Finance & Development, June 1999 - Time to Rethink Privatization in Transition Economies?

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A quarterly magazine of the IMF June 1999, Volume 36, Number 2

Time to Rethink Privatization in Transition Economies?

John Nellis

Privatization has won the day in transition countries . . . or has it?

Where have privatization efforts—particularly those in Central and Eastern

Europe and the former Soviet Union—succeeded, where have they failed, and

how can these countries best pursue further privatization?

Privatization appears to have swept the field and won the day. More than a

hundred countries, on every continent, have privatized an estimated 75,000

state-owned companies. Assessment after assessment has concluded that

privatization leads to improved performance of divested companies and that

privately owned firms outperform state-owned enterprises. This has been

conclusively proved in industrial and middle-income countries, and there

is increasing evidence that privatization yields positive results in

lower-income and transition countries as well.

In the transition countries, the evidence of good results comes mainly

from Central and Eastern Europe and the Baltic states. Evidence—early and

fragmentary, but impossible to ignore—from farther east—Armenia, Georgia,

Kazakhstan, the Kyrgyz Republic, Moldova, Mongolia, Russia, and

Ukraine—shows less promising results:

Private ownership often does not lead to restructuring (that is, making

changes to position a firm to survive and thrive in competitive

markets).

Some partially state-owned firms perform better than privatized

companies.

In some countries, there are few differences in performance between

(wholly) state-owned and privately owned firms.

In other countries, there are clear performance improvements only in

those very few firms sold to foreign investors.

What is the explanation for these poorer results, and what should the

affected transition governments, and those who assist them, do to improve

these results?

Russia's experience

Russia's privatization experience illustrates the problems. The mass

privatization program of 1992–94 transferred ownership of more than 15,000

firms through a distribution of ownership vouchers. A worrisome result of

this program was that "insiders"—managers and workers combined—gained

control of an average of about two-thirds of the shares of privatized

firms. Still, by the fall of 1994, hopes were modestly high that

privatization would lead the way toward rapid transition to a market

economy. Financial discipline would, it was anticipated, start to force

secondary trading in shares of insider-dominated companies and introduce

outside ownership, and transparent and sound methods would be used to

privatize the half or more of industries still in state hands.

This, by and large, did not happen. First, insiders—particularly the

workers in the newly privatized firms—deeply feared outside ownership and

a loss of control (and jobs). Second, because the financial and physical

conditions of many firms were unattractive, not many outsiders were

interested in acquiring their shares. Third, there was an acute lack of

defined property rights, institutional underpinnings, and safeguards for

transparent secondary trading; this further discouraged outside investors.

Fourth, various Russian governments failed to put in place supporting

policies and institutions—such as hard budget constraints, reasonable

taxes and services, and mechanisms to permit and encourage new business

entrants—that might have channeled enterprise activity to productive ends.

Worse was to come: a donor-led effort to persuade the Russian government

to sell at least a few large firms using transparent and credible

"case-by-case" methods produced few results. Much of the second wave of

privatization that did take place—in particular, the "loans-for-shares"

scheme, in which major Russian banks obtained shares in firms with strong

potential as collateral for loans to the state—turned into a fraudulent

shambles, which drew criticism from many, including supporters of the

first, mass phase of Russian privatization.

Others concluded that not just the second phase of privatization but the

whole approach was wrong; that it should have been preceded (not

accompanied) by institution building; and that the proper way forward

would be to concentrate on strengthening the structures of the state,

especially mechanisms to manage public firms.

Czech Republic's experience

By 1995, the Czech government had divested more than 1,800 firms in two

waves of voucher issuance, sold a group of high-potential firms to

strategic investors, and transferred a mass of other assets to previous

owners or municipalities. In 1996, then prime minister Vaclav Klaus

claimed that transition had been more or less completed and that

henceforth the Czech Republic should be viewed as an ordinary European

country undergoing ordinary economic and political problems. At the time,

almost all economic indicators supported this judgment.

In 1998, however, GDP contracted by more than 2.5 percent. The Czech

economy is in recession—in contrast to 4–5 percent annual expansion in

neighboring countries. There are many reasons for the slide, but much of

the blame is placed on the way privatization was carried out.

An Organization for Economic Cooperation and Development (1998) report

states that the Czech voucher approach to privatization produced ownership

structures that "impeded efficient corporate governance and

restructuring." The problem was that insufficiently regulated

privatization investment funds ended up owning large or controlling stakes

in many firms privatized through vouchers, as citizens sought to limit

their risk by transferring their vouchers into these funds in exchange for

shares in the latter. But many of the largest funds were owned by the

major domestic banks, in which the Czech state retained a controlling or

majority stake. The results, say the critics, were predictable.

Investment funds did not pull the plug on poorly performing firms,

because that would have forced the funds' bank owners to write down the

loans they had made to these firms. The state-influenced, weakly

managed, and inexperienced banks tended to extend credit to high-risk,

unpromising privatized firms (whether or not they were owned by

subsidiary funds) and to persistently roll over credits rather than push

firms into bankruptcy.

The bankruptcy framework was weak and the process lengthy, further

diminishing financial market discipline.

The lack of prudential regulation and enforcement mechanisms in the

capital markets 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 firms' financial health.

While the most visible reasons for inadequate enterprise restructuring are

weaknesses in capital and financial markets, the voucher privatization

method itself—with its emphasis on speed, postponement of consideration of

many aspects of the legal/institutional framework, and initial atomization

of ownership—is seen as the underlying cause.

Other countries' experiences

Other countries that tried mass privatization schemes—such as Albania,

Kazakhstan, Moldova, and Mongolia—have not yet gained much from their

efforts. Dispersing ownership among inexperienced populations seems not to

have led to effective governance of firm managers, who in all too many

cases have not changed, have failed to restructure, and have remained

largely unaccountable for their actions. These experiences and factors are

being used to justify a slower, more cautious, more evolutionary, and more

government-led path to ownership transfer.

Summary of critique

In many transition countries, mass and rapid privatization turned over

mediocre assets to large numbers of people who had neither the skills nor

the financial resources to use them well. Most high-quality assets have

gone, in one way or another (sometimes through the "spontaneous

privatization" that preceded official schemes, sometimes through

manipulation of the voucher schemes, and perhaps most often and acutely in

the nonvoucher second phases), to the resourceful, agile, and politically

well-connected few, who have tended not to embark on the restructuring

that might have justified their acquisitions of the assets. In many

instances where ordinary citizens managed to obtain and hold minority

blocks of shares in high-quality firms, they have been induced to turn

over these shares to others at modest prices or have seen—without warning

or much subsequent explanation—the value of their minority shares fall to

nothing.

These outcomes have been most pronounced where the post-transition state

structures have been weak and fractured, allowing parts of the government

to be captured by groups whose major objective is to use the state to

legitimate or mask their acquisitions of wealth. (Poor outcomes can also

occur when stronger governments fail to create a modicum of prudential

regulation for financial and capital markets.)

The international financial institutions must bear some of the

responsibility for these poor outcomes, because they requested and

required transition governments to privatize rapidly and extensively,

assuming that private ownership would, by itself, provide sufficient

incentives to shareholders to monitor managerial behavior and encourage

firms' good performance. Although the international financial institutions

recognized the importance of competitive policies and institutional

safeguards, they believed these could be implemented later. The immediate

need was to create a basic constituency of property owners: to build

capitalism, one needed capitalists—lots of them, and fast.

But capitalism requires much more than private property; it functions

because of the widespread acceptance and enforcement in an economy of

fundamental rules and safeguards that make the outcomes of exchange

secure, predictable, and widely beneficial. Where such rules and

safeguards are absent, what suffer are not only fairness and equity but

also firms' performance. In an institutional vacuum, the chances are high

that no one in or around a privatized firm (workers, managers, creditors,

investment fund shareholders, or civil servants managing the state's

residual share) will be interested in or capable of maintaining the

long-run health of its assets. In such circumstances, privatization is as

likely to lead to stagnation and decapitalization as to improved financial

results and enhanced efficiency.

Can the problem be corrected?

In many transition countries with weak institutions, privatization's

promise has not been fulfilled. Some therefore argue that the best course

of action for such countries is to postpone further privatization until

competitive forces and an enabling institutional/governmental framework

are in place. With regard to what has already been done, there have been

calls for the renationalization of some or many divested firms, with the

intention of undoing the damage inflicted and managing these assets more

in the public interest, through greater state involvement—possibly with

these firms being "reprivatized" at some later date.

Renationalization may not appear to be a highly likely option, but it has

been proposed in and for Russia and Ukraine and even by some officials of

the present government of the Czech Republic. Despite its prima facie

appeal, it would be a desperate measure, with a high likelihood of

failure, particularly in those countries of the former Soviet Union where

its adoption is most likely to be strongly urged. Renationalization would

involve selecting some or all of the most egregiously misprivatized firms;

putting them back into the state's portfolio; managing them adequately

while there; and then, eventually, selling them again, this time

correctly.

The problems are obvious. How many transition governments outside (or even

inside) Central and Eastern Europe could reasonably be expected to

undertake this process and handle it well? How many can prevent asset

stripping in state-owned companies or have demonstrated a capacity to

divest firms in an open, transparent manner, in accord with the

established standards of international practice? Regrettably, there are

few. The irony is that countries with the skills and will to run

state-owned firms effectively and efficiently are usually the same ones

that can privatize well. Conversely, the forces and conditions that lead

governments to botch privatization are the same ones that hinder decent

management of state-owned enterprises. The conclusion: renationalization

is not the alternative; instead, ways must be found to privatize correctly

and to set and enforce performance standards for those firms that are

already privatized. The crucial question, of course, is how this can be

done.

One view runs as follows: in institutionally weak and politically

fractured transition countries, long removed from or never fully

integrated into the Western commercial tradition, privatization of the

remaining portfolio (majority or minority stakes) should be halted and

efforts shifted toward strengthening market-supporting institutions. The

goal of such efforts would be to channel present "wild east" commercial

activity into socially productive and acceptable modes, and to impose

discipline on, and competition in, the remaining public enterprises. These

steps should be accompanied or followed by staged, incremental shifts in

ownership patterns, in a more or less evolutionary manner, as has been

done in China. This proposed solution, too, has a prima facie appeal. But,

again, it assumes the existence of the end at which it aims—an effective

state mechanism and institutional framework.

The overall assessment thus appears bleak: privatize incorrectly and the

result will not be increased production, job creation, and increased

incomes but rather stagnation and decapitalization. But keeping

enterprises in the hands of a weak and venal state is likely to lead to

much the same thing. In both instances, the evident medium-to-long-term

solution is to build up the administrative, policymaking, and enforcement

capacities of the government.

Can anything be done in the shorter term? Several transition governments

have tried to compensate for managerial and institutional deficiencies and

a lack of political consensus by contracting out much or all of the

privatization process to private agents and advisors. Armenia, Bulgaria,

Estonia, Poland, and Uzbekistan are among the countries that have tried or

are contemplating this approach, the Estonians with documented success.

These efforts attempt to circumvent political constraints and find

technical solutions to perceived political and institutional difficulties

by turning over significant responsibility and decision-making power to

the agents employed. This delegation or contracting out is an option well

worth considering, but it is far from a general—or, indeed, a

speedy—solution (as Poland can attest). And the effectiveness of the

effort will, as always, depend heavily on the existence of a modicum of

governmental capacity.

Based on experience with privatization in Poland, Romania, Russia, and

Uzbekistan, the World Bank's Itzhak Goldberg (1999) argues for a

particular form of reprivatization. He suggests that the principal

obstacle to progressive restructuring in privatized firms in Russia and

elsewhere is the excessive concentration of ownership in the hands of

insiders, who lack the means and incentives to lead the firms forward.

Goldberg accepts the futility of renationalization and argues instead for

increasing the capital in privatized firms and then immediately diluting

the stakes of insiders by selling the new shares to external investors.

Once again, the political and institutional deficiencies elaborated above

deeply affect both the likelihood that a government will undertake

reprivatization or will succeed in implementing it, even if the government

makes a sincere effort to do so. The implication is that the reforming

elements in the transition governments and the international assistance

community—international financial institutions, the European Union, and

bilateral donors—should abandon efforts to privatize firms as rapidly as

possible and instead attempt to carry out slower, case-by-case and tender

forms of privatization following established international procedures.

Conclusion

It is time to rethink privatization, but only in those transition

countries where history, geography, and politics have resulted in

seemingly laudable economic policies producing clearly suboptimal

outcomes. In Russia and elsewhere, too much was expected of privatization.

But admissions of error should not be overdone. When it can be carried out

correctly, privatization is clearly the right course of action. Recall

that in a number of Central and Eastern European transition countries the

policy is an undoubted success, far superior to letting the firms remain

in state hands. It was not clear at the outset of transition how difficult

privatization would prove in institutionally weak countries (and those

commentators who claim they have long perceived this did not offer a clear

alternative strategy), or that a fair amount of time was available in

which to carry out reform.

One must continually ask what was and is the alternative to privatization.

It is not clear that Russia would be better off today had it not

undertaken the mass privatization program of 1992–94. Several other

institutionally weak transition economies that avoided or delayed

privatization or approached it more cautiously—such as Belarus, Bulgaria,

Romania, and Ukraine—have made little economic progress (though in no

case, of course, is privatization or its absence the whole explanation).

Armenian officials, for example, vigorously argue that despite the

problems their privatized firms have experienced, the absence of domestic

or foreign purchasers gave them no choice but to proceed with voucher

privatization. They insist that even weak private owners are better than

state ownership. Were they still in state hands, these firms would be

making irresistible claims on nonexistent public resources, threatening

all the hard-won progress Armenia has made in developing a market-oriented

economy. The same argument could be made for other transition countries.

So, in sum, privatization is the generally preferred course of action, but

its short-term economic effectiveness and social acceptability depend on

the institutional underpinnings of capitalism described earlier. If these

underpinnings are missing but government is effectively working toward

their construction or reinforcement, then delaying privatization until the

government's efforts have borne fruit might be the optimal course of

action. Hungary and Poland offer cases in point.

The heart of the matter is whether and how privatization can be achieved

where governments are unwilling or incapable. The necessary long-term

course of action is to support measures enhancing governments' will and

capacity (assuming that one knows what these are). The reasonable

short-term course of action is probably to push ahead with case-by-case

and tender privatization and reprivatization, along the lines espoused by

Goldberg and in cooperation with the international assistance community,

in hopes of producing some success stories to emulate.

References:

Itzhak Goldberg, 1999, "The Vicious Circle of Insider Control: A Proposal

for Reprivatization of Russian Enterprises through Investor-Local

Government Cooperation" (unpublished, World Bank, March).

Organization for Economic Cooperation and Development, 1998, Czech

Republic (Paris), pp. 56–58.

John Nellis is Senior Manager of the Enterprise Group in the World

Bank's Private Sector Development Department.

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