Transition to Market

Chapter 12 Privatization: Trade-Offs, Experience, and Policy Lessons from Eastern European Countries

Vito Tanzi
Published Date:
June 1993
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Gerd Schwartz

Just as state-owned enterprises lie at the heart of planned economies, privately owned enterprises lie at the heart of market economies, and privatization is central to the transition from plan to market. While for market economies the fundamental argument for privatization is that it improves allocative and productive efficiency (Hemming and Miranda (1991)), for economies in transition three other arguments have been suggested: creating a market economy, establishing a political system based on private property rights and individual freedoms, and boosting state revenue (Dhanji and Milanovic (1990)). While privatization and efficiency gains are usually thought to go hand in hand, evidence from recent large-scale privatizations in Eastern Europe indicates that efficiency gains may have to be obtained particularly at the expense of privatization proceeds (Schwartz and Silva Lopes (1993)).

Given vastly overextended public sectors, both goals and methods of privatization in economies in transition are fundamentally different from those in market economies. While many enterprises may remain state owned for a while, several economies in transition, notably some of the early reformers in Eastern Europe, have already achieved significant progress in privatizing their economies. In reviewing this experience, this chapter outlines some fundamental problems encountered in large-scale privatizations, discusses unresolved policy choices, and draws preliminary conclusions regarding the desirable properties of privatization schemes for economies in transition. Like the other chapters in this volume, it presents a case study, but unlike the others it does not primarily focus on fiscal issues. However, privatization policies have important fiscal implications, which arise not so much from the direct budgetary impact of asset transfers, but more from the indirect macroeconomic consequences of the selected speed and scope of privatization (Hemming (1992)). Given that many state enterprises have grown used to soft budget constraints, privatization has become an important mechanism for consolidating the financial discipline imposed on the state enterprise sector during stabilization and transformation.

After examining the general trade-offs encountered by all policymakers, this chapter reviews the general experience with privatization in several Eastern European countries. It concentrates on issues that affect the quality of privatization schemes, such as the role of privatization in the process of transition, the selection of privatization goals and tools, property rights and corporate control, bank restructuring, and the problem of large enterprises. Following this discussion, the final section offers some preliminary conclusions regarding the desirable properties of privatization schemes for economies in transition.

Constraints and Trade-Offs

It has been argued that policymakers, faced with having to initiate large-scale privatizations, typically tend to define privatization policy objectives broadly (Maurer and others (1991)), thereby running the risk of creating a set of mutually inconsistent policies. This section argues that these broadly defined objectives frequently obscure the trade-offs all policymakers face.

The definition of a “good” privatization scheme strongly depends on a country’s specific economic, political, and social conditions; the policymaker's objective function has to be adjusted according to the particular circumstances of each country. With privatization schemes having been promoted in countries with public sectors of very different size (Table 1), it has become clear that there can be no standard recipe for privatization. As a result, the experience of one country may be of only limited use in another country with a state-owned enterprise sector that is significantly different in size and scope.

Table 1.Share of State Sector in Selected Economies
Percent ofPercent of
Value AddedEmployment
Eastern Europe
Czechoslovakia (1986)97.0
East Germany (1982)96.594.2
Soviet Union (1985)96.0
Bulgaria (1990)92.0
Poland (1985)81.771.5
Hungary (1984)65.269.9
OECD economies1
France (1982)16.514.6
Austria (1978-79)14.513.0
Italy (1982)14.015.0
Turkey (1985)11.220.0
West Germany (1982)10.77.8
United Kingdom (1983)10.77.0
Portugal (1976)9.7
Denmark (1974)6.35.0
Greece (1979)6.1
Spain (1979)4.1
Netherlands (1971-73)3.68.0
United States (1983)1.31.8
Sweden (early 1980s)10.6
Finland (early 1980s)10.0
Norway (early 1980s)6.0
Other economies
China (1984)73.6
Venezuela (1978-80127.5
Tunisia (1978-79)25.4
Malawi (1984)25.08.0
Malaysia (1985-88)25.0
Singapore (1983)25.0
Jamaica (1984)21.01 1.0
Sri Lanka (1988)20.040.0
Trinidad and Tobago (1985)I 6.013.0
Kenya (1984)15.015.0
Bolivia (1974-77)12.1
India (1978)10.36.0
Papua New Guinea (1989)10.0
Niger (1980s)10.0
Korea (1981-83)9.07.0
Pakistan (1974-75)6.02.8
Paraguay (1978-80)3.1
sorces: Milanovic (1989); Adam and others (1992); and data provided by the World Bank.

Excludes government services, but includes state-owned enterprises in commercial activities.

sorces: Milanovic (1989); Adam and others (1992); and data provided by the World Bank.

Excludes government services, but includes state-owned enterprises in commercial activities.

Still, independent of a country’s particular circumstances, its policymakers are likely to have objective functions that comprise a fairly large number of general privatization objectives. The declared goals of selected Eastern European privatization schemes, shown in Table 2, may be considered typical. In Poland, for example, following an initial criticism that the Government's privatization program was devoid of any clearly identifiable goals (Gruszecki and Winiecki (1991)), the Ministry of Privatization put forward eight specific privatization objectives (Table 2). A proliferation of goals naturally leads to the question of mutual compatibility.

Table 2.Typical Goals of Privatization Programs 1
Former Czechoslovakia 2
The aims of the privatization program are both political and economic. Among
the political aims are changes in the social structure. The economic aim of
privatization is to increase the ability of the economy to adapt to external
Germany 3
The German privatization program has three primary objectives:
(1) Restructuring viable enterprises in order to make them competitive under market conditions.
(2) Privatizing enterprises.
(3) Promoting de-monopolization in order to provide eastern Germany with an efficient market structure.
Hungary 4
The principal aim of the Hungarian privatization scheme is to create a real
market economy. It is the Government's objective to reduce the share of
state-owned enterprises in the sphere of industry, trade, banking, and other
economic activities from 90 percent to 30-40 percent in a few years.
Poland 5
The Polish privatization program is based on the following objectives:
(1) Move the economy from a centrally planned system to a competitive

market system which would encourage the creation of a profitable

private sector.
(2) Improve the performance of enterprises through a more efficient use of

labor, capital, and management skills.
(3) Prevent possible distortions of the privatization process, such as the sale

of state assets to foreign investors at unduly low prices.
(4) Reduce the size of the public sector and the burden on the public budget

and administration.
(5) Generate funds from the sale of enterprises or their shares.
(6) Ensure a wide diffusion of ownership of privatized assets.
(7) Provide an effective system of corporate governance.
(8) Commence the program of exchanging the country's external debt into

equity of privatized enterprises. The privatization program will transform

Poland's ownership structure to resemble that of Western Europe

within five years, with approximately half the state-owned assets to be

transferred into private hands within the first three years.

The goals listed here do not necessarily represent the current policy objectives of the various privatization agencies.

Czechoslovakia, Ministry of Finance (1991).

Maurer and others (1991).

Hungary, State Property Agency (1991).

Poland, Ministry of Privatization (1991b).

The goals listed here do not necessarily represent the current policy objectives of the various privatization agencies.

Czechoslovakia, Ministry of Finance (1991).

Maurer and others (1991).

Hungary, State Property Agency (1991).

Poland, Ministry of Privatization (1991b).

In general, typical policymakers may initially want to (1) privatize the economy in the shortest possible time, (2) maximize privatization proceeds, (3) select the “right” buyers, (4) safeguard employment, and (5) obtain investment guarantees. It is a well-known argument that in order to meet all five objectives–speed, proceeds, ownership, employment, and new investment–the number of independent policy tools has to equal the number of goals. If this is not the case, trade-offs may be inevitable, and they may occur in different ways. For example, when it is decided to privatize an economy within the shortest possible time, any constraint imposed on the other four variables will tend to slow down the process of privatization. Conceptually, it may be useful to think of privatization policies as constrained optimization processes, where one variable is optimized subject to constraints on all other variables. This implies that a government that wants to pursue more than one policy objective at the same time may have to group state-owned enterprises, and define separate policy goals and policy constraints for each group of enterprises to be privatized.

Given multiple and not necessarily independent goals, it is no surprise that actual privatization schemes are usually multidimensional and operate with multiple privatization tools (Table 3) that are separately applied to individual subgroups of enterprises. Specific privatization tools are often closely related to specific privatization objectives. For example, mass privatization schemes, designed to transfer ownership rights of a large number of state-owned enterprises to the population at large, can easily be associated with speed objectives. Speed being dominant, constraints on proceeds, ownership, employment, and investment will have to be set carefully to avoid jeopardizing the main objective. Similar conclusions hold for other privatization tools, such as one-by-one asset auctions, which are probably most appropriate when policymakers wish to maximize privatization proceeds, or special employee or management buy-out or leasing schemes, which target specific groups of potential buyers.

Table 3.Privatization Tools
Restitution of agricultural land, small shops, some industrial property, and residential
Small enterprise privatization involving the auctioning of small shops and gasoline
One-by-one privatization using a multi-track approach that includes public
offering, public auction of shares, publicly invited tender, and publicized
private placement. Shareholding schemes allow for some minority shareholding
by employees (who can purchase nonvoting shares at a discount),
and establishing of mutual funds. Privatization is preceded by commercialization.
Former Czechoslovakia
Restitution of land and of commercial and noncommercial properties.
Small enterprise privatization in the form of auctioning or leasing small business
units with priority being given to domestic investors.
Large enterprise privatization in the form of:
  • Direct sales to foreign or domestic investors.

  • Mass privatization with no provision for minority shareholding by employees is carried out via vouchers and competing investment funds.

Restitution of land and of commercial and noncommercial property.
One-by-one privatization via trade sales, in whole or in parts, to domestic and
foreign buyers, but also via management buy-outs, management buy-ins, and
worker buy-outs. Simplified privatization rules for small enterprises.
Restitution of agricultural land; compensation for nonagricultural property
given in the form of partial compensation via securities.
Small enterprise privatization via direct sale to domestic individuals of selected
small commercial units, mostly in retail trade, services, and tourism.
One-by-one privatization, alternatively through:
  • Public share offering or trade sales to domestic or foreign investors of selected medium to large enterprises; the program is initiated by the privatization agency which brings companies to the market simultaneously in small groups of 20 to 40.

  • Self-privatization in the form of management- or worker-initiated privatization proposals that are supervised by the privatization agency; this may involve management buy-outs, management buy-ins, or worker buyouts, or trade sales to foreign or domestic investors.

  • Investor-initiated privatization, supervised by the privatization agency.

Small enterprise privatization involving the direct sale to domestic buyers of
small commercial properties, mostly in retail trade, services, and tourism.
Commercialization path: after being transformed into a joint-stock or limitedliability
company wholly owned by the state treasury, enterprises may be privatized in one of the following ways:
  • One-by-one capital privatization in the form of public share offering or trade sale to domestic or foreign investors.

  • Mass privatization with a provision for employees to become minority shareholders, but with details still to be defined.

  • Sectoral privatization primarily as a support for decision making, but also as a way to “package” weaker companies with stronger ones.

  • Privatization with restructuring to assist small to medium-sized stateowned enterprises to prepare for eventual privatization.

Liquidation path: after being liquidated as a legal entity (small to medium size)

enterprises are either sold or leased. This may involve:
  • Sale, in whole or in parts, in the form of management buy-outs or worker buy-outs, purchase by a joint venture, or direct purchase by domestic or foreign investors.

  • Leasing, in whole or in parts, but typically in the form of an installment sale to the employees of the former state-owned enterprise, where employees pay a leasing fee until the company is paid for in full.

  • Restitution still to be decided.

Small enterprise privatization via leasing, management contract offers, or sale
to domestic buyers of up to 75 percent of the total asset value of small
commercial units, mostly in retail trade, services, and tourism.
Early privatization of 30 commercial enterprises in good financial condition.
Mass privatization with no provision for minority shareholding by employees.
Privatization of land: establishing a land reform program that is to privatize
about 80 percent of all agricultural lands.

Experience with Privatization

Ever since the rapid demise of socialism, the new governments of Eastern Europe have been busy transforming their economies into market-based economies. Fischer (1991) has argued that advice on how to privatize Eastern Europe has rapidly converged on a standard approach: small firms should be privatized fast; larger firms should be corporatized quickly, put under the direction of independent corporate boards, and their shares should be distributed to some combination of current workers, current management, mutual funds, holding companies, banks, insurance companies, pension funds, citizens, and the government. But even though the issues addressed by the various existing privatization schemes necessarily show a number of important commonalities, privatization policies (and successes) differ significantly across Eastern Europe. Drawing upon the privatization experience of selected Eastern European countries, this section discusses five aspects of privatization policies with an important bearing on the eventual success or failure of privatization schemes: (1) the role of privatization in the process of transition, (2) the selection of privatization goals and tools, (3) property rights and corporate control, (4) banking sector reform, and (5) the problem of large enterprises.

Privatization in Economies in Transition

Across Eastern Europe, privatization is commonly viewed as a prime mover of transition from plan to market. Still, as Hare and Grosfeld (1991) have argued, the virtual absence of well-established and functioning financial markets and the lack of an established and well-understood legal and regulatory framework require great care in determining the role of privatization and its place in the sequence of transition. In spring 1992, some countries, such as Bulgaria and Romania, were still in the early stages of setting up a fully defined privatization scheme, while others, notably the former Czechoslovakia, Hungary, and Poland, appeared to have their basic systems in place, even though changes, refinements, and amendments were frequently found to be necessary.

Initially, the discussion of the role of privatization focused on the speed of transition and privatization; it was far from clear whether privatization should lead, accompany, or follow the process of transition. Proponents of slow privatization put forward three main arguments. First, macroeconomic stabilization, domestic price liberalization, and current account convertibility have to precede privatization because efficient decisions can only be made on the basis of correct relative prices. Second, the introduction of competition policies and current account convertibility has to precede privatization to prevent monopoly profits. Third, the introduction of modern tax systems and accounting procedures, and reforms of financial and capital markets have to precede privatization to allow for proper enterprise valuation (Keating and Hoffman (1991)). In contrast, proponents of fast privatization pointed toward the broader macroeconomic consequences of continuing to burden the economy with a large and inefficient state enterprise sector for decades to come (Hemming (1992)).

It is widely accepted now that the transition from plan to market and the urgently needed improvements in enterprise efficiency are unlikely to occur without extensive and rapid privatization (Hemming (1992)). This view is reflected in the mass privatization programs set up or proposed in countries such as Poland, Romania, and the former Czechoslovakia, which was the first country to advance mass privatization to an operational stage, when the shares of over 1,400 state enterprises went on offer to the public in mid-May 1992. Poland, the first country to embark on a comprehensive approach to macroeconomic reform, has mostly been experimenting with one-by-one privatizations that involve valuations, prospectuses, subscriptions, and underwritings, but, after experiencing very slow progress, decided to broaden the approach in summer 1990 (Gruszecki and Winiecki (1991)).1 However, the mass privatization program currently envisaged will only comprise a maximum of 400-600 enterprises, the main selection criterion being that they are bigger and in better financial shape than the average Polish enterprise.

In general, the rapid progress achieved in devising mass privatization schemes that allow rapid divestiture of state assets while delaying the question of asset valuation significantly strengthened arguments in favor of speedy and comprehensive privatization. In addition, with all Eastern European countries implementing bold macroeconomic reform and stabilization policies, arguments for delaying comprehensive privatization were further weakened.

Privatization Goals and Tools

Having broad policy objectives, and recognizing a general need to match the number of goals with the number of independent policy tools, policymakers in most Eastern European countries have decided to apply separate policy tools to separate subsets of state-owned enterprises. Accordingly, new owners are carefully selected for some enterprises, prices are maximized for others, a strict timeframe is pursued for a third group, and investment guarantees or employment are safeguarded in a fourth. This has led to a range of privatization tools, including special programs for small enterprise privatization, enterprise liquidation with asset sale or auction, leasing of state assets, management/employee buy-out/buy-in, direct sale (by either trade sale or public share offering) to foreign or domestic investors, restitution to previous owners, and mass privatization. While the strategy of pursuing a variety of policy goals by applying different policy tools to separate parts of the existing portfolio of state assets tallies well with the highly differentiated demand for state assets, it has also made the meaning of “privatization” complex and often ambiguous. Privatization schemes in many countries are characterized by complicated economic and legal relations that may sometimes impede the clarification of property rights and the transformation to a market economy (Frydman and Rapaczynski (1993)).

The case of Poland may be used to illustrate the broadness of privatization objectives and the differentiation of privatization tools. According to the Ministry of Privatization, Poland’s privatization program is based upon “a multi-track approach comprising separate privatization paths for the various categories of the enterprises, often with a simultaneous use of different techniques of privatization within a category” (Poland, Ministry of Privatization (1991b)). Consequently, enterprises are separated along the lines of size, demand, perceived economic and financial viability, level of state ownership and clarity of legal situation, quality of labor relations between management, workers, and unions within the enterprise (Poland, Ministry of Privatization (1991b)). In principle, privatization is then carried out as a two-step procedure. In the first step, enterprises that have applied for privatization are either “liquidated” in the legal sense or “commercialized,” that is, transformed into joint-stock or limited-liability companies wholly owned by the State Treasury and governed by the commercial code. The second step consists of applying one of the various possible privatization tools (see Table 3).

While the Polish case may be extreme in its degree of compartmentalization, it is not unlike the schemes operated by other countries (see Table 3). In fact, all Eastern European privatization programs show important common features such as separate arrangements for privatizing small enterprises, early privatization of enterprises in “good financial health,” and special procedures for restitution.

Small enterprises, such as retail stores, hotels, restaurants, gasoline stations, small service enterprises, and cinemas, have faced a strong domestic demand in all Eastern European countries. Governments reacted to this strong demand by devising simplified procedures; private savings were often sufficient to purchase individual units. As a result, privatization of small enterprises has been very successful. In Hungary, the “preprivatization” law of September 1990 requires the privatization agency to auction off all catering establishments with fewer than 15 employees and all shops with fewer than 10 employees. By February 1992, the privatization agency had sold over 35 percent of all units it had identified for sale (European Bank for Reconstruction and Development (1992)). In Germany, by the end of February 1992, close to 80 percent of all small commercial entities of the former German Democratic Republic had been sold (Table 4). In the former Czechoslovakia, the privatization of small enterprises began in January 1991; foreigners were barred from participating in the program at least during the first round of sales. While unclear property rights and the need to resolve reprivatization questions initially resulted in a more cautious approach to selling small enterprises and to an extensive use of leasing arrangements, auctions of small enterprises were being held as often as four times a week throughout the country. By March 1992 over 25,000 small enterprises had been leased or sold. In Romania, since November 1990, many small enterprises have been sold or leased to domestic individuals and to joint ventures between domestic and foreign partners (Demekas and Khan (1991)). In mid-1992, auctions of assets of about 3,600 small public sector enterprises were expected to start soon, with foreigners not being allowed to bid in the first round of the auctions but being free to participate thereafter.

Table 4.Results of Privatization
Size of state sector
3,356 large state enterprises at end-1991, of which 1,891 industrial sector
An unknown number of small enterprises (retail stores, cinemas, restaurants,
hotels, etc.).
4.6 million ha. of agricultural land.
Privatization results (until end-January 1992)
(1) Industry
Commercialized, to be privatized1,320(69.8%)
Status unchanged,
commercialization under way571(30.2%)
(2) Other
Auctions of retail stores and gas stations were suspended in June 1991;
the program is expected to be continued with 1,500 small enter
prises being prepared for privatization.
589,000 restitution claims received for 1.9 million ha. of agricultural
Former Czechoslovakia
Size of state sector
Small enterprises (mostly retail stores, cinemas, hotels, and restaurants): orig­
inally about 120,000 units.
Large enterprises: 5,482 units.
Privatization results (until March 1992)
(1) Small enterprises
Leased and sold, mostly via auctions: approximately 25,000 units
(over 20 percent of all small enterprises); many more restituted
(number unknown).
(2) Large enterprises
To be mass privatized or sold in a first
round that started May 19922,285(41.7%)
To be mass privatized or sold in
consecutive rounds1,844(33.6%)
To remain state-owned1,271(23,2%)
Listed for liquidation82(1.5%)
Potential restitution affects only about 6 percent of the total value of state
assets. Actual restitution will be in the form of physical restitution; finan-
cial compensation will be in cash (up to Kcs 30,000) or securities. Close to
100,000 restitution claims for properties and land had been filed by the
end of 1991.
Eastern Germany
Size of state sector
(1) Industry
270 Kombinate (vertically integrated state holding companies).
8,000 individual industrial enterprises.
(2) Other
14,800 restaurants, retail outlets, cinemas, and tourist facilities.
Privatization results (as of February 29, 1992)
(1) Industry
Break-up of the Kombinate and of individual companies increased the
total number of enterprises to 11,447; these can be categorized as
6,779 privatizations, partial privatizations, and re-privatizations au-
thorized until March 1992, with the following breakdown:
Totally privatized3,038(26.5%)
Restitution (re-privatization)711(6.2%)
Majority privately owned589(5.1%)
Majority state-owned; most
to be privatized further2,441(21.3%)
496 enterprises were turned over to local authorities, liquidated, or
temporarily administered by a third party:
Turned over to local authorities193(1.7%)
Administered by third party

4,172 enterprises remain fully owned by the privatization agency, of
To be given to local authorities101(0.8%)
To be liquidated1,079(9.4%)
Privatization to be initiated2,992(26.2%)
(2) Other
About 80 percent (close to 12,000) of all restaurants, retail outlets,
cinemas, and tourist facilities sold by March 1992.
About 3 percent (700 out of 24,300) of all land parcels

sold by March
1992; privatization of land has been slow because of restitution
Size of state sector (end-December 1989)
2,399 industrial sector enterprises.
10,200 small businesses eligible for privatization.
Privatization results (during 1990-91)
(1) Industry
Industrial firms privatized246(10.3%)
No privatization procedures
Privatization in progress
(as of end-1991) via:
Investor-led privatization176(7.3%)
(2) Small enterprises
Fully privatized2,120(20.8%)
Identified for sale3,911(38.3%)
No clear action proposed yet4,169(40.9%)
Size of state sector (as of end-1990)
(1) Industry
8,453 fully state-owned enterprises.
1,135 partially state-owned enterprises.
32 municipal enterprises.
248 enterprises owned by the State Treasury.
(2) Other
An unspecified number of small enterprises (retail stores, hotels, res-
taurants, cinemas, etc.).
Privatization results (as of end-1991)
(1) Industry
Commercialization path:
Completed privatizations26(0.3%)
Commercialized and to be privatized218(2.6%)
Liquidation path:
Completed privatizations198(2.3%)
Liquidation due to bad financial
standing; to be privatized490(5.8%)
Liquidation due to nonfinancial
reasons; to be privatized262(3,1%)
Other enterprises (details on
current status not available)7,259(85.9%)
Size of state sector
A total of 6,320 large state-owned enterprises.
An indeterminate number of small enterprises (retail stores,

hotels and tourist facilities, etc).
Privatization results (as of March 1992)
(1) Large enterprises
Undergoing privatization30(0.5%)
Listed for privatization5,970(94.5%)
To remain state-owned320(5.0%)
(2) Small enterprises
Units identified for sale4,409
Sources: Information provided by the countries' authorities and Fund staff estimates. All data are approximations.

Enterprises in good financial health usually have no difficulty in attracting potential foreign and domestic investors. While only Romania has developed a separate early privatization program for enterprises thought to be in good financial condition, it is clear that all Eastern European privatization programs have found it easier to privatize well-run, profitable enterprises than to privatize perpetual loss makers. Eventually, all privatization programs will have to face up to the problem of enterprises that are unlikely to sell at any positive price. Not only in Germany, where privatization has already reached an advanced stage, this has led to a renewed debate on industrial policy and on the need for extensive enterprise restructuring, which typically is used as a euphemism for artificially keeping alive nonviable enterprises (Bos and Kayser (1992)).

All Eastern European privatization programs address the issue of restitution. While restitution may be justified on moral grounds, it implicitly favors people who used to possess real estate over those who used to possess financial assets or human capital (Hinds and Pohl (1991)). Some countries, like Hungary, have chosen a moderate financial compensation over a direct return of the physical assets; others, like Germany and Bulgaria, use extensive in-kind restitution as an integral part of their privatization programs.

In eastern Germany, where large parts of all buildings and land are subject to restitution claims, the issue of restitution has tended to obscure property rights, slow the process of privatization, and give disincentives to potential investors. As a result, the German privatization agency, the Treuhandanstalt, was given permission to use financial compensation instead of in-kind restitution when it deems this solution to be indicated by an overriding public interest.

In Bulgaria, where the National Assembly passed three laws providing for the restitution of large areas of agricultural land, small shops and warehouses, some industrial property, and residential and urban properties confiscated during the communist government, there is a clear danger that restitution questions will further delay privatization.

In general, Eastern European countries have favored less extensive restitution or financial compensation than Germany or Bulgaria. In the former Czechoslovakia, the Government limited restitution by imposing a strict deadline for filing claims and by restricting restitution to property that was nationalized under communist rule, that is, between 1948 and 1989. Notwithstanding that most nationalizations of large industrial enterprises were carried out under the democratic government between 1945 and 1948, about 6 percent of state assets were affected by restitution (Organization for Economic Cooperation and Development (1992)).

In Hungary, the Government has decided to compensate rather than to restitute former owners or their direct descendants. A key problem of direct financial compensation is that, in its economic effects, it is equal to an untied transfer from the state budget to households; that is, it may either be used for savings or consumption, and its effects on investment are uncertain. In Hungary, this problem has been solved by offering compensation in the form of property vouchers that can only be used for certain purposes such as buying stocks or acquiring land, apartments, or commercial properties. While at first it was planned to provide compensation only for the loss of private property that occurred after June 1949, the Hungarian Constitutional Court ordered a revision of the initial draft legislation to address illegal confiscations of private property between May 1939 and June 1949. This has caused a large number of properties to be subject to compensation claims–about 830,000 compensation applications were filed by the end of February 1992–and the amount of financial compensation for individual properties via the property vouchers had to be strictly limited (Okolicsanyi (1991)).

In Poland, the issue of restitution remains unresolved; in early 1993 legislation still had not been passed by parliament. Poland’s large state budget deficit appears to make direct monetary compensation that would go beyond a symbolic gesture unfeasible (Górska and Henderson (1992)). In any case, it can be expected that restitution or financial compensation will not encompass a major portion of state-owned enterprises, and that, even when it eventually will be permitted, in most cases, no legitimate claimants will exist (S. Wellisz (1991)).

While there are certainly many common features, there also exist marked differences among the privatization programs in Eastern European countries. Examples include the acceptance of mass privatization, the openness to foreign investors, and the involvement of foreign institutions in the privatization process. Given that domestic credit in Eastern Europe is severely constrained, particularly compared with what is available to potential Western buyers, a rejection of mass privatization implies that extensive sales to foreign investors are almost unavoidable if privatization is to proceed. In Hungary, for example, the nonuse of mass privatization has brought about a broad openness to foreign investment. In addition, Hungary has effectively privatized the privatization process by granting permission to around 400 enterprises with fewer than 300 employees to deal directly with potential foreign and domestic buyers. The supervisory responsibility for these transactions, as well as for decisions on asset valuation and transformation, was delegated to 80 predominantly foreign consultants selected by the Hungarian privatization agency. An individual enterprise is free to choose any consultant from the list; only a final review is carried out by the privatization agency. Other countries, particularly those in which mass privatization is expected to play an important role, have usually placed more restrictions on foreign investment and foreign involvement. Stricter controls on foreign investments have often been justified by the need to ensure congruence of interests between enterprises and nations regarding long-term corporate strategies (Carlin and Mayer (1992)). Poland, for example, requires foreign investors to obtain formal approval by the Agency of Foreign Investment when the par value of the shares they want to acquire exceeds 10 percent of the share capital of the enterprise (Poland, Ministry of Privatization (1991a)).

Property Rights and Corporate Control

Eastern European governments have sometimes been reluctant to mandate changes in enterprise behavior, be it through privatization, the development of restructuring and business plans, or participation in technical assistance programs. This has been attributed to a desire to avoid charges of centralized control over firms, which had been blamed for the economic crisis under the communist governments (Kharas (1991)). In Poland and Hungary, for example, privatization is largely carried out on a voluntary basis, and at least in Poland, a fundamental clarification of property rights has yet to take place. More generally, the lack of action in defining property rights has slowed the creation of a modern system of corporate control, and contributed to a severe lack of enterprise guidance and supervision during the first few years of transition.

In principle, two models of corporate control are available: the outsider model, which is found in the United Kingdom and the United States, and the insider model, which is found in most of Western Europe and in Japan. The outsider model is characterized by (1) dispersed ownership and separation of ownership from control; (2) little incentive for outside investors to participate in corporate control and consequently weak commitments of outside investors to long-term strategies of firms; and (3) friendly and hostile takeovers and frequent market entrance and exit. In contrast, the insider model is characterized by (1) concentrated ownership and association of ownership and control; (2) corporate control exercised by shareholding parties (banks, other firms, employees), with outside interventions being limited to periods of clear financial failure; and (3) absence of takeovers, and infrequent market entrance and exit (Corbett and Mayer (1991)).

Under the outsider model, commercial banks rarely hold equity shares and play no active role in management; enterprises rarely hold substantial equity stakes in their suppliers or customers. Instead, commercial banks hold enterprise debt, while equity shares are held by a wide range of individuals and financial and nonfinancial institutions, with few stakes being large enough to ensure a controlling interest (Hare (1991); Corbett and Mayer (1991)). In the outsider model, exit (for individual shareholders) and friendly and hostile takeovers are the main mechanisms for ensuring management discipline: if an enterprise is perceived to be poorly managed, individual investors will either sell their equity shares quickly, or put together a group that will attempt to acquire the enterprise and introduce changes and adjustment measures (Hinds (1991); Borensztein (1991)). Under the insider model, mutual funds, commercial banks, and other interest groups make up the core investors who hold substantial equity, and enterprises are frequently interlinked through extensive cross-shareholding. In this model, core investors are active participants in enterprise management as it is considered the most effective way of protecting and increasing the value of their stake (equity plus debt) (Hinds (1991)).

After first considering the “British model” of privatization via initial public offerings, the governments of the former Czechoslovakia, Poland, and Romania began to advance mass privatization schemes; in Hungary, Bulgaria, and Germany mass privatization was never actively considered. Under mass privatization the core investor principle can be preserved in a number of ways, and each possibility involves mutual funds that act as core investors and which are owned by the general public. Lipton and Sachs (1991) envision core investors to be created by the government, which would endow them with initial equity holdings and appoint their first directors. In contrast, Frydman and Rapaczynski (1991) propose free entry into the mutual fund market and competition among mutual funds to obtain shares from the public. While Sachs (1991) argues against allowing mutual funds to gain a majority stake in individual enterprises, Frydman and Rapaczynski (1991) propose auctioning enterprises to the different mutual funds in such a way as to ensure a few large initial shareholders. Clearly, countries that consider mass privatization with mutual funds have, implicitly or explicitly, given an important role to the insider model of corporate control. However, Bolton and Roland (1992) question whether this approach has yielded beneficial results, arguing that, in practice it has tended to create an environment that is too favorable to incumbent management. In their view, the mass privatization program in the former Czechoslovakia, for example, has led to the privatization of cash-flow claims without establishing effective corporate control. This view, however, seems excessively narrow for three reasons. First, there is a danger of failure to establish corporate control under any method of privatization, not only under mass privatization. Second, fully developed systems of corporate control will take years to establish, and it is clearly too early to derive strong general policy recommendations from the less than one year of mass privatization in the former Czechoslovakia prior to the country’s split-up. Third, outright rejection of mass privatization may prolong the agony where the old system, in which corporate control is exercised by the state, continues to prevent rapid efficiency gains. Particularly because Eastern European governments have little experience with regulating the private sector in a nonintrusive way, the design of a simple and unambiguous system of corporate control should be a priority task, which can proceed only when privatization gets under way.

Bank Restructuring and Privatization

This section discusses proposals to use privatization as an instrument of banking sector reform. Eastern European banks were traditionally agents of the central authorities, part of the mechanism for plan implementation. Abolishing central plans has left the commercial banking sector of Eastern European countries disoriented and virtually paralyzed. While it would be difficult to make a compelling argument for privatization to precede banking sector reform, this is what is currently happening in Eastern Europe.2

Svejnar (1991) has argued that the limited availability of commercial credit caused by Eastern Europe’s underdeveloped banking sectors has been the single most important hindrance to the growth of private sector activity. Failure to undertake comprehensive banking sector reforms has meant that the role of banks in the emerging corporate structures of Eastern Europe remains yet to be defined. In addition, given extreme differences in the amount of credit available to foreign and domestic investors, it becomes arguable whether privatization via sale of enterprises allocates ownership and control appropriately (Carlin and Mayer (1992)).

Comprehensive banking sector reform in Eastern European countries has four main elements: (1) restructuring and possibly consolidating stateowned banks; (2) enacting a banking law that provides for establishing new private banks; (3) adopting and implementing modern banking supervision standards; and (4) resolving the problem of nonperforming loans in bank portfolios. Of these four, probably the most difficult problem to resolve concerns nonperforming bank loans to enterprises. The magnitude of the outstanding bad loans was estimated to be in the range of 15-20 percent of total loans to enterprises in Hungary and the former Czechoslovakia, and may be 30 to 40 percent in Poland and Bulgaria (Bruno (1992)). While there are different ways to address this problem,3 for the purpose of this chapter, proposals that link bank recapitalization to privatization are clearly most important.

One way to address the problem of nonperforming enterprise debt to banks is to earmark the cash proceeds from privatization for bank restructuring. This solution was adopted in the former Czechoslovakia. Another option currently under discussion in various Eastern European countries is to provide banks with shares of newly privatized enterprises. Both solutions address the recapitalization needs of banks and facilitate writing off nonperforming assets in bank balance sheets. Fischer (1991) has pointed out that, since part of the nonperforming bank assets are loans to the same firms that are being privatized, there is some logic in compensating the banks in advance.

This solution, however, is not without controversy. One problem is that it may just replace one bad asset (nonperforming loans) with another bad asset (shares of bankrupt enterprises), and hence simply fail to resolve the issue of bank recapitalization altogether. More fundamentally, however, bank participation in privatization also means bank participation in the exercise of corporate control over enterprises, which takes us directly back to the issue of property rights and corporate control. While providing banks with enterprise shares has been advocated by several authors, such as Lipton and Sachs (1991) in the case of Poland, others have strongly opposed it, arguing that it causes inequities, misallocation of resources, increased financial instability, and potential conflicts of interest. Borensztein (1991), for example, on the basis of evidence presented by Hinds (1991) and by Lipton and Sachs (1991) for the case of Chile, suggests caution in establishing close relationships between banks and their clients. Similarly, Kornai (1991) has argued that putting a sizable proportion of industrial shares in the hands of large banks is premature in Eastern Europe, particularly when banks are still state owned. He suggests that banks, as shareholders of large stock companies, may fail to apply regular business criteria to the stock companies in which they hold a stake, and generally share the interest of the stock companies of being bailed out and artificially sustained. This argument is supported by Schwartz (1991) who, citing evidence from Hungary, has pointed out abuses of close bank-client relationships. The need for unambiguous incentive structures has led McKinnon (1991) to propose an extreme solution, where privatized firms are given no access to credit from the traditional banks, which implies that they would have to finance investments either from retained earnings or by raising funds in capital markets from the nonbank public.

All this points to the urgency of a comprehensive reform of the banking system, and to the specific problems related to the recapitalization of banks. Using shares of privatized enterprises to recapitalize banks is highly controversial. Hence, it should not be considered as a general solution, but also not be completely ruled out from the outset. If it is decided to use privatization in the recapitalization of banks, mechanisms and incentive structures need to be designed carefully. The solution that was adopted by the former Czechoslovakia, earmarking cash proceeds from privatization, is less controversial than the direct provision of enterprise shares to banks, but may fail to generate sufficient funds. An alternative, proposed by Fischer (1991), would be to hold the shares earmarked for banks in a separate general fund, which would be used at a later stage to infuse funds into banks, and to restructure bank balance sheets with safer assets. In general, privatization policies can provide valuable support, but are no substitute for a comprehensive bank restructuring scheme.

The Problem of Large Enterprises

The privatization of small enterprises, mostly retail stores and enterprises in trade and services, has proceeded rapidly and successfully across Eastern Europe; privatization of large enterprises, such as mines, steel mills, shipyards, petrochemical complexes, and textile mills, has been much slower (see Table 4). There are two main reasons. First, many large enterprises have an obsolete capital stock and use outdated production technologies and are therefore unlikely to attract interested buyers at positive prices (C. Wellisz (1991)). Second, large enterprises account for a major share of employment and production in the economy, and privatization, particularly to foreigners, or shut-down may run into strong popular opposition,4 with arguments ranging from a potentially strong adverse impact on output and employment to a perceived antagonism between foreign ownership and national interests (Applebaum (1992)). Still, it is clear that ultimately there may be only two solutions for these enterprises: massive investments to modernize the capital stock, or shut-down, liquidation, and asset disposal. Given that few local individuals have the financial resources to make the necessary investments, governments have three basic choices, each of which will move problem enterprises out of their responsibility: (1) find ways to attract foreigners on a large scale, (2) establish diluted share ownership by local individuals via mass privatization, and (3) break the existing large-scale enterprises into smaller units that can be privatized separately.

Eastern European governments have not yet tackled the question of large enterprises comprehensively. Instead, governments have begun to build privatization policies around the possibility that many enterprises remain state owned for a while. Usually, this involves the construction of “halfway houses,” which may come in different forms, but usually involve putting the enterprise under the control of an independent board of executive directors, and transforming it into a joint-stock or limitedliability company.

In Hungary, for example, property rights were redefined to make the State Property Agency the sole owner of all state enterprises; the enterprises were then given boards of directors who required them to produce properly audited balance sheets, and independent contractors were brought in to help with supervision. More recently, the Hungarian Government has begun to create a separate supervisory board, the State Ownership Institute, which is to oversee the activities of commercialized enterprises. In Poland, the concept of commercialization is similar in that it legally transforms state-owned enterprises either into limited-liability companies or into joint-stock companies wholly owned by the state treasury. A basic difference between the Hungarian and the Polish concepts is that in Hungary commercialization is independent of the intent to privatize, while in Poland commercialization is a possible outcome of a voluntary enterprise decision to be privatized. As a result, most state-owned enterprises in Poland remain under the control of individual ministries; the Polish privatization agency has concentrated its efforts almost exclusively on profitable enterprises, leaving the problem of unprofitable enterprises to be resolved by the ministries.

In Romania, commercialization has been pursued vigorously since August 1990. With the exception of enterprises in strategic sectors such as telecommunications, mining, and defense, most enterprises were required to become commercialized, to inventory and value their assets, and then to transfer 30 percent of their value to five private ownership funds which would use these shares for the mass privatization program. Under the mass privatization program each eligible citizen will receive a share in each of the five private ownership funds. The remaining 70 percent will be retained by the Government in a state ownership fund for future sale.

The former Czechoslovakia adopted a more radical position; the speedy transfer of ownership rights to the private sector was thought to alleviate the need for halfway houses. Accordingly, mass privatization was championed as the main tool of privatizing large enterprises.5Bruno (1992) has argued that halfway houses to privatization are generally inevitable, unless one is willing to take the line that what cannot be privatized instantaneously had better be junked immediately. While commercialization entails a number of problems, the perceived advantage is that state-owned enterprises start being covered by normal commercial law and obtain corporate governance through a professional board of directors (Sachs (1991)). Recent evidence from Poland suggests that commercialization is superior to the present self-governance structure that is dominated by the Workers’ Council, and which clearly conflicts with long-term restructuring and profit maximization considerations (Pinto and others (1992)). The empirical finding that managers of state-owned enterprises in Poland are an important source of change has strengthened arguments in favor of an expanded role for commercialization, where power is delegated to managers, where managers are empowered to make all operational and most strategic decisions without prior consultation with government officials, and where managers are given contracts that link their compensation to the long-run value of the firm and its privatization (Pinto and others (1992)). In addition, it somewhat weakens the argument by Bolton and Roland (1992) that incumbent management is necessarly inefficient.

Still, commercialization and other halfway houses do not solve the problem of privatizing large enterprises; they may often be unavoidable, but are certainly not sufficient for successful privatization. In particular, halfway houses fail fully to expose state-owned enterprises to a uniformly hard budget constraint that implies the risk of bankruptcy (Kopits (1991)). In addition, they do not fully alleviate concerns about decapitalization by the firms' managers (Bruno (1992)), and the government may easily find itself in a position where it either has to provide bailouts or let enterprises go bankrupt. Halfway houses may allow governments some breathing space, but eventually decisions that are more far reaching will have to be made.

Preliminary Policy Lessons

The Eastern European privatization experience presents some preliminary policy lessons for governments of other economies in transition wishing to reduce an overextended public sector. The following five policy considerations should provide a nucleus around which further discussion on privatization policies in economies in transition may be focused.

First, privatization is a key mover of the transition from plan to market. Hence, it must be accomplished in a speedy and comprehensive fashion. Rapid creation of a legal framework that defines ownership rights clearly facilitates public understanding of privatization, stimulates broad-based ownership, prevents abuses of power, and speeds up privatization. Given a variety of policy objectives and a highly differentiated demand for the portfolio of state assets, a diverse set of privatization tools will be needed. Separate programs for small enterprises targeted at domestic buyers should be part of any privatization scheme. Settling questions of restitution has both a moral and a practical dimension. In general, favoring people who used to own real estate over those who used to own financial assets or human capital should be avoided. Generous restitution programs are likely to result in a flood of claims that will strain administrative capacities and impede the clarification of property rights. Direct financial compensation will add further adverse pressure on state budgets. In practice, restitution should be limited to a symbolic gesture. Exclusive reliance on one-by-one privatization is time-consuming and unnecessarily slows down the transition to a market economy. Problems of valuing enterprise assets are no reason for delaying privatization. Mass privatization schemes and other techniques that allow changing the structure of property rights without necessarily requiring prior asset valuation should be given due consideration. While broad-scale commercialization should be accomplished rapidly, mass privatization should be used to prevent halfway houses from becoming costly semipermanent solutions. Foreign investment should generally be welcome; there is little economic rationale for placing an upper limit on the share of state-owned property that foreigners may buy.

Second, people are more willing to bear an inevitable burden if they can expect tangible benefits. To enhance social acceptability, any privatization scheme should have a distributive component. Creating broadbased ownership rights, as envisaged under the various mass privatization programs, facilitates the formulation of incomes policy and aids efforts to reform social policy. For the same reason, it is useful to encourage leveraged buy-outs by management and employees, and partial employee ownership schemes. It is unlikely that creating broad-based ownership rights will jeopardize macroeconomic stabilization efforts by fueling consumption. Still, distributive questions have to be handled carefully. For example, many people would be excluded from employee ownership schemes because they do not work for the companies that are privatized. Given strong quality differences across the various state assets, employee ownership schemes are generally inequitable. This can easily lead to tensions. While offering a minority share to workers can be useful, preferential treatment, in particular with respect to purchase prices, has to be avoided.

Third, for privatization to be successful, financial sector reform is crucial. Reasons for this include the significant investments required to make Eastern European industries competitive and the problem that property rights may not be reallocated efficiently if potential buyers have no access to credit. Credit should be given on “hard” terms as this signals from the outset that potential owners need to be willing and able to take on risks, and that privatization is not just a legal procedure where the ownership is transferred to the private sector while the financial risks remain with the public sector. A central element of financial sector reform is banking sector reform. Comprehensive banking reform has three main elements: (1) restructuring and possibly consolidating state-owned banks, (2) enacting banking laws that provide for establishing new private banks, and (3) resolving the problem of nonperforming loans in bank portfolios. The latter issue remains highly controversial, because some of the proposed solutions, like providing banks with shares of privatized enterprises, have direct implications for questions of corporate control. Given the potential problems that may arise from close cooperation between banks and enterprises, great care has to be used in the design of control mechanisms and incentive structures. It is clear that comprehensive banking sector reform has to be accompanied by the creation of an efficient system of bank supervision, the creation of a deposit insurance scheme, and the creation of market structures that facilitate trading financial assets and stocks.

Fourth, since Eastern European governments have little experience with regulating in a nonintrusive way, particularly in the context of a market environment, the design of a simple and unambiguous system of corporate control is a priority task. The two main Western systems of corporate control, the insider model and the outsider model, each have advantages and disadvantages for economies in transition. For Eastern Europe, most advice has favored the insider model, characterized by (1) concentrated ownership and association of ownership with control, (2) corporate control being exercised by shareholding parties (banks, other firms, employees) with outside interventions being limited to periods of clear financial failure, and (3) absence of takeovers and infrequent market entrance and exit. Explicit or implicit acceptance of the insider model implies that banks and nonbank financial institutions become closely involved in privatization and in issues of corporate control over enterprises.

Fifth, the problem of large enterprises has to be tackled early. Given that it will be difficult to sell many of the large industrial enterprises at any positive price, and given the employment implications of forcing these enterprises into immediate bankruptcy, solutions may take time. One way to address the problem is large-scale commercialization, which provides state-owned enterprises with an improved system of corporate governance and subjects them to the regular commercial code. While commercialization provides some breathing space to governments, it remains a halfway house–not a permanent solution. In particular, commercialization alone may not provide the hard budget constraint needed to improve overall efficiency; governments may still be forced to offer bailouts to commercialized companies. But eventually, governments may face a credibility crisis and will have to let some enterprises go bankrupt. Bankruptcy decisions, however painful in the short run, are best made before a credibility crisis arises.


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See C. Wellisz (1991) for a detailed account of the problems of enterprise valuation experienced in Poland.

Corbett and Mayer (1991) have suggested that, in the minds of most people, capitalism is synonymous with stock markets, and that the creation of domestic stock markets epitomizes the break with socialism more than anything else. This may help to explain why most Eastern European governments first addressed the politically visible task of opening a stock market (on which there is still hardly anything to trade), but have delayed comprehensive banking sector reform.

See Bruno (1992) for an in-depth discussion.

In Poland, for example, the top 400 enterprises, ranked by sales, accounted for 36 percent of total employment in 1990 (Lipton and Sachs (1991)). Given that employment in some regions depends heavily on large industrial enterprises, shutting down these enterprises may severely strain the economies of these regions, particularly since there is a severe housing shortage that reduces labor mobility.

For a detailed description of the mass privatization program of the former Czechoslovakia, refer to Aghevli and others (1992).

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