fund dealing with Federal controlled property, for political reasons oblast level property funds were created and also municipal property funds, thereby creating a parallel structure to the GKI, but responsible to the Duma Parliament. The local property funds controlled the actual sales process, such as publishing the legal notice announcing an auction and distributing property titles. They also exercised political and logistical ownership rights on behalf of the state and were responsible for the management and divestiture of the Government’s residual shares in the MPP. Tension arose between the GKI and the Federal Property Fund, compounded by the overlap in administrative roles. Infighting, however, generally did not filter down to the local or municipal level. Indeed, cooperation between the local and municipal property committees and property funds was the norm, and this ensured a measure of continuity in the privatization process. Russia was the only one of the transition countries, to our knowledge, to create dual privatization agencies, reflecting

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the political tensions between the reformist wing of the Yeltsin Administration and the more conservative Duma, representing both a strong communist party bloc and in time a strong and vociferous, nationalist bloc (as the 1995 elections approached, there was concern that this red and tan coalition would combine to take over both the Duma and the government).

4. PRIVATIZATION: INITIAL STEPS 4.1. Segmenting the Pie All privatization programs in the region had to segment companies as to how they would be privatized. Chapter 2 in this book, ‘‘An Overview of Privatization in Transition Economies,’’ discusses alternative methods of privatization and to some extent this process of segmentation. A series of laws passed by Parliament in 1991–1992 categorized state property as federal, local (oblast), or municipal and allocated responsibility for privatization to property committees and property funds at the appropriate level. State enterprises were also characterized as small or large for the purposes of the privatization program. A large state enterprise was defined as an enterprise with more than 1,000 employees or assets over 50 million rubles as of January 1, 1992. A small enterprise was defined as an enterprise with fewer than 200 employees or assets less than 1 million rubles as of January 1, 1992. Medium-size enterprises were defined by exclusion. Small enterprises followed a different privatization procedure than large enterprises. Most small-scale enterprises were owned by municipal authorities who were responsible for their privatization, whereas most large-scale properties were owned by the federal or oblast authorities. Further, although federal authorities were responsible for the privatization of federal properties, oblast property committees and funds carried out the tasks of privatizing federal properties, getting the approval of the GKI or the Federal Property Fund before proceeding with the privatization. All enterprises, whether federal, local, or municipal, large or small, were allocated to one of five broad categories in the 1992 state program. The 1992 Russian Privatization Program in the Russian language started with a very long list of enterprises by category or sector excluded from privatization. Most were in fact sensible exclusions such as the police, the Central Bank, and Russian bath houses, as an example. This long list of exclusions was a legacy of socialist drafting, making it clear what the state forbid. The English language translation annexed the list of the exclusions

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and worked on the draft for readability, so that the program was presented in a positive light and Western donor agencies would understand that the program meant real reform. All enterprises, whether federal, local, or municipal, large or small, were allocated to one of five broad categories in the 1992 state program.9 (1) Mandatory privatization. This included firms in wholesale and retail trade, construction and construction supply, food processing, light industry, textiles, furniture, agricultural produce, road transport, and all loss-making enterprises (except those that fall into one of the other categories). Most small-scale enterprises fell into this category, together with some 5,000 large enterprises. By having a mandatory category, the Russians created a pipeline of firms to be privatized. This put pressure on oblast authorities to begin privatization as quickly as possible. (2) Privatization with the approval of the federal GKI (after consultation with sectoral ministries). This included large firms that either dominated the market they operated in, employed over 10,000 people, or had assets worth over 150 million rubles on January 1, 1992 (such as railroads, airlines, shipping lines, alcohol, tobacco, pharmaceuticals, and medical equipment). When these enterprises were privatized, the state retained a controlling stake for up to three years. (3) Privatization permitted with government approval. These were firms in industries of strategic importance (natural resources, steel, defense, information and wireless agencies, grain storage, and so on). Given the opposition of anti-reformers in government, privatization of these industries was slow. (4) Privatization forbidden in 1992. This category included entities such as major natural resource industries, the Central Bank, social infrastructure, television and radio stations, ports, and nuclear production facilities. (5) Local privatization programs. This category included most social infrastructure under the auspices of local authorities (such as mass transit systems, health, education, and cultural and sports facilities).

4.2. The Start: Corporatization Corporatization is the process by which a state enterprise becomes a joint stock company with a legal identity. It is no longer an adjunct to a branch ministry. It has its own charter (rights and obligations of shareholders), a board of directors that has the right to appoint and dismiss management

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and operates under the same commercial law as the private sector. All largescale enterprises except those for which privatization was forbidden, had to be corporatized. Subdivisions of large enterprises, meaning at the plant or subsidiary level could also corporatize as a first step towards independence. Medium-size enterprises could also be privatized through either the small (which did not require corporatization) or large privatization program. To be corporatized, an enterprise had to submit a privatization plan, a valuation of its assets (as of July 1, 1992), and a joint stock charter to the local property committee by October 1, 1992.9 Tight-deadlines were set for the corporatization process, as well as for particular stages. In practice the timetable was untenable. Many enterprises filed late, and even a year after the original deadline the process was still far from complete. Insofar as the intention was to create a pipeline of firms ready for privatization, however, the tight deadlines had the desired effect. The constant mantra of Chubais’ team was speed at all costs. There was a concern that the Communists would return to power and annul reforms such as privatization, if it was not made irreversible as quickly as possible. Power over the privatization process was in the hands of enterprise insiders, with the balance of power usually lying with managers. Thus, the composition of the privatization commission (which carried out the practical tasks of the corporatization procedure) was determined by the chief executive of the enterprise. The only requirements were that the commission have between three and five members, one of whom had to be from the workers’ collective. The original 1991 Privatization Law envisaged a much larger privatization commission, with representatives from local state property committees, local citizens, officials of financial agencies, managers, and workers. To accelerate privatization and strengthen the role of managers, the composition of commissions was curtailed in a presidential decree of July 1992 (President’s decree 721). The KIs could do little to hinder the enterprise’s proposals on privatization. For example, the KIs had to approve asset valuations prepared by the privatization commission, but they had little information on which to assess or contest the validity of management’s valuation. In privatization, management always has the advantage of asymmetric knowledge of the insider over potential outside investors. Management had a big incentive to underestimate the valuation since the valuation was taken as the founding capital of the privatized firm and, hence, the basis on which managers and workers bid for shares in the closed subscription. Indeed, this methodology was modified by the July decree to favor speed (and, thus, insiders). The original 1991 Privatization Law envisaged that the valuation

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would be calculated on a market or discounted cash flow basis. Given the understandable difficulties of making projections under rapidly changing economic conditions, the methodology was changed to one based on book values (as of July 1, 1992).10 With inflation running at over 1,000% in 1993, this was a huge transfer of wealth from the state to insiders.

5. SMALL-SCALE PRIVATIZATION Russia’s small-scale privatization was larger than in other Eastern European countries. But the small business sector in Russia was small given the country’s geographic size and population. The GKI estimated the number of retail and service outlets, at the beginning of 1992, were about 270,000 of which a third were in the mandatory privatization category. Given the exclusion of many enterprises from the mandatory category, measuring the extent of the program was difficult. 5.1. Framework The 1991 privatization law and the 1992 annual state privatization program outlined the main features of the small-scale program, leaving municipalities to fill in the details. The legislation stipulated that small enterprises were not to be corporatized (unlike large-scale enterprises) and were to be sold for cash through either an auction or commercial tender. In auction, the enterprise was to be sold to the highest bidder, with no special conditions attached. All potential bidders had to pre-register, deposit 10% of the price as a sign of good faith, and bid in person. The tender process gave municipalities great discretion, which they were quick to use. They could impose post-privatization conditions on potential bidders, with the highest bidder satisfying these conditions acquiring the enterprise. Restrictions covered employment, investment, change of business profile, the financing of social programs, and the preservation of historical buildings. Bidding could be open or closed. Commercial tenders were used for most sales. The two most common restrictions were a moratorium on layoffs and on changing the line of business (i.e., converting from a bakery to a seller of electronics). There was a failed attempt at the federal level to impose a three-year limit on post-privatization restrictions. Such restrictions could be in force between 1 and 15 years. Because of the limited liquidity of the Russian real estate market and the low value of the enterprise’s other assets, usually access to real estate was the

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only asset of real value that ownership of a privatized small enterprise brought. Federal legislation stopped short of giving entrepreneurs the right to buy the premises on which an enterprise stood. For residential or multiunit buildings, a successful bidder acquired the right to lease the premises for 15 years, with the option to buy after a year. Federal authorities, however, did not indicate the valuation methodology and legal procedures by which the premises could be sold. This gap effectively stalled the follow on sale of enterprise premises, even though there were thousands of bidders who, in theory, could exercise their option. This led to a reluctance by entrepreneurs to take part in auctions and tenders. Privatization legislation also provided for liquidation of small enterprises. In this case, a business was halted, its bank accounts closed, employees dismissed, and all assets sold. All liabilities were transferred to the municipal authorities and paid off with the proceeds raised from the sale of the assets. Apart from a few progressive municipalities, liquidation was rarely used. Bidding was open to all interested domestic parties, such as workers’ collectives, Russian firms, or individuals. Foreign participation was allowed only at the discretion of the municipal Soviet, which effectively excluded foreigners. Federal legislation gave workers and managers substantial privileges. If they bid successfully, they received a discount on the purchase price; if they were unsuccessful or did not bid, they received part of the cash from the sale. To qualify for the bidder’s discount, at least a third of the employees must have formed into a partnership or joint stock company. If the employees’ bids were successful, they received a 30% discount and could pay over three years (an installment sale as utilized in Poland), with a down payment of not less than 25% of the purchase price. Given that there was no adjustment for inflation, the three-year payment period dramatically reduced the real value of the purchase price. If the employee partnership or company did not win the bid (or did not bid) in an auction, they received 30% of the cash proceeds, up to an individual limit of 20 times the national minimum monthly salary. If a competitive tender was held, employees received 20% of the purchase price, up to an individual limit of 15 times the national minimum wage. Small-scale privatization started in the city of Nizhny Novgorod (with considerable assistance from the International Finance Corporation, part of the World Bank Group) in April 1992, nine months before the large-scale program began. Nizhny Novgorod was chosen as a pilot city because of the political commitment of the oblast and city authorities (both executive and legislative), to privatization. In April 1992 alone, some 6,700 small-scale enterprises were sold throughout Russia.

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Russia essentially completed small-scale privatization by the middle of 1994. Though it was apparent that small-scale privatization did not catalyze the growth of the small-scale sector in Russia. The business environment – licensing and registering new green-field entry, remained difficult, as it was subject to corrupt bureaucrats at the municipal level. So-called mafia pressures on small businesses remained high as well. The GKI estimated that by March 1994, 75% of the 94,300 wholesale and retail networks in the 1992 mandatory privatization category had been privatized. Another 30,000 nonretail enterprises could be added to those estimates, making a total of about 100,000. The mixed success of the program can be attributed to several causes. First, the number of small enterprises per capita and per unit area in Russia was low to begin with. This was compounded by excluding a large number of enterprises from the program, such as municipal utilities and transport companies and bath houses. Second, even for those included in the program, the nature of their privatization was uneven. It was originally hoped that many of the practices adopted in Nizhny Novgorod (such as transparent procedures, the exclusive use of auctions, lack of restrictions, and the liquidation of enterprises prior to the sale of assets) would serve as a model for other municipalities. But with few exceptions, this did not happen.11 Commercial tenders were clearly the favored technique. More than twothirds of auctions and tenders were won by workers’ collectives, that is, insiders already were running the business. As such, small-scale privatization paralled the MPP. There were numerous instances of post-privatization restrictions on changes of business profile and employment. It is estimated that more than 90% of auctions and tenders were of enterprises as going concerns, rather than liquidation prior to sale. The International Finance Corporation (1992a, 1992b, 1993a, 1993b, 1993c) estimated that 14% of all municipal objects were removed from the privatization process. It also identified many abuses: Yakutsk (Sakha Republic): No auctions or tenders were held and small enterprises were sold exclusively to workers’ collectives. Taganrog (South Central region): Almost all of the small enterprises slated for privatization were leased under Gorbachev’s leasing policy. One leased enterprise was an 87 store monopoly. The municipality patently failed to break-up a torg. Vladivostock (Far East region): The torgs were not liquidated, but reorganized and leased to the workers’ collectives. This left few enterprises that could be sold through auction or commercial tender. Municipal officials

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introduced an additional 80 enterprises into the privatization pipeline and sought ways of introducing another 500 previously excluded enterprises. Petropavlovsk-Kamchatski (Far East region): The authorities sold only unprofitable enterprises and held profitable ones. The mayor also transferred responsibility for privatization from the KI to a department reporting directly to himself, stalling privatization. Nakhodka (Far East region): The city KI, department of trade, and the municipal Soviet excluded 40 of the city’s largest enterprises from privatization ‘‘to demonstrate the city’s ability to manage property and trade enterprises.’’ Ptomaine (western Siberia region): The municipal Soviet removed 60 small enterprises from the program. Moreover, the municipal KI was interested in establishing ‘‘mixed enterprises,’’ in which it retained an equity stake. Those enterprises that were sold were placed under particularly onerous conditions. In the case of one cafe, the KI went so far as to insist that each serving of dumplings be limited to 200 grams per customer. Voronezh (Central region): Eighty percent of the municipality’s enterprises were leased with right-to-buy provisions by the workers’ collectives. Some of these enterprises, tried to resurrect the old torgs. Vologda (North region): The municipal Soviet flouted federal legislation by selling all enterprises to workers’ collectives for book value without using auctions or commercial tenders.

6. SMALL-SCALE PRIVATIZATION EVALUATED The problem of the small number of retail outlets were compounded by a failure to privatize what there was and to privatize it efficiently. To rectify the situation, privatization procedures should have been modified, the connection between privatization and a commercial real estate market strengthened, and the business environment for small-scale entrepreneurs improved. To increase the privatization pipeline torgs should have been liquidated, enterprises excluded in the 1992 privatization program should have been brought in, and the scope of the 1992 program widened. But privatization was only one input into the development of the smallscale private sector. Another was a liquid commercial property market. Because of a lack of supporting legislation, privatization became a surrogate for such a market. But given the restrictions placed on changes in business line and the bias towards workers’ collectives, it was a poor one. Federal authorities should have quickly laid down the methodology by which owners of privatized enterprises could buy premises and then allow these

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owners to sell or lease their property. This would have laid the basis for the emergence of new businesses (though restrictions on changes in business profile would have continued to slow down reallocation of resources). Allowing owners to buy their premises would have underscored the federal authority’s commitment to not changing the ‘‘rules of the game.’’ In contrast to Western retailers, who rarely own their premises, but who have welldefined and legally enforceable property rights or leasehold rights, Russian entrepreneurs were likely to have hostile municipalities as landlords. The way in which municipalities conducted the privatization process did not bode well for the future. It was not just a question of post-privatization restrictions; entrepreneurs also faced excessive municipal taxes as well. For example, businessmen in Oriol, a city in the Central region, faced city taxes of up to 48% of profits, with federal levies on top of that. Access to credit was poor and wholesale supply and transportation conditions unreliable. Municipalities needed to drastically reduce both their involvement in the running of small enterprises and the tax burden, and take up the supervisory roles more traditionally associated with municipal authorities in the West, such as trade promotion, encouragement of investment, and so on. By observation, most small retailers remained in small kiosks through 1995 and were very limited in the range of products they sold. Russian consumers did not benefit, to the same extent, from the flourishing small-scale private sectors that were a feature of Eastern European countries.12

7. THE RUSSIAN MASS PRIVATIZATION PROGRAM (MPP)13 7.1. Overview From early 1992 through June 1994, the Russian Government (GOR) under the auspices of the Russian State Property Committee (GKI), and its Chairman, Anatoly Chubais, designed and implemented one of the boldest privatization programs for medium and large enterprises in the Eastern and Central Europe (CEE) and Former Soviet Union (FSU). The MPP was developed along the lines of similar developments in the Czech Republic, Lithuania, and Poland. However, the Russian MPP was sui generis and audacious in its speed, complexity, and scope. In just two years, the GOR corporatized, registered as joint stock companies, some 24,300 medium and large state-owned enterprises (SOEs), it distributed vouchers to virtually the entire population, 144 million Russians, and carried out auctions in 86 of

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Russia’s 89 oblasts. It succeeded in privatizing some 16,500 enterprises, predominantly in the tradables sector. Nearly 41 million Russian citizens became shareholders, either through direct ownership of shares in the newly privatized companies or through share ownership in voucher investment funds. (Voucher investment funds, financial intermediaries similar to mutual funds, were formed by groups of private investors to acquire vouchers from individuals to invest these vouchers in companies being privatized.) Altogether some 650 voucher investment funds were formed. As a result of the MPP, in excess of 50% of Russia’s industrial production was in private hands as of end June 2004 and some 18 million workers were employed by private enterprises.14 The program was the centerpiece of Russia’s formal privatization process. In contrast to other formerly communist countries, which used a variety of methods to achieve their privatization goals, Russia’s reliance on a largescale MPP imposed a high degree of conformity on the privatization process. In Russia, medium and large-scale enterprises were privatized essentially by a closed subscription to the employees followed by an open voucher auction. In this respect, it differed from the process in the Czech and Slovak Republics and Poland – where a menu of privatization techniques (such as IPOs, trade sales, mutual fund schemes) were part of the overall privatization program.15 The uniformity in the method of privatization not only captured most of the ways that large enterprises in Russia were privatized, but also explains the speed of privatization. Not all Russian enterprises, however, followed the prescribed privatization route. Russia’s significant defense industry, for example, was excluded from the privatization program. The privatization of enterprises in this industry proceeded slowly and informally, away from the public glare. An analysis of the privatization of these enterprises – which, in any event, has been limited – is not within the scope of this chapter (nor is agricultural privatization). As the first country to embrace communism, Russia had an industrial and commercial base that was more heavily distorted by communist planning than most.

7.2. Objectives/Principles of the Mass Privatization Program In drafting the Russian program, reformers focused on a few key principles: De-politicization: Remove the old-line ministries, the governors, and other state institutions from interference with firms and the functioning of the market to the full extent possible, ‘‘We argue that the most important

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objective of privatization is depoliticization of firms or freeing them from politicians’ control.’’16 Speed: As the power of the center receded, managers and workers found themselves in a governance vacuum. On the one hand, the best assets were being systematically looted by spontaneous privatizations. On the other, the state was bailing out loss-making enterprises (either directly through subsidies or indirectly through financing by the state-owned banks) on such a scale that macroeconomic stability was threatened. It was therefore essential to establish a privatization program by which many firms could be quickly privatized. Moreover, Russian reformers, especially Anatoly Chubais and his team at GKI, emphasized speed for political reasons. There was real concern that Communists or Nationalists would come to power and annul reforms, particularly privatization, if they were not made irreversible by facts on the grounds. Hence the desire to give all citizens a share in the process. Transparency and fairness: Proper regulation and procedures were required to ensure that each privatization was adequately reviewed, that a transparent environment was created, and that bidding was as fair and competitive as possible. Political feasibility: There had to be enough incentives to ensure the support of all directly affected stakeholders (workers and managers) and of those who implemented the process (oblast authorities). Political popularity and equity: Market reforms led to a marked decline in living standards for most Russians. It was important to offer incentives to the general public. If privatization were successful, it would have been the first reform that brought benefits to the general public through short-term financial rewards and access to goods and services. Reformers had to create a large and powerful constituency that would have a vested interest in ensuring the continuance of economic reforms. Demand: The program had to stimulate demand for assets as public savings were too low and foreign investment too uncertain to ensure that more than a small fraction of the assets on offer could be sold, even at book values unadjusted for inflation. Decentralization: The program had to be ‘‘bottom-up’’ in approach – that is, enterprises had to carry most responsibility for developing their privatization plans. Moreover, implementation and supervision of privatization had to be at the local level – at the level of the 89 oblasts, autonomous republics, and below that at the municipal level. That demanded uniformity of process through largely local auctions. Only later in the process were inter-regional and all national auctions to be held, the latter largely focused on the 300 or so very large companies (in excess of 10,000 workers per enterprise) that

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joined the MPP with special permission of Minister Chubais, once they saw how substantial the ownership incentives were for managers and workers. Governance: Privatization had to transfer state assets to economic agents with both the incentives and the expertise to undertake the restructuring required to build a healthy and profitable economy. 7.3. Closed Subscriptions One of the major decisions managers and workers had to make as part of corporatization was over the closed equity subscription. Employees had three choices Option 1: Managers and workers were given 25% of the enterprise’s equity in preferred, non-voting shares.17 They also had the option to subscribe for another 10% of ordinary (voting) equity on favorable terms. Given the very high level of inflation at the time, the ruble denominated price in effect became almost a gift. Option 2: Employees could buy 51% of the ordinary shares of the enterprise for 1.7 times the book value (as of July 1, 1992). There were no discounts or deferred payment terms and no sales of non-voting shares. Vouchers and cash could be used to pay for the shares (no less than 50% must be in vouchers). The entire payment had to be made in 90 days. The 70% markup on the book value was an inadequate attempt by the GKI to compensate for inflation. But the pricing did deter managers and workers from gaining majority control of very large SOEs. Option 3: This was open only to enterprises with more than 200 employees and assets of between 1 and 50 million rubles as of January 1, 1992. Managers assumed responsibility for running the enterprise under a contract with the local property committee. They agreed to maintain both the competitiveness of the enterprise and a certain number of jobs for at least two years. If the terms of the contract were fulfilled, managers could acquire 20% of the voting capital at book value with payment over three years. All enterprise employees (including managers) were also given the right to acquire a further 20% of the voting capital at a 30% discount to book value. Option 3 was rarely used. This option was very rarely adopted, as the rules were complex and few trusted what the situation would be like in three years. A vote on which option to choose was made at a general meeting of the workers’ collective. A two-thirds majority was required to choose option 2 or 3. If there was no such majority, option 1 applied.18

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Employees also had two other important subscription privileges – Personal Privatization Accounts and the Share Fund for Employees’ of the Enterprise (FARP). Privatization accounts were a part of an enterprise’s social fund. This was composed of such items as a housing fund, wage fund, bonus payments, and more recently, privatization accounts. Each year part of the enterprise’s net income was allocated to the social fund. Employees could use these privatization accounts to finance their share purchases in the closed subscription (though inflation had reduced their value in real terms). FARPs allowed certain groups of employees to subscribe for up to 5% of the enterprise’s capital after the closed subscription and the voucher auction. FARPs applied to those who could not participate in the closed subscription, such as former or retired employees. Significant restrictions were placed on the use of shares in the hands of the local property fund after the closed subscription. The fund could not vote more than 20% of the equity. Any stock held by the fund in excess of this (40% in the case of option 1 or 29% in the case of option 2) had the status of non-voting, preferred shares with a minimum dividend equal to the bank discount rate. Only on sale to a private investor were these shares to become common stock. These restrictions were imposed to thwart local property funds from trying to maintain direct control over enterprises. Because substantial equity ended up in the hands of insiders, however, these restrictions had unintended consequences. Under option 1, for example, insiders who took up their full subscription received 15% of the equity; but because of the restriction on property fund’s voting rights, insiders had 47% of the voting rights; they did not need to buy many more shares in open subscription to gain voting control. Under option 2 insiders could subscribe for majority control, but even when they failed to subscribe for their full allotment or subscribed for their full allotment and then sold their shares, the 20% voting limit on the funds provided insiders with considerable leeway – before they lost voting control.19 The scale of equity transfer offered through closed subscription was enormous, a reflection of the strength of implicit ownership claims spawned by the Gorbachev enterprise reforms. Managers and workers, through their de facto control of enterprises and their vocal representation in Parliament, were able to mold privatization legislation. Enterprise workers received generous concessions, perhaps more than in any other privatization program in the world.20 Not only did they receive 35% of the equity on generous terms under option 1 or 51% under option 2 (with an opportunity to increase their shares in open subscription), they also had a voice, through the workers’ council, on the choice of option. More importantly, they were

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able to prevent the immediate dominance of strong powerful outside shareholders. In acquiring stakes, managers and workers invested little of their own money, but were usually able to subscribe for the full amount open to them. After taking into account the effects of very high inflation (1,000% in 1993) and the use of discounts, vouchers, payback periods, and privatization accounts, the actual contribution made by workers and managers was negligible. Closed subscription represented a significant transfer of wealth from the state to workers and managers. The original privatization plan envisaged only option 1, which did not offer immediate majority control, inhibit outsider involvement, or represent a de facto veto on future restructuring. Option 2 offered both substantial equity and immediate control. Not surprisingly, more than 70% of corporatized state enterprises chose option 2. The rest chose option 1 and only a handful of enterprises chose option 3.

7.4. Vouchers Vouchers were put on sale a month ahead of schedule (from October 1, 1992) at Sberbank, the state savings bank, to demonstrate that privatization had started in a meaningful way and to build support for the program. The main characteristics of the voucher scheme were: For a fee of 25 rubles, each Russian would receive one voucher with a denomination of 10,000 rubles.21 All citizens would receive a voucher regardless of age, residence, workplace, or income. Vouchers could be accepted by a privatization agency anywhere in the Russian Federation for the sale of state assets. Once received by the agency, the voucher would expire. Vouchers were bearer documents and could be used to buy shares of the enterprise in which the voucher holder works or to purchase shares at the auction of any other enterprise in the Russian Federation, traded in a commercial or investment tender, exchanged for shares of a voucher investment fund, sold for cash, or used to pay for housing and small-scale property. Only the Russian Federation could issue vouchers and only federation vouchers could be accepted by privatization agencies. No local vouchers were permitted. As such for the limited period they were in circulation, vouchers were an important monetary instrument in Russia. Their price rose and fell often related to political events in Russia at the time. Russian reformers had several reasons for allowing voucher trading.22 First, any restrictions on trading would limit an individual’s portfolio

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choices. Second, some people, especially the poor, could sell their vouchers to increase their consumption. Third, given that many people would want to sell their vouchers, even if it were illegal to do so, a black market was bound to emerge – an official market could be somewhat regulated. Fourth, tradability would allow large and powerful shareholders to emerge. It would permit individuals, firms, and voucher funds to acquire as many vouchers as they wished, which is precisely what happened. One argument against voucher tradability was its possible effect on inflation-vouchers, functioning as high-denomination bills, would add to the money stock. In addition, distributing vouchers led to an increase in the nominal wealth of all citizens who, in turn, would potentially increase their consumption and thus inflationary pressure; borrowing against vouchers for current consumption would only result in an increase in the relative price of goods consumed by the poor (food, clothes, and so on). Restricting the use of vouchers so that they were not redeemable for goods and services mitigated their inflationary consequences, but the most potent method was to ensure that there was a rapid supply of enterprise shares, thereby reinforcing the equity-linked basis of vouchers.23 A related issue was allowing vouchers and cash to be used as alternate forms of payment. The decision on payment depended on satisfying a number of policy objectives and constraints.

7.5. Open Subscription The privatization commission had to present a proposal for the sale of the equity remaining after the closed subscription. The three choices for the enterprise were a voucher auction, a voucher auction combined with commercial tender, or a voucher auction combined with investment tender. Given the absence of control from the center, the nature and speed of the sale of the remaining equity was negotiated between the enterprise, local politicians, the KI, and the local property fund. This left a large amount of discretion over the form of the open subscription in the hands of the insiders. Insiders might try to delay the sale either to keep equity in the hands of the property fund, which was likely to be more responsive to their interests and to share their concern over outsider control, or to allow time to accumulate enough capital to buy some or all of the remaining equity. In voucher auctions, local property funds and enterprises often tried to evade the 29% minimum by selling a smaller percentage through a series of auctions in which small stakes were sold. The situation deteriorated so much

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that another decree was issued after the April 1993 presidential referendum reiterating the 29% target and threatening disciplinary measures for failure to comply with the target (presidential decree of May 8, 1993). Compliance improved considerably after this decree. Local property funds also reduced their stakes by using the option of selling up to 5% of the share capital offered in the voucher auction for cash (i.e., up to 5% of the minimum 29%). Property funds were reluctant to sell further shares for vouchers, and most were waiting for the expiration of vouchers at the end of June 1994, when they hoped to sell shares for cash. In contrast to the 5% cash sales, the proceeds from these cash sales were not meant to accrue solely to the local property fund. They were being split with the federal property fund, the local KI, the central GKI, and the federal and oblast authorities. Local property funds retained the option of selling shares through an investment or commercial tender beyond the June voucher deadline. In fact, cash and tender sales took place starting in the Fall of 2004, following the completion of the MPP. The process was far from satisfactory and will be discussed later in this chapter.

7.6. Voucher Funds Russian investment funds were all privately sponsored. The state was limited to providing and ensuring compliance with a prudential regulatory framework. Legislation, including a presidential decree issued in October 1992, followed by an Investment Company Law in 1993, allowed for the creation of both voucher and non-voucher investment funds. The voucher funds were licensed and regulated by the GKI and the non-voucher funds by the Ministry of Finance (MoF). Investment funds were slow to emerge. The first investment fund licenses were not issued until December 1992, three months after vouchers first went on sale. There were logistical hurdles to the formation of funds, such as raising finance, registering, and so on. There was also a lack of public understanding of investment funds, due in part to poor marketing. Even so, the number of funds grew rapidly. It is estimated that by May 1994, there were 624 licensed investment funds (mostly voucher funds), with 550 investment fund managers and 21 million shareholders controlling 45 million vouchers – about 30% of the total number issued.24 By May 1994 voucher funds had invested 27.6 million vouchers. Moscow city had the highest concentration of funds with more than 120 (the Moscow oblast had about 150), while the St. Petersburg oblast had about 35. The largest fund

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had more than 2 million shareholders and 4 million vouchers. Voucher and non-voucher funds could subscribe for cash, though this was not a priority and little cash was raised. Investment funds and managers were regulated in a number of ways, such as the form and nature of investment funds, licensing requirements, the relationship between funds and fund managers, portfolio investment restrictions, valuation procedures, reporting requirements, the rights of shareholders, and so on. Legislation saw voucher funds acting as passive portfolio investors, playing much the same sort of role as their Western mutual fund counterparts. (The Investment Company Law was based on the 1940 U.S. Investment Company Act.) In particular, various restrictions were placed on voucher funds’ portfolios. Funds were not allowed to invest more than 5% of their assets in one enterprise, to own more than 15% of the debt instruments of an enterprise, or to invest outside of Russia. One important restriction was that a fund could not own more than 10% of the stock of an enterprise. This rule (later changed to 25%) initially placed voucher funds at a disadvantage not only to insiders, but also to other private investors who faced no such restrictions, and severely limited the corporate governance role they could play. In comparison, in the Czech Republic, the limit was set at 20%. Thus in the Czech Republic it would require three voucher funds voting together to control an enterprise, whereas in Russia it initially required six. The funds’ behavior was quite different from that originally envisaged. There seem to have been two stages of development. At first the funds were active participants in the voucher market. In addition to trading vouchers for capital gains, funds were selling vouchers to raise cash to meet their current expenses, since they found themselves in a position with little or no interest or dividend income and an illiquid share portfolio. Their only cash reserves were their founders’ capital. The voucher market was the only avenue by which funds could be obtained for current expenses. To the extent that cash proceeds from voucher sales did not come out of trading gains, the fund was paying expenses out of principal. As the pace of voucher auctions increased, funds focused on acquiring blocks of equity in specific enterprises and industries. There seemed to be two broad explanations for this behavior. The first is that, like Czech funds, Russian funds saw more profit in acting as proactive restructuring agents of corporate assets rather than as portfolio investors. Singly or in concert, Russian funds challenged management at shareholders meetings and sought to remove them or otherwise promote restructuring. To gain control, many funds ignored the 10% restriction. Because of the widespread disregard for the

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rule and because it was felt that funds were being unfairly penalized, the limit was raised to 25% in the 1994 privatization program. The second reason for acquiring blocks of equity is the exact opposite of the first. Many enterprise managers sought to expand their shareholdings beyond the level they acquired in the closed subscription. Funds often acquired shares in voucher auctions or in the secondary market with the intention of selling them back to management at a markup. This practice proved to be a lucrative source of profits with which to pay dividends, though in doing so funds were forsaking a long-term investment role and instead fulfilling the role of a broker. By decree, Russian voucher funds had to be closed-ended. That is, they had a fixed number of shares in issue. An investor subscribed capital during specific offer periods, and once the fund was set up, the investor could recoup his or her investment by selling voucher fund shares on the secondary market. Unlike investors in open-ended funds, investors in a closed-ended fund could not subscribe more capital or ask the fund to redeem shares. Though voucher funds were closed-ended, many developed a lopsided nature in that they had semi-continuous subscription periods (in contrast to the limited offer period of a Western closed-ended fund). These funds therefore fell halfway between a closed-ended fund and an open -ended fund in that they subscribed for vouchers on a semi-continuous basis without being obligated to redeem their shares. This caused a number of problems, including the rate at which funds were exchanging their shares for vouchers. Most funds issuing their own shares for a fixed number of vouchers (normally ten shares for each voucher), with little or no attempt to update the price of their shares on any net asset valuation basis. Thus, one group of shareholders was being short-changed at the expense of another. If a fund’s assets were worth more than the price at which that fund’s shares were being sold, shareholders’ investments were being continuously diluted, whereas if the fund’s assets were worth less than the price at which fund shares were being sold, then future shareholders were being short-changed. Thus there was little relationship between fund share prices (to the extent that they existed) on the primary or secondary market and net asset values. Indeed, so long as funds engaged in semi-continuous subscriptions, they had little interest in seeing a secondary market in their shares emerge. Like their Czech and Slovak counterparts, funds were aggressive advertisers, particularly on television. Many made exaggerated claims about future dividends, causing concern among policymakers. Thus there was a regulation forbidding Russian voucher funds making guarantees on future performance. This rule was instituted because of the experience of the Czech and Slovak authorities.

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Still, there were many examples of misleading claims. Indeed, a large number of unlicensed funds were operating. There were a number of scandals in which fund shareholders were defrauded. The GKI sought to improve the situation by setting-up a Funds Monitoring Unit in Moscow to collect information on developments in the industry from oblast KIs, analyze funds’ financial statements, and initiate action against unlicensed funds and other illegal behavior. Two trade associations formed, the Association of Investment Funds and the League of Investment Managers. The latter had self-regulatory status with the GKI and the MoF and was modeled after the Association of Security Dealers in the U.S. and the Canadian Independent Dealers Association in Canada. The connections between banks and the voucher funds were looser in Russia than in the Czech Republic. In the Czech Republic, a small number of privatized former state banks dominated the banking sector. All major investment management companies were owned by the big banks. Thus, through their direct credit relationships and their influence over investment funds, Czech banks emerged with a large amount of control over enterprises. In Russia the banking sector was fragmented. There were over 2,000 banks, most of which were privately established. Although Russian banks established funds, they did not dominate the fund industry.

7.7. Voucher Auctions Most state enterprises were sold locally, though a national and inter-oblast auction scheme was created in 1993. In a typical regional auction, the shares of between 5 and 20 enterprises were sold at the same time. Bidders had to report to the voucher auction center or to a satellite bid center within a specified period (normally in two to six weeks). In the voucher auction, voucher holders had two choices. They could submit any number of vouchers, not specify the number of shares they expected, and accept the strike price that cleared the auction (type 1 bid). Or they could submit any number of vouchers with a specific maximum price, that is, the maximum number of shares per voucher (type 2 bid). Those who bid at or above the strike price were then allocated shares. Those who bid below the strike price did not receive any shares and had their vouchers returned for use in a future auction. There was a large variation in the speed at which regions held auctions. Determined opponents could stall privatization, prevent shares from being sold to voucher holders from outside the region, or both. By March 1994,

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some regions had sold shares in over 370 state enterprises, while others had sold shares in less than 20. As auctions took place, the government became concerned that the intraoblast nature of the auctions was helping those forces seeking to fragment the Russian Federation. It was thought that if inter-oblast holdings could be encouraged, the unity of the Federation would be strengthened. Thus a voucher depository scheme and a national auction network were introduced during 1993 to facilitate inter-oblast holdings. The voucher depository scheme consisted of 30 centers around the country; it allowed voucher holders to deposit vouchers at one of the centers in exchange for a receipt. The receipt was used to bid at a voucher auction held in other oblasts. At that auction, authorities verified the receipt and confirmed it has not been used in another auction. On verification, the voucher holder’s account was debited. This depository system relieved the voucher holder of the need to carry large numbers of vouchers around the country. In addition, an ‘‘All Russia Auction Center’’ was in place starting in March 1993. Although the center was based in Moscow, auctioned enterprises came from anywhere in Russia and could be sold concurrently through a large number of oblasts, Twelve regions participated in the first auction of Zil, the car manufacturer, and the national auction scheme grew to include 72 regions. The center was reserved almost exclusively for the largest enterprises, almost all of which were federally owned properties. Virtually all of these enterprises were outside the mandatory privatization category because of their size, and instead fell in the category requiring federal GKI approval. Because of the political clout the sheer size of the enterprise gave them, managers of these enterprises had considerable discretion over their passage through the privatization and national auction process. In many cases they were able to negotiate special terms not available to firms privatized on a local basis. In addition to the national auction center, a more limited inter-oblast voucher auction was created in which the shares of an enterprise in one oblast were offered to voucher holders in at least three regions. There were no requirements regarding whether a property has to go through this limited inter-oblast auction, but it appeared that most had capital of about 100 million rubles.

7.8. Public Information Campaign Privatization was an intensely political process everywhere, including in Russia. Russian interest groups or stakeholders (workers, managers,

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bureaucrats, politicians, or investors) had a keen interest in privatization, given the possible rewards. Billions of dollars worth of assets were due to move from state to private hands in a short period of time. Not surprisingly, there was considerable maneuvering among the stakeholders for control over outcomes. Policymakers felt that there was a need for an information campaign to mold the public into a constituency with a clear interest in pushing forward the program. The campaign had to overcome indifference and hostility to both economic reform and privatization. Various media were used in the campaign – advertising on national television, on the radio, in print, and in prime-time weekly programming devoted specifically to privatization issues. Regional information offices were set up and regional training seminars held. An educational brochure, ‘‘Privatization in Your Pocket,’’ was produced, and mass publicity ‘‘privatization days’’ were organized. The campaign was split into phases. The first was an aggressive promotion of the voucher-distribution program. The second distinguished privatization from hyperinflation (which many thought stemmed from privatization), by portraying privatization as the principal means for economic change. The next phase dealt with the irreversibility of privatization. In this phase, the campaign moved beyond discussing vouchers by highlighting the national voucher auctions and identifying privatization success stories. Another use of public information was to increase transparency in privatization. The privatization law required advertising for enterprises that were to be sold in national or local media. Additionally, at bid centers, information on companies to be auctioned was provided (such as sales and export figures, number of employees, major products, and so on). While this requirement increased the cost of the public information program, it was critical to keeping privatization transparent. The provision of public information also signified a break from the communist past.

8. IN THE WAKE OF MASS PRIVATIZATION Despite all of its accomplishments, the Russian MPP has been criticized for leaving in its wake a legacy of problems many of which had to be overcome, if Russia was to succeed in restructuring its industrial sector so that it was efficient, competitive, and truly market-driven. Problems included the following: (i) excessive insider ownership by managers and workers; (ii) failure of the MPP to address the real restructuring needs of Russian industry; (iii) imperfect property rights for Russian shareholders and

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governance practices which ignored the rights of minority, primarily external shareholders; (iv) failure of the process to generate revenues for the Government; (v) special deals which gave undue protection for sectors such as oil, gas, and electricity; (vi) a residual government stake held in many large firms which still needed to be divested to prevent the Government from ‘‘clawing back’’ into recently privatized firms; (vii) an inadequate legal and regulatory framework for the newly created private sector to operate within; (viii) capital markets and a capital market regulatory framework unable to cope with the results of privatization; and (ix) a number of very large firms, particularly in the military industrial complex, which were left out of the MPP whose restructuring and conversion needs also had to be addressed. In fact, it is clear that Russian capitalism was going through an unbridled ‘‘wild west’’ or in this case perhaps more appropriately termed a ‘‘wild east’’ stage. This chapter will not address criticisms of the MPP listed above; many of these issues were questions of timing and sequencing of reforms. However, they were meaningful in light of the subsequent stages of privatization, and lack of sufficiently robust reform efforts thereafter meant to address many of these issues.25,26

8.1. The Average Citizen’s Point of View From the perspective of the Russian population, the so-called average citizen, the issues are perhaps simpler and more telling in the long run. There was the perception that the MPP process overwhelmingly favored the nomenklatura and the ‘‘Mafia’’ (meaning in this case any one with the wealth to acquire significant stakes in Russian industry). Despite the distribution of vouchers to the entire population, people felt that they have received relatively little from privatization as their inheritance from the former system. Especially, as they had always been told that they were the real owners of the enterprises. In addition, the widening income disparities and the visible wealth of the ‘‘new Russians’’ left much of the population feeling excluded from any benefits of the reforms and, in particular privatization the most publicized, talked about, and demonstrable part of the reforms. Rampant inflation had eroded people’s savings. Public opinion surveys taken during the privatization process indicated that the population tended to confuse and intermingle the results of privatization and the ravaging effects of inflation, the only two very visible changes from its perspective from the reforms.

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8.2. Too Much is Expected from Privatization and a Small Group of Reformers From its inception, the Yeltsin administration had within it some very strong conservative, anti-reform elements, and a relatively small group of ardent reformers. The reformers had little real resources or real power to stabilize the economy, provide for the general welfare of the population and create a truly competitive and efficient market economy. The MPP was designed to rapidly transform ownership in thousands of enterprises in the tradables sector, but initially these were seen as enterprises without much strategic impact on the economy. In order to gain Duma (Parliamentary) approval of the program, the MPP was forced to provide for substantial insider ownership incentives to workers and managers. In its review of the program the Parliament, added an option for workers and managers to acquire a majority stake in their enterprise, an option not contained in the original MPP proposal as submitted to the Parliament by GKI. The 1992 Privatization Program, also excluded very large SOEs with over 10,000 workers from being privatized without Government permission. Strategic enterprises – oil, gas, electricity, and other natural resources, military industrial enterprises, and enterprises affecting public health and safety were all excluded from being privatized under the MPP. The initial battle over the MPP by enterprise managers was how to get their enterprises on an exclusion list. In fact, the program in its Russian language version started with a very long series of lists of enterprise categories excluded from the MPP. It was only as the MPP was being implemented, that enterprise managers of very large and strategic enterprises realized that they could gain control of or a significant ownership stake in their own enterprise. They, therefore, began ‘‘jumping over the wall’’ at a rapid rate so that by June 1994 some 313 of Russia’s largest enterprises were privatized or partially privatized under the national auction system created by the GKI to supplement the strictly regional auctions which formed the original basis of the MPP. Many of these enterprises such as oil and gas were privatized under specifically negotiated arrangements for the sector. For example, in the oil sector the Government was to retain 38% of the shares, equal to 51% of the common voting rights, for a minimum of three years. Also, a special block of shares was set aside for workers in the oil industry and native populations living in oil producing regions. The Government was not able to tap or have access to its rich resource companies to assist the stabilization effort, to support a welfare net for poorer elements of society, or to service its external liabilities. Neither royalties from

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resource extraction, dividends on its ownership stake, or taxation of those enterprises which were nominally or truly private accrued to the government in any meaningful way. Nor had the Government, until the inadequate attempt to privatize Svyazinvest, tried to privatize any of the larger enterprises to maximize its revenue from the sale. Ownership and governance was an odd mixture of insider (largely management) control, government patronage amid protection of these ‘‘strategic’’ enterprises at very high levels and overall avoidance of taxation through legal and illegal means.27 Gazprom, for example, maintained a large capital expenditure reserve, which kept much of its earnings immune from taxation. Oil and metals were simply exported out the back door during the nineties, allowing these companies to avoid taxation, while accumulating substantial offshore cash reserves. All attempts to reform and re-write Russia’s tax code was blocked by the Duma. Throughout the period, the errors and omissions statistics in Russia’s balance of payments reporting was very substantial, indicating that there was a very substantial flight of funds from the country, just when more Federal resources were required as a safety net for a struggling population, many of whom were adversely affected by the transition. Not surprisingly, during the last phases of privatization, many of Russia’s most valuable or strategic enterprises were included in special insider arrangements, known as loans-for-loans transactions, discussed in detail in subsequent sections of this chapter. The one exception to the loansfor-shares (LFS) transactions, was Svyazinvest, a telecom holding company spun off from the Ministry of Communications. The Svyazinvest transaction was conducted as an international tender under the auspices of the Russian Privatization Center (RPC) in cooperation with GKI and the Federal Property Fund. The Svyazinvest transaction failed because the RPC was given just four months to put together an advisory team and close the deal so that the Government could generate $500 million dollars in revenue for its stabilization program, in turn for a 25% stake in the company. It was clear from the start that neither the Government’s advisers, nor the potential buyers could do satisfactory due diligence for the transaction. Moreover, the regulatory framework was not adequately spelled out.28 Too much was expected from privatization in Russia, when in fact privatization was but an important part of overall reforms. In the Czech Republic and in Poland, and at a later date Hungary, as examples, privatization was integrated and sequenced into the overall reform and liberalization program of the Government. In Russia, privatization occurred in a macroeconomic environment, which was highly unstable and volatile, characterized by very high rates of inflation, an unstable exchange rate regime, and large fiscal

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deficits. Moreover, government interventions in the economy were often as not unpredictable and destabilizing. Reformers were made dependent on loans and grants from institutions such as the World Bank, the IMF, or bilaterals such as USAID in order to affect any real reforms and to stabilize the economy. The old guard, the nomenklatura in Russia’s Government, divided up the spoils of oil and gas and metals among their family and friends. More than any other country in the region – the CEE and FSU, Russia had all of the means to turn around its economy. However, the reformers, led initially by Gaidar and thereafter largely by Chubais, never had these resources available to them, nor the political will of the Government and the Duma.29

8.3. The Political Situation As fiscal deficits grew and it became clear that the government needed to become serious about stabilization, the GOR found itself with little room to cushion large segments of the population from increasing poverty, particularly as major revenue generating resources and assets had been sequestered from taxation and supporting overall public welfare.30 This led to a political situation where by the 1995 parliamentary elections and thereafter the Presidential elections, much of the population favored a radical change in government either on the left, presumably to return to a state led system to cushion it from the adverse effects of the market; or, on the right to elect a ‘‘strong’’ leader who would lead the country out of its social and economic morass. The potential for a brown and red coalition was widely talked and written about, both within Russia and abroad. Presidential elections in July 1996 had significant implications for continued reform and specifically privatization.31 Given the political situation at the time, and the highly political nature of privatization, reform elements in the Government had little power or influence to reestablish a truly open and transparent privatization program. There may be a number of things which could have been addressed at the margins. However, privatization of important enterprises via an open and competitive process which established a level playing field for potential investors and entry for foreign investors was not feasible at that time.

8.4. Institutional Failure At the end of the MPP, in September 1994, the original team which had conceptualized and implemented the MPP left GKI and spread out to deal

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with other pressing reform issues. Anatoly Chubais left GKI, was promoted to First Deputy Prime Minister, and eventually took charge of all aspects of the economic reform program. Above all he focused on the stabilization/ anti-inflation program as the Chairman of the Reform Committee of the Russian Federation. Dmitry Vassiliev, the former Deputy Chairman of GKI under Chubais, moved over to become the Chairman of the Russian SEC. Maxim Boycko, a key adviser to Chubais and Vassiliev at GKI, moved over as the CEO of the Russian Privatization Center (RPC) and focused on post-privatization technical assistance such as restructuring. He eventually joined the Reform Committee of the RF as a Deputy to Chubais and worked largely on tax reform and redrafting the tax code. Jonathan Hay and Albert Sokin, the other primary advisers to the GKI, moved on to legal reforms and to assist Vassiliev in capital market development. Virtually the entire team, which had developed and implemented Russia’s initial privatization program, left GKI, leaving a knowledge and leadership vacuum. President Yeltsin named a new Chairman for GKI to replace Chubais, V. Polevanov, a geologist from the city of Blagoveschensk, Amur oblast, who had no background in privatization. He threatened to renationalize Russia’s larger industrial firms. Polevanov was soon replaced by Sergei Belayev who came to GKI from the St. Petersburg GKI where he had been in charge of the city’s privatization. However, the damage had already been done. The perception existed that Russia was stepping backward. Soon thereafter Belayev was moved on to a political post of the election campaign manager of the newly created party – Our Home Russia (Nash Dom Rossia), and later became the party’s whip in the Duma. Albert Koch, was left as Acting Chairman of GKI. He came to the position with detailed knowledge of Russian industry, but generally unprepared to deal with large-scale privatization tenders or the proposed LFS transactions. Moreover, GKI had no procedures or guidelines established for conducting such tenders, as none were carried out at the time the MPP was being implemented. The Federal and Regional Property Funds, on the other hand, were left on their own to implement residual share sales and tenders with little in the way of policy guidelines from GKI, no advisory assistance and little in the way of resources. The Government hoped that cash privatization would generate significant budgetary revenues. Donors’ support was channeled into other areas of post-privatization reforms – capital markets, legal reform, and restructuring. Cooperation between the RPC and these institutions barely existed. In conclusion, both GKI and the Property Funds were institutionally weak and were not qualified to carry out the next phases of privatization.32

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9. PHASE II: RESIDUAL SHARE SALES FOR CASH AND ON TENDERS33 After the voucher program was completed, the GOR started the second phase of privatization. The rules of the cash phase were summarized in a new version of the privatization program approved by a presidential decree in July 1994. Compared to the previous program, the new one was based on the following principles: (i) abolition of the mandatory quantitative indicators relative to the number of enterprises to be privatized, assigned to each region; (ii) reduction of insiders’ privileges (if managers and workers want to acquire more than 10% of common shares the price would be indexed to reflect the revaluation of fixed assets); (iii) increasing role of the regional administrations in privatization; (iv) channeling most of the privatization proceeds to the enterprise itself (more than 51%); (v) standard valuation methodology; and (vi) active real estate privatization. Among the methods for the cash phase the program envisaged the following: (i)

Cash auctions, were to be used for sale of small- and mediumsized enterprises, or for sale of relatively small blocks of residual shares. Cash auctions were widely used during the MPP, since about 10% of equity of each enterprise were reserved for cash sales to cover the costs of voucher auctions. At these auctions typically (but not always) a block of shares was sold at an open auction for a higher price. (ii) For bigger companies and/or blocks of shares specialized cash auctions were organized (7,000 enterprises were slated for these auctions). This type of auction was conducted in much the same manner as voucher auctions, with cash used in place of vouchers, when the auctioned share block was pro rata distributed among the cash bids, which were – higher (or at least, equal) than the auction price – a market clearing price. Bids lower than auction price were not satisfied. Non-priced bids were accepted and satisfied at the auction price. As in the MPP the second phase envisaged inter-regional specialized cash auctions (those in which not less than 15 regions – subjects of the Russian Federation – participated) and national specialized cash auctions (more than 25 regions) for larger companies which were sufficiently known to attract investors from the regions beyond the one where it was located. Some 811 enterprises were slated for national specialized cash auctions.

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(iii) Investment tenders were typically conducted as a closed bid and may or may not have included a requirement for direct enterprise investment (commercial banks were excluded from participating in investment tenders directly, but that did not exclude their industrial holding groups from participating): Usually the bids were evaluated by a tender commission, comprising of the local government officials, on the basis of the investment program proposed by a bidder. (iv) Commercial tenders usually attached specific requirements to the bids which were evaluated not only on the basis of the highest price, but on the specific tender criteria as well (e.g., keeping the existing production profile of the enterprise, keeping the employment level, and/or supporting the social assets). Some times the bids were evaluated on the basis of the ‘‘best business plan proposal’’ and were often quite subjective. (v) Sale of shares at the stock exchange was envisaged in the program, but not widely used due to the lack of demand from investors who were reluctant to buy shares of newly launched companies unless they were floated on the market previously and had an established value. Implementation problems: Since the focus of the new stage of privatization was on restructuring and investment needs of enterprises initially, the leading method of privatization became investment tenders and not cash auctions. Other reasons for the limited usage of cash auctions were lack of sufficient information about the cash sales and a small number of potential investors willing to spend cash to buy blocks of shares of less attractive enterprises slated for cash sales. A belated approval of the procedures for specialized cash auctions (April 1995), similar to voucher auctions, was another reason for very poor showing of cash auctions at the inception of the second stage of Russian privatization. The experience of investment tenders in late 1994 and in 1995 proved to be unsatisfactory. The non-transparent procedures and formal and simplistic criteria gave an opportunity for dubious firms to acquire blocks of shares for a nominal price. Firms with a charter capital of some hundred thousand rubles presented applications with offers to invest billions of rubles. Having won the tender, such firms could re-sell the shares. The investment programs were not examined properly. There was no systematic control-over investment commitments and investment schedule. There were cases when the shareholders meetings changed the program and/or business plan envisaged by the sales contracts. The owner could illegally sell the

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shares to a new one without fulfilling the investment program. But the new owner could only be deprived of the shares through inefficient court procedures. By early spring 1995, the Government realized that investment tenders did not meet their targets. Experience with cash auctions were not satisfactory either. Many sales failed to draw any bids when the offer price was not attractive enough. Even the companies which were well known, failed to bring in many bids due to the lack of sufficient information on the companies and small investors’ reluctance to pay cash for shares. The national specialized cash auction for 4.5% of the stock of the Central Electric Grid RAO UES Rossii lasted for two months and closed in late December 1995. The authorities managed to place only 0.62% of the shares putting pressure on the employees to bid for shares in order to avoid a total fiasco.

9.1. Fiscal Pressure on the Russian Government In the second half of 1995, the GOR approach to privatization changed: privatization was not viewed anymore as a major institutional transformation, but as a means to replenish the state budget with non-inflationary proceeds. The record in this respect was not as good as with quantitative targets of the voucher privatization. The Russian Government expected to receive 9.1 trillion rubles of privatization proceeds in 1995. In reality the target was missed by more than 50%. In the first quarter of the year the federal budget received only 39 billion rubles or less than 0.5% (see Table 1). On May 11 a Presidential Decree was signed on measures to secure privatization proceeds for the federal budget. The allocation of privatization proceeds to the federal budget from sales of federal property was increased to 55% (and reducing that of the regions). In order to meet the proceeds target the total value of shares to be sold in 1995 was targeted at about 24 trillion rubles (see Table 2). Table 1. Privatization Proceeds, 1993–1995 (in Billion Rubles).

Total privatization proceeds As percentage of tax receipts Federal budgets’ share Regional budgets’ share Source: GKI

1993

1994

1 Quarter 94

1 Quarter 95

310.1 0.8 62.6 247.5

734.7 0.5 113.5 621.2

116.7 0.6 23.0 197.6

272.3 0.5 39.0 233

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Table 2.

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Expected Privatization Proceeds for 1995 (in Billion Rubles).

Sources of Proceeds

Shares of the newly created oil companies Other state blocks of shares (except oil and gas) Residual shares at the disposal of the RF Property Fund Shares of newly privatizing enterprises Plots of land Real estate Dividends Leased buy-outs Total

Expected Proceeds (Billion Rubles, 1995)

Percentage

10.66

43.5

1.65

6.7

4.86

19.9

0.8 1.05 3.41 0.82 1.24 124.49

3.3 4.3 13.9 3.4 5.0 100.0

Source: GKI

9.2. Failure at the Regional Level The regional authorities were unable to play the role of locomotive of the new phase of the Russian privatization. One obvious reason was redistribution of the privatization proceeds in favor of the center at the expense of the periphery. The incentives had changed. Local authorities were less motivated to push for quicker massive sales. The initial targets of 1 trillion rubles GKI expected to be collected from the sales at the regional level in 1995 were not reached, and not more than 400 billion rubles were received. Foreign investors were totally absent in almost all regional privatizations. Another reason for the regional failure was the attitude to privatization of many regional administrations who were reluctant to pass authority over the enterprises to private owners, especially to outside investors. The directors of the SOEs were afraid of losing their positions after privatizations, lobbying with the local administrations in order to postpone privatization. In many oblasts not a single privatization happened during 1995 (e.g., Orenburg, Sverdlovsk, Ulyanovsk, Murmansk, Altai krai). Some local authorities initiated re-nationalization using different pretexts for their actions. The city of Moscow ran its own privatization program. For example, the Moscow City government demanded a 50% share in the capital of GUM, the central department store on the Red Square in Moscow, because the building was a historic monument which belonged to

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the state (represented by the city authorities), hence the building was not privatized, when GUM became a private company. The ethnic diversity of the Russian Federation added another dimension to the problem of the regional compliance with the privatization targets of the central government. Some republics approved their privatization programs not necessarily coordinated with and/or supportive of the federal one. For example, the government of Tatarstan, an Autonomous Republic within Russia, was busy until August 1995 with implementation of its own voucher program which was in conflict with the federal one, and envisaged opening of privatization accounts to its citizens. To these accounts compensation was added for the citizens which had less dwelling space than an officially established average. The republic’s citizens were given privileges equal to the insiders’ rights in acquiring the shares of attractive enterprises. The government of Tatarstan was reluctant to privatize fully the enterprises under its jurisdiction. The outcome was not surprising in this respect: in this republic 41% of the charter capital of the ‘‘privatized’’ enterprises remained state-owned compared to 13% in the rest of the federation.

9.3. Real Estate Privatization The sale of real estate during 1994–1995 went slowly. The purchase of land under the privatized enterprises was an important feature of the formation of the real estate market. Nevertheless, the plots of land brought only 0.1% of the total amount of the privatization cash sales. The major obstacle was insufficient regulatory basis for land owners’ rights, lack of a legal basis for registration of owner’s rights and absence of the land cadastre, reluctance of the local authorities to permit land sales, and the unfavorable tax structure which made it more attractive to lease the plot of land than to sell it.

9.4. Cash Sales, Tenders, and Real Estate Sales In short the tenders were open to wide scale abuse and corruption and the cash sale of shares unattractive to the general public. This gave Financial Industrial Groups (FIGs) such as Menatep the opportunity to bid through regional tenders or at relatively cheap cash auctions and to amass large-scale industrial holdings on a national scale.34 Real estate sales largely failed to materialize as the legal, regulatory, and institutional framework for such sales was not yet ready.

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The Russian Government, under Chubais’ leadership as the First Deputy Prime Minister for the Economy, had committed to generating 1 billion in fiscal revenue for the Federal budget from privatization in order to meet IMF conditionality on a $10 billion standby facility. Chubais and his team began to caste around for a way to resolve this dilemma. In the spring of 2005, Chubais and Maxim Boycko organized an external Privatization Commission35 for advice on case-by-case privatization. After reviewing a long list of Federal properties with members of Chubais’ team, primarily A. Koch, who was subsequently to become the Chairman of GKI during the LFS transactions. The Commission concluded that it would take a minimum of a year to 18 months to privatize any of the listed assets or companies, such as Moscow’s airport, Russia’s largest shipping company, large oil holdings, and large pulp and paper companies. Several of these companies formed the list of companies to be privatized under the LFS scheme. Also, it was not altogether clear that GKI could take control over any of these large companies or assets in the face of potential opposition from their managers and/or the Duma. The Commission was thanked for its work and Chubais and his team turned to the large Moscow banks, who had submitted an alternative proposal to Chubais.

10. LOANS-FOR-SHARES (LFS) TRANSACTIONS IN RUSSIA36 10.1. Background In March 1995, a group of Russian commercial banks approached the government, which was desperately looking for ways to increase budget revenues, and proposed taking and privately managing state-owned shares as collateral for the banks’ loans to the state. Besides collateral, the Russian banks sought two additional, farther-reaching objectives: (1) to prevent the collapse of the emerging Russian stock market; and (2) to retain national control over strategic assets by restricting the participation of foreign investors in collateral deals.9 Declaring that the domestic commercial banks had amassed enough funds to credit the government, the group of Russian banks produced the first draft of the LFS scheme; it provided for exclusive participation by Russian banks. A group of Moscow banks – that is, Uneximbank, Menatep, Incombank, Imperial, and Stolichny – suggested, in March 1995, that the Russian government set up a bank consortium with two roles: a collective creditor of

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the state and a joint trustee of state-owned controlling blocks of shares in specific enterprises. The banks were prepared to surrender the dividends on the collateralized shares to the state, but, in return, they sought a substantial interest rate on their loans (LIBOR plus 3% adjusted every three months) and a recovery of their trust management costs, limited to 25% of the dividends. In addition, the banks also required broad rights in managing the companies they would hold in trust. The Russian government studied the proposal for four months, maintaining an active dialogue with the banking group and potential corporate candidates for the deals. Eventually, the government developed its version of the scheme, which was approved by Presidential Decree on August 31, 1995; the scheme was subsequently amended, and it was expanded several times.

10.2. The Rules The banks’ original proposal was modified in several ways.37 First, the notion of a consortium as a collective creditor and trustee of a pool of stateowned shares in a number of enterprises was abandoned. It was replaced by a series of separate auctions for shares of individual companies, which would be open to all interested bidders, both foreign and domestic. This was an attempt to create a transparent, open, and competitive process. Second, the terms and conditions of the credit, collateral, and commission agreements were made less attractive to auction participants from the private sector; interest rates were lowered and recovery of management costs was disallowed. Third, the trustee had to seek consent from the GKI before voting on crucial corporate management issues. In early November, on the eve of the LFS auctions, the Russian government placed additional conditions on the transfer of shares. A Presidential Decree specified that shares could be sold by successful bidders no earlier than September 1, 1996, instead of January 1, 1996, as stated in the original decree. By delaying the opportunity to receive 30% of any capital gain, as provided by the commission agreement, the restriction upon sale reduced the incentive for investment. The government, moreover, was given the authority to revoke the winner’s right to sell the collateralized shares. ‘‘Obviously, the banks’ incentive to participate in the LFS program was unrelated to the opportunity to earn interest on their loans.’’38 The consortium consisted of banks that desired control and full ownership of the shares they initially possessed as creditors–trustees. The split in the consortium, and the subsequent split in the government as to the design and

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implementation of the LFS scheme, contributed to the eventual debasement of the entire LFS program.

10.3. Consortium 2 versus Consortium 1 It was easy to predict that most Russian commercial banks would reject the idea of a banking consortium that would, on the one hand, receive unjustified privileges as a closed group, and on the other hand, make it extremely dependent on the government then in power. The most outspoken critic of the consortium version of the LFS scheme was Bank Rossiyski Credit (Russian Credit), which stated that it would never join such a consortium because ‘‘it was a political, and not an economic affair.’’12 The bank never joined the group, consistently running a campaign with likeminded banks called Consortium 2 (C-2)39 – against the government’s LFS scheme and its proponents – called Consortium 1 (C-1)40 (Table 3 and 4). Some banks initially criticized the LFS deal but eventually embraced it. Tokobank, for example, initially stated that ‘‘as going against the principle of honest competition,’’ the loans would ‘‘hardly be repaid, with the shares ending up in the hands of consortium members which would, therefore, gain unjustifiable advantages.’’41 Nevertheless, driven by its interest in acquiring Table 3. Number

1 2 3 4 5 6 7 8 9 10 11 12 a

Company

Svyazinvest Eastern Oil Co. Tyumen Oil Company Norilsk Nikela UES Surgutneftegaza Sibnefta KomiTEK LUKOIL Slavneft Sidankoa Chelyabinsk Iron and Steela

LFS scheme companies.

LFS Transactions (1997–1998). Size of Stake (%)

Sale Price per Lot ($ Millions)

Required Investment ($ Millions)

25.00 50.00 40.00

1,875 879 25

0 0 810

38.00 8.50 40.12 51.00 21.70 0.33 2.17 51.00+46.00 15.00

256 335 73 110 132 52 39 400 13.8

370 0 211 50 0 0 0 0 0

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Table 4. Banks Partnering in LFS Deals: Consortium 1 (C-1) and Consortium 2 (C-2). Bank’s Name

Initial Affiliation Regarding LFS Deals

ONEXIMbank

Founder of C-1, GKI agent in bond collections Founder of C-1, GKI representative in documents registration for some auctions Founder of C-1 Founder of C-1

Menatep

Incombank Stolichny Bank

Bank Imperial Alfa-Bank Russian Credit Tokobank

Not confirmed founder of C-1 Considered joining C-1 Opposed any LFS deals Opposed any LFS deals

Final Affiliation Regarding LFS Deals

No. of LFS Auctions Won

No. of LFS Auctions Lost

Stayed with C-1

4

1

Stayed with C-1

3

1

Switched to C-2 Stayed with C-1, kept low profile in public debate Distanced from C1 Switched to C-2

0 2

2 0

1

0

0

2

Founded C-2

0

3

Joined C-1, keeping low profile

2

0

shares of YUKOS and Novorossyisk Shipping Company, Tokobank participated in LFS auctions, and coordinated its bids with the two leading C-1 members, Menatep and Uneximbank. Although the transformation of the LFS scheme from ‘‘closed consortium’’ to an ‘‘open auction’’ configuration was initially publicized by the Russian government as ‘‘opening the doors to hundreds and thousands of individuals interested in participation in the privatization process,42 the LFS auctions were attended by a limited number of bidders. Most banks were in poor financial shape in the aftermath of the August 1995 banking crisis. In addition, bidders usually colluded before the auction. Because the rules did not recognize a one-bid auction, when there were few participants, bids were often presented by two or three dummy firms run by the same bank. When real competition occurred between opposing banks or banking groups, in

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most cases, the auctions were poorly organized and highly politicized. The winners of most of the LFS auctions in late 1995 were the banks that belonged to the C-1 group.’’43 These banks were loyal to the government and had numerous connections to various governmental ministries and agencies. The outsiders and critics of the scheme, even if they tried to participate in LFS auctions, were, in most cases, disqualified before the auction date for ‘‘technical’’ reasons, such as inadequate documents and/or bank guaranties. None of the C-2 members won a single LFS auction. The LFS auctions accomplished just what the reformers initially sought to avoid through privatization. It politicized the entire privatization process for the sale of large companies, by awarding these share blocs to FIGS with close ties to the Government. Eventually, several of these same banks backed Yeltsin’s campaign for re-election as President of Russia.

10.4. Company Management in LFS Deals The reluctance of companies to participate in the LFS program was a principal reason for the delay in the program’s start. The branch ministries, prompted by the management of strong companies, suggested that enrollment in the LFS scheme be limited to bankrupt and insolvent companies. Soon after the first proposal by GKI was announced in the spring of 1995, many managers of potentially attractive enterprises – specifically, enterprises that C-1 wanted to include in the program-publicly denounced the proposal and refused to cooperate with auction preparations. The management of Gazprom, United Electric Grids of Russia, Rostelecom, and some pulp-paper companies used their connections in the government to ensure that they were excluded from the list of enterprises to be given away to the banks. The Gazprom chairman, for example, stated that amateur investment bankers from C-1 could not sell his company’s stock better than the ‘‘professionals.’’44 The chairman referred to Kleinwort Benson, ‘‘a U.K. investment bank that he was working with to place Gazprom’s shares on international capital markets.’’45 In September 1995, after multiple changes, the GKI issued a list of 29 companies to be included in the LFS auctions. The Committee’s decision regarding the list did not end the companies’ fight against inclusion in the process (Table 5)46. The list was almost identical, minus the pulp and paper companies shown to the Privatization Commission to examine the feasibility of case-by-case transactions. The directors of four aircraft manufacturers, a uranium exporter, and a strategically located shipping company successfully

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Table 5. The List of 29 Enterprises Selected for LFS Auctions by the GKI’s Decision of September 25, 1995. Enterprise Name (Industry) Novorossyisk Shipping

Murmansk Shipping

Arkhangelsk Commercial Port Murmansk Commercial Port Far Eastern Shipping

North Western Shipping

Tuapse Sea Merchant Port LUKOIL

YUKOS (oil)

Surgutneftegas (oil)

SIDANCO (oil)

Nafa-Moskva (oil trading)

Outcome Conditions Auctioned on December 13, foreign investors were excluded Auctioned on December 7, foreign investors were excluded Announced, but no bid presented GKI decided not to auction it Excluded from the list by the decision of the President of December 7 Auctioned November 17

Announced, but no bids presented Auctioned on December 7, foreign investors were excluded, the winner had to pay fiscal arrears of the LUKOIL subsidiaries Auctioned on December 8, foreign investors were excluded

Auctioned on November 3, foreign investors were excluded, the winner had to pay fiscal arrears of Surgutneftegas Auctioned on December 7, foreign investors were excluded

Auctioned on November 17, since the backing

Comments Won by company with Tokobank guarantee Winner was strategist with Menatep guarantee

Won by MFK (ONEXIMbank’s affiliate

Won by the consortium of LUKOIL and Bank Imperial

Most controversial deal with extensive coverage in the media, fierce struggle among competitors, split in the government, the winner was Laguna, a Menatep dummy A controversial deal with negative coverage in the media, the winner was the company’s pension fund Won by SFK, due to an incomplete corporate structure a subsidiary tried to prevent the deal backed by Bank Imperial Euroresources, the winner of the void auction, was

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Table 5. (Continued ) Enterprise Name (Industry)

Outcome Conditions foreign bank declared its guarantee forged, the action was declared void, re-auctioned on December 28

Novolipetsk Iron and Steel

Oskol Electric Metal Plant Norilsk Nickel

NOSTA (Orsk-Khalilovsk iron and steel) Western Siberian Metals

Beloretsk Metals Chelyabinks Iron and Steel, Mechel

Bratsk Lumber and Timber

Auctioned on December 7, three weeks later than initially announced, due to an inaccurate indication of the auction stake (14.84% of the company capitalization instead of the advertised 15%) GKI decided not to auction it Auctioned on November 17, foreign investors were excluded

Excluded from the list by the Decision of the President of December 7 Excluded from the list by the Decision of the President of December 7 GKI decided not to auction it Auctioned on November 17

Auction scheduled for December 25; postponed until the court decision

Comments excused from $3.5 million fine due to a force-majeur situation recognized by the auction commission, the final winner was Nafta-Moskva itself and Unibestbank backed by ONEXIMbank No real competition, the two bidding groups were controlled by ONEXIMbank, the formal winner was MFK

Bitter competition between ONEXIMbank and Russian Credit, a dummy of the latter was disqualified because of an inadequate bank guarantee, a controversial deal with negative publicity

Auctioned on November 17, but no bids were presented

Won by an investment group Rabicom (affiliation?) against a dummy of the Russian Credit The company management challenged the auctioning in the arbitration court

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Table 5. (Continued ) Enterprise Name (Industry) Arkhangelsk

Solombalsk Paper

Kirovlesprom (lumber) Bor (Far Eastern Krai, lumber) Tekhsnabexport (rare metals export, inc. uranium) Sukhoy (aircraft)

Irkutsk Aviaprom (aircraft)

Ulan-Ude Aviaprom (aircraft) Arseniev Progress

Sibneft (oil), added to the list by a Presidential Decision of November 27

Outcome Conditions

Comments

Auction scheduled for December 25; postponed until the court decision Auction scheduled for December 25; postponed until the court decision Announced, but no bids presented Announced, but no bids presented Excluded from the list by the Decision of the President of December 7 Excluded from the list by the Decision of the President of December 7 Excluded from the list by the Decision of the President of December 7 Excluded from the list by the Decision of the President of December 7 Excluded from the list by the Decision of the President of December 7 Auctioned on December 28, excluded foreign investors, the company itself, and Russian legal entities with fiscal arrears

The company management challenged the auctioning in the arbitration court The company management challenged the auctioning in the arbitration court

Auctioned on November 17, but no bids were presented

The winner is NFK backed by Menatep and Stolichny Banks

Source: GKI, RFPF, the Russian press.

removed their companies from the LFS auction list by employing a national security argument. The reasons for elimination of three steel companies from LFS sale remained unclear.47 Three pulp-paper companies initially placed on the LFS list went to arbitration, claiming that they found a strategic investor before the list was complete. These tactics allowed them to avoid the auctions scheduled for December 25.48 Of the 30 companies slated for LFS auctions, 1 company was added at a later date and only 12 were actually auctioned.49 In the other 18 cases, the

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government, prompted by the Gl members, failed to force the companies into the LFS transactions. In the cases where the government succeeded, the enterprise management was likely part of the LFS deal, joining with the banks destined to win. No hostile takeovers took place during the LFS auctions, illustrating the insiders’ strength in Russian privatization and the collusive nature of the LFS auctions. The only exception was the Norilsk Nickel deal, where, after the auction, the interests of the winning bank conflicted with those of management. The suit filed by management, asking to reverse the deal and transfer the shares back to state supervision, was rejected by the arbitration court.

10.5. The Power of the Auction Commission: Opaque Procedures and Dubious Conditions In order to run the LFS auctions, the GKI had to establish a broad-based, interagency auction commission with representatives from the MoF, the Russian Federal Property Fund, and other governmental agencies. This commission had to abide by the rules specified by the presidential decree of August 31, 1995, as amended, but it was also empowered with the right to attach additional conditions to the auction procedures. The conditions most frequently added included the following: (1) the winner had to pay the fiscal arrears of the auctioned company; and (2) the LFS auctions were restricted to Russian participants. 10.5.1. Fiscal Arrears This first condition illustrated the weakness of tax enforcement in Russia. The Russian government lost any hope of collecting tax arrears and therefore loaded the auction stakes with overdue fiscal obligations, fully aware that some companies possessed the necessary funds to pay those debts. A perfect example was the auction of one of the newly created integrated oil producer associations, Surgutneftegas, a closely held, tightly run company. The struggle for more than 40% of Surgutneftegas’ shares reached a climax two weeks before the LFS auction date. At that time, Rosneft, a state-owned Russian oil holding, announced its intention to bid for the right to extend a loan to the government in exchange for the Surgutneftegas shares as collateral. The auction sight was hardly accessible to bidders because it was located in Surgut, a remote Western Siberian town. To prevent the arrival of unwanted bidders, the Surgut airport was closed for two days before the auction.

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Known as the first effort by a Russian oil company to publicly seek to take over another Russian oil company, the Rosneft bid was presented but declined by the auction commission because the bidder’s bank guaranty was not properly signed and the company was not accredited by GKI. After Rosneft’s bid was disqualified, results of the auction were easy to predict; the remaining two bidders were the company’s pension fund and an affiliate called Swift. The company’s pension fund presented the higher bid, offering the government an $86.9 million loan. Additionally, the auction winner had to pay the company’s (mostly fiscal) arrears to the state budget, which amounted to $223 million.50 The Surgutneftegas auction demonstrates the problems that arose from the additional conditions placed upon the auction procedures. First, it was an extreme burden for outside bidders to pay overdue tax payments of a company to which they have no connection. On the other hand, some Russian companies amassed huge currency reserves on the accounts of their subsidiaries, some of which were created exclusively for tax evasion purposes. The insiders, therefore, could more easily meet the burden of overdue tax payments.51 The Surgutneftegas transaction also showed that the Russian government would accept insider transactions, namely, the purchase of a company’s shares by its own pension fund. 10.5.2. Discrimination Against Foreign Investors Using an additional condition attached to the LFS deals, the powerful interagency auction commission excluded foreign investors from one-third of the LFS auctions, mostly for the enterprises in the natural resources industries – particularly oil – and for strategically located shipping companies – Murmansk and Novorossiysk. Although the Russian government declared LFS deals open to the international community, nationalism prevailed and foreign investors were formally excluded when common ground was found among security-driven government bureaucracies, the companies, and the Russian commercial banks; all of the groups wanted to limit the number of potential bidders at these auctions to Russian financial groups. Due to the opaque procedures governing the LFS deals, the politicized environment, and the unstable investment climate, no foreign investor dared to openly take part in so-called non-restricted LFS auctions.52

10.6. Conflict of Interest Another major problem at LFS auctions became evident during the offering of 38% of Norilsk Nickel:53 conflict of interest. Control of the Norilsk

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Nickel stake was acquired by Uneximbank, which offered the government $170.1 million as a loan. Norilsk Nickel and Uneximbank where both founder members of INTERROS, a major FIG. Other bidders included two dummy corporations established by Uneximbank to give the appearance of competition at the auction. The third bidder was Kont, a subsidiary of another major bank, Russian Credit, which offered $355 million in credit to control the company. The bid by Kont was rejected, however, because its guarantor (Russian Credit) issued a guarantee ($170 million) exceeding the amount of its statutory capital ($100 million). Ironically, Kont’s participation was blocked at the auction, despite the auction rule that potential bidders be notified before the auction of any problem with the documents submitted. Because Kont was excluded at the last minute, Russian Credit had no opportunity to involve other banks in backing Kont’s bid.54 The rejection of Kont’s bid appeared to be more than a mere technical mistake on the part of the organizers of the LFS auction. Uneximbank was faced with a clear conflict of interest. On the one hand, GKI designated Uneximbank as the auction organizer and as the bank that would hold all of the bidders’ bonds in escrow. On the other hand, Uneximbank was also a participant at the auction. Russian Credit, moreover, claimed that the balance of Uneximbank’s capital for the first half of 1995 was only $100 million and therefore Uneximbank was also ineligible to bid. The auction commission, however, had announced previously that Uneximbank had a capital base of $700 million.55 The fact that LFS auction organizers could also participate added to the dissatisfaction of other bidders with the entire process. This conflict of interest also reinforced the public’s perception that the privatization process was a free-for-all, again ‘‘Wild-East’’ capitalism, where Russia’s rich and powerful parceled the state’s wealth among themselves. As the media accurately observed From the outset, critics, particularly the Communist Party, denounced the plan as a veil for insider deals between the government and select banks. Now, a row for control of one of Russia’s biggest mines, part of the loan-for-shares program, had exploded. The battle involved Russia’s largest private bank, Uneximbank, which loaned the government $170.1 million and, in turn, was handed a hefty 38% controlling interest in Norilsk Nickel, which produced a fifth of the world’s nickel and more than 40% of its platinum.56

10.7. Methods of Payment: Kerenki were not Accepted The conflict-of-interest issue was aggravated further by the payment methods employed for the shares of the auctioned companies. The sale of

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YUKOS was the most complex and scandalous offering of the late 1995 LFS season. The offering had three components and the bidders were obliged to bid for all three: (1) a LFS deal for 45% (2.98 million shares) of YUKOS stock at a starting price of $150 million; (2) an investment tender for 33% (2.19 million shares) of YUKOS stock at a starting price of $350 million; and (3) a direct investment into YUKOS of an additional $350 million for three years. A deposit of $350 million was required from each bidder.57 The bidders’ exposure, in this deal, was at least $850 million – an exceedingly large amount for any single Russian commercial bank to collect. Menatep Bank, which announced its intention to bid for YUKOS, was also retained as GKI representative for the YUKOS LFS auction. Menatep organized a group of commercial banks, Russian companies, and individuals to bid for 78% of YUKOS shares. The membership of the group was not disclosed until the end of the bidding. Besides Menatep, it comprised Tokobank, Stolichny Bank, Promradtechbank, and some major suppliers – customers of YUKOS, such as Nafta-Moskva, Roscontract, a FIG called Splav, and Kurganmashzavod. But the first in the list of the group, in front of Menatep itself, was YUKOS management. The competing group consisted of three banks: Incombank, Russian Credit, and Alfa-Bank – the banks comprising C-2 (Table 6). Because banks were not permitted to participate in investment tenders,58 Menatep could not bid at the YUKOS auction, and it did not authorize any of the partner companies to bid on its behalf. Menatep, therefore, opted to create two proxy companies for the YUKOS auction – the closed joint-stock companies Laguna and Reagent, both registered in a provincial town of the Moscow oblast named Taldom. Laguna and Reagent had bank guarantees from Menatep ($160 million), Stolichny Bank ($159 million), and Tokobank ($161 million). The winner of the YUKOS LFS auction was Laguna, which offered credit of $159 million to the government; the starting bid price was $150 million. Those wishing to participate in the YUKOS investment tender were required to deposit $350 million into the MoF’s account in the Central Bank by December 5. Only the two Menatep dummy companies – Laguna and Reagent (the latter doomed to be the loser) – managed to make the deposit. In addition, if a bidder did not present its balance sheet to the auction commission in accordance with the rules, the rights were assigned to the guarantor. Laguna failed to present its balance sheet, and all its rights with respect to the YUKOS shares were transferred to Menatep. The identity of the future owner of YUKOS was obvious two days before the auctions when the three C-2 banks failed to register their bid for YUKOS.

Results of the LFS Auctions of November and December 1995 (in Millions of US Dollars).

Company Name

November 3 Surgutneftegas

November 17 North Western Shipping Company

Percent of Shares Tendered at LFS Auction

40.12

Starting Price of Auctioned Shares

65.3 (additional condition was to pay fiscal debt of 223.0 6

Nafta-Moskva

25.5

6

Chelyabinsk Iron and Steel

15

5

Norilsk Nickel

38

170

Winner

Surgut pension fund (86.9); Swift (76.1); Rosneft disqualified

Surgut pension fund (ONEXIMbank guarantee)

Carat and ONEXIMbank (6); MFK (6.05) Nafta-Moskva and Unibest-bank (16.1); Nafta-fin and MFK (16.4); Euroresources (35.55) Union and Russian Credit (5); Rabicom (13.3); United mining company and LightM Ltd. (10.5); Unicor and Russian Credit (8) MFK (170); Reola (170.1); ONEXIMbank (170.1); Kont (Russian Credit) disqualified

MFK

Euroresources (guarantee of Yokoshima Trust Company) Rabicom

ONEXIMbank

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25.5

Bidders (the Amount of the Offered Loan)

310

Table 6.

5

35

SIDANCO

51

125

Novolipetsk Iron and Steel

14.84

30

Murmansk Shipping Co.

23.5

4

December 8 YUKOS

20

150 (additional requirement was direct investment of 350)

15

LUKOIL and Bank Imperial

MFK and ONEXIMbank

ONEXIMbank

Strategist and Menatep

Reagent and Menatep Bank (150.1); Laguna and Menatep Bank (159); Babayevskaya (Incombank, Russian Credit, Alfa-Bank) disqualified

Laguna and Menatep

The company and Tokobank (22.65);

The company with Tokobank guarantee

311

December 13 Novorossyisk Shipping Co.

45 (additional 33% of shares were sold simultaneously at investment tender); the bidders were required to bid for both

LUKOIL and Kank Imperial (35.01); LUKOIL and National Reserve Bank (35) Consul, Alfa-Bank and Incombank (126); RTD and ONEXIMbank (127); MFK and ONEXIMbank (130); Russian Credit and Incombank – disqualified ONEXIMbank, MFK (31); Mashservice and MFK (30.5) Vagant and Menatep Bank (4.05); Strategist (4.125)

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Table 6. (Continued ) Company Name

Percent of Shares Tendered at LFS Auction

Starting Price of Auctioned Shares

Bidders (the Amount of the Offered Loan)

Winner

ONEXIMbank and MFK (17.1); Astarta and Menatep (15.05) December 28 Sibneft (oil)

Nafta-Moskva

51

100

15

20

NFK, Stolichny Bank and Menatep; Tonus and Menatep; SAMECO, Incombank, Mosbusinessbank disqualified Nafta-Moskva, Unibest-bank and ONEXIMbank (20.01); Nafta-fin, MFK and ONEXIMbank (20)

Nafta-Moskva, Unibestbank, and ONEXIMbank

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Note: The auction was declared invalid due to the Euroresources inappropriate financial guarantee.

NFK, Stolichny bank, and Menatep

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The joint-stock company Babayevskaya (a famous chocolate and confectionery enterprise in Moscow), which represented the C-2 banks, offered only $82 million in cash, with the rest of the bid – $307.22 million – in the form of short-term government treasury bonds (GKOs). Babayevskaya’s deposit was rejected by the GKI, however, because of incorrectly prepared banking documents; the payment was required in hard currency. One auction commission member jokingly rejected the bid stating ‘‘kerenki were not accepted,’’59 implying that the government bonds were as unreliable as the illfated currency of the Russian Revolution and the Civil War. Developments then took a bitter twist. On November 27, 1995, the three C-2 banks claimed that at 49 previous privatization investment tenders, Menatep had taken investment responsibility for more than $600 million in future investments, none of which was fulfilled. With the YUKOS bid, Menatep’s exposure would increase to ten times its capital. The C-2 banks claimed that Menatep was planning to use state funds for the YUKOS bid, thereby taking advantage of the special relations between Menatep and the Ministry of Finance (MoF), the latter having acquired approximately 10% of Menatep’s equity.60 On November 29, the MoF issued a press release which rejected the claim that the MoF’s funds were used by Menatep to participate in the auction and tender. The C-2 banks held a press conference and proposed the establishment of a commission to audit the investment commitments of banks. The G2 banks further insisted that the YUKOS auction be postponed and that half of their bid be accepted in GKOs. If the latter demand was not satisfied, the C-2 banks threatened to convert their GKO notes into cash. From the C-2 banks’ perspective, conversion would lead to the collapse of the GKO and the foreign currency markets. GKI rejected the banks’ claims as groundless. On November 30, 1995, the Deputy Chairman of the Central Bank, Alexandre Khandruyev, promised to retaliate against the C-2 banks if they tried to destabilize the GKO market.61 Sergei Dubinin, then the newly appointed chairman of the Central Bank, unexpectedly broke the government’s unity and supported the C-2 banks’ proposal to pay a portion of the bid in GKOs, instead of the entire bid in hard currency. Minister of Economy Evgeni Yasin, in turn, issued a statement that expressed his opposition to the idea of accepting GKOs for credits in LFS auctions. The C-2 banks, however, had gained wide support from the Moscow banking community. The Moscow Banking Union and the Association of Russian Banks issued statements supporting the C-2 banks’ bid and called for revisions of the LFS auction rules. The banks claimed that Menatep had an unfair advantage as both agent and bidder.62

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The C-2 banking group was trespassing into delicate territory; they were trying to revisit the ‘‘gentlemen’s agreements’’ reached long before the auction was opened. The deal was set and C-2 had lost.

10.8. Do Insiders Always Win? From the beginning it appeared that Menatep was destined to win the YUKOS bid. Senior YUKOS officials, a month before the sale, appeared on television, with Menatep, stating their approval of the sale to Menatep and their desire for the deal to go forward. Upon examination of the Menatep bid, this television appearance is not surprising. Menatep put together a group of Russian banks and companies to make the purchase. Besides Menatep, the most significant players in this group were, not surprisingly, YUKOS’ management officials. In order to recoup their investment, the group initiated discussions to sell 25% of its shares to foreign investors after September 1, 1996.63 The entire YUKOS LFS deal was therefore structured to prevent control from slipping away from company management. The stronger the corporate structure of a company, the easier it was for its management to manipulate the LFS deals in their favor. Among newly created, vertically integrated oil holdings, LUKOIL was the most advanced in pursuing the benefits of corporate integration, establishing corporate profit centers, and contracting out services. LUKOIL had begun to exchange shares of its subsidiaries for unified corporate shares – a program that other Russian oil companies could only dream about. This is one of the reasons why the LFS auction for 5% of LUKOIL stock was seen as routine. LUKOIL, backed by its bank, Imperial, easily beat the ‘‘competition,’’ a proxy group also lead by LUKOIL. Alternatively, the weak corporate management of SIDANCO and Sibneft – the two other oil companies that were put on LFS auction – lacked the leverage necessary to influence the outcome of their deals.64 SIDANCO was an amorphous structure with independent subsidiaries. Between 15 and 35% of the subsidiaries’ shares, for example, were transferred to the holding; the rest were distributed among the workers and management of the affiliates, and other banks and firms. This ownership structure did not permit a holding company to effectively control its subsidiaries. On the eve of the auction, Bank Imperial – a major shareholder in one of SIDANCO’s subsidiaries – sued the holding company in the arbitration court for failing to repay a $9 million debt and demanded that the court declare SIDANCO bankrupt. Imperial, however, refused to fight for control of SIDANCO, leaving the incomplete holding to the insatiable appetite of Uneximbank.

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The major challenge, once again, originated from the C-2 banks. Russian Credit, backed by Incombank’s guarantee, attempted to file the bid application with Uneximbank, the GKI’s appointed representative. Uneximbank refused to file the application because the application arrived at 6:23 p.m., 23 min past the official cut-off time. The auction commission ultimately rejected the bid ‘‘because the bond of $3.75 million was not transferred in time on the account specified in the information announcement.’’65 The only other C-2 bid – that from an Alfa-bank dummy was lower than that of the invincible Uneximbank. SIDANCO ultimately lost much of its value, when the Government transferred its most valuable subsidiary to another oil company, closer to the Administration at that time. Sibneft was the youngest oil holding company, created hastily in early 1995 after carving out an upstream producer and a refinery from Rosneft. The new management, weakened after the mysterious death of one of its leaders, was hardly expected to play an important role in the partnering process, which was dominated by a Menatep-led group. This group included the interest of Boris Berezovsky, a Russian financial mogul, who was later appointed deputy head of the Presidential Security Council. The C-2 showing at the Sibneft LFSS auction was similar to its participation at the SIDANCO auction. The bank guarantee was not properly signed; the guarantor, Mosbusinessbank, did not possess sufficient funds to support the bid; and the documents were presented late. An unknown entity, Oil Finance Corporation (NFK), created by Menatep with the aid of another proxy company, won the auction.66 Whether the insiders wanted this outcome remains unclear. It is apparent, however, that due to Sibneft’s volatile status and corporate weakness, the bargaining power of Sibneft’s management was considerably weaker than that of the C-1 bankers and Boris Berezovsky.

10.9. Conclusions Regarding LFS Transactions (1) Inefficacy of the C-2 banks: The C-2 banks-Russian Credit, Alfa-Bank, and Incombank were among the 20 leading Russian commercial banks. It is impossible to believe that they were unable to put together a group of experts who could understand and properly follow the LFS auction procedures. Either the C-2 banks chose to abandon their targets and invade the ‘‘territory’’ that was assigned to other players during preparation of the LFS scheme, or they lost much of their financial

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power and clout with the government in the wake of the banking crisis. It would appear that some of the C-1 banks were more connected to the bureaucracy and thus better able to control the bidding process. Therefore, the process was highly politicized and contrary to the stated objectives of the reformers. (2) Revenue targets and privatization: GKI claimed to have exceeded the Russian government’s revenue targets for the LFS transactions. During the planning of the 29 LFS auctions, the government expected to receive $430–$640 million in interest-free loans by the end of 1995. With only 12 transactions completed, the state budget reportedly received about $800 million in loans and $223 million in satisfied fiscal arrears. Although the total amount generated exceeded $1 billion, the auctions were far from successful. Several issues need to be considered with respect to revenue targets and privatization. First, the legitimacy of loading the auctions with fiscal collection is ill founded because such a policy favors insiders, discriminates against outsiders willing to bid in the auction, and fails to provide incremental budgetary revenues. The state tax inspectorate should have independently stopped the massive tax evasion occurring through the use of domestic and foreign affiliates and off-shore accounts. Second, the Russian government missed a real opportunity for true competition when it excluded foreign investors from the auctions. Some foreign investors had the capital to effectively compete for offered shares, thus bidding up the returns to the Russian government. In addition, some foreign companies – especially in the oil, mining, and pulp-paper industries – could have offered much needed managerial know-how, technology, and capital to aid these important Russian industries in restructuring. Commercial banks, acting alone, could not undertake this task. One analyst has noted thus When the auctions began last fall, it became all too obvious that a fix was in. Foreign investors were barred from bidding for the most desirable assets, and the same banks that were assigned by the Government to organize the auctions ended up winning them, and usually at only a fraction over the minimum bid.67

(3) The eve of the LFS auctions Russia’s monetary policy: There was only one other player in Russia that possessed adequate funds for corporate restructuring and privatization – the Russian government itself. The state allowed the banks to accumulate the necessary resources to bid by increasing the banks’ reserve funds and providing attractive investment opportunities in the government bond market. Before the Russian

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government stabilized inflation in August 1995, for example, certain banks were enabled to earn hefty profits in the bond market. Even after inflation was under control, the Russian government nevertheless continued to maintain high yields on short-term bonds, about three to three and a half percent per month, thus providing an attractive return despite the imposition of the currency ‘‘corridor.’’ Although a lower yield, about two to two and a half percent per month, would have satisfied investors, the short-term rate remained steady until late November 1995. The profits earned by the banks in the government bond market were loaned to the Russian government in exchange for control of the state-owned shares; in essence, the government took loans from itself. 10.9.1. The 1997 Privatization Program: Recommended Changes to the LFS Auction Rules The Russian government insisted that the LFS auctions helped it replenish the budget with privatization proceeds. In reality, the transferred cash increased the state debt, which was repaid by passing title to the shares to the trustees. Among knowledgeable circles in Russia, there was little or no expectation that the government would repay the loans; it was assumed that the banks would become the owners of the shares. In effect, the 1997–1998 privatization transactions were a confirmation and the final act of the LFS auctions. The lenders became owners of the assets or shares they bid for, thereby controlling some of the most important companies in Russia. Tables 1–3 detail the LFS transactions. Table 3 provides a summary of LFS transactions as they were concluded in 1997–1998. Other transactions in those years followed the same script.

11. SVYAZINVEST68 In late 1995, the GOR sought to sell a 25% stake in Svyazinvest, a recently formed enterprise which held an average of 38% of the share capital (but 51% of the voting rights) in 85 local and regional telecommunications operating companies located throughout the Russian Federation. With 20 million access lines installed and a considerable need for new lines to support the substantially increased traffic of the prior few years in Russia, as well as potential licenses for long distance and international services, Svyazinvest presumably presented an opportunity to establish a far-flung

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telecommunications organization which could be upgraded to world standards. The Svyazinvest privatization was a ‘‘last chance’’ effort by the reform team working for Chubais to demonstrate to him and other members of the Government that Russia had a great deal to gain from open and transparent privatization process. The RPC, acting as agent for the GOR and represented by its advisor, N. M. Rothschild & Sons, attempted to raise a minimum of $1.2 billion for 25% of the company. This amount consisted of a minimum asking price of $430 million, plus an investment commitment of an additional $770 million. If successful in the sale of this initial tranche, the Government intended to sell an additional 24% of the capital through an IPO both in Russia and abroad during the first quarter of 1996. Up until the eleventh hour, the winning bidder appeared to be STET, the Italian state telecommunications company, which offered $630 million. (A competing group composed of France Telecom, Deutsche Telecom, and the Russian subsidiary of U.S. West apparently did not submit a final bid.) Among other requirements, bidders were requested to submit an investment proposal detailing its plans for the company. The transaction ultimately fell apart, due to investor perceptions of the risks. Under Russia’s privatization Law, investment tenders were in theory to be used to attract a single or small number of investors to the purchase of shares of privatizing Russian companies. Such investors were often industry participants who could offer technology and effective management to enterprises as well as additional capital. Indeed, the requirement for future investment directly into the enterprise was a frequent feature of investment tenders. In reality, however, investment tenders, as previously discussed in this Chapter, typically proved to be non-transparent, closed transactions utilized to deter outsiders or assist insiders in gaining further control. The Svyazinvest transaction, on the other hand, was intended to serve as a model international investment tender. Svyazinvest was an appropriate candidate for a sale conducted in a manner approaching international standards, intended for attracting a foreign investor that could offer not only the deal financing and direct investment but the management and expertise required, with little question regarding the investor’s ability or inclination to perform its contractual obligation. Despite its unrealistic timeframe (Chubais gave his team four months, extended to six months) to complete the transaction, the transaction provided a clear set of sales procedures and bidding rules, marked by an openness and abundance of available information and the determination of Government officials to remain true to the tender process it put forth. A ‘‘bidding process’’ was

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employed not only for the selection of the winning bidder but for the determination of the investment banking consortia retained to advise the GOR on the transaction as well. However, by identifying as a priority the requirement to provide, in an unrealistically short timeframe, significant funds to the federal budget, the Government undermined the possibility of a successful deal from the start. The Government required that the Svyazinvest transaction be closed prior to the end of 1995 so that the sale proceeds could be allocated to the state budget, which had fallen substantially short of the 8.7 trillion roubles ($1.9 billion) the GOR had promised as the result of privatization sales during 1995. Revenue targets from privatization were tied to Russia’s stabilization program and the specific objective of reducing the fiscal deficit. Therefore, revenue generation in the shortest possible time became the overriding objective of this transaction (just as sale of companies in the MPP was in the earlier stage of privatization). Other countries divesting their fixed line carrier, typically restructured the company first, established a clear regulatory framework and a regulator and allowed for competitive entry, even if the buyer was given initial monopoly privileges of three to five years as an example. In the case of Svyazinvest, there was a good argument, advanced by this author, for breaking the company up into five or more regional telecom companies, ‘‘Baby Bells’’ following the approach taken in breaking up ATT in the U.S. But this would have taken considerable time to structure and RPC, GKI, and the advisor were against it.69 According to knowledgeable analysts the transaction was unsuccessful in 1995 due to several key issues: (1) the particularly short period of time (e.g., the initial bid was due in ten days, with a revised second bid expected one month thereafter, compared to several months offered in comparable transactions elsewhere) prevented potential investors from performing an appropriate level of due diligence on which to base their investment decision; (2) with Svyazinvest only just spun out of the Ministry of Communications and recently corporatized with a staff of just six employees, it remained unclear what degree of governance the holding could exercise over its subsidiaries; (3) a commitment by the Ministry of Communications to offer an international license remained unclear, potentially tied to a future joint venture with Rostelecom or the ability of Svyazinvest to provide new digital lines for international service some time in 1999. The investors, therefore, remained unconvinced that they would receive a clear and unencumbered right to provide international service through Svyazinvest; (4) the regulatory framework for the sector was inadequately developed relative to the size and importance of the

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transaction – pricing, access, and interconnection policies, for example, were only generally spelled out; (5) the GOR’s negotiating strength was hampered by the need to sell the investment so rapidly. Even in the event the deal had been concluded, the short bidding time-frame may have nonetheless reduced the final price. This experience indicates that short-term priorities to raise funds are not compatible with the development and execution of a strategic transaction such as Svyazinvest, and pales in importance in comparison to Svyazinvest’s large capital and restructuring requirements. The Svyazinvest transaction model had considerable implication for the GOR given its interest in maintaining control of so-called ‘‘strategic’’ enterprises, as the model provided a mechanism through which the GOR could obtain for these enterprises efficient, market-based management, and the potential benefits of enterprise restructuring this implies, while nonetheless selling only a minority interest. By providing the investor a variety of contractual rights to ensure a significant degree of Board and management control, the transaction supplied a privatization methodology applicable to other tenders for incorporating a higher degree of corporate control than might otherwise be available to a minority investor. These contractual rights could be structured so that periodic renewals permitted their review by the Government which could have resulted, assuming GOR satisfaction, in the sale of additional state shares to the investor.70 While granting specific management and control rights to a potential outside minority investor, the Svyazinvest transaction offered no special deals for insiders or other potentially privileged or favored bidders. The GOR by and large upheld its initial bidding structure format,71 while at the same time demonstrating considerable flexibility in terms of pricing and investment risk (it recognized the risks of the transaction to the foreign investor and provided representations, warranties and guarantees ultimately backed by a contractual obligation for compensation were they not met). These representations and warranties, as well as the contractual management rights, would not have been granted had the GOR not understood the nature of the risks perceived by the foreign investor, and been willing to accommodate these risks as best it could given its self-imposed timeframe for bidding. Risks common among most Russian enterprises include the lack of audited financial statements and an appropriate legal framework and, frequently, an incomplete or non-functioning regulatory regime. The Svyazinvest transaction, marked by similar risks, nonetheless demonstrated that even among foreign bidders, an attractively and appropriately priced deal can elicit significant interest despite the perceived risks of such investments.

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As a post-script to this transaction, a couple of years later one of the major oligarachs in the LFS transactions, Viktor Potanin purchased a 25% stake in Svyazinvest with George Soros, the international investor, as his partner in the transaction. However, Svyazinvest continued to languish without real restructuring, modernization or real entry into the new age of telecom. The company was simply not viable as the owner of all regional telecommunications carriers in Russia. Most of the regional carriers had cut their own joint venture deals with equipment and technology suppliers and were difficult, if not impossible, for Svyazinvest to govern. Soros eventually sold his interest in Svyazinvest to Russian investors. There was clearly no upside in restructuring and the potential break-up of the monopoly into competing regional entities.

12. THE EFFECTS OF RUSSIA’S PRIVATIZATION PROGRAM ON VARIOUS STAKEHOLDERS The second round of privatization transactions – cash auctions, tenders, and above all LFS auctions substantially discredited Russia’s privatization efforts. The MPP, despite its criticisms, was generally perceived, in Russia and abroad, as a transparent process. The second round of privatization programs, however, specifically LFS transactions, lacked transparency and were viewed as corrupt and collusive, favoring a small group of inside bidders. The question that necessarily arises is: How did these transactions affect the interests of various stakeholders? 12.1. Government as Owner The Government emerged as a substantial loser: it has lost considerable credibility, both in Russia and abroad, and a significant amount of revenue. With respect to the latter, for example, any one of the major Russian oil companies sold via a transparent, international tender would have yielded far more revenue than all of the LFS auctions combined. Simply put, the Russian government transferred its controlling stakes in various companies to banks, leaving it with fewer chances to sell those interests for a reasonable price in the future. In addition to the loss in revenue, the Russian government sacrificed quality. Large Russian enterprises were in dire need of restructuring. The LFS transactions turned these large companies over to banks – entities largely incapable of corporate restructuring.

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Privatization reached a stalemate in Russia. Although the government may have thought of continuing with cash sales and variants of LFS transactions, real privatization stalled. Subsequent efforts by the World Bank to reinvigorate the process on a case-by-case basis after the 1998 financial crisis, through a series of policy adjustment loans, totally failed. An exception was the privatization of the coal sector.72 The new privatization law and the 1996–1997 Privatization Program did not clear the Duma. In addition, much of the subsequent privatization activities were devoted to alternatives to divestiture, such as Trust Management Contracts, where blocks of shares are placed under trust arrangements. These Trust Management Contracts, however, were seen as an alternative form of LFS transactions. It should be noted that LFS transactions did not constitute real privatization efforts. In fact, these deals perpetuated a continued form of government influence over or politicization over major industrial sectors through the use of proxies, namely, insider banks. The LFS auctions also perpetuated insider governance of these enterprises, benefiting a small number of insiders and presumably their patrons. Meanwhile, these enterprises, did not contribute to the overall economic welfare of the Russian population. When average Russians were getting poorer and poorer during the transition period, tax revenues, royalties, and/or dividends from these companies could have been utilized to underwrite a social safety net. The LFS transactions deepened the government’s commitment to an industrial policy focused on large regional and national FIGs. This policy implied an increase in the concentration of corporate ownership, less competition, and more government intervention in the economy. The Russian economic model, therefore, was not modeled after competitive Western markets but Japanese keiretsus and Korean chaebols.

12.2. The Banks The large Russian banks added large industrial holdings, particularly the winner of all the LFS bids, namely, the C-1 banks, consisting of Menatep, Uneximbank, Stolichny Bank, Imperial Bank, and Tokobank. Prior to the LFS transactions, for example, Menatep was said to control about 40 major industrial companies. It ended up owning YUJKOS, potentially one of the largest integrated oil producers in the world. This heavy concentration of ownership in a relatively small number of financial-holding groups, such as the individual banks that comprise the C-1 group presented a new threat to

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the Russian economic, systemic risk with respect to poorly regulated universal banks. In fact, the 1998 financial crisis hit Russia soon after the LFS deals were finalized, in August 1998. Several of the large FIGs defaulted on loans to Western banks and other lenders. Some such as Menatep simply closed their door, left their creditors hanging, and moved its premises opening under a different name. The Russian private and state banks restructured and reformed very little after the crisis, unlike most banks caught-up in the Mexican crisis (1995), the East Asia Crisis (1997–1999), or the Turkish Crisis (2001–2002). In the aftermath of these other crises major international banks entered the local markets affected by the crisis – Mexico, Korea, and Turkey, as examples, and purchased substantial shares in the major commercial banks in these countries, part of the continuing trend of globalizing international capital markets and banking.73 12.3. The Companies and the Formation of FIGs74 Large-scale Russian enterprises needed to restructure. They needed to become complete enterprises in the sense of having sales and marketing operations, finance and accounting departments, and research and development facilities. In addition, Russian enterprises needed substantial capital to upgrade their technology and to modernize obsolescent plants and equipment. Eventually, they needed to make associated investments in energy conservation and environmental controls. The privatization transactions did not offer assistance to meet these corporate needs. In fact, by 1995 there was an emphasis in some parts of the Government in creating FIGs of various types – regional FIGs, transnational FIGs, and industry FIGs, in order to restore production, create a powerful industry sector able to compete with the rest of the world and closely allied to Government policy. Russian industry, therefore, in the long run, was the major loser from loansfor-shares, which consolidated the holdings and the power of the oligarchs and national FIGs, with a major Moscow Bank at their center.75 12.3.1. Why FIGs? During the initial years of transition, with the severe decline in industrial production in the increasingly difficult financial position of Russia, the disintegration of ‘‘transnational’’ companies in the CMEA and the failures of the CMEA trading system, leading Russian figures such as Arkady Volsky, Director of the Union of Entrepreneurs and Industrialists, and

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others advocated and participated in the formation of Financial-Industrial Holding Groups (FIGs) in Russia. In my interviews with Volsky he compared the Russian FIGs to Korean chaebols. He also noted that with the failure of the FSU, many large, Russian companies that had important subsidiaries in other countries in the FSU, primarily the near abroad – Ukraine and Belarus, as examples, lost ownership and control of those subsidiaries and were badly hurt by the break-up. Others compared national FIGs, created by the oligarchs, to Germany’s universal banks. Volsky and others such as the, the chief of the FIGs department at Goskomprom (State Committee on Industry), Mr. Kitaev, noted, ‘‘Russian economy today, more than ever, is hungry (in need of) for leading groups in re-activating investments, structural adjustment, manufacturing of production competitive on the domestic and world markets, revival of industrial power of the country, strengthening positions of priority, R&D industries.’’ FIGs were seen by many as a panacea in overcoming the crisis situation. They were viewed as bringing together not only the synergies and powers of industrial, banking, insurance, and trade capital, but also the intellectual potential of most capable, long-term oriented, and successful businessmen.76 12.3.2. Why FIGs were Needed Analysts of Russia’s industrial decline provided two lines of reasoning for FIGs. One was what can be called ‘‘argumentative and pro-active,’’ that is, its advocates presented reasons for pro-active creation of FIGs; the other – ‘‘explanatory,’’ that is, took the view that economic processes in Russia naturally led to the FIGs’ formation. ‘‘Argumentative and pro-active’’ advocates started by saving that Russian industrial production was in havoc. Industry faced many problems ranging from the existing socioeconomic situation to predominant reliance on production of raw materials, and physical as well as technological obsolescence of fixed assets. All of these required drastic measures to revamp the investment climate. That is where integration of industrial and financial (banking) capital was required. With the level of industrial investments at its lowest, enterprises needed to revert to co-operation in different areas of activity aimed at increasing competitiveness by reducing costs of production. At the same time this prompted various investments for production modernization, and thus new investment sources become unveiled. The ‘‘explanatory’’ advocates maintained that the creation of FIGs was based on existing integration processes in the economy, but in their view this was happening on its own due to liberalization of industrial activity and functioning of the capital market, which opened new possibilities of transfer

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of capital into attractive areas of activity, diversification of production, and creation of different economic structures, which combine financial and trade capital. Whatever the reason, the creation of FIGs picked up substantial momentum in 1995. The often cited example of the successful operation of FIGs is the first four FIGs enlisted in the FIG Register (Uralskie Zavodi, Sibir, Dragotsennosti Urala, Ob’edinennaya Gorno-Metallurgicheskaya Company), who in 1994, while the industrial production was in a general slump, succeeded in increasing their production volumes by 4% compared to the previous year while maintaining more or less constant working force. The alliance of capital and industry allowed the FIGs to more than double their investments in industrial projects due to own and borrowed capital. The export volume of these FIGs also grew and was 139% of the 1993 level. To a certain degree the financial situation of the companies was improved due to 13% reduction in overdue inter-company payables (Table 7). 12.3.3. Legal Framework FIGs in Russia were being created not only de jure, but also de facto. De jure FIGs were being created in the forms envisaged by the President’s Decree no. 2096 dated December 5, 1993. In 1994 and 1995, Goskomprom together with Goskomimushestvo, State Committee on Antimonopoly Policy, Ministry of Economy, and other ministries were actively involved in setting up FIGs. FIGs became one of the key elements of the Russian industrial policy. On January 16, 1995, the Government of Russia (GOR) issued Decree no. 48 ‘‘On Program to Promote Establishment of Financial Industrial Groups,’’ which explicitly stated that FIGs were created in the interests of stabilization and growth of industrial production, increase in investment activity, and more efficient use of the accomplishments of the scientific-industrial progress. The Program designated the State Committee of the Russian Federation on Industrial Policy as a recipient of the Program on behalf of the state. In 1995 there was significant activity in creating transnational FIGS. Their creation became possible with a signing of the ‘‘Agreement on Assistance in Creation and Development of Industrial, Commercial, CreditFinancial and Mixed Transnational Amalgamations’’ by the GORand several other governments of the CIS countries. Based on this basic legislative document (within CIS), a number of agreements on establishment of transnational FIGS among the governments of Russia, Belarus, Kazakhstan, Uzbekistan, and Kyrgyzstan were adopted. This would have been a partial return to previous structures of production cooperation with

FIG

Financial-Industrial Groups, Included in the FIG Register of Russian Federation on December 1, 1995. City

Number of Enterprises

Number of Employees (Thousands)

Financial and Credit Institutions

Activities by Industry

Izhevsk: KB Aksion, AO Evroasiatskaya Strakhovaya Companiya (Eurasian insurance company), Evroasiatskii Bank, AO Tsentralnyi Investitsionnii Fond (Central Investment Fund) Unknown: APB Kurskprombank, AB Voronezh; Voronezh: KB Energia (Energy)

Telecommunication equipment, communication systems, medical equipment, equipment for fuel and energy complex and agro-industrial complex, construction materials

Izhevsk

20

46

Sokol

Voronezh

22

81

Dragotsennosti Urala

Yekaterinburg

Rushim

Moscow

9

21

3.2

86

Yekaterinburg: APB Zoloto-Platina Bank (Gold-platinum), AOZT investment company Standard-Invest; Moscow: Akb LantaBank Moscow: AK Rossiiskii Credit (Russian Credit), AO russkii Strokhovoi Centre (Russian Insurance Center); Unknown: AO Komintek LTD

Equipment and parts for auto-building; fuel and energy complex; agroindustrial complex; construction industry; radioelectronics; agroproducts Extraction of precious metals and stones; production from precious metals and stones; production of jewelry Production of products of chemical industry; agrosector; machinebuilding; food and light industry; consumer goods

IRA W. LIEBERMAN

Uralskie Zavodi

326

Table 7.

Novossibirsk

18

48.1

Unknown: Promradtekhbank

Ob’edinennaya Gornometallurgicheskaya Companiya

Moscow

9

97.9

Chelyabinsk: AKB Bank Sodeistviya

Skorostnoi Flot

Moscow

18

25

Ob’edinennaya PromyshlennoStroitelnaya Companiya

Ryazan

21

10.6

NOSTA- TROUBI-GAZ

Novotroitsk, Orenburg Oblast

6

59.1

Moscow: AO TNK Germes-Soyuz, MAB Germes-Centre; St. Petersburg: AO investment company Germes-Neva Ryazan: KB Stankobank, AO Chekovii Investitsionnyi Fond (Check Investment Fund), Course-E, TOO Strakhovaya Companiya SIF Moscow: AKB Incombank; Novotroitsk: AKB Nosta

Vostochno-Sibirskaya Grouppa

Irkutsk

26

107.8

Construction and repair of non-industrial objects; production of construction materials, leather consumer goods, fish products; transportation services Production of different kinds of steel, steel tubes for oil and gas pipelines, including ‘‘in northern design’’, consumer goods Development of fields of oil and gas extraction;

327

Irkutsk: AO FinansovoPromyshlennaya

Manufacturing of electronics products, electro-technical equipment, medicine and agro products, mini-plants on processing consumer waste, construction industry Production and sale of products of non-ferrous metallurgy; mining and production of tradable ferrous ore; production, processing and sale of metal products

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Sibir

328

Table 7. (Continued ) FIG

City

Number of Enterprises

Number of Employees (Thousands)

Financial and Credit Institutions Companiya [FinancialIndustrial Group], AO Vostochno-Sibirskii Commercheskii Bank

Nizhny Novgorod

40

241.2

Svyatogor

Chelyabinsk

14

49.8

Primorie

Vladivostok

21

19.7

Nizhny Novgorod: AKB Avto-GAZ Bank, AKB NBD, AO RosgosstrahPolis; Moscow: AKB Avtobank, MAB ASMClearing-Bank, jointstock insurance company ContinentPolis; Zhukovskii, Moscow oblast: TOO insurance company KALLISTO Moscow: Bank Rossiiskii Credit, KB Avtobank, InvestitsionnoFinansovaya Grouppa (Invesment Financial Group) Moscow: AIKB Promstroibank; Vladivostok: AKB Agroprombank, AKB Evrobank, TOO

generation of electro and heat-energy, chemical and petrochemical production, packing materials, consumer chemical products and consumer goods Production of trucks and cars, diesel and petrol engines, refrigeration vans, rubber-technical goods, glass goods, and consumer goods

Production of tractors, pipeline-placement equipment, equipment for oil exploration, geology research, drilling devices, construction equipment Industrial-civil construction; manufacturing of construction structures, goods and materials;

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Nizhegorodskie Avtomobili

Activities by Industry

Magnitogorsk

27

264

Exsohim

Moscow

22

54.8

AtomRudMet Volzhsko-Kamskaya

Moscow Moscow

13 3

90.5 231

Evrozoloto Tulskii Promyshlennik Edinstvo Doninvest TFIG Interros

Moscow Tula Perm Rostov-on-Don Moscow

7 18 18 6 24

3 39 30 10 306

Zhilitshe Rossiiskii Aviatsionnii Consortium Promprobor METALLOIND USTRIA SOYUZAGROP ROM

Moscow Moscow Moscow Voronezh Voronezh

13 8 22 13 40

21.6 71 25.4 206.7 24.8

Moscow: AIKB Promstroibank; Tolyatti: PK AvtoVAZbank; Magnitogorsk: TOO insurance company SKM; Tver: AKB Tveruniversalbank

Moscow: bank Menatep

Production of cars and trucks

Moscow: AKB Mezhdunarodnaya Finansovaya Companiya, AKB ONEXIMbank, NPF Interros-Dostoinstvo

Production and export of chemical fertilizers, aluminum, nickel, copper, food, and other products

329

Magnitogorskaya Steel

housing-social-cultural construction; amelioration; ore mining; wood processing; agroprocessing Production of metal products, tubes; mining of ferrous ore; preparation and processing of scrap; construction works; production of cars, metallurgical, drilling and excavation equipment Manufacturing and sale of chemical materials and consumer goods

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Insurance Company PrimASTRO-VAZ

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these countries and also the basis for renewal of CMEA trade, perhaps with different rules and conditions. FIGs were also being created de facto, in the privatization process and during formation of securities market without even officially obtaining the FIG status by using market methods of consolidation of packets of shares. The examples of de facto FIGs included such powerful formations as RAO Gazprom, AO VAZ, AO KamAZ, MAK Vympel, and a group of banks closely working with them, and also banking holdings and alliances, such as Menatep, other integrated structures, such as Russkaya Nedvizhimost, OLBI, and group Alfa, which combined financial, insurance, industrial, and other structures. 12.3.4. FIGs Statistics At the beginning of December, 1995 the FIG Register contained 27 FIGs. The FIGs Register was reflective of the speed of creation of FIGs: in 1993 only 1 FIG was registered, whereas in 1994 – 6 FIGs. The 27 registered FIGs in 1995 comprised of 446 enterprises that joined FIGs voluntarily, including 65 credit-financial institutions, commercial banks, insurance companies, and investment institutions. FIGs included some of the very big industrial enterprises such as plants of the city of Izhevsk; RAO (RJSC) Norilskii Nickel (part of a LFS transaction); Kuznetskii metallurgical and Novokuznetskii aluminum plants; Lebedinskii Mining Combinat; Oskolskii electrometallurgical combinat; chemical plants of the city of Angarsk; Novolipetskii, Chelyabinskii, and Magnitogorskii Metallurgical Combinats; VAZ; KamAZ; AO (JSC) AvtoGaz, GAZ; Uralskii autoplant; Chelyabinskii tractor plant, Orsko-Halilovskii metallurgical combinat; Tulachermet. Total number of employees of registered FIGs (all enterprises and institutions) exceeded 2 million with the annual turnover in excess of $10 billion.77 12.3.5. FIGs Profile The majority of participants in FIGs were privatized or private enterprises, which were integrated vertically or horizontally, and differed in their industry and regional origin. FIGs included enterprises of any size, not necessarily only large ones. Companies with different profile orientation and magnitude could be included in FIGs. The integration into FIGs follows three main lines: (i) industry specific; (ii) bank-dominated; and (iii) regional. The creation of regional FIGS went back to the beginning of privatization, when in the middle of 1993, some of the enterprises in Primorsky Krai joined forces and created a FIG called PAKT – the Primorsky Manufacturers Shareholders Corporation. Initiated by local

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enterprise directors (without pressure from Moscow), but allegedly approved by Prime Minister Chernomyrdin, PAKT was a holding company whose founders included 31 large enterprises. A publicity brochure prepared by PAKT listed the organization’s goals: to expedite the structural reorganization of the Primorsky Krai economy; to further regional interests in the Pacific Basin; to facilitate the development of competitive technologies and services, with foreign participation if possible; to preserve and increase the effectiveness of krai industry by means of inter-regional cooperation and by encouraging development of small and medium enterprises; to create an economically efficient financial investment system that can provide insurance against seasonal and structural fluctuations in markets; to transfer capital from non-profitable to profitable branches of the industry; and to create a socially stable and economically protected structure for voucher investment by krai citizens and Russian voucher funds during the period of economic instability and bankruptcy. Uniting krai enterprises across a wide spectrum of industries (from ship repair to meat processing), PAKT aspired to replace the old branch monopolies that dominated the local economy.78 In effect the regional FIGs tried to protect regional companies against competition from both national and international companies and investors. The Deputy Governor of the region often chaired these FIGs and as such they were an extension or transformation of old control structures. They also contributed to blocking inter-regional trade in Russia. While financial institutions per se are a very important component of FIGs, powerful banks and other financial organizations were in many instances a driving force in the formation of national FIGs. Such FIGs, although not formally called as such, are the bank-dominated FIGS. Six of the largest fifty banks in Russia – ONEXIMbank, Incombank, Rossiiskii Credit, Promstroibank, Avtobank, and Menatep – played an important role in FIGs. Also, worth mentioning were International Financial (Mezhdunarodnaya Finansovaya) Company, Germes-Soyuz, and AvtoBAZbank. Industry-specific FIGs were found in metallurgical industry. According to the Committee of the Russian Federation on Metallurgy, the creation of FIGs was a priority task in carrying out structural restructuring of the metallurgical complex of Russia. The Transnational FIGs (TFIGs) combined in themselves the three integration features applicable to creation of FIGs mentioned above. TFIGs were regional, but in a different way from FIGs – they included enterprises of different CIS countries. On September 1, 1995 Goskomprom of Russia

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registered the first TFIG ‘‘Interros’’ with participation of Russian and Kazakh enterprises and organizations. From Kazakhstan’s side, the state holding company ‘‘Ulba’’ (nuclear energy) joined the TFIG. Participation of Ukranian companies in this TFIG was discussed. Another project that was considered by Goskomprom was the creation of TFIG ‘‘Sokol’’ (on the basis of an existing FIG) with participation of Russian, Kazakh, and Kyrgyz enterprises and organizations. TFIGs could also be industryspecific. For example, a proposal for creating TFIG ‘‘Electrometpribor’’ was evaluated in the machine-building industry. Participants might have included Russian and Kazakh enterprises of electro-technical industry. It was also decided to create 11 metallurgy-related TFIGs.79 A World Bank Country Economic Memorandum on Russia, Russian Federation From Transition to Development, March 2005, analyzes firm structure and industrial concentration in Russia in some detail. Its conclusion on FIGs ‘‘Financial-industrial conglomerates are likely to out perform stand-alone firms – not due to any superior organization of production ands trade, but because they are better suited to cope with an imperfect economic environment.’’80

12.4. Direct Foreign Investment The privatization program continued to discriminate against foreign direct investment. By systematically squeezing foreign investors out of the LFS transactions, particularly in ‘‘strategic’’ natural-resource sectors such as oil and metals, the transactions served as a signal to foreign investors that they were not welcome in Russia. The LFS transactions, in addition, not only discouraged investment in companies being privatized but also discouraged investment in other sectors of the Russian economy. Finally, Russia’s privatization efforts were a warning to all foreign investors and portfolio investors; there was a non-level playing field in Russia’s investment arena, and the political risks of investing, in the absence of a stronger commitment from the Russian government, remained high.

12.5. Capital Markets Planned and sequenced correctly, privatization of major enterprises, such as YUKOS, LUKOIL, and Norilsk Nickel, on a case-by-case basis, would have deepened Russia’s capital market and promoted access to international

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capital markets for its major companies. All of the larger companies could have raised substantial equity and justified large bond flotations or convertible debentures. From the end of 1995 through the 1998 financial crisis, Russia’s equity market steadily dropped and had had little on the supply side to stimulate the market. 12.6. Conclusion Russia’s privatization process was a complex undertaking that attempted to make the move to a market economy irreversible at the earliest possible moment. It also sought to de-politicize the ownership and management of enterprises, that is, to sever the link with the state in the most complete way possible, so that the strategic decisions what to produce, how to restructure, when and how much to invest and who and how many workers to employ remained with private actors as did the incentives. The LFS was a lose–lose proposition for all of the stakeholders in Russia. The government sacrificed revenue and quality in the LFS transactions. Any of the large Russian companies – such as YUKOS, LUKOIL, or Norilsk Nickel properly prepared for privatization would have yielded the government more revenue, than all of the LFS transactions combined. Case-by-case privatization could have brought in quality investors who could have assisted these enterprises in restructuring, so urgently needed. By systematically squeezing foreign investors out of the LFS transactions, the transactions served as a signal to foreign investors that they were not welcome in Russia. Finally, the LFS transactions severely damaged the Russian government’s credibility in international financial markets. Russia’s LFS transaction substantially undermined its stated commitment to ‘‘real’’ privatization; and de-politicization of enterprise ownership.

13. POST-SCRIPT ON RUSSIA PRIVATIZATION AND REFORMS This chapter concludes as the 1998 financial crisis emerged. Thereafter there was little if any privatization in Russia. In fact, since the Putin Administration came to power in 2000, there has been a reversal of free market forces and institutions, as well as political institutions, primarily the free and independent media and the independence of Russia’s Oblast Governors.81 Russian industrial policy has appeared to favor state ownership in a select number of sectors – namely media, oil and gas. Also,

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there has been no real effort to privatize the large utilities such as energy and electricity – Rao UES or to restructure and privatize Svyazinvest. Although both enterprises have private shareholders. In fact, the reversal started with the break-up of the empires of two Oligarchs, that of Vladimir Gusinsky and Boris Berezofsky, both of whom had important media holdings among numerous other assets. Freeland indicates that: ‘‘Gusinsky was the first of the future oligarchs to grasp how central a role the media would play in the advancement of business interests,’’82 Berezofsky was supposedly instrumental in bringing Putin to power, so that breaking up his empire was a signal of Putin’s independence and his emerging power. The next move from the Kremlin was against Mikhail Khodorkovsky, who initially controlled Menatep Bank and a large number of industrial holdings that eventually became one of the earliest FIGs, with a Moscow bank at its center.83 When Khodorovsky began to organize a political movement in opposition to Putin, the Kremlin went for the jugular and arrested him for tax evasion. He is now serving a long jail sentence. The Government also began to break-up Yukos, one of the largest of the integrated oil producing associations (oil major), auctioning off its key subsidiaries ostensibly to recover back due taxes estimated at $26 billion, but also to ensure that the holdings ended up with the state-owned oil giant Rosneft or the state-owned gas giant, Gazprom.84 The Kremlin recently moved against oil and gas development joint ventures with several of the international oil majors, including Royal Dutch Shell, who had invested billions of dollars to develop the world’s largest oil and gas field, SakhalinII in the Russian Far East, in order to redress what was deemed a bad deal struck by the Yeltsin Administration. The method of choice this time was not the tax administration, but the environmental agency which claimed that these firms had not lived-up to the environmental covenants in their agreements and threatened to fine them each billions of dollars. Quietly Gazprom and Rosneft have moved in on behalf of the Government to acquire larger stakes in these joint ventures than originally contracted. Gazprom acquired the majority stake in the SakhalinII field from Shell and Shell’s share fell from 55% to 25%, with Shell’s Chairman subsequently thanking Putin for his support.85 In addition, the Government is seeking to merge Russia’s two oil pipeline companies so that Transneft will join Gazprom and Rosneft as the third large state player in the sector.86 While Gazprom exports significant amounts of gas to Western Europe (some 30–35% of the regions requirements), Transneft is its counterpart for oil.

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Finally, the Putin Administration has utilized oil and gas to extend state power to the ‘‘near abroad’’ threatening administrations in Ukraine, Belarus, and Georgia with dramatic price hikes and utilizing sudden cut-offs to demonstrate its power. ‘‘On New Year’s Day of 2006, Russia abruptly cut gas exports to Ukraine.’’87 This raised great concern in Western Europe which gets 35% or so of its gas from Russia. The European Union tried to have Russia sign an understanding with it on a ‘‘code of conduct’ with respect to gas exports, but the Russians did not engage. It is not surprising that the Russian state has moved to assert its power over Russia’s energy resources – oil and gas. Acquisition of oil and gas holdings under the Yeltsin Administration was not exactly transparent. Though coal mines, a major burden for the Yeltsin administration, were successfully privatized with World Bank assistance. The Government’s renationalization of oil and gas was consistent with that of other countries whose major economic resource was energy – Saudi Arabia, Venezuela, Iran, Mexico to name just a few. While in other cases the oil and gas simply stayed in state hands – Kazakhstan, Norway and Nigeria, as examples. With the world hungry for oil and energy security and the Chinese looking to secure oil resources wherever it can, it is not surprising that Russia is using its strong natural resource position to project state power whenever it deems it appropriate. In the case of Ukraine and Georgia, it was against regimes that seemed to be rejecting close relationships with the Kremlin in favor of the West and potentially NATO affiliation and eventual EU membership in the case of Ukraine. Recently Putin spoke out sharply with respect to NATO encroachment on Russia’s borders. Moreover, though the Kremlin, the Federal Government, has grown much more powerful under Putin that is a natural reaction against the loss of power during the Yeltsin era. Most Russians one approaches on this issue feel that Putin has brought order and dignity to the Presidency and is the ‘‘strong man’’ Russia needs at the helm. There has been no move to broadly re-nationalize or reverse privatization. Instead the Government is following an industrial policy that one would historically associate with France, dirigisme. The loss of media freedom, the individual assassinations of perceived critics, and the general loss of an aura of openness, should concern Russians greatly. However, on the economic front, as long as oil and gas prices remain high, Russia remains a prosperous and an economically powerful country and for the most part a free market economy.

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NOTES 1. This discussion on the industrial legacy, the Gorbachev reforms, small-scale privatization, and mass privatization in this chapter is largely drawn from previously published work by Lieberman and Rahuja (1994). I acknowledge the prior contributions of my colleague. The conclusions, however, are my own and may not reflect his views. 2. Milanovic (1989). 3. Nellis (1991) points out that these numbers are likely to be underestimates, since a significant number of enterprises are made up of subunits that in the West would be considered independent firms. Indeed, as privatization has got under way, a significant minority of enterprises has splintered in to smaller units. 4. For a contrary view on industrial concentration in Russia, see Brown, Ickes, and Ryterman (1993). 5. See Boycko, Shleifer, and Vishny (1993, p. 13, pp. 38–43), for an extensive discussion on evolving stakeholder rights during this period. 6. I met with Mr. Volsky on several occasions from 1992 to 1995 at the request of the Director of the Russia Country Department at the World Bank. Mr. Volsky expressed the view that many of Russia’s largest enterprises were transnational companies with plants scattered throughout the CIS. The break-up of the Soviet Union badly damaged these large groups in his opinion and they needed time to restructure and re-integrate again where feasible. He favored the Korean Chaebol structure as a direction for Russia; See Boycko et al. (1993, op. cit., p. 77) for a discussion of Arkady Volsky’s Civil union and the lobbying power they exerted over the Duma (the Russian Parliament) on behalf of the managers. 7. Chubais and Vishevskaya (1993). 8. The 1992 state privatization program, entitled’’ State Program of Privatization of State and Municipal Enterprises in the Russian Federation for 1992,’’ was issued in conjunction with the ‘‘Amendments and Additions to the Law of RSFSR on Privatization of State and Municipal Enterprises in the RSFSR.’’ 9. The program in the English translation was The 1992 Privatization Program of the Russian Federation: Description and Explanation, prepared by the State Committee of the Russian Federation for the Management of State Property, April 7, 1992. 10. ‘‘Interim Methodological Guidelines for the valuation of Properties Targeted for Privatization,’’ issued as Supplement 2 to the ‘‘Acceleration Decree.’’ 11. The International Finance Company part of the World Bank Group put considerable time and effort into small-scale privatization in Russia utilizing Nizhny Novgorod as their model oblast. Nizhny Novgorod had a reformist Governor, Boris Nimzov, who was willing to work closely with the IFC to advance reform in his region. IFC Internal Memorandum, Small Scale Privatization, June 15, 1993 describes in some detail the problems with the small-scale program. 12. 10 years of transition. 13. The Russian MPP is discussed in Chapter 3 on Mass Privatization in this book and also to some extent in Chapter 2. Chapter 3 discusses the Russian mass privatization programs on a comparative basis with Poland and the Czech Republic. For a comprehensive treatment of the Russian MPP see Boycko et al. (1993).

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14. Boycko et al. (1993, p. 104). The authors cite some 14,500 enterprises privatized under the MPP; however, another 2,000 or so enterprises were privatized through lease purchase agreements as a result of the Gorbachev reforms. 15. For a more detailed comparison of these mass privatization programs, see Lieberman, Ewing, Mejstrik, Mukherjee, and Fidler (1995). 16. Boycko et al. (1993, p. 69). 17. Holders of preferred shares receive fixed dividends of 10% of the previous year’s profits. If the holders of the common stock receive higher dividends on a per share basis than preferred shareholders, then dividends on preferred shares have to be increased to match those on common shares. 18. Options 2 and 3 were included in privatization program at the insistence of the Duma because of the considerable lobbying power of enterprise managers and workers. Volsky’s lobby, The Union of Industrialists and Entrepreneurs, was a primary protagonist in this case. The original program had only option 1. Chubais had to accept options 2 and 3 or risk losing the entire program. 19. Employees could fail to subscribe for the full allotment if the enterprise was particularly capital-intensive. 20. Boycko et al. (1993, pp. 76–78). 21. Chubais’ team realized that the value of voucher was a very important signaling device to the Russian public. I attended the initial meeting when this decision was made. Maxim Boycko gave a presentation worthy of a top-notch economist and applied mathematician. Chubias then went around the room inquiring of the team as to the appropriate price. When Albert Sorkin, his legal advisor, also originally from St. Petersburg, indicated that the public expected the value to represent a month’s wages. That sealed the deal and the value was set at 10,000 rubles. 22. Ibid., pp. 86–87. 23. In reality, the potential inflationary impact of vouchers was a non-issue given that inflation was in excess of 1,000% during 1993. At the time vouchers were to be issued, I raised this concern with Jeffrey Sachs, who was advising the Government on macroeconomic issues. His reply in effect was that vouchers would do little to stoke inflation, given how the Russian Central Bank was behaving in stoking inflation. 24. Price Waterhouse (1993–1994). 25. For a cogent criticism of mass (voucher) privatization see the chapter in this book by Itzhak Goldberg and John Nellis on Lessons Learned; also see Black, Kraakman, and Tarassova (2000), Broadman (2000), Filatotchev and Bleaney (1999), Desai and Goldberg (2000), Glinkina (2005). 26. There were also those analysts who pushed back, at such criticism, principally those involved in Russian reforms who realized how much was actually achieved against such tough odds, Shleifer and Treisman (2000), and Mau (1999). 27. See Shleifer and Treisman (op. cit., pp. 91–95), The Stagnation Syndrome. 28. See the sections of this chapter which deal with a detailed discussion of loansfor-shares and Svyazinvest. 29. See Shleifer and Treisman, op. cit., Chapters 4–7 for a detailed discussion of these issues and the politics surrounding them. 30. Ibid. 31. See Kidelsky (1995).

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32. The author and a small team of highly educated and qualified Russian staff at the World Bank worked throughout this period with the Russian Privatization Center in supervising a $90 million technical assistance loan the World Bank had provided to the Russian Federation to support Privatization and other reforms such as bankruptcy and anti-monopoly activities. 33. This part of the chapter dealing with cash auctions and tenders, loansfor-shares, and FIGs draws on previously unpublished work by the author and team that worked with him on the Russian privatization program. The original document was prepared as a briefing note for World Bank management and was never published. I acknowledge the contributions of Igor Artemiev, Gary Fine, and Enna Karlova to this part of the chapter through the previously prepared briefing note. The conclusions, however, are my own and do not necessarily reflect the views of my colleagues. 34. See the section in this chapter which deals with FIGs. 35. The Commission was an internationally diverse group, which included Lord Lawson, former Chancellor of the Exchequer under Prime Minister Thatcher, a senior officer in the European Investment Bank and the author of this chapter among others. 36. This discussion on loans-for-shares was published previously as Lieberman and Veimetra (1996, pp. 737–768). I acknowledge my colleague’s contribution to this chapter, but the conclusions are my own and may not reflect his views. 37. See Decree of the President of the Russian Federation (1995). 38. A provision in the August 31 decree, unmodified by any subsequent amendments. 39. See infra Table 3. 14. Id. 40. Id. 41. Id. 42. Segodnya (1995a, p. 1) (quoting Anatoly Chubais). 43. See Table 3. 44. Kommersant-Daily (1995a, p. 5, 19). 45. Id. 46. See infra (Table 5). 47. Theories as to why the steel companies were excluded from the list include the following: (1) to punish the C-2 members for ‘‘destructive behavior’’ during the LFS auctions; (2) the C-2 banks themselves lost interest or the necessary financial resources to acquire the steel companies; or (3) management was successful in fighting back against the banks’ offensive. 48. See infra Table 2. 49. See infra Table 3. 50. Kommersant Daily (1995b). 51. As a response to this concern, the Russian government excluded, in subsequent LFS auctions, bidders with fiscal debt and arrears in excess of $4 million. 52. Only in 1997 did it become known that Glencore Corp. (formerly known as Marc Rich) stood behind Rabicom, the winner of the Mechel auction. See infra Table 2. 53. Norilsk Nickel is a major non-ferrous metals conglomerate located in Eastern Siberia, north of the Polar Circle.

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54. Kommersant Daily (1995c, p. 15). 55. As the Russian State Property Committee representative for the auction. Uneximbank was also a member of the auction commission. 56. Wall Street Journal (1996, p. A10). 57. According to privatization rules, payment of the investment tender portion could be made with a down payment and installment payments for the balance over three years. 58. Banks could, however, directly bid at LFS auctions. See supra notes 16–17 and accompanying texts. 59. Kerenki were inflation-prone notes circulated in 1917 by the Russian Provisional Government, headed by Alexandre Ivanovich Kerensky. 60. Kommersant Daily (1995d, p. 5). 61. Kommersant Daily (1995e, p. 5). 62. Financial Izvestiya (1995, p. 1). 63. The group, however, has promised that it will not put the controlling interest of YUKOS in the hands of foreign companies, either through sale, as collateral, or in trust. 64. The stakes in the SIDANCO and Sibneft auction were much higher than the LUKoil sale. SIDANCO offered 51% of its common stock for $125 million of Sibneft tendered the same percentage for $100 million. 65. Delovoy Mir (1995, p. 1, 4). 66. Segodnya (1995b, p. 1). 67. New York Times (1996, p. 1, 8). 68. Valuable comments and insights into the transaction were provided by Ioannis Kessides, an infrastructure and competition policy senior economist at the World Bank. 69. The author was involved with this transaction as the World Bank provided financing for the advisors through its technical assistance loan to the Government, noted previously. I also worked with the advisors to some extent and discussed the idea of breaking Svyazinvest into a number of regional telecom companies, i.e., Russian ‘‘Baby Bells.’’ 70. Such rights negotiated with STET included (1) management control, with clear authority over financial, technical, and operations functions, provided through the contractual control of a management committee reporting to the Board; (2) the delivery of four of nine board seats (with a 75% Board approval requirement for material decisions); and (3) substantial influence over the annual selection of the General Director. As part of these contractual obligations, the investor was required to second several hundred of its management and staff to Svyazinvest and subsidiaries, who would only gradually be withdrawn. 71. The GOR did not, however, reject second bids not accompanied by an unconditional bid bond of $25 million specified in the bidding procedures, an unprecedented requirement with which, along with the initial $2.5 million bid bond, no publicly traded or accountable enterprise could comply. 72. GAO (2000). 73. World Bank (2002). 74. In addition to the analysis of FIGs below see Frenkman (1995). 75. See Freeland (2000) for an excellent discussion of the oligarchs and how they emerged to power.

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76. A number of advanced and emerging market economies have developed large financial industrial groups (FIGs) as leading groups in their economies. This emerges, in my view, from the desire of the parent or holding company within a large group to intermediate capital for all of its subsidiaries and affiliates, as well as for expansion, joint ventures, and acquisitions. In addition to Korea, Japan, and the Universal Banks in Germany, Sweden, Turkey, and Chile (in the early 1980s) followed. In other countries such as Mexico and Argentina a few large groups have traditionally dominated the economy, but not necessarily with banks at their core. 77. The exchange rate used is $1=4,672 rubles on 1/12/96 (World Bank nonmandatory rate). 78. See Vacroux (1995). 79. TFIGs were an extension of Russian international politics at the time that focused on keeping the countries in the so-called ‘‘near abroad’’ closely aligned with Russia. In addition, many industrial sections in the FSU had cooperated together for years, were now facing difficult times and it was natural for them to think about re-integrating. 80. World Bank (2005, p. 90). 81. See The New Yorker (2007, pp. 56–57). 82. Freeland (2000, op. cit., p. 150). 83. Ibid., pp. 15–127. 84. Washington Post (2007). A subsequent auction, sold these stakes to Eni and Enel, Italian State-owned energy giants, who pledged in turn, to sell these stakes within a few years to Gazprom; see also The New Yorker (2007, op. cit., p. 56). 85. The New Yorker (2007, p. 59). 86. Wall Street Journal, April 17, 2007. 87. Ibid.

REFERENCES Black, B., Kraakman, R., & Tarassova, A. (2000). Russian privatization and corporate governance: What went wrong? Stanford Law Review. Boycko, M., Shleifer, A., & Vishny, R. (1993). Privatizing Russia. Cambridge, MA: MIT Press. Broadman, H. (2000). Reducing structural dominance and entry barriers in Russian industry. World Bank. Brown, A., Ickes, B., & Ryterman, R. (1993). The myth of monopoly: A new view of industrial structure in Russia. World Bank. Chubais, A., & Vishevskaya, M. (1993). Main issues of privatization in Russia. In: A. Aslund & R. Layard (Eds), Changing the economic system in Russia. St Martin’s Press. Decree of the President of the Russian Federation. (1995, August 31). No. 889. Delovoy Mir. (1995, December 8). The LAFS auctions: Aliens keep out! p. 1, 4. Desai, R., & Goldberg, I. (2000). The vicious circles of control: Regional governments and insiders in Russian enterprises. The World Bank, Policy Research Paper 2287. Filatotchev, I., & Bleaney, M. (1999). Insider controlled firms in Russia. University of Nottingham. Financial Izvestiya. (1995, December 7). The confectionary factory was prevented from buying largest oil holding in Russia, p. 1.

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Freeland, C. (2000). The sale of the century, Russia’s wild ride from communism to capitalism. Crown Publishing. Frenkman, L. (1995). Financial-industrial groups in Russia: Emergence of large diversified private companies. Journal of Communist Economics and Economic Transformation, 7(1), 51–65. GAO. (2000, November 1). International Efforts to Aid Russia’s Transition Have had Mixed Results. Glinkina, S. (2005). Outcomes of the Russian Model. In: J. Nellis & N. Birdsall (Eds), Reality check: The distributional impact of privatization in developing countries (pp. 297–324). Washington, DC: Center for Global Development. International Finance Corporation. (1992a). Nizhny Novgorod: First privatization in Russia. Draft. International Finance Corporation. (1992b). Small-scale privatization in Russia: The Nizhny Novgorod: Model (Guiding Principles). Draft. International Finance Corporation. (1993a). Large-scale privatization in Russia. Draft. International Finance Corporation. (1993b). Russia: small scale privatization monthly report. Draft. International Finance Corporation. (1993c). Small scale privatization. The World Bank. Kidelsky, R. (1995). Russia’s stormy path to reform. The Social Market Foundation. Kommersant Daily. (1995a, April 18). Government started to put together the mosaic: A proposal of the bank consortium, p. 5, 19. Kommersant Daily. (1995b, November 9). In Surgut, Rosneft met with disillusions, p. 5. Kommersant Daily. (1995c, November 16). It could not happen without a scandal: The LFS auctions have started, p. 15. Kommersant Daily. (1995d, November 20). The banks decided to fight together for Yukos, p. 5. Kommersant Daily. (1995e, December 1). Alexandre Khandruyev advised the banks not to collapse to GKO, p. 5. Lieberman, I., Ewing, A., Mejstrik, M., Mukherjee, J., & Fidler, P. (1995). Mass privatization in central and eastern Europe: A comparative analysis. World Bank. Lieberman, I., & Rahuja, S. (1994). An overview of privatization in Russia. In: I. Lieberman & J. Nellis (Eds), Creating private enterprises and efficient markets. Washington, DC: The World Bank. Lieberman, I., & Veimetra, R. (1996). The rush for shares in the ‘klondyke’ of wild east capitalism: Loans-for-shares transactions in Russia. George Washington Journal of International Law and Economics, 29(3), 737–768. Mau, V. (1999). Russian economic reforms as perceived by western critics. Bank of Finland, Institute for Economies in Transition. Milanovic, B. (1989). Liberalization and entrepreneurship dynamics of reform in socialism and capitalism. Armonk, New York: M. E Sharpe. Nellis, J. (1991). Improving the performance of soviet enterprises. Discussion Paper 118. Washington, DC: The World Bank. New York Times. (1996, January 28). Russian banking scandal poses a threat to privatization, p. 1, 8. Price Waterhouse. (1993–1994). Funds monitoring report. Draft. Segodnya. (1995a, September 6). A new stage of Russian denationalization, p. 1. Segodnya. (1995b, December 29). The LFS Epopee of 1995 is over: Menatep guarantees a credit to government against Sibneft collateral, p. 1. Shleifer, A., & Treisman, D. (2000). Without a map. Cambridge: The MIT Press.

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The New Yorker. (2007, January 29). Letter from Moscow, Kremlin, Inc. The State Committee of the Russian Federation for the Management of State Property. (1992a). The Russian privatization program: A guide for foreign investors. Draft. The State Committee of the Russian Federation for the Management of State Property. (1992b). The 1992 privatization program of the Russian federation: Description and explanation. Vacroux, A. (1995). Privatizations in the regions: Primorsky Krai. In: I. Lieberman & J. Nellis (Eds), Russia creating enterprises and efficient markets. World Bank. Wall Street Journal. (1996, February 14). Russian communists exploit loan flap, p. A10. Wall Street Journal. (2007, April 17). Wall Street Journal. Washington Post. (2007, March 28). Auction opens final phase in dismantling of Yukos Oil. World Bank. (2002). Building trust: Developing the Russian financial sector. Washington, DC. World Bank. (2005). Country economic memorandum, Russian federation from transition to development. Washington, DC.

FURTHER READING Boycko, M., & Shleifer, A. (1993). The voucher program for Russia. In: A. Aslund & X. Layard (Eds), Changing the economic system in Russia. St. Martin’s Press. Charap, J., & Webster, L. (1993). A survey of private manufacturers in St. Petersburg. Technical Paper 228. World Bank: Washington, DC. Commission of European Communities. (1993). European Bank for Reconstruction & Development, and the State Committee of the Russian Federation for the Management of State Property (GKI). The Privatization Manual, 1, 2. Debevoise, & Plimpton. (1993). Privatization in The Russian Republic. Draft. Djelic, B., & Tsukanova, M. (1993). Voucher auctions: A crucial step toward privatization. Radio Free Europe/Radio Liberty Research Report, Vol. 2 (30). Earle, J., Frydman, R., & Rapaczynski, A. (1993a). Transition policies and the establishment of a private property regime in eastern Europe. New York, NY: Central European University Press. Earle, J., Frydman, R., & Rapaczynski, A. (1993b). The privatization process in Russia, Ukraine and the Baltic States. Chapter 1. New York, NY: Central European University Press. European Bank for Reconstruction and Development. (1993a). Privatization in Russia. Discussion Paper for the Consultative Group in Paris. European Bank for Reconstruction and Development. (1993b). Privatizing the Bolshevik Biscuit Factory. Draft. Federov, B. (1993). Privatization with foreign participation. In: A. Aslund & R. Layard (Eds), Changing the economic system in Russia. St. Martin’s Press. Harding, A. (1993). Small-scale privatization in central Europe: Lessons for Europe. Draft. Lieberman, I. (1993). Poland’s mass privatization program. World Bank. Draft. Nellis, J. (1993). Bolshevik biscuit in private hands. Transition, 4(2). Washington, DC: The World Bank. Phelps, E., Frydman, R., Rapaczynski, A., & Shleifer, A. M. (1993). Needed mechanisms of corporate governance and finance in Eastern Europe. Working Paper 1, European Bank for Reconstruction and Development, London.

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Sawyer/Miller Group. (1993). Privatization and popular mandates: Using communications to ensure sustainable reform. Washington, DC. Draft. St. Giles, Mark, & Sally Buxton. (1993). The role of investment funds in the Russian privatization programme. London. Draft. The Economist. July 1993. Russian industry: The revolution begins. Thomas, S., & Kroll, H. (1993). The political economy in Russia. Draft. World Bank. (1992a). Russian economic reform: Crossing the threshold of economic reform. Washington, DC. World Bank. (1992b). Memorandum and recommendation of the President of the International Bank for Reconstruction and Development. Washington, DC.

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CHAPTER 8 METHODS AND INSTITUTIONS – HOW DO THEY MATTER?: LESSONS FROM PRIVATIZATION AND RESTRUCTURING IN THE POST-SOCIALIST TRANSITION$ Itzhak Goldberg and John Nellis Privatization during the transition from a socialist to a market economy differs from privatization elsewhere in terms of: (i) scale – the larger number of firms to be divested; (ii) political requirement for speed; and (iii) the lack of savings and private property readily convertible to purchasing power. Moreover, the economic transition has been paralleled by (iv) severe political upheavals in many countries, for example, the breakup of the former USSR and Yugoslavia, both resulting in conflict and sanctions; the wars in Tajikistan, Armenia, Moldova, Bosnia, Kosovo, etc. Lastly, (v) the legal and institutional framework inherited from socialism was far less conducive to privatization than the framework in the developing

$

This chapter draws on the authors’ following previous papers: Nellis (2005) and Goldberg and Radulovic (2005) unpublished paper for the World Bank.

Privatization in Transition Economies: The Ongoing Story Contemporary Studies in Economic and Financial Analysis, Volume 90, 345–370 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1569-3759/doi:10.1016/S1569-3759(07)00008-3

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economies, let alone the developed ones. (This fact was not sufficiently foreseen by internal policy makers or academics, or external advisors, in the early 1990s.) These factors mean that the fundamental task of reforming the enterprise sector has required new and different approaches in transition economies as compared to other states. This chapter discusses the approaches followed, the results achieved to date, the problems encountered, and the lessons learned. It then lays out a set of policy and practice recommendations which could be helpful in implementing the remaining agenda of unfinished privatization and restructuring (which is larger than many realize). The objective of this discussion is to recommend what to do and what mistakes to avoid in countries with an unfinished agenda of privatization in East Europe and Central Asia – henceforth ECA – (Ukraine, Central Asia) and, depending on political developments, for future privatization in Vietnam, North Korea, Cuba, or elsewhere. The countries of ECA can be classified in three groups, according to the primary privatization method they followed in the 1990s: Group I. Case-by-case trade sales or sales via tenders and auctions, mostly to individual investors, many of them from outside the country (e.g., Hungary, Estonia, and partly Poland, Serbia, and Romania). Group II. Mass privatization programs, which ostensibly aimed at mass ownership but almost everywhere ended up with control going to ‘‘insiders’’: managers, workers, suppliers, clients, and financial institutions (e.g., Czech Republic, Russia, and most parts of the former Soviet Union, most of Southeast Europe). Group III. No or limited privatization (most Central Asia, Ukraine, Belarus, Azerbaijan). In many countries more than one method was followed, but we concentrate on the method primarily adopted by country policy makers. The chapter is organized as follows: 1. 2. 3. 4.

Privatization Methods and Institutions – How Do They Matter? Why Restructuring? Rationale for Public Intervention Privatization – Policy and Institutions Concluding Lessons for Future Privatization

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1. PRIVATIZATION METHODS AND INSTITUTIONS – HOW DO THEY MATTER? In theory, the method employed to transfer ownership from public to private hands is a secondary concern. But when the legal-institutional environment is weak, the method of sale matters greatly. The experiences of the transition economies have taught us that different forms of sales methods produce very different types of owners, who vary greatly in their commitment to, and ability to carry out restructuring (meaning the changes required to allow the firm to survive in a competitive market setting). The method of privatization is thus an important factor in determining1 an efficient allocation of ownership rights. When the Berlin wall came down, the challenge of privatizing thousands of enterprises in Eastern Europe and the former Soviet Union was daunting. As shown in earlier chapters, non-conventional, quicker methods were sought and found. Mass privatization via vouchers was designed to achieve political separation of enterprises from the state, and speed and broaden distribution of ownership. In the early transition period, voucher privatization was enthusiastically promoted by both internal reformers and external donors. By the mid-1990s it was the primary or at least a secondary privatization track in most of Eastern Europe and the former Soviet Union countries. Between 1995 and 2000, as evidence accumulated regarding the operational and legal shortcomings of firms privatized by vouchers, the viewpoint shifted and observers started expressing their critique: ‘‘In Russia and elsewhere, proponents of rapid, mass privatization of state-owned enterprises (SOEs; ourselves among them) hoped that the profit incentives unleashed by privatization would soon revive faltering, centrally planned economies. The revival didn’t happen’’ (Black, Kraakman, & Tarassova, 2000). One of the authors of this chapter wrote in 1997: ‘‘While (insider) entrenchment in the Russian Mass Privatization Program (MPP) can partly be attributed to the political power of enterprise managers and the weakness of the central government, it is also a reflection of the design of the MPP. Insider entrenchment in Russia stems, inter alia, from the free distribution of privatization certificates. Free distribution encouraged citizens to re-sell their certificates for a pittance to insiders and contributed to the weakness of the investment funds, which lacked liquidity and could not establish control over enterprise directors.’’2 Czech voucher privatization was elegantly designed but it started to be seen that its effects on corporate governance and on enterprise restructuring

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were poor (see Mass Privatization in Transition Economies in this volume). Moreover, the negative social effects of the approach, in the Czech Republic as elsewhere, became more evident: even in some of the less corrupt settings privatization often degenerated into a ‘‘two-sided grab fest by fund managers and enterprise managers;’’3 and the farther east one traveled the more obvious the corruption and the poorer the results. The negative public perception of privatization grew rapidly. Similar results were obtained in less developed transition countries that followed the mass (voucher-based) privatization approach, including latecomers such as Macedonia and Bosnia. An illustration of the problems engendered by mass privatization is provided by Macedonia. Here, as elsewhere, the approach resulted in insider entrenchment, which in turn led to weak accountability and failure to maximize shareholders’ value. It rarely produced the expected gains in firm resources and trade links from foreign direct investment.4 As of 2000, insider privatization in Macedonia accounted for 62% of employment, while strategic investor bought companies accounted for only 16% of employment. The transfer of unsold or undispersed shares, and of the shares not paid for by their buyers, to the privatization agency allowed a powerful state agency to continue to intervene in the governance of these enterprises. According to the privatization agency, the portfolio of residual shares amounted to about Euro 500 million spread over 650 enterprises in 2002.5 Mass privatization and the resulting dispersed ownership proved particularly problematic in post-conflict countries, plagued by ethnic and social divisions. In such circumstances, a strong concentrated owner is needed to overcome internal divisions among employees, shareholders, and other stakeholders. In post-conflict Bosnia and Herzegovina, consisting of three ethic entities of Serbs, Bosniaks, and Croats, mass privatization resulted in such a widely dispersed ownership structure that little restructuring and consolidation of ownership has taken place since privatization.

1.1. Case-by-Case Methods In contrast, the more traditional methods of privatization – a nonvoucher-based search for a core, stable, knowledgeable, and monied owner; what is called a ‘‘case-by-case’’ privatization approach – better succeeded in attracting a large amount of direct foreign investment. For example, while the Czechs privatized the bulk of their firms through vouchers, they did hold out of the voucher program a set of high-potential firms which they divested

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in a case-by-case manner. On average, these firms have done far better than those privatized through vouchers. The problem, of course, is that it is hard to say that the method was the sole cause of the better results; it may simply be that these were the best firms. Moreover, the countries that used the method were those having better initial financial and institutional conditions, such as the Czech Republic and Hungary. Nonetheless, despite the analytical difficulties, the general superiority of the case-by-case approach is now well established. In Poland, the original intent was to use mass privatization. But the scope and impact of mass privatization was eventually limited, and a panoply of other methods was used. The Polish privatization program, on the whole, has been conducted in a case-by-case approach with careful preparation of privatization deals (e.g., leasing, MEBO, IPO, trade sale, liquidation), both in the technical and social dimensions. We argue below that the case-by-case approach is the recommended method for countries in which the institutional capacity to organize privatization is weak. Case-by-case should be the method of choice in Group III (see above) countries which have done so far limited or no privatization. This conclusion derives from the linkage between institutions and privatization methods: while successful privatization requires institutions, one cannot build institutions without privatizing. Experience shows that there is a set of ‘‘institutional underpinnings’’ which represent conditions precedent to successful privatization: developed property rights; enforceable contracts, or, more generally, court decisions that are timely and based on the law, not payments or social precedence; regulatory agencies that deliver timely, law-based decisions that are reasonable and credible for both investors and consumers; and a public administration that meets modicum standards of predictability, competence, and probity. Countries with such an institutional base are more attractive to investors and manifest more and better privatization transactions. The discouraging aspect is that many Group III countries lack welldeveloped ‘‘institutional underpinnings,’’ the institutional base that improves transaction quality, and attracts the desired sort of investor. For these countries, should the prescription be: ‘‘Prior to privatizing, improve your investment climates and ‘get your institutions right’?’’ The regrettable fact is that there are no simple or quick ways to create or reinforce the needed institutions. Institutions evolve slowly, more from deep-rooted societal causes than from external or governmental interventions. This has led one knowledgeable expert to conclude: ‘‘over time the development

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paradigm has shifted from ‘get your prices right’ to ‘get your institutions right’; the latter instruction has proved as useless as the former.’’6 So what to do? The sequencing of building institutions and managing privatization in the countries in Group III requires a careful balancing act of action and institution building. ‘‘Getting your institutions right’’ cannot simply precede privatization because building institutions requires learning by doing. One cannot acquire experience in managing tenders, auctions, or bankruptcy without experimenting with the processes. A striking example of hard-to-build institutions is bankruptcy implementation. It requires a shift in the mindset of the legal and business community from a debtor-friendly to a creditor-friendly approach. Judges are not likely to change unless they adjudicate bankruptcy cases, and managers will keep seeing bankruptcy as the ultimate catastrophe unless they see from experience that there may well be life for assets – and managers – after a business failure. Moreover, in economies with weak institutional capacity, concentrated ownership is doubly important because the weak capacity does not allow protection of investors, particularly minority investors (whether foreign or domestic) and exacerbates the agency problems associated with dispersed ownership.7 In sum, Group III policy makers should opt for case-by-case privatization because:  Case-by-case privatization creates concentrated ownership which has been shown8 to result in faster and deeper restructuring;  It requires lesser supervisory capacity in capital markets;  Case-by-case privatization is slow and thus allows parallel institutional building and privatization, restructuring, and bankruptcy;  Case-by-case via trade sales or tenders conducted by international financial advisors increases the transparency of the process; and  Case-by-case of small and medium enterprises (SMEs) conducted in highly visible, transparent, and widely publicized auctions protects the transparency of the process.

1.2. Issues in Implementing Case-by-Case Privatization 1.2.1. Use Competitive Tenders, Not Private Trade Sales In developing market economies, due to supposedly ‘‘strategic’’ considerations, trade sales, mergers, and acquisitions are often conducted without a competitive bidding process. We argue that competitive tenders are critical in all transactions, with almost no exceptions. A well-organized competitive

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tender can be structured as a built-in self-policing mechanism. Although collusion among buyers and bribing of officials of a privatization or selling institution or agency is still possible, it is less likely to remain undetected than in a private trade sale. 1.2.2. Use International Financial Advisors and Select Them Competitively No government, neither in a developed nor in a developing or transitional country, should engage in selling its companies without professional help, in the form of a financial advisor or firm, an investment bank, or other qualified sales agent, normally on a ‘‘retainer plus success-fee’’ basis. Many transition governments have been quite reluctant to engage financial advisors on a retainer/success-fee basis. Even governments that have eventually accepted paying a ‘‘success fee’’ to financial advisors, strongly opposed paying a retainer, or a fixed sum fee. The function of the retainer is to share the risk undertaken by the financial advisor by covering its expenses regardless of the outcome of the transaction. We argue that hiring financial advisors, on a ‘‘retainer plus success-fee’’ basis, is essential to the transparency of the process. Ensuring transparency requires hiring, through competitive procurement procedures, an internationally reputable financial advisor that risks its reputation in the international markets if the transaction turns out to fail or be corrupted. Notwithstanding the success fee and retainer, the incentives of the financial advisor are not always fully aligned with the government’s incentives. The financial advisor may opt, for example, for a lower price, in spite of a resulting lower success fee, because of asymmetric information: the selling agency and the company know more than the advisors about hidden financial and environmental liabilities which might undermine the sale; or at least the advisors may think that the selling agency has some negative information that they do not. To overcome the misalignment of incentives and protect the interests of the government vis-a`-vis the financial advisor, the privatization agency must supervise the selling efforts of the advisor. To supervise, the agency should, for example, hire independent industry experts (hired directly by the agency, not via the financial advisor) to form its own assessment of the quality of investors’ bids at the critical stage of bids evaluation. 1.2.3. Small and Medium State-Owned Entities: Auctions Observers of privatization have generally focused their attention on the larger, economically more important firms. But in most transition

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economies the state was previously operating thousands of small business units and entities as well. What should be done with these? An auction is an efficient instrument to allocate an asset to the person who values it most, and to maximize returns to the seller.9 Winner-take-all auctions offer the majority of shares to concentrated investors having both the incentive and the authority to establish good corporate governance, and to raise cash. Accordingly, auctions are a good way to sell off the bulk of the small- and medium-sized companies one wishes to divest. In principle, the approach is simple, transparent, and speedy; and the process has successfully been applied in a number of transition countries, including Poland, Romania, and others. However, auctions are subject to several risks and/or critiques:  First, auction sales for cash may be seen as discriminating against local buyers, who, in transition countries, often have no money. Worse, the funds they possess may have been obtained by illegal means.  Second, low prices, and thus low revenues are common results from transition auctions because of the low quality of the companies, leading to low demand. The dilemma in the transition countries is how to privatize SMEs quickly, to good new owners, but at the same time to encourage or at least not discriminate against local purchasers, few of whom have ample resources. Therefore, to increase political support for the program without going so far as a voucher or giveaway type approach (and sacrificing all revenue from the sales), several governments have adopted various forms of deferred payments10 including: (i) installments – domestic (normally not foreign, who usually must pay in full) buyers pay the purchase price in annual or timed installments; and (ii) the use of bonds. In the latter, auctions start with cash. If no cash bids are made, the auctioneer accepts bids made in bonds. In Serbia, for example, frozen foreign currency bonds (FFCB) were issued to many Serbs as compensation for foreign exchange accounts frozen by the Milosevic regime. Auctions always started with cash; if no cash bids were made, the auctioneer would accept bids made in FFCB.11 This option increased demand while reducing public debt, assuming of course that the bonds used to pay at the auction replaced potential cash redemption of the FFCB by the government. 1.2.4. Policy on Installment Payments Many economists oppose the use of installment payments in privatization. The argument is that turning over management to owners with minimal

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equity holdings increases the likelihood of improper or inadequate restructuring, or even asset stripping, entails administrative costs of monitoring and collecting payments, and keeps the government involved as a major actor in the productive sector. Economically, the optimal pricing system is unconditional sale to the highest bidder, with immediate, full payment of the purchase price. But, as often occurs, the economically optimal conflicts with the politically palatable. Governments fear that requiring full and immediate cash payment will lay them open to charges that this will benefit mainly the rich, the foreign, or the corrupt. Moreover, the likelihood is high that auctions will fail if full and immediate payment is the rule. Governments also realize that low prices for firms being privatized reflect the extent to which these assets were mismanaged and eroded under public or social ownership. Governments thus often prefer to see, and publicize, high nominal prices, even if they often end up, after a certain amount of default and non-payments, receiving less than the publicized amount. Economists generally are also opposed to the idea of preferential treatment of local investors in privatization. The idea is that sales to the highest bidder shorten repayment periods and lead to faster and deeper restructuring. Yet, since locals are assumed to have little cash, shortening the repayment period might well increase the number of unsold companies, and would certainly reduce the nominal selling price. Moreover, of course, there is continuing, intense political pressure to discriminate in favor of local buyers. One escape from the dilemma is to shorten the repayment period for the first and second auction rounds, and apply the longer repayment period only where firms fail to sell in the first two rounds. When they are unavoidable, installments should be limited to SME auction privatization; they should not be allowed in tenders or trade sales of larger companies to international investors. This would discourage FDI and strategic investors, as they would be crowded out by local investors who could bid higher and pay with installments for significant companies. 1.2.5. What to Do with Firms After Failed Auctions? Some small firms placed on the market will not attract bidders; other will not attract bidders if the reserve price – often set by governments to protect themselves against the charge of ‘‘giving away the family silver’’ – is too high. Some transition countries have decreased or eliminated the reserve price for an SME following a failed first auction, and, as noted below, many firms that failed to sell the first time round have subsequently been privatized. Still, some usually remain. What can be done?

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Following a second failed auction attempt, shares in the firm might be distributed, free of charge, to employees and managers. The argument goes as follows: ‘‘If nobody wants to buy this company, it is only fair to give it away to its workers.’’ Free distribution of shares to insiders is administratively quite feasible and often politically palatable; but it has a severe economic drawback: It provides a strong incentive to employees and management to prevent the success of the first two rounds in order to receive more or less gratis the shares (and debt forgiveness). Proponents claim that this approach would deal with companies that are not bad enough to go to bankruptcy and yet not good enough to attract buyers. But experience in several countries shows that a number of companies have found a buyer at the third or even fourth auction round, undercutting the primary justification for a giveaway. Other, less damaging options that might be considered to resolve the problem include: introduce a decreasing ‘‘starting price’’ scheme. A second option, in the event of two failed auction rounds, is immediate imposition of bankruptcy. This would impose a hard budget constraint, and provide an opportunity to put at least some of the remaining assets back in the market. But, in addition to the political difficulty of imposing such a ‘‘guillotine’’ bankruptcy regime of this sort, the fact that some sales have occurred in the third and fourth rounds argues for a policy of persistence and patience. 1.2.6. Conclusion The experience of Groups I and II countries with mass and case-by-case privatization suggests that the case-by-case method is generally preferable for Group III countries. The weak institutional capacity in Group III requires a slow process of privatization, restructuring, and bankruptcy in parallel with the process of building implementation institutions. The experiences presented show that the case-by-case approach applies both to large companies by using competitive tenders with financial advisors and to SMEs by using competitive auctions. For companies which do not initially sell in auctions or tenders, we propose various options: more flexible pricing and repeated auctions or tenders, restructuring followed by repeated offering for sale and finally, when all fails, bankruptcy.

2. WHY RESTRUCTURING? RATIONALE FOR PUBLIC INTERVENTION Governments around the world have found it difficult to sell state-owned firms, but they have found it doubly difficult to declare them bankrupt and

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close them. Bankruptcy and closure are the ultimate admission that the state failed utterly in its role of owner and manager. When a firm is sold a government can claim that it has simply shifted its approach and strategy, and that it has obtained a good price for the property divested. It is much harder to save face during closures; and most governments do their best to avoid them. There is an additional factor at play in transition countries: it can be argued that while no one may wish to buy a particular firm in its present state, or in the present state of the economy, some relatively simple and lowcost changes (in policy, in the structure of assets and liabilities in the firm) could easily make the firm – or parts of it – attractive to buyers. Thus, many transition states have enthusiastically adopted programs of what is called ‘‘pro-active restructuring;’’ i.e., steps undertaken in advance of sale, paid for by government, to determine what can and cannot be sold, to clean up the balance sheet, to settle contingent liabilities, etc. In spite of the negative experiences with pro-active restructuring in the transition countries during the 1990s (see ‘‘hospitals’’ and ‘‘jails’’ below), many policy makers still believe that it is legitimate for governments to direct financial and policy support to companies, not primarily because it makes economic sense, but rather because of these firms’ social and political importance, particularly with regard to maintaining employment. This notion is usually strongly supported by the unions, by a broad range of political parties and movements, and it is normally a popular idea among a majority of the citizenry. However, to many of these stakeholders, restructuring is looked upon less as a step toward privatization, and more as an alternative to ownership change – or at least a delay, and preferably a lengthy one, before ownership change is introduced. Thus, the broader meaning of the word restructuring offers fertile ground for the growth of unreasonable expectations of employees and the general public. Economic theory is clear in its verdict on loss-making SOEs. Publicly or socially owned firms that persistently run losses, that the state either does not wish to or can no longer afford to subsidize, and that attract no buyers when put up for sale, should be closed; and their assets sold piecemeal or otherwise disposed of. The approach proposed in this chapter for the remaining privatization agenda in Group III deviates from this purist conception. Taking into account the realities of political economy, the argument is that modest and temporary public intervention is warranted to make the firms sellable by reducing the baggage of the past – through write-offs of old debts at the time of sale, public funding of severance pay, and the imposition of hard budget

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constraints to induce recalcitrant insiders to participate in the process. The economic justification for public intervention is that simply selling firms to the highest bidder would result in artificially low selling prices for assets or parts of the firm that, with only slightly improved conditions, might fetch a reasonable sum. Economists cannot tell without a ‘‘market test,’’ whether a company is sellable or not (at a positive value) and what is the market price. Only a market test can discover whether the company’s asset value plus the social cost of its crowding out more efficient new entrants exceeds that market price so that exit is welfare enhancing. Another rationale for this sequenced approach – restructuring, market test, and bankruptcy – is that politically it is easier to place in bankruptcy a company if all other options have been demonstrably and visibly exhausted. Second, there are other political considerations as well that no government can blithely ignore. The issue is to find a way to lightly and temporarily intervene to improve the sales prospects of these firms, with a clear exit goal – and timetable – in mind, and to do so in a manner acceptable to the body politic.

2.1. History: Isolation Programs Pro-active restructuring has a long history in transition economies. An early approach was termed ‘‘Isolation’’ programs; these were implemented in seven transition economies – Albania, Armenia, Bulgaria, Kazakhstan, the Kyrgyz Republic, Macedonia, and Romania. All these countries had been through mass privation programs. The rationale for isolation programs – ‘‘enterprise hospitals and jails’’ are other terms for this approach – in transition economies was based on the belief that the fledgling bankruptcy system could not handle the large number of loss-makers expediently; and that if all the firms badly hit by the collapse of communism were to simply cease operation this would be an enormous drain on the state budget, and would provoke a collapse of the banking sector and political instability. Thus, in these programs a number of large loss-making enterprises were isolated in order to ensure that their losses were not financed through building up arrears to banks, to suppliers, to the state budget, and the social funds. A monitoring unit which tracked the financial and operational performance of each firm on a monthly basis was established either in the newly created agencies for restructuring (as in Romania, Albania, Armenia, the Kyrgyz Republic), or in the Ministry of Finance (Bulgaria, Macedonia, Kazakhstan). The isolation programs were time-bound – designed to last for

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two to four years. Beyond the program, any firm that was failing was supposed to go through the normal court bankruptcy procedures. The burden to take such firms to court would be on their creditors and not the government.12 Djankov (1998) analyzes the relative performance of firms selected into the Romanian isolation program and argues that none of the intentions of the isolation program were fulfilled. Worse still, the program may have delayed restructuring by not imposing financial discipline on loss-making enterprises. The difficulties that the isolation program faced were due to the selection of enterprises into the program and its subsequent implementation. Loss makers were not selected on objective criteria, and the agency in charge was not sheltered from political pressures to keep funding pet firms. Djankov questions the feasibility of designing programs in which government agencies can decide on the scope of activity and selection of beneficiaries. This conclusion is supportive of the insistence of international donor organizations in the 1990s that governments in transition economies privatize rapidly, and not attempt to restructure enterprises prior to privatization. That donors’ recommendation from the 1990s is contrasted below against a pre-privatization transaction-oriented restructuring approach (privatization through restructuring) tried in Serbia.

2.2. Privatization and Financial Discipline – The Inseparable Twins Transition states that failed to impose systematically hard budget constraints – the Czech Republic for a period in the mid-1990s and Ukraine, for example – paid a very high price in terms of budget costs and delayed restructuring. In contrast, in Poland, the reform government of Balcerowicz was able to impose hard budgets on many of its firms at an early date and profited greatly from its bold move.13 One can argue that the earlier in the transition process the issue of large loss-makers is directly addressed, the higher the likelihood of affecting a satisfactory solution in both economic and political terms. Countries which maintained soft budget constraints were also slower in privatization and their private sector remained smaller than in those countries which were quicker to impose financial disciple. In Fig. 1 we show the negative correlation between budgetary subsidies and current transfers and the share of private sector (PS) in GDP. The variables are taken from the EBRD and the definitions are as follows: private sector value added includes income generated by the activity of private registered companies, as

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ITZHAK GOLDBERG AND JOHN NELLIS Budgetary Subsidies vs. Private Sector Shares in GDP (2001-2005 Average)

100 90 Czech Republic Estonia

Private Sector Share in GDP

80 Albania

70

Bulgaria

Armenia

60

Azerbaijan

Croaitia

Slovak Republic

Hungary

Lithuania Latvia Mongolia Romania

Kyrgyz Republic Georgia FYR Macedonia

50

Slovenia

Ukraine

Tajikstan Serbia

40 30 Belarus

20 10 0 0

5

10

15

20

25

30

Budgetary Subsidies and Current Transfers (share in GDP)

Fig. 1.

Budgetary Subsidies and Current Transfers Plotted Against Share of Private Employment. Source: EBRD.

well as by private entities engaged in informal activity. Budgetary subsidies and current transfers include subsidies to enterprises and transfers to enterprises and households, excluding social transfers.14 In six of the transition countries shown in the figure, budgetary subsidies and current transfers in 2001–2005 exceeded 15% of GDP: Slovak Republic, Slovenia, Ukraine, Serbia, Tajikistan, and Romania. The share of PS in GDP fell below 2/3 (67%) in nine countries: Azerbaijan, Belarus, Croatia, Macedonia, Serbia, Slovenia, Tajikistan, Ukraine, Georgia, and Romania. In four countries (Ukraine, Serbia, Tajikistan, and Romania), both subsidies were high and PS share was low: subsidies exceed 15% of GDP and PS/ GDP was below 66%. To test the hypothesized negative correlation between these two variables, we run a regression with ‘‘subsidies’’ as a dependent variable and PS/GDP as the exogenous variable and find a negative relationship, significant at 5%. Obviously, causality can run either way but regardless whether it is that soft budget constraints hamper privatization or that privatization hardens budget constraints, both issues should be dealt with simultaneously.

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We illustrate the implications of the lack of financial discipline and restructuring thorough privatization in two countries with low private sector share and low financial discipline: Ukraine and Serbia.

2.3. Ukraine’s Soft Budget Constraints Transfers to enterprises in Ukraine had an almost fourfold rise between 2001 and 2005, reaching 2.22% of GDP, with only one-third of these transfers going to fixed investments and the remaining being allocated for the energy and financial sectors (in the format of repeated re-capitalization of public financial institutions). The World Bank estimates that roughly 1.2% of GDP could have been saved if the most inefficient transfers to enterprises (excluding those to the agricultural sector) had been eliminated. Subsidies to the energy sector, that currently correspond to just less than 1% of GDP, have been allocated essentially to the coal sector, mainly in the format of production and investment subsidies. Only 30% of this subsidy was applied to finance the restructuring or closing inefficient mines or to mitigate the potential negative externalities of this activity. Subsidies to the energy sector and related quasi-fiscal activities have sustained inefficient energy use and worsened the financial position of energy companies and their ability to attract private capital. At best, this subsidization has discouraged necessary investments in energy efficient technology and left Ukrainian enterprises (particularly in metallurgy) vulnerable to foreign competition. At worst, much needed restructuring and exit of inefficient firms (not least in the coal industry) has been postponed, delaying the necessary redeployment of resources into more productive uses.15 A critical component therefore of Ukraine’s transition to a market economy will be to subordinate the use of these subsidies to a legal discipline similar to the EU principles for State-Aids, reducing their distortionary impact. A strategy to fully restructure the coal sector –combining the privatization of potentially viable mines with the phasing-out of production and investments subsidies and deregulation of the coal prices – should be considered. A protracted process of mine closures adds to the final costs of closure and contributes to social tension, but the impact of an increase in the price of coal on the costs of the metallurgy industry indicates a potentially difficult political economy process.

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2.4. The Serbian Restructuring Model In Serbia, restructuring is clearly defined in Article 19 of the 2001 Privatization Law as measures undertaken by the government to increase the privatization potential of individual companies. It follows, therefore, that restructuring measures should be tightly and exclusively connected to privatization; restructuring is not the rescuing of the firm so that it may continue to operate indefinitely as a loss-making state-owned or socially owned company. This principle of preparing the firm for privatization or partial privatization via the sale of non-core subsidiaries or assets is the essence of the Serbian restructuring concept. In 2001, the government put together a group of firms (the List) consisting of originally about 30, which by 2007 grew to 79, conglomerates or large companies with many subsidiaries. All were socially important (total employment was about 200,000), all were making losses, but all were thought to contain some decent assets. A typical firm on the List was expected to undergo analysis and ‘‘segmentation’’ (division into core and non-core assets, likely viable and likely non-viable units, etc.), incorporation of new companies created from parts of the old one, sale – in tenders or auctions – of these new companies and assets remaining after the breakup, and liquidation of the portions not sold. The ultimate sale of the enterprise or its various viable parts was to drive the restructuring effort. The premise, again, is that various subsidiaries and/or assets of loss-making enterprises could be viable and attractive to potential investors even if as a whole these conglomerates were initially non-viable and unsellable. Why put a company into restructuring if it is highly likely from the start that the logical action and probable outcome is a shutdown and asset sale? The answer is that although the outcome might be evident to industrial experts, political reality demands that authorities tender the company, and, if the tender fails, try to restructure it. The efforts are required to deal with the expectations of the employees, management, and the public regarding the quality of the company in question. The gap between the perceived value of the company in the eyes of the management, the employees, and actual market value is usually large, and the larger the gap the longer and more protracted the process must be. Management of expectations is very much a part of the restructuring process. By 2007, out of the 79 large socially important loss-making companies on the Serbian Government’s List, 25 companies were sold; 7 are in bankruptcy, managed by a court appointed trustee; 5 failed an auction or a tender at least twice but are not yet in bankruptcy; 20 are on offer for sale in

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auction or tender, and 22 are in preparation for sale. As usual, much more time has been taken for this process than originally anticipated, but some positive results have emerged.

2.5. Conclusion The approach proposed in this chapter for the remaining privatization agenda in Group III is the transaction-oriented approach (privatization through restructuring) tried in Serbia, as opposed to the ‘‘business as usual’’ approach of Ukraine.

3. PRIVATIZATION – POLICY AND INSTITUTIONS A key lesson of experience in ECA is that enterprise reform, including privatization, must be an integral component of an economic reforms program. The first stage should be a stabilization program and the second, structural and institutional reforms, such as price liberalization, foreign trade reform, public expenditure reform, tax reform, energy sector reform, and social protection and labor market reforms. Countries that fail to reform in other areas such as macroeconomic reforms, stabilization (e.g., early-day Russia), and liberalization (e.g., Uzbekistan) also privatize poorly. A host of countries have privatized small-scale companies without liberalizing new entry and without providing for exit or bankruptcy, while maintaining a business environment harmful to small business development (e.g., Russia, Ukraine, Kazakhstan, the Kyrgyz Republic). This has resulted in arrested development of small business, failure of the service sector to grow, and develop and create new employment opportunities and the growth of a substantial informal or gray economy. Several countries have discriminated against entry by foreign investors missing the opportunity to attract FDI generally and to attract necessary managerial know-how and transfer of technology to privatized companies (e.g., in Russia and Ukraine).16 Enterprise reform and financial sector reforms should progress in parallel; an integrated approach is needed. Financial sector reforms are needed to boost financial intermediation, and encourage domestic savings, generating the much needed working capital and investment finance needed for the real sector to expand. At the same time, the privatization/liquidation of SOEs and new entry of firms supported by the business-enabling environment,

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should lay the basis for sustainable growth. At the interface between private and financial sector reforms, there is the problem of asset resolution/debt workout: the interrelated issues of the banking system weakness and lossmaking enterprises. Since privatization and restructuring take a number of years to implement it is important that scarce resources in the interim are not absorbed in subsidies to state-owned firms (as continues in Ukraine). Unless hard budgets are imposed and payment obligations are enforced, there is likely to be a cascade of arrears through the system, severely damaging many productive activities. Imposing financial discipline is best achieved through privatization and liquidation, and the strengthening and enforcement of bankruptcy of SOEs, which cannot be restructured. Practically, this means stopping direct political loans and allocating loans based on rate-of-return considerations. The linkages with financial sector reforms shown in the figure below are crucial to the success of privatization efforts.17 FINANCIAL SECTOR REFORM

Bank and Enterprise Sector Reforms

Regulatory/ Institutional Environment

Banking Sector Reform

Financial Sector Regulatory Framework

PRIVATE SECTOR REFORM

Bank Assets / Enterprise Workouts

Reform of Socially-Owned Enterprises

Business Environment Reform

3.1. Policies to Implement Privatization It was argued above that where institutions are weak, concentrated ownership is required to protect investors. We argue further that where institutions are weak, only a high concentration of ownership can protect the investor from corruption and an unfriendly investment climate. Thus, to compensate for weak institutions, strategic investors demand a majority interest or at a minimum operating control. In very weak institutional regimes investors might require protection against a blocking minority by demanding 75% of the shares (when the blocking minority is 25%). In

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Serbia, for example, the Law on Privatization adopted in June 2001 required enterprises to offer 70% of their available shares in each enterprise to a strategic investor, using a competitive process. Employees may take up to but never more than 24% of the shares in an enterprise prior or upon its privatization; the objective is to reserve a legal controlling majority for a core investor. Under this approach, privatization is driven by the interest of investors and the viability of the enterprises. As a result, the process is slower, as it depends to a large extent on market forces, in contrast to the massvoucher-based privatization programs in other countries. Many governments have chosen to keep a residual share of a company with the expectation that its value will rise under private ownership and they can cash in later.18 Worse, governments have held residual shares explicitly to influence the future governance of divested companies. Russia tried to divest residual share holdings in thousands of companies in which the government retained a residual holding of up to 25% of the shares during the mass privatization (voucher) program. Some of these residual holdings had great value , for example, 15% of Lukoil. But many of these holdings are of companies in the tradeables sector that are without much intrinsic value. Russia and other governments have been ineffective at improving governance in companies in which they hold residual shares. Generally they have been unable to sell most of their residual holdings, such as in the Kyrgyz Republic, and when they have it has proven costly as the government virtually repeats its privatization program for little cash return.19 The intensive privatization since the beginning of Polish economic transition resulted in the decline of the public sector value added from 69% of GDP at the beginning of transition in 1990 to 24% of GDP in 2003. Work force employment in the public sector as a share of the total work force was cut in half over the same period, to about 30%. Nevertheless, the state remained a significant owner and controller of companies in Poland. By the end of 2004, the State Treasury (ST) had ownership rights in 1,536 operating SOEs. Most SOEs, i.e., 1,189 entities operate in form of commercial companies: joint stock companies (spo´lka akcyjna, S.A.) or limited liability companies (spo´lka z ograniczona odpowiedzialnoscia, Sp. Z o.o.).20 The legal form of state enterprise is in decline and only 390 out of 918 (42%) entities established in this legal form are operating entities21 (Table 1). Political realities may dictate that governments hold a ‘‘golden share’’ for a defined period of time in large strategic companies, for example, five to seven years. This is better than holding a large minority block. The golden share is a single special share that allows the government to have blocking

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Poland: State Treasury Shareholdings in Operating Commercial Companies (31.12.2004).

Table 1. Size of Shareholding 0–5% 5.01–15% 15.01–25% 25.01–49.9% Total 0–49% 50.00–100% Total

Number of Companies

Nominal Value (’000s PLN)

244 133 86 228 691 490 1,189

317,505 307,825 468,562 5,336,451 6,430,343 n/a n/a

Source: World Bank (2005).

rights over major material events, including the sale of a majority of shares or major assets used to run the business to a third party, substantial legal reorganization of the company and motions to file for liquidation or bankruptcy. The Polish ‘‘Act on corporate governance of the companies with participation of the State Treasury and on ownership transformations,’’ in preparation in early 2007, includes a section on ‘‘Specific rights of the State Treasury and execution thereof in companies of significant importance to the law and order or public safety.’’ Our view on golden shares is that they are of little value to the selling government and a nuisance to the new owner.

3.2. Institutions to Implement Privatization Early experience in transition countries taught the lesson that it is preferable to separate the policy and implementation arms of privatization. While the Ministry sets policy, creates the legal and regulatory framework for privatization, establishes the privatization program and transaction priorities, a separate privatization agency, with staff trained in sales techniques and processes, should be established to implement sales, normally outside of the formal civil service. A separate division of the agency or a related agency may be necessary to handle restructuring, pursuant to sale, of large, complex holding groups (often corporatized former line ministries). Building the capacity of the privatization agency early on in the process is critical: even the most reputable financial advisors have not prevented scandals, particularly in small low-income countries where the capacity of

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the privatization agency is weak. A strong institutional capacity at the agency is critical to properly select the financial advisors in a transparent international competition and then professionally and diligently supervise the work of the advisors. The latter calls for staffing the agency with highly trained and well-paid project managers, each dedicated to only a few transactions. The critical importance of transparency remains the single most important lesson. Transparency means that there is a clear legal framework for the program, augmented by regulations and procedures that are well defined and also published. Financial advisors and other specialists – lawyers, accountants, environmental engineers, and industry specialists as appropriate – should be hired to carry out the privatization transaction. It is crucial that results or outcomes from privatization transaction be thoroughly and transparently disclosed. Companies should be divested through some form of competitive process – auction, tender, public share offering, or combination thereof. In general, negotiated sales open the process to accusations of corruption. To the extent possible, foreign and domestic investors should compete on a level playing field. Governments that have deviated from these principles have devalued their programs, and hence the value of their privatization transactions22. They have also failed to attract quality buyers23 who could provide managerial know-how, technology, and future investment resources. In the 1990s many companies were sold to investors through sub-optimal practices or processes. Government officials overseeing privatization should also be concerned with transparency; privatization involves the sale of the nation’s assets and privatization is inevitably politically contentious. Officials have been frequently accused of selling the ‘‘family silver’’ too cheaply or to political insiders and have often been investigated following a change in government.

4. CONCLUDING LESSONS FOR FUTURE PRIVATIZATION Retrospective evaluation of a historical process such as the post-socialist privatization in ECA in the 1990s, is problematic because the ‘‘counterfactual’’ – the results of a ‘‘road not taken’’ – remains unknown. The researcher cannot assess the effectiveness of the privatization method which was actually used without comparison to the counterfactual, the alternative

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privatization methods which could have been used, say, in Russia, in 1990–1995. To judge the success of case-by-case privatization in certain countries, for example, in Hungary and Estonia, in theory one should know what success could have been achieved in these countries had they followed mass privatization (and any other method) in the 1990s. Moreover, there is the problem of economic trends other than privatization: the privatization success of Hungary and Estonia may have been successful due to better initial economic and institutional conditions, rather than to their choice of the case-by-case privatization method over mass privatization. Nonetheless, despite the analytical difficulties, the general superiority of the case-by-case approach is now well established. Case-by-case privatization is better equipped than the other methods to install at the helm of the company a core investor, who is knowledgeable, experienced in the sector, and well funded. Mass privatization, in contrast, rarely produced the expected gains in firm resources and trade links from foreign direct investment The dispersed ownership resulting from mass privatization proved particularly problematic in post–conflict countries, plagued by ethnic and social divisions. In such circumstances, a strong concentrated owner is needed to overcome internal divisions among employees, shareholders, and other stakeholders. These lessons from experience are supported by the economic literature, which find that a core owner is more likely to restructure companies and thus significantly increase their productivity. An important survey of the literature until 2002 on enterprise reforms24 finds that ‘‘state ownership within traditional state firms is less effective than all other ownership types, except for worker-owners, who have a negative effect. Privatization to outsiders is associated with 50% more restructuring than privatization to insiders (managers and workers). Investment funds, foreigners, and other block-holders produce more than 10 times as much restructuring as diffuse individual ownership.’’ A more recent major study25 of long dynamic panel data for nearly the universe of initially state-owned manufacturing firms in four transition economies finds that the impact of privatization is immediate in Hungary and Romania, and nearly immediate (one year later) in Ukraine; in these countries, the impacts are sustained and in Romania and Ukraine they continue to increase even after three years. By contrast, the profile of the dynamics remains negative in Russia until the fifth year after privatization. The findings that privatization to outsiders, including strategic investors, investment funds, foreigners, and other block-holders is associated with more restructuring than privatization to insiders (managers and workers)

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supports the recommendation case-by-case, a method best equipped to yield such owners, should be the method of choice in Group III countries which have done so far limited or no privatization. According to economic theory, SOEs that persistently run losses, should not be subsidized and if they attract no buyers when put up for sale, should be closed; and their assets sold piecemeal or otherwise disposed of. Taking into account the realities of political economy, we argue for the transactionoriented approach (privatization through restructuring) tried in Serbia: the argument is that modest and temporary public intervention is warranted to make the firms sellable by reducing the baggage of the past – through writeoffs of old debts at the time of sale, public funding of severance pay, and the imposition of hard budget constraints to induce recalcitrant insiders to participate in the process. Countries which maintained soft budget constraints were also slower in privatization and their private sector remained smaller than in those countries which were quicker to impose financial discipline. We find a negative correlation between budgetary subsidies and current transfers and the share of private sector in GDP. Regardless whether this correlation indicates that soft budget constraints hamper privatization or that privatization hardens budget constraints, both issues should be dealt with simultaneously. Hardened budgets are a prerequisite for the cooperation of managers and employees in restructuring. As long as employees do not feel pressure and face layoffs while the firm is still under the old ownership regime, they oppose restructuring since they fear it will result in increased redundancies. All parties, including employees, must recognize that old ownership/ subsidization scheme cannot be sustained. It is worthwhile reiterating that the sequencing of building institutions and managing privatization in the countries in Group III requires a careful balancing act of action and institution building. Implementation agencies can accumulate experience in managing tenders, auctions, or bankruptcy, only by implementation and learning by doing. Since case-by-case privatization is slow, it allows time for parallel institutional building and privatization, restructuring and bankruptcy. Summary of Specific Recommendations for Group III countries: (1) For large companies, use competitive tenders, not private trade sales. Use international financial advisors and select them competitively. (2) For SMEs, use winner-take-all auctions, which offer the majority of shares to concentrated investors having both the incentive and the authority to establish good corporate governance, and to raise cash.

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(3) For companies which do not initially sell in auctions or tenders, we propose various options: more flexible pricing and repeated auctions or tenders, restructuring followed by repeated offering for sale and finally, when all fails, bankruptcy. (4) For the large loss-makers, the approach proposed in this chapter is the transaction-oriented approach (privatization through restructuring) tried in Serbia, as opposed to the ‘‘business as usual’’ approach of Ukraine. (5) The critical importance of transparency remains the single most important lesson. Transparency means that there is a clear legal framework for the program, augmented by regulations and procedures that are well defined and also published and, most importantly, strictly enforced. (6) Building the capacity of the privatization agency early on in the process is critical: Even the most reputable financial advisors have not prevented scandals, particularly in small low-income countries where the capacity of the privatization agency is weak.

NOTES 1. There are many other goals associated with privatization in the literature and in the political discussion. Privatization should be designed so as to create competitive market structures, to mitigate the social costs of restructuring, to attract foreign capital and expertise, and to achieve a fair or equitable distribution of wealth. See Maskin (2000). 2. Goldberg, Jedrzejczak, and Fuchs (1996). The acronym MPP is not spelled out in the original. Other commentators believe that insider entrenchment in Russia was primarily due to ‘‘Option 2’’ of the Russian Privatization program, imposed on the reformers by the Duma, which gave powerful managers and their workers the ability to acquire majority control before auctions even occurred. Still, had the remaining shares been sold in a winner-take-all auction, it would have been possible for a core strategic owner, (say a local oligarch) to bid for the package of the remaining 49% with the intension to obtain control by acquiring shares from employees. Also, mass privatization led to insider entrenchment in other countries where a mechanism like Option 2 was not always used. 3. Ellerman, 1998, 11. 4. Zalduendo (2003); IMF Working Paper WP/03/136. 5. Privatization and restructuring of the socially and state-owned enterprises (SOEs) in the Republic of Macedonia and its implications on corporate governance, Jovanoska, Belogaska, and Sajnlski (2002). 6. Shirley (2003). 7. Pivovarsky (2001) argues in favor of privatization that grants concentrated ownership stakes in Ukraine because of its weak institutional environment. 8. For an empirical analysis of the effects of different sorts of owners, see the study of Djankov and Murrell (September 2002). 9. See e.g., McAfee and McMillan (1987), Milgrom (1987), and Klemperer (2002).

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10. Compare to installments in China in Chapter 10 in this volume and to Uzbekistan in Goldberg et al. (1996). 11. FFCB were accepted at face value as opposed to market value, which was considerably less. 12. Djankov (1998). 13. But even Poland left a number of large, politically sensitive firms (such as coal mining and steel) outside the hard-budget framework, and this has come back to haunt the Polish economy, presently posing substantial financial problems. 14. European Bank for Reconstruction and Development (2005, pp. 206–207). 15. Based on World Bank (2006) Public Finance Review (PFR) – Phase 1. Mimeo. 16. This section draws upon Lieberman, Kessides, and Gobbo (this volume). 17. The section and the figure are based on World Bank, Report of the President on Private and Financial Sector Adjustment Credit, Federal Republic of Yugoslavia, April 2002. 18. This section draws upon Nellis (this volume). 19. See Lieberman, Nestor and Desai (1997), Op. Cit., Section 3: Residual Share Management and Divestiture for three chapters that illustrate the experience in several transition countries. 20. A number of other separate legal forms of state-owned entities, which can conduct business activity in competitive sectors and thus should be considered SOEs, are not included in the preliminary analysis of this paper. These are entities operating pursuant to separate legal acts, such as research and development units (jednostki badawczo-rozwojowe), or utility enterprises (e.g., the Polish Post Office, the Polish Railways). 21. This paragraph and Table 1 are from World Bank Corporate Governance of State-Owned Enterprises in Poland, October 2005. 22. See Lieberman and Veimetra (1996) for a discussion on how lack of transparency devalues a privatization program. 23. Qualified buyers are defined as firms who have extensive experience in the industry or sector of the firm being privatized. The buyer can bring managerial know-how, technology, market access, and financial resources to meet future investment requirements of the firm acquired. Bidders will not bring these qualities in equal dimensions. A critical role played by the investment banker is to understand the industry sufficiently well so as to identify qualified buyers as possible bidders for the firm being privatized. 24. Djankov and Murrell (September 2002). 25. Brown, Earle, and Telegdy (October 2005).

REFERENCES Black, B. S., Kraakman, R. H., & Tarassova, A. (2000). Russian privatization and corporate governance: What went wrong? Stanford Law Review, 52, 1731–1808. Brown, J. D., Earle, J., & Telegdy, A. (2005). Does privatization hurt workers? Lessons from comprehensive manufacturing firm panel data in Hungary, Romania, Russia, and Ukraine. CERT Discussion Papers 0509, Centre for Economic Reform and Transformation, Heriot Watt University.

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Djankov, S. (1998). Enterprise isolation programs in transition countries. Policy Researching Paper No. 1952. The World Bank. Djankov, S., & Murrell, P. (2002). Enterprise restructuring in transition: A quantitative survey. Journal of Economic Literature, 40(3), 739–792. European Bank for Reconstruction and Development (EBRD). (2005). Transition report 2005: Business in transition. European Bank for Reconstruction and Development. Goldberg, I., & Radulovic, B. (2005). Hard budget constraints, restructuring and privatization in Serbia: A strategy for growth of the enterprise sector, private sector note (PSN). Mimeo, World Bank. Goldberg, I., Jedrzejczak, G. T., & Fuchs, M. J. (1996, June). A new approach to privatization: The ‘‘IPO-Plus’’. World Bank Working Paper no. 1821. Jovanoska, M., Belogaska, E., & Sajnlski, S. (2002). Privatisation and restructuring of the socially- and state-owned enterprises in the Republic of Macedonia and its implications on corporate governance. Unpublished paper. Klemperer, P. (2002). How (not) to run auctions: The European 3G telecom auctions. European Economic Review, 46(4–5), 829–845. Lieberman, I., Nestor, S., & Desai, R. (Eds). (1997). Between state and market: Mass privatization in transition economies. Washington, DC: World Bank/OECD. Lieberman, I., & Veimetra, R. (1996). The rush for state shares in the ‘Klondyke’ of Wild East capitalism: Loans-for-shares transactions in Russia. George Washington Journal of International Law and Economics, 29(3). Lieberman, I. W., Kessides, I. N., & Gobbo, M. (this volume). An overview of privitization in transition economies. In: I. W. Lieberman & D. J. Kopf (Eds), Privitization in transition economies: The ongoing story (in press). Maskin, E. S. (2000). Auctions, development, and privatization: Efficient auctions with liquidity-constrained buyers. European Economic Review, 44(4–6), 667–681. McAfee, R. P., & McMillan, J. (1987). Auctions and bidding. Journal of Economic Literature, 25(2), 699–738. Milgrom, P. (1987). Auction theory. In: T. Bewley (Ed.), Advances in economic theory: Fifth World Congress (pp. 1–32). London: Cambridge University Press. Nellis, J. (this volume). Leaps of faith: Launching the privitization process in transition. In: I. W. Lieberman & D. J. Kopf (Eds), Privitization in transition economies: The ongoing story (in press). Pivovarsky, A. (2001, April 10). How does privatization work? Ownership concentration and enterprise performance in Ukraine. IMF Working Paper no. 01/42. Shirley, M. (2003). Institutions and development: A statement of the problem. Presented at a conference at Stanford University. The World Bank. (2002). Report of the President on private and financial sector adjustment. Federal Republic of Yugoslovia. The World Bank. (2005). Corporate governance of state-owned enterprises in Poland. Zalduendo, J. (2003). Enterprise restructuring and transition: Evidence from the former Yugoslav Republic of Macedonia. IMF Working Paper.

ABOUT THE AUTHORS Mirko Cvetkovic is currently Minister of Finance of the Republic of Serbia. Previously, Mr. Cvetkovic ran his own consulting and advisory firm in Belgrade. Prior to that, he was the Deputy Minister of Economy and the Director of the Serbian Privatization Agency. Mr. Cvetkovic was deeply involved in formulating the country’s privatization strategy, its regulations and subsequently in implementing this strategy. As Director of Serbia’s Privatization Agency, he was directly responsible for divesting a large number of socially owned companies through auction, tender and restructuring/privatization. Mr. Cvetkovic also had a significant role in drafting the Serbian Bankruptcy Law. Raj M. Desai is currently a fellow at the Wolfensohn Center for Development at the Brookings Institution. He is on leave from Georgetown University where he is an Associate Professor of International Development in the Edmund A. Walsh School of Foreign Service, where he has taught courses on privatization and public sector reform. Mr. Desai also worked for the World Bank, where he worked on the privatization programs of a number of the transition economies. He wrote his doctoral thesis at Harvard on the Privatization Program in the Czech Republic. He has co-authored and edited a number of works on privatization in the transition economies including works with Itzhak Goldberg and separately with Ira Lieberman, as well as papers on the political economy of economic reform in transition economies. He was also a contributing author to the World Bank’s World Development Report 2005: A Better Investment Climate for Everyone. Mario Gobbo works for Natixis Bleichroeder, a US bank part of Natixis, an international financial institution, and specializes in health care and biotechnology. Prior to his current employment, Mr. Gobbo worked for the International Finance Corporation, part of the World Bank Group and for the World Bank. He also spent nearly nine years with Lazard in London, focusing on privatization and restructuring in the CEE and SEE.

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Itzhak Goldberg works in the ECA Vice Presidency in the World Bank (The ECA Vice Presidency includes all the countries of Central and Eastern Europe, the CIS, South East Europe and Turkey). Over the last 15 years, Mr. Goldberg has worked on privatization, restructuring, the business environment and most recently the knowledge economy in a number of the transition economies including Poland, Russia, Uzbekistan and Serbia. He recently returned to Washington from three years in the World Bank’s office in Belgrade, where he worked closely with the Ministry of Economy and the Privatization Administration in the design and implementation of Serbia’s privatization program. Mr. Goldberg has written extensively on privatization in transition economies. Recent publications include Public Financial Support for Commercial Innovation, ECA Chief Economist’s Regional Working Paper Series, Vol. 1, No. 1, World Bank, 2006 (with M. Trajtenberg, A. Jaffee, J. Sunderland, T. Muller and E. Blanco Armas) and Enhancing Russia’s Competitiveness and Innovative Capacity co-edited with Raj Desai, World Bank (forthcoming). Ioannis N. Kessides is a Lead Economist at the World Bank where he specializes on competition, regulatory and privatization policies in network utilities. Mr. Kessides’ publications on these topics appeared in the Quarterly Journal of Economics, Economic Journal, Review of Economics and Statistics, Economica, and Southern Economic Journal. He also authored the World Bank’s Policy Research Report entitled Reforming Infrastructure, Privatization Regulation and Competition, World Bank and Oxford University Press, 2004. Daniel Kopf recently returned from a year in Vietnam where he observed the Vietnamese transition process first hand, through a Princeton-in-Asia fellowship, while living and working in a small city in the Mekong Delta. While there, he also worked for VinaCapital, a local investment bank, on a number of projects. Ira W. Lieberman over the last few years, Mr. Lieberman has been advising the Government of Serbia and the Serbian Privatization Agency on the privatization of a large copper mining complex, RTB Bor. He has also reviewed the Privatization Agency’s restructuring/privatization program for socially owned enterprises, including the provision of direct and indirect subsidies to these enterprises. Mr. Lieberman worked for the World Bank for a number of years, where he co-managed the World Bank’s privatization assistance to client governments. He subsequently worked as a Senior

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Manager and then Senior Advisor in the ECA Vice Presidency of the World Bank. He has advised a variety of client Governments on the creation and implementation of their privatization programs including amongst the transition economies – the Governments of Poland, Russia, Kazakhstan, Ukraine, Albania and Serbia. He has also advised several developing countries including the Governments of Argentina, Colombia, Mexico and Turkey. Mr. Lieberman has written extensively on privatization. William P. Mako is a lead specialist in the East Asia & Pacific Region of the World Bank. He recently returned to Washington after four years in the World Bank’s Beijing office, where he advised the authorities on investment climate and corporate governance issues. He has worked on SOE privatization, restructuring, corporate governance and capital market development in 15 transition economies throughout Eastern Europe and the former Soviet Union, as well as China and Vietnam. During post-1998 crises, Mr. Mako was closely involved in advising financial supervisors on corporate restructuring and adjustment lending in South Korea, Thailand, Indonesia, Turkey and Argentina. Prior to joining the World Bank in 1997, Mr. Mako was a management consultant at Price Waterhouse for 13 years, including in its bankruptcy practice. John Nellis is a non-resident Senior Fellow at the Center for Global Development, and Principal of the consulting/research firm, International Analytics. He previously worked for the World Bank’s Private and Financial Sector Vice Presidency where he co-managed the Bank’s privatization assistance to client countries. Mr. Nellis assisted the privatization programs of a number of the transition economies including the Czech Republic, Russia, Estonia, Romania and Serbia. He has also worked extensively on privatization in Africa and Latin America. Prior to his work at the World Bank, Mr. Nellis was a university professor in Kenya, Canada and the United States, and an official of the Ford Foundation in North Africa. Mr. Nellis has written extensively on privatization. Recent publications include: a volume co-edited with Nancy Birdsall: Reality Check, The Distributional Impact of Privatization in Developing Countries, Center for Global Development, 2005; and ‘‘Privatization in Developing Countries: A Summary Assessment,’’ Cairo: Egyptian Centre for Economic Studies, Distinguished Lecture Series No. 24, 2006. Alexander Pankov is a Senior Private Sector Development Specialist working in the ECA Vice Presidency of the World Bank. Over the past

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six years, he has been working closely with the Serbian authorities on a number of World Bank projects supporting privatization, restructuring and bankruptcy of enterprises and banks. Most recently, Mr. Pankov has led the team of World Bank staff and consultants assisting the authorities with restructuring and privatization of the mining complex of RTB Bor in eastern Serbia. Andrej Popovic works for the World Bank in Belgrade, Serbia as a specialist for financial and private sector operations. On behalf of the World Bank Mr. Popovic has closely followed progress on Serbia’s privatization program and has been deeply involved with the privatization process of RTB Bor, a large copper mining complex in Eastern Serbia. Dick Welch currently serves as an advisor to several governments and institutions on privatization, including the Governments of Serbia and its Privatization Agency, for the World Bank and the Turkish Privatization Agency and the Government of Romania. Mr. Welch worked for a number of years for the World Bank focused on privatization in transition economies. Prior to the World Bank, Mr. Welch worked for some time in the Canadian Ministry of Finance where during a period of several years, he directed the Government’s privatization program. Chunlin Zhang is a lead private sector development specialist in the World Bank’s Beijing office, where he has worked since 1999 and advised several government agencies. Prior to that, as an official in the State Enterprise and Trade Commission, he was responsible for policy research on SOE reform. Mr. Zhang has written extensively on SOE restructuring and privatization, public sector reform and innovation. He is co-author of a 2002 World Bank and International Finance Corporation study, Corporate Governance and Enterprise Reform in China: Building the Institutions of Modern Markets.