III Reform of Microeconomic Decision Making

János Somogyi, and Anthony Boote
Published Date:
March 1991
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As part of the 1968 economic reforms, the central authorities lost the power to set physical output targets for individual enterprises and abolished the centralized allocation of materials. Enterprises were expected to evolve into autonomous entrepreneurial units responding to market signals and to uniformly applied macroeconomic policy measures. The latter measures—implemented through laws, decrees, guidelines, and financial incentives—were designed to serve as instruments of indirect control for achieving the priorities set out in national economic plans.

The institutional relationships of enterprises to their supervisory agencies—mostly ministries or local authorities—and the methods of appointment, evaluation, and remuneration of managers, however, were not fundamentally changed. Enterprises remained subject to the formal and informal interference of government supervisors and representatives of social and political organizations. In particular, in 1972 the Government reversed reforms by decreeing a large wage rise for Hungarian workers. The State Enterprise Act of 1977 sought to strike a better balance between centralized control and state enterprise autonomy by loosening the ties of enterprises to their supervisory agencies. The act established a legal framework for the creation of supervisory boards for trusts and conglomerates, which would assume part of the supervisory functions of the central authorities. The boards were organs of the supervisory state bodies, which appointed their members. The State Enterprise Act of 1977 also allowed the optional establishment of boards of directors in large enterprises. The boards were entitled to make strategic decisions concerning the future of the firm, while current operational decisions remained the prerogative of the enterprise’s director. In order to reduce further the scope for formal and informal outside intervention in enterprise activities, the authorities, in January 1981, merged the three industrial branch ministries into a single Ministry of Industry and transferred their marketing and price-setting prerogatives to the National Materials and Price Board. They also modified, in 1981 and 1982, regulations concerning the selection of top managers and the appointment of senior staff in enterprises to encourage the appointment of company directors for fixed terms on the basis of open tenders.

These measures were nevertheless insufficient to resolve the ambivalent relationship between the central authorities and state enterprises. They did not succeed in severing the vertical ties between enterprises and supervisory authorities. Moreover, the discretionary reallocation of resources based on a heavy reliance on a differential system of taxes and subsidies and centralized allocation of credits—which validated central priorities and accommodated the lack of financial discipline at the enterprise level—remained essentially unchanged.

Amendments to the State Enterprise Act of 1977 and other legislation, which took effect January 1, 1985, established a new institutional framework for state enterprises—excluding trusts, public utilities, defense-related industries, and other selected large companies—based on self-management with workers’ participation. The State retained the right to establish and own state enterprises and to supervise the legality of their activities. In large state companies, basic decisions over production, marketing, investment, organization, and mergers, and over the creation of subsidiaries, however, were delegated to enterprise councils—representing employees and managerial staff; in small enterprises of up to five hundred employees, these decisions were delegated to the assembly of employees, with a role secured in the new supervisory organs for representatives of the enterprises’ party, youth, and trade union organizations. Responsibility for current operations resided with the chief executive elected by the enterprise council or assembly for fixed-term appointments of up to five years. Candidates were vetted by the regional party organization, and the sponsoring government authority could veto the appointment but not present its own candidate. The enterprise councils and assemblies could also decide on the performance criteria and remuneration of managers. By the latter part of 1987, about 73 percent of state enterprises had been transformed in this fashion and were under the supervision of enterprise councils or assemblies; 27 percent—more than one half representing public utilities—remained under direct state control. To guard against excessive wage payments, the premia of managers—which accounted for 40-60 percent of their remuneration—were linked to the profitability of the enterprise and were subject to cuts if wage growth outpaced that of the value added of the enterprise.

With a relaxation of fiscal and monetary policies in 1985 and 1986, macroeconomic imbalances became an increasing source of concern. Tax-based wage controls were consequently tightened and the rules requiring prior notification by enterprises of contemplated price adjustments were enforced more strictly, which limited the decision-making authority of enterprises.

The poor performance of state enterprises resulted largely from interference by the central authorities. It also reflected the lack of effective exercise of ownership rights in state enterprises. The Law on Transformation adopted in June 1989 sought to provide the legal framework for transforming state enterprises and cooperatives into joint stock companies. It also allowed for the transfer of ownership in part or whole to foreign investors. However, the law did not remove the ambiguity in ownership rights. This continued ambiguity—and the interaction of the Enterprise Law and the Law of Association—permitted enterprise managers to abuse the transformation process. To check these abuses, Parliament approved legislation establishing a State Property Agency (SPA) in January 1990 and appointed a managing director in February. Subsequently, Parliament decided to make the Agency responsible to government. It also adopted legislation to establish a mechanism to control enterprise-initiated privatizations to ensure that the process was transparent and fair.

The new Government sees a pivotal task for privatization in reducing the State’s role in the economy. Its goal is to reduce the share of state-owned property to less than half of total assets in the competitive sphere of the economy by 1993. Privatization will be accomplished through three main channels. Retail shops and restaurants are being auctioned to private owners through the preprivatization program, which was approved by Parliament in September 1990. The SPA will launch active privatization programs for the sale of large enterprises, with privatization managers—often western experts—selected through a tender process. By the end of 1990, two such programs—each involving about twenty enterprises—were initiated. Privatization initiated by the enterprise itself or by a potential buyer will be encouraged, with the SPA role limited to ensuring that the enterprise is appropriately valued and that the process is transparent. The emphasis will be on achieving privatization through market means. Partial compensation will be provided to former owners of property nationalized under the past regime. The Government, in its four-year program launched in March 1991, proposes to accelerate privatization by drawing up a national privatization strategy, streamlining the State Property Agency, and decentralizing the process.

The Government recognizes that foreign investment brings not only much needed financial resources, but also modern management methods, modern technology, and better market access. It plans to encourage foreign investment; in 1991, only the five largest banks and enterprises with monopolistic positions were ineligible for foreign investment. The regulations governing the foreign acquisition of property and real estate will be gradually liberalized. Direct foreign investment rose sharply in 1990 (see Section X).

The Government intends to strengthen financial discipline and management for enterprises remaining within the state sector. It is also preparing a new accounting and auditing law—to be implemented at the beginning of 1992—to bring Hungarian accounting procedures in line with recognized international standards.

Financial Discipline and Bankruptcy Provisions

In 1983, new regulations took effect to accelerate the phasing-out of inefficient enterprises. The regulations provided that loss-making enterprises draw up restructuring programs aimed at eliminating losses. If this were not done, the supervisory authorities could order a withdrawal of capital and labor resources, a replacement of managers, forced restructuring, or, as a last resort, liquidation of the enterprise. These regulations, however, were rarely invoked.

In the mid-1980s, the authorities took new initiatives to foster financial responsibility and economic efficiency among unprofitable enterprises. In 1986, new multiyear restructuring plans were adopted for the ferrous metallurgy and coal mining industries, which had been in chronic financial difficulty, and the authorities developed a program to restructure the construction sector. Also, in September 1986, a new bankruptcy law provided a legal framework for restructuring or closing inefficient enterprises. This framework relied primarily on negotiations between creditors and debtors for an out-of-court settlement of claims. If settlement were not reached, a State Restructuring Institution—under the auspices of the Ministry of Finance—determined within thirty days whether restructuring of the ailing enterprise warranted state support through a refloatation agreement on account of regional employment, national defense considerations, or to meet international obligations (mostly stemming from trade agreements with Council for Mutual Economic Assistance (CMEA) partner countries). As a last resort, creditors could turn to the courts to initiate bankruptcy proceedings. After the enterprise was declared bankrupt, its assets were liquidated under the supervision of the State Restructuring Institution. The proceeds were used to cover the cost of the proceedings and to satisfy to the extent possible all claims on the bankrupt enterprise, with priority given to settling wages and other employee claims.

Until 1989, the provisions of the bankruptcy law were largely used to liquidate small enterprises on a modest scale. Creditors were reluctant to initiate bankruptcy proceedings against large, chronic loss makers that might be their principal or sole customers. Banks were also reluctant to absorb such losses (see Section VIII). Nonviable and illiquid enterprises continued to operate by not paying their creditors (mainly other enterprises and commercial banks).

In December 1989, the Government reached agreement with the three major commercial banks to accelerate the process of liquidation; the Government gave up the option of “refloating” targeted loss-making companies and commercial banks were free to initiate appropriate procedures against debtors judged not to be creditworthy on commercial criteria. Banks were permitted to use part of their blocked risk reserves to write off resulting bad debts. As a result of this agreement, some forty enterprises were instructed to repay outstanding loans or develop restructuring plans approved by the banks; the restructurings involved asset sales, management changes, and staff reductions. About one quarter of the enterprises repaid their outstanding loans or developed approved restructuring plans; the remainder was subject to liquidation proceedings. In addition, the authorities took action against enterprises with tax arrears. Proceedings were also initiated independently by creditors against some well-known large companies, and restructuring plans involving foreign investors were drawn up.

An amendment to the bankruptcy law, effective May 1, 1990, provided for compulsory self-liquidation of state enterprises with net payments arrears, with penalties against enterprise directors for noncompliance. During 1990, liquidation procedures were initiated against more than four hundred enterprises.

The new Government recognizes that the transformation of the Hungarian economy into a modern market economy requires the restructuring or elimination of loss-making enterprises. It will formulate a new bankruptcy act aimed at shortening the liquidation process. Bankruptcy proceedings will be initiated against any enterprise with tax or social security contribution arrears of more than three months. The Government has also taken steps to increase the number of courts competent to deal with bankruptcy cases and to simplify procedures. Stronger prudential regulation (see Section VIII) should discourage banks from lending to loss-making enterprises. The Government has begun implementing a plan to improve the efficiency of the construction sector, including privatization of large state companies and support for private companies.

Promotion of Competition and the Private Sector

The industrialization of the postwar period entailed heavy industrial concentration to promote central control and large-scale production. The result of successive mergers was a virtual absence of small- and medium-sized enterprises in the socialized sector; the share of industrial employment in enterprises of up to fifty employees was only 0.1 percent in 1980. A review of concentration in 1979 concluded that it inhibited competition, hampered progress toward greater enterprise autonomy, and explained much of the sluggishness in the structural adaptation of industry. Subsequently, the authorities launched a process of decentralization, which involved the dismantling of a number of trusts and conglomerates.

During most of the period under review, the main activity laid down in an enterprise’s founding charter could be modified only upon approval by the founding organization and branch ministry. More flexible rules were introduced in 1982 and 1983. These rules permitted enterprises to engage in other than their main line of activity for up to 30 percent of their output; removed the territorial and sectoral constraints on the activities of trading companies; and permitted retail traders to deal directly with producers. In early 1985, the authorities abolished the distinction between an enterprise’s main line of activity and its ancillary operations and shifted the prerogative to determine the enterprise’s lines of activity to the enterprise council or staff assembly and management. In January 1986, the “profile restrictions” of specialized foreign trade companies were eased and their monopoly positions ended.

At the start of 1982, new legal rules took effect to promote the creation and expansion of small and medium-sized enterprises in the socialized sector; to legalize activities in the second economy; and to open opportunities for new private sector undertakings (Chart 1). These rules helped achieve remarkable success in improving the supply of goods and services. In the state enterprise sector, the new legislation provided scope for establishing independent small companies and subsidiaries of existing firms, transferring facilities of state enterprises to private operators, and organizing partnerships among the staff (so-called “enterprise economic partnerships”). The members of these partnerships operated the equipment of the enterprise on their own time to perform specific tasks that, together with their separate remuneration, were contractually agreed with management. New enterprise forms—including independent economic partnerships and civil law companies—were also permitted in the cooperative and private sectors.

Chart 1.Breakdown of GDP by Social Sector1

Sources: CSO, National Accounts; Hungarian authorities.

1 In 1985 prices, in billion of forints.

On the whole, the impact of the rapid growth of the private sector on the competitive environment up to 1988 remained limited; the most rapid expansion occurred through economic partnerships of employees in socialized enterprises in activities that complemented goods and services produced by those enterprises. Also, despite steps to liberalize foreign trading rights, foreign trade had only a moderate effect on competition, as import licensing was used to encourage potential importers to give preference to domestic suppliers.

Against this background, the authorities took new steps in early 1989 aimed at corporate reform and import liberalization. The new corporate association law and complementary legislation allowed great freedom for resident and nonresident individuals and legal entities to establish and participate in a variety of corporate entities suited to their purposes; these included unlimited liability companies, silent partnerships, limited liability companies, and joint ventures with a limited liability, as well as joint stock companies. The law permitted individuals to acquire shares in enterprises with the State as the majority shareholder; it also authorized private enterprises to expand to five hundred employees (from thirty). The legislation also established more liberal rules for joint ventures with foreign partners, requiring government approval only in the case of a majority share or full ownership by the foreign investor.

These measures led to the registration of 4,578 new enterprises in 1989, compared with 1,377 in 1988. In 1990, the authorities abolished the employment limit on private businesses. They also adopted a comprehensive program to encourage new ventures; this program provided for accelerated depreciation for investment in marketing and equipment, credit facilities, creation of investment companies, and improved access to supporting infrastructure services. Also in early 1990, the authorities established a deregulation law establishing a deregulation board reporting directly to the prime minister. The aim was to repeal unnecessary regulations—notably those discouraging the entry of new businesses.

Until recently, progress toward effective institutional reform and structural transformation of the economy was limited, notwithstanding the initiatives undertaken to modify the organization of state enterprises and legislative actions that would provide a liberal environment for the operation of enterprises. This was partly the result of the dominance of short-term priorities promoting the basic materials industries in production and in convertible currency exports. Ownership rights over state enterprises were not effectively exercised. This reflected ambivalence by the State over whether these rights should be exercised at the enterprise level by managements or some self-governing body or should remain centralized. The result was weakened financial discipline and an undermining of managers’ interest in the most efficient allocation of the resources at their disposal. This in turn justified the continued interference of supervisory bodies in microeconomic decisions. Finally, the implementation of restructuring programs was hampered by systemic and policy constraints that encouraged the avoidance of the consequences of restructuring, in terms of changing the composition of output and exports, reallocating labor, and writing off capital.

The new Government is determined to tackle this legacy. It sees the transfer of state property to the private sector as a main means of resolving the unsatisfactory relationship between the State and state enterprises. The Government is determined to achieve a major breakthrough in privatization over the next three years. It also wishes to foster the growth of private property through the active promotion of new enterprises. It continues to provide tax incentives—such as accelerated depreciation for investment in machinery and equipment—to the private sector. And the authorities plan to encourage private sector access to credit by restricting credit demands by the budget and large state enterprises. Legislation is planned for 1991 to promote the flow of venture capital.

The Government wants to enhance the spirit of enterprise by both deregulating the Hungarian economy and promoting competition. It will continue to relax or eliminate restrictions. And it implemented a new law prohibiting unfair market practices at the start of 1991. The law establishes a Cartel Office to investigate complaints of monopolistic and noncompetitive behavior and to monitor mergers and acquisitions. The Cartel Office will implement an effective anti-trust policy that sends a strong signal to business that competitive, efficiency-enhancing behavior is acceptable and that conversely, monopolizing, rent-seeking behavior is unacceptable. The Cartel Office will take action to break up existing monopolies, such as in the domestic trade sector.

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