The relationship between state enterprise reform and macroeconomic policies forms the crux of the most important issues relating to the economies that are trying to move from centrally planned to market-based systems. I will talk about this relationship mainly in the context of the countries of Eastern Europe and the former Soviet Union (FSU). The topic is of considerable interest in this setting, because the problems of state enterprises in countries where the state sector dominates the productive processes differ from the problems of state enterprises in countries where the state sector plays a lesser role. The linkages between enterprise reform and macroeconomic policies in an economy with some two hundred thousand enterprises that account for 95–99 percent of its economic output likewise differ from the linkages in an economy where several dozen enterprises account for 20–40 percent of output.

Constantine Michalopoulos

The relationship between state enterprise reform and macroeconomic policies forms the crux of the most important issues relating to the economies that are trying to move from centrally planned to market-based systems. I will talk about this relationship mainly in the context of the countries of Eastern Europe and the former Soviet Union (FSU). The topic is of considerable interest in this setting, because the problems of state enterprises in countries where the state sector dominates the productive processes differ from the problems of state enterprises in countries where the state sector plays a lesser role. The linkages between enterprise reform and macroeconomic policies in an economy with some two hundred thousand enterprises that account for 95–99 percent of its economic output likewise differ from the linkages in an economy where several dozen enterprises account for 20–40 percent of output.

The state enterprises I will be discussing cut across all productive sectors: mining, agriculture, public utilities, and industry.

The Linkages in General

The traditional view of the linkage between state enterprise reform and macroeconomic policies holds that, in the beginning of a transformation process, both elements of reform must move forward simultaneously. Macroeconomic stabilization policies are needed to arrest inflation, which is likely to be high in the aftermath of the decision to move to a market economy. In both the FSU and Eastern Europe, there was repressed demand and monetary overhang when reform began. Price liberalization has tended to result in a one-time shock to the price level. The combination of this shock and ineffective macroeconomic policies has led to accelerated inflation.

The traditional view has been that stabilizing early in the transformation process is necessary for two important reasons. First, in the presence of high inflation, new investment is inhibited. Second, rapidly rising prices make the effective allocation of resources difficult. There is too much “noise” in the system for relative prices to work; that is, rapid and large relative price changes cause prices to lose their effectiveness as signals in the allocation process, making it difficult to identify appropriate investments. And since stabilization measures are likely to depress overall demand and economic activity, enterprise reform needs to proceed quickly in order to increase supply, raise productivity, and stimulate future growth.

Enterprise Reform

What are the elements of enterprise reform necessary to increase productivity and stimulate supply and future growth? Five main elements are normally associated with state enterprise restructuring and reform.

First, institutional reforms are needed to encourage new private sector activities. These reforms involve creating the legal and regulatory framework necessary to support the entry of new private sector firms into the market.

The second element of enterprise reform is privatization. New firms alone cannot transform the economy into a market-based or even a mixed system, because they cannot enter the market fast enough. State-owned enterprises must be privatized as well.

The third element is enterprise restructuring and possibly liquidation of some lossmaking firms. Liquidations may occur at the same time as privatization, and restructuring may come before or after privatization, since the privatization process need not and usually does not affect all state enterprises. Certain enterprises may appropriately remain in the state sector, but it is important that they function more efficiently. They may need financial or physical restructuring, or both, or they may actually need to be shut down.

A fourth element, which applies to those enterprises that are to remain in the public sector, is improved governance. State-owned firms require improved management and the introduction of hard budget constraints.

Finally, all of the above reforms must be supported by financial sector reforms that permit the efficient intermediation of flows of resources from savers to investors in both new and existing firms.

As I said earlier, traditionally it has been felt that stabilization should begin early in the transformation process. It has also been recognized that enterprise reforms of the type I am discussing will take time. But even if the reforms start early, the changes involved are so major that considerable time is required to implement them. One of the significant lessons of the recent experience in a number of countries in Eastern Europe, and more especially in the FSU, has been that certain aspects of enterprise reform must be introduced much earlier in the process than was previously thought. If they are not, the effectiveness of macroeconomic policies may be seriously undermined. And this undermining of policies is, I think, the key issue facing policymakers today. What aspects of enterprise reform need to be started early in the enterprise process so that macroeconomic policies are not undercut?

The Russian Experience

I am using Russia as my primary example, mainly because the situation there is somewhat easier to understand than the situation in other FSU countries. Certainly more information and more data are available about Russia than about some of the other countries. And it is in Russia, in fact, that the links between enterprise reform and macroeconomic policy have been most vivid in 1993. However, what I say about Russia has validity for other countries as well—Ukraine, for instance.

Let me describe briefly what has been happening, or at least what I perceive to have been happening, in Russia with regard to enterprise reform and macroeconomic policy. It is clear that a good deal of privatization has been taking place and that it has begun to outpace restructuring. There is little restructuring going on in firms that have not been privatized. At the same time, there has been a significant increase in private sector activity from new, primarily small enterprises. In fact, small enterprises, including firms that are actually spin-offs from existing large state enterprises, have become the main source of new market entrants and new production.

In parallel, the government and the Central Bank of Russia have been providing a tremendous amount of budgetary subsidies to the enterprise sector. These subsidies undermine the establishment of macroeconomic stability and retard efficient enterprise restructuring. In 1993, direct subsidies from the budget to the enterprise sector are estimated to account for around 20–22 percent of GDP, a large share. Some of these subsidies go directly to producers, but the largest are import subsidies for both industry and agriculture (equivalent currently to around 10 percent of GDP). I will come back to the reasons for these subsidies and the implications for enterprise efficiency a little later.

In Russia and other transition economies, the central banks have also been providing large quantities of directed credits at very low interest rates to specialized banks, which then on-lend, mostly to industrial and agricultural enterprises. The purpose of passing on these credits at rates below even the prevailing negative real interest rates is to support the state enterprise sector in industry and agriculture. In 1993, such credits are estimated to account for around 16 percent of GDP in Russia. Additional directed credits that are made available from the budget for working capital amount to approximately another 4 percent of GDP. In total, then, aside from the 20–22 percent in direct subsidies, another 20 percent of Russia’s GDP goes to enterprises in the form of directed credits.

Let me stress that this amount of assistance is not directed to investment. It is essentially directed to the enterprise sector and permits enterprises not just to maintain their operations at existing levels but, in many cases, to avoid restructuring altogether. Some of the subsidies are necessitated by continued price controls at the consumer level, in particular agricultural subsidies. Whatever the underlying reasons, the practice of granting significant budget subsidies and directed credits has a direct inflationary impact and undermines a government’s ability to reduce the budget deficit and curtail monetary expansion.

A large number of indirect subsidies are being provided alongside these direct subsidies. For example, there are price controls on many of the major inputs for production, especially energy and raw materials. Subsidization of imports is accompanied by cross-subsidization through energy export taxes. The trade regime in many FSU countries continues to support significant differences between controlled domestic prices and international prices, primarily through export controls and import subsidies. International relative prices have not yet been introduced into the domestic price structure. This situation tends to inhibit exports, encourage imports, discourage domestic restructuring, and lead to rent-seeking activities, corruption, and capital flight.

It is easy to see that large subsidies make stabilization more difficult and simultaneously discourage enterprises from restructuring. In the current circumstances, it is easier for firms to accept assistance in the form of public sector credits than to try to make the necessary adjustments—or to repatriate some of the funds enterprises hold abroad. It is also clear that not all enterprises have equal access to credits and subsidies. Although determining exactly which firms do have access is difficult, the large enterprises, especially those with political clout, seem to be in the best position.

Let me suggest that in this situation lie the beginnings of a nasty and vicious cycle. This kind of enterprise support leads to macroeconomic instability, which has a tendency to promote capital flight. In turn, capital flight depresses the exchange rate more than is appropriate. The depressed rate then makes further import subsidies and enterprise support necessary, and the cycle begins again. The steps that must be taken to correct this situation are in some ways obvious. It is desirable to privatize quickly, to eliminate directed credits and budget subsidies, and, very importantly, to move to world prices. But these reforms are often difficult to implement. There are many transitional problems, and it is to these problems that I want to turn.

Problems of the Transition

The first problem is clearly that privatization takes time. Even under the best of circumstances, resolving a number of issues will take a long time, primarily because of the question of equity. Who will get what is a thorny economic issue and has become the main problem in implementing privatization. Additionally, it will take time to restructure many enterprises, even after they are privatized. Other enterprises, of course, are public utilities that will stay in the public sector, while still others will not be candidates for privatization in the short term and will remain in the public sector by default. Russia may have one or two thousand large state-owned enterprises that cannot be privatized soon, if at all.

While it is clear that directed credits and subsidies to enterprises must be reduced, these reductions alone will not be enough: management structures and incentives must also change radically. Whatever support is still needed should be budgeted and made conditional on certain reforms. Assisting enterprises in their restructuring efforts will undoubtedly strain the budget, a fact that leads directly to the subject of the complicated trade-offs policymakers are facing in Russia and elsewhere at the moment. If in fact budgets continue to be strained by such subsidies, one way of relieving the pressure is with outside support. This is one of the important justifications for providing international assistance to encourage the restructuring process in the FSU.

Budgetary resources could be strained for still another reason. So far Russia’s pension funds, unemployment funds, and other social services have not come under severe pressure. But widespread restructuring that includes the downsizing of many enterprises and the closing down of others will increase unemployment substantially. Open unemployment has not yet increased in Russia because enterprises have not really shed labor in significant amounts. They have kept workers by introducing short shifts and part-time arrangements, even if these workers are not particularly productive. If enterprises are finally forced to lay off workers or to close down altogether, the growth in unemployment will increase pressure to raise budgetary allocations for unemployment benefits and other types of social support.

A related point, and one that is not widely understood, has been made by other speakers but needs to be emphasized. Enterprises in centrally planned economies have traditionally provided a significant portion of social services, including housing, kindergartens, and certain health services. Enterprises functioning in a true market environment justifiably will not wish to continue to provide most of these social services. However, if the enterprises do not provide them, somebody else must. Providing these services will put increasing pressure on budgets, usually at the local level. This is another dilemma that needs to be addressed in the context of enterprise reform and macroeconomic policy.

Price Reform

Let me move on to another set of issues that are also of considerable importance at the moment. While progress has been made on price reform in all the FSU countries, much remains to be done, especially in the energy sector. Energy prices in Russia remain far below international levels. However, if energy prices rise, there will be a massive transfer of resources to the energy sector, which at present is taxed through controls that keep output prices low. A price movement toward international levels will also expose other sectors as uncompetitive when resources move to the energy sector.

It can be argued that what is needed in these circumstances is a way to tax the energy sector more efficiently and then to use the proceeds to ease the adjustment burden of other industries. Again, however, this reform is difficult to implement, because it means introducing a new tax system, and introducing such a system takes time.

In some respects, it is probably easier to eliminate the import subsidies that currently make up an important component of the production structures of many industries. It will be still easier to eliminate these subsidies if the real exchange rate appreciates once stabilization has taken hold, since real exchange rate appreciation will reduce pressure on import subsidies and help eliminate price distortions. It is necessary to take action on both sides of this equation, because if both issues are not addressed, neither will be dealt with effectively.

Eliminating import subsidies for agricultural products will probably require eliminating price controls on consumer products. However, if price controls on agricultural products are eliminated, another set of issues will arise. Existing price controls, in a sense, are a kind of social safety net. Removing them will put yet more strain on the system and affect the livelihood of a large number of people at the lower end of the income scale. To deal with this problem, any new social safety nets need to be more precisely targeted than they have been in the past.

Let me sum up by emphasizing the following. The experience of the Bretton Woods institutions in Eastern Europe and the FSU has shown that without improved enterprise performance, stabilization policies are not likely to be effective. Not only will enterprise reform take some time, but targeted social safety nets will have to be created in order to make the reform package socially acceptable. Whether these nets will prove sufficient to make the adjustment process socially acceptable, only time will tell.

Donal Donovan

My talk will also focus mainly on Russia, in part because of the greater degree of information available about this transition economy. I will cover some of the same ground as Constantine Michalopoulos, but my focus will be on the Russian Government’s short-term strategy for dealing with the problems he described. To start, let me briefly review the progress that has been made in two areas: first, in the creation of competitive markets (the phrase “enterprise reform” seems to me to put too much emphasis on the actions of the enterprises themselves); and second, in macroeconomic stabilization.

With respect to the creation of competitive markets, privatization has proceeded relatively rapidly and is still picking up speed. However, the progress made thus far has had more to do with the institutional and legal transfers of assets than with changes in the behavior of enterprises. Many prices have been liberalized, but controls remain on some essential items—energy, certain foods, and rents and other government-provided services. Significant progress has been made in the external sector, especially with respect to the liberalization of imports, and most goods can now be imported freely. However, numerous quotas remain on the export side, particularly for key energy sector and food items. Again on the positive side, a unified exchange system has been implemented, although in practice the exchange rate for items imported with government or foreign assistance is still heavily subsidized. However, there has been a more or less freely determined exchange rate for the ruble.

So the progress achieved in the course of just 18 months has been substantial, and it is certainly more than many people anticipated at the outset. Of course, in many areas progress has been disappointing. The banking system has not really developed, for various reasons. It remains seriously undercapitalized and dependent on many directed and subsidized credits. More generally, high rates of inflation have discouraged banks from undertaking investment-type activities. As is well known, necessary legal reforms have also been delayed. To some degree, these delays reflect the uncertain and at times unstable political situation within Russia. Laws on ownership, accounting, commercial banking, and the like have remained essentially “under discussion.” Other laws that have not been enforced and that are important include the bankruptcy and antimonopoly statutes. Finally, the major weakness, to repeat the well-spoken phrase, is the absence of hard budget constraints for enterprises, as evidenced by certain facts: enterprise output has decreased far more than employment, and virtually no bankruptcies have taken place. Furthermore, the rapid emergence of interenterprise arrears during the second half of 1992 shows exactly how difficult it is in the current setting to enforce a tight credit policy effectively. Enterprises simply ran up bills with one another and settled them with extensions of credit.

On the structural side, the glass is indeed either half empty or half full, depending on the observer’s point of view. My own view is that, overall, there has not been a great deal of progress. As a general indicator, the massive demands from enterprises for subsidies through the budget and for subsidized directed credits for different sectors or regions—an important and politically very sensitive issue in Russia—have exerted enormous pressure on the system. The figures Mr. Michalopoulos mentioned speak for themselves: budget subsidies and subsidized credits are both well in excess of 20 percent of GDP.

A final point of particular interest in the context of the former Soviet Union (FSU), and the subject of much debate within Russia, is the subsidized lending Russia has provided to other FSU countries. Up to now, this lending has certainly contributed significantly to the general financial instability in the ruble area. While some politically sensitive issues are involved here, this activity has been a significant negative factor.

As regards the second area, macroeconomic stabilization, the matter is more clear-cut: there has been little or no progress. Inflation has continued at about 20 percent a month, fueled by the large fiscal deficit and credit demands from state enterprises. Programs designed to tighten fiscal and monetary policy have been adopted but not implemented. Although hyperinflation has been avoided thus far, little more has been achieved.

Economists are now well aware, as Mr. Michalopoulos said, that these two aspects of reform—namely, the creation of competitive markets and the pursuit of macroeconomic stability—cannot be divorced. This proposition is not theoretical. The matter is a practical one in Russia today, given the size of the country’s current budget deficit and the amount of credit expansion that is taking place. It is impossible to make the needed fiscal and monetary adjustments without also attacking the problem of subsidies, which are so large and pervasive that they effectively dominate both the budget and much credit expansion. In addition, a reversal of the decline in production is unlikely to be fully realized unless major inroads are made into the inefficiencies that give rise to the need for such large subsidies.

The Government’s Strategy

What is the strategy of the Russian authorities in the short run? There has been much internal debate in Russia, particularly in the first months of 1993, about the appropriate course of policies to follow. There have also been well-publicized disagreements among the country’s various institutions. For instance, the Central Bank of Russia (CBR) has not adopted the traditional stance of central banks, arguing instead that its role should tend more toward preventing the decline of production and employment than toward fighting inflation. However, in the last few months a consensus has begun to emerge that is reflected in a joint agreement between the CBR and the government on the overall approach to stabilization in the period immediately ahead. Reaching a consensus is essential in Russia because, for example, the CBR is responsible to the Parliament under the Russian constitution, and the government and Parliament often have very different views on economic issues.

The fundamental short-term position now accepted by most of the Russian authorities is that the economy will go nowhere unless inflation is reduced fairly quickly from its current level of around 20 percent a month to well under 10 percent—perhaps to 5 percent—a month. As I said earlier, to reach that target, progress must be made on the problem of subsidies and transfers.

The government has thus indicated fairly clearly, and in reasonably quantitative terms, its intention to tackle a number of subsidies, such as those on grain, coal, and imports. The last problem is particularly worrisome. The average subsidy coefficient for imports in Russia in 1992 was 80 percent. Effectively, what this figure means is that if the prevailing exchange rate was, say, 1,000 rubles per dollar, enterprises receiving import subsidies paid, on average, the equivalent of only 200 rubles per dollar—the 80 percent import exchange rate subsidy. The government has reduced that subsidy to around 50–55 percent. Much of the subsidy had been “hidden,” or financed implicitly by foreign grants and loans, so that the immediate budgetary savings may not be enormous. However, the overall impact of the measure on efficiency will be quite significant.

A second area the government has attacked is subsidized credits. There are several ways to proceed on this issue. It is possible to argue that the CBR should have a precise plan, with detailed, specific measures, for reducing the amount of directed or subsidized credits. Interestingly, the Russian authorities have preferred not to follow that particular approach but to adopt another, which has two components. The first ensures that interest rate subsidies are provided directly from the budget, and only from the budget. The second is an explicit reduction in the amount of such budgetary subsidies. This approach has had the effect of transferring some of the problem from the CBR to the Ministry of Finance, where many people probably prefer to see it.

In other words, the authorities have made subsidized credits as transparent as possible by including them fully in the budget and then indirectly setting limits on them (taking into account other expenditures, of course). As stabilization takes hold, as it hopefully will, this policy could become quite restrictive. At present, interest rates are far below positive real levels. As they rise, the constraint on subsidized lending to the banking system will become even greater because of budgetary limits on the actual volume of loans that can be given. In this connection, an important step has also been taken in raising the CBR’s refinance interest rate, which was previously set at slightly more than half the market rate, to a level very close to the market rate.

The authorities hope these measures will reduce inflation significantly. However, it seems fair to say that the measures represent something well short of what needs to be achieved, even if they are fully implemented. Lowering the inflation rate to 5-10 percent a month would be an accomplishment, but the situation would still be a long way from ideal. To arrive at a lower and sustainable level of inflation—say, somewhere around international levels of 10 percent a year—the authorities need to do much more about subsidies and directed credits.

Mr. Michalopoulos concluded his talk with the comment that only time will tell what will happen in Russia. Of course, he is right. I will try to offer one or two additional observations. Although the need to address the question of subsidies and related issues, and the urgency attached to this problem, seem to be understood, I am not sure that the potential short-term effects are fully comprehended. What I mean is that there does not seem to be either a political or a social awareness in Russia that widespread unemployment is likely to emerge as hard budget constraints are enforced. Until now, unemployment has been extremely low, because, as other speakers have pointed out, enterprises have kept workers on the payroll despite falling production. But this situation will change radically if the authorities enact new measures that seriously affect state enterprises—for example, if energy prices were to be raised to world levels, a move that would, incidentally, be the largest single contribution that could be made to the achievement of stabilization and the removal of economic distortions in Russia.

Unfortunately, because there has been no major public debate on this issue, preparations for a social safety net to cushion the effect of rising unemployment are not very far advanced. There is a great deal of interest in this problem, and many international organizations, such as the World Bank and the IMF, are eager to see what can be done. However, I do not have the sense that either the imminence of the impending unemployment problem or the urgent need to do something about it has yet taken hold on the ground in Russia. Thus, there is a serious risk that if the stabilization program begins to work—which is the only way to get to an annual inflation rate of, say, 10 percent—the system will be seriously strained. If the authorities try, as they should, to further reduce inflation next year, the strain will become even more severe. For this reason, the authorities should try to explain to people the very significant income redistribution effects that will result from the anti-inflation measures. A consensus must emerge on the need for offsetting mechanisms such as a social safety net. This kind of action could also help sustain political support for difficult adjustment measures.

In summary, the issue of creating competitive markets and the issue of stabilization are absolutely linked. Major action will be needed on both issues simultaneously if there is to be any progress. Unfortunately, in the case of Russia, I am not sure that the foundation has been laid to sustain political support for the needed measures, and perhaps laying this foundation is the most pressing task for the next few months.

Karim Nashashibi

Since the last two speakers have focused on Russia, where the public sector completely dominates economic activity, I will focus on developing countries. In these countries, typically much of the agricultural and services sectors is already in private hands, but much of industry, mining, energy, and transportation tends to be in public hands. My primary example will be Algeria, an economy in transition that is trying to reorient itself toward a market-based system, and some of the problems and experiences this economy has had.

The Need to Integrate Macroeconomic Stabilization and Public Enterprise Reform

In an economy whose major public enterprises and banks are suffering losses, effective macroeconomic stabilization cannot take place without public enterprise and bank restructuring. It does not make sense to focus only on reducing the central government’s budget deficit when the quasi-fiscal deficit, which is made up of losses by public enterprises or commercial banks, is increasing. Remember that various expenditure items in the public sector can be shifted from the center (the budget) to the periphery (enterprises, local government) and vice versa. Financing instruments outside the budget are diverse and include extrabudgetary accounts, implicit subsidies (through the exchange and interest rates), directed credits, payment arrears to suppliers, tax arrears, and arrears on social security contributions. As economists have learned from the experience of the former Soviet Union, fiscal stabilization by the central government can be more than offset by losses incurred in the rest of the public sector that are not captured in the fiscal accounts.

Turkey is a good example in this respect, simply because its public sector deficit, which has been fully quantified, illustrates the magnitude of the quasi-fiscal deficit that must be addressed along with the central budget deficit. In 1991, Turkey had a central government deficit equivalent to 6.5 percent of GDP. However, Turkey has about 200 public enterprises, 7 of which are heavy lossmakers (largely because of government interference in their employment and pricing policies). These enterprises have incurred losses equivalent to 7.9 percent of GDP. This deficit and the deficits of extrabudgetary funds, including social security, add up to another 2.4 percent of GDP. In total, then, Turkey’s public sector deficit was some 16.8 percent of GDP.

As this example shows, focusing only on the central government deficit can be misleading. The economic impact of the overall public sector may be larger than the central government deficit suggests. For instance, money-losing enterprises may borrow from the credit markets, pushing up interest rates and diverting resources from the private sector. If the enterprises continue to lose money, the solvency of some banks may be jeopardized, and this insolvency can become a major fiscal burden when it is revealed. Clearly, if the public sector’s net claim on resources can be quantified in this way, macroeconomic policies can then be formulated to restore public sector balance. But in most developing countries, such detailed information is not available to the central government, and the consolidation of public sector accounts is not feasible.

Public enterprises cannot be restructured successfully without macroeconomic stabilization and an enabling regulatory environment that supports enterprise autonomy. A large government deficit cannot be consistent with price stability unless there is severe crowding out of the rest of the economy, including public enterprises. Moreover, the persistence of an overvalued currency, or distortions caused by relative prices that are not adjusted to their equilibrium level, will result in misallocation of resources; firms may not choose the most cost-effective technology or the optimal capital-labor mix. In turn, resource allocation will make assessing viability and competitiveness at international prices impossible. Thus, enterprise restructuring in a distorted price system may end up supporting noncompetitive enterprises. Nonproductive, energy-intensive enterprises will flourish if energy prices are subsidized, for instance.

One major implication of this dynamic is that economic managers must identify areas of persistent losses within the public sector so that some estimate can be made of the true public sector deficit, as has been done in Turkey. While it is difficult in most developing countries to construct a consolidated budget balance covering the entire public sector, it is possible to define the public sector more narrowly. It would then include the central government, extrabudgetary accounts, local governments, and those public enterprises having a major impact on the budget or on credit markets. The idea is to develop a meaningful notion of the public sector borrowing requirement, which can then provide a measure of the fiscal impact of public sector operations on the economy. A number of developing countries in Central and Latin America, not to mention the more industrialized countries of Europe, have made such an accounting.

In order for public enterprise restructuring and macroeconomic stabilization to succeed, there must be a social safety net that can absorb some of the social costs public enterprises have incurred at the government’s behest. These include overstaffing to maintain employment levels and indirect consumer subsidies through artificially low prices. It is difficult to advocate enterprise restructuring, which inevitably involves shedding labor, in the absence of an unemployment insurance system and increased housing availability in growth areas to facilitate labor mobility.

The experience of developing countries has shown that privatization does not significantly reduce quasi-fiscal deficits or mobilize resources for the government unless it is accompanied by some degree of restructuring and macroeconomic stabilization. Even in countries that have pursued successful macroeconomic adjustment programs (e.g., Egypt and Tunisia), privatization efforts have faltered, in part because of inertia and resistance to changing the regulatory environment to one investors will accept. Nevertheless, privatization can be started on a small scale in service industries such as tourism, insurance, and banking, where the potential profits are easier to assess than they are in nonfinancial enterprises.

Another factor that delays privatization is the lack of domestic venture capital. The shortage of domestic capital means that privatization efforts become focused on foreign participation, which can be attracted only if the macroeconomic framework is stable and the regulatory environment is conducive to investment, particularly with respect to price and trade policy, labor practices, and repatriation of profits. At a minimum, currency convertibility at the external current account level is necessary.

Some countries have rushed to attract private foreign investment in an uncertain environment, before the necessary institutional and macroeconomic reforms are in place, by offering major tax concessions that discriminate against domestic investors and ultimately are counterproductive. Typically, such countries offer a “tax holiday” on income tax, an exemption on custom duties, and substantial tariff protection for a company’s products. These concessions not only erode the tax base and deplete government revenues but also protect inefficiency by failing to lure serious foreign investors. In the dynamic Asian economies, including Singapore, Hong Kong, Malaysia, and Taiwan, concessions to lure foreign investment did not play a significant role. These economies merely strove to create a macroeconomic and regulatory environment that is predictable, simple, and clear, with little government interference in the market.

The Algerian Approach to Public Enterprise Reform

Algeria is a good illustration both of a phased approach to enterprise restructuring and of the need to synchronize such a reform with macroeconomic stabilization.

In Algeria, roughly two thirds of industrial value added is in public hands, and the public sector dominates energy, mining, and transportation. Algeria is a significant producer of hydrocarbons: the country produces around eight hundred thousand barrels of oil per day and earns around $10–11 billion in oil and gas revenues per year. It is a country with substantial resources. While most of its oil revenues have been used to build up its economic and social infrastructure, large amounts of these earnings have also been invested over the years in an import substitution strategy, particularly in industry. Many Algerian enterprises were created under a highly protective commercial policy and therefore cannot compete effectively because of their low-quality goods, inadequate product mix, and poor marketing strategies. Moreover, much of the technology used in these plants may be obsolete or inefficient. Finally, because of persistent overvaluation of the exchange rate, the capital-labor ratio has shifted toward capital, a trend that will adversely affect competitiveness when the exchange rate is restored to its market level and that partly explains the high unemployment level.

Until 1989, public enterprises in Algeria were governed by the Central Plan, which set price and employment policies, established priorities, and allocated investment funds. Reforms begun in 1989 decentralized control over production. Their basic goals were to provide public enterprises with financial autonomy and to create the conditions under which enterprises could exercise discretion in management, pricing, and employment policies. The first phase of restructuring involved identifying those enterprises that could be made autonomous relatively easily and those that were heavy lossmakers requiring not only financial but physical restructuring. Of the approximately 390 enterprises initially reviewed—and these businesses account for the bulk of total value added in industry and construction—365 were considered reasonably well prepared for financial autonomy. The other 25 were incurring large losses and would require in-depth restructuring.

The financial situation of those enterprises selected for privatization was determined by a review of balance sheets to ensure that each firm had a positive net worth and cash flow as well as some working capital. In some cases, the Treasury was required to take over some debts and bank overdrafts and to provide the banks with interest-earning Treasury bills in return. Here, bank restructuring and enterprise restructuring needed to go hand in hand. Having been compelled under the Central Plan to provide credit to finance enterprise losses, state banks found themselves holding nonperforming loans that weakened their balance sheets and required recapitalization.

Strengthening financial autonomy also requires decentralizing the ownership of capital. To this end, the Algerian Government created eight “participation funds” to hold enterprise shares and oversee restructuring and management. In some cases, these holding companies provided guarantees to banks, which would then extend loans to the enterprises. Potentially, this approach could result in a quasi-fiscal deficit for the Government, since these guarantees become a contingent liability of the state. Thus, the financial ramifications of enterprise restructuring can last for a long time.

Basically, the first phase of Algeria’s enterprise restructuring program has involved creating—through changes in labor and property legislation—a regulatory environment that allows for the autonomy of most enterprises. As the regulatory environment improves, policymakers have been able to concentrate their efforts on the heavy lossmakers.

The enterprises that have incurred persistent losses suffer from two major ailments: either (i) the government has interfered in their price and trade policies, as is the case with fertilizer producers that have been forced to sell at low prices to farmers and some other enterprises that are unable to import the necessary inputs; or (ii) the enterprises have relied heavily on imported inputs and low value added, making them particularly vulnerable to recessions and shortages of foreign exchange. The first ailment can be remedied with trade and price liberalization, while the second requires reassessing the enterprises’ competitive positions. Both problems can be addressed in the context of a major macroeconomic adjustment that includes price, exchange rate, and trade policy reform. While this new macroeconomic policy is being formulated, the government has adopted a two-pronged interim strategy.

First, the enterprises have been made financially viable with the assistance of a World Bank Enterprise and Financial Adjustment Loan. The World Bank contracted for the auditing of 22 enterprise accounts in order to come up with a true picture of each company’s balance sheet position. Then, it devised the financial instruments necessary to stop the ongoing losses and allow these enterprises to stand on their own. A special Rehabilitation Fund was established in 1991 and, with the support of budgetary allocations, has covered recapitalization costs and foreign exchange losses. Much of this cleanup has been completed by the government takeover of nonperforming debts to the banks and Treasury.

The second stage—completing the necessary physical restructuring of these enterprises—will be much more difficult. Physical restructuring raises issues related to competitiveness, changes in technology and production, and the need for adjustments in the labor force in response to market pressures and profitability criteria. Many of the enterprises in question are operating at only 50 percent capacity and are seriously overstaffed. The plan is to focus on those enterprises that can become competitive, while nonviable enterprises—particularly those with a negative value added at world prices, as measured at a market-determined exchange rate—will be shut down. Those that can survive under more favorable macroeconomic conditions will be physically rehabilitated. Here, two considerations are very important. Major restructuring of public enterprises requires that labor and, in particular, labor unions be full participants in the process. Indeed, a broad political consensus is required to make macroeconomic and structural reform acceptable and sustainable. And as I have already mentioned, this type of restructuring also requires the establishment of an effective social safety net.

Finally, it may be possible to use performance contracts to ensure adequate management during restructuring. This approach has been tried in various countries, and in Algeria it can only support the movement toward autonomy. Performance contracts are made between the government and the enterprise managers and establish clear objectives for management performance, including productivity norms (for example, output per worker or the marginal efficiency of capital); and financial norms (for which managers will be held accountable). Policymakers often point to the lack of incentives in enterprises remaining within the public domain. Performance contracts, combined with some flexibility in terms of wages, salaries, and bonuses, can offer a way to significantly improve the management of enterprises for which privatization is not a realistic prospect in the near term.

Several problems have developed with this two-pronged strategy. First, medium-term physical restructuring plans have not yet been drawn up, so that lossmaking enterprises continue to lose money. Second, macroeconomic stabilization has not been completed, resulting in further losses. There has been some price liberalization, but certain key prices are still controlled. The exchange rate continues to be overvalued. Third, all kinds of other restrictions are imposed on enterprises. For instance, firms must find foreign suppliers of capital equipment willing to extend credit for three years. Enterprises are also not entirely free to adjust prices to reflect production costs, particularly for major products, and are also restricted in their labor practices. It is difficult to put enterprises on a stronger footing when the macroeconomic and regulatory environments have not been synchronized with the restructuring program. Delays in macroeconomic reforms threaten financial reforms, since the losses will continue to accumulate as long as enterprise managers do not have an appropriate framework within which to make their decisions.

However, macroeconomic stabilization and deregulation will also generate social pressures. Inevitably, prices will increase and the real incomes of some groups will fall. Those affected will need an effective social safety net, just as those who lose their jobs or want to seek new ones will need unemployment insurance and housing in growth areas. Housing in Algeria has been particularly neglected under central planning in the last decade. The number of people per housing unit (8.3) is almost as high as it is in Hong Kong. The gap between the demand for and the availability of housing is around two million units.

In summary, in order to move away from an inwardly oriented, centrally planned economy to an outwardly oriented, free-market economy, developing countries must address the major issues on several fronts simultaneously. There must be macroeconomic stabilization, enterprise and bank restructuring, a targeted social safety net, and improved housing availability. On the other hand, large-scale privatization and the breakup of monopolies can wait until at least some progress has been achieved on these other problems.

The Algerian approach is a concrete example of what can be attempted in economies in transition outside the former Soviet Union. The program has some deficiencies, which I have mentioned, primarily because it is not well synchronized with macroeconomic stabilization. Nevertheless, it is a program that is in place and that may be potentially successful, provided the slippages that have occurred so far are quickly reversed.

Summary of Discussion

Three working groups and an open meeting were the basis for this discussion. The first group, which focused mainly on Russia, suggested that during the process of reform, too much emphasis has been placed on privatization and not enough on the fundamental aspects of enterprise reform. In particular, governments have not enforced the hard budget constraints necessary to improve economic efficiency. Some discussants suggested that private ownership alone is unlikely to change the behavior of state enterprises until virtually all businesses are in private hands and operating on a competitive basis.

Discussants also focused on how the revenues from privatization should be used. Most countries tend to use the funds to support the budget. Poland tries to link privatization revenues with the new expenditures they make possible. Latvia earmarks a certain amount of privatization revenues as credit (on favorable terms) for the newly emerging private sector. It was agreed that there is no single best use for these funds.

The problem of state-owned enterprises in Russia was addressed next. Managers of these enterprises, some of whom have considerable political clout, often continue not only to pursue the management practices that flourished under central planning but to lobby to protect their companies from adjustment. Even in the face of these efforts, however, some enterprises have become more market oriented. Discussants also noted that Russia’s lack of success in using vouchers to promote the restructuring of privatized enterprises parallels the experience of other countries. In a similar effort in Latvia, large numbers of vouchers were distributed to older citizens, who showed little interest in the management of the newly privatized enterprises, and the vouchers thus did little to improve the governance of these firms. In general, vouchers were seen as an ineffective method of trying to achieve social objectives. Discussants felt that trying to use privatization to meet social needs—rather than solely to improve economic efficiency—is unnecessarily confusing.

A final concern was that low rates of domestic savings may cause governments to rely too heavily on foreign purchasers during the privatization process.

The second group also discussed the problem of enterprises in Russia. Discussants noted that the costs of the necessary restructuring will be large and that it is essential to take into account the additional costs of the much-needed social safety net. While the issue of social safety nets is a new one for the IMF, the agency recognizes that these nets are an important element of reform and should be treated accordingly. The group also noted that Russia’s efforts to limit transfers to enterprises have been hampered by continuing negative real interest rates. Higher interest rates and more progress toward macroeconomic stabilization would make limiting these transfers easier.

Because economywide privatization in a country as large as Russia is not possible in a short period, discussants felt that a better method is to privatize or restructure one narrowly defined sector at a time. Completely revamping enterprises on a sector-by-sector basis eliminates one potential danger—that is, that some enterprises in a sector will be operating under hard budget constraints while others will not. In addition, this approach may prevent new private firms from picking up bad habits from the sector’s remaining state-owned enterprises.

Group three focused on the fundamentals of privatization. It was noted that privatization should not be seen as an end in itself, but as a means of improving the utilization of national resources. Discussants argued for a broader definition of privatization, contending that it should not be thought of only in terms of the transfer of ownership from the public to the private sector. A more complete definition ought to include intermediate arrangements between full state and full private ownership—for example, the limited use of contracts with private managers in state-owned firms to improve governance.

Addressing the issue of how a country should undertake privatization, the group concluded that each economy is different and that this fact must be fully recognized when privatization programs are designed. Discussants also identified several other important areas that need attention, including sequencing and, in particular, the establishment of an institutional and regulatory environment conducive to market-oriented practices.

In the general discussion, participants asked why the working groups had devoted most of their time to privatization rather than to enterprise reform in general. Several attempts were made to explain this focus. First, because information about the details of privatization is scarce, it is important to work toward a definition of the process. Second, because privatization tends to be nonreversible, it is extremely important politically. Third, policymakers are always concerned during the reform process that a new disruption in the economy or a new political crisis will undo any progress that has already been made. In this sense, privatization stands in sharp contrast to other approaches to enterprise reform because it is less risky.

The discussion then turned to the question of government control of commercially motivated enterprises. These businesses were seen as likely to face instability in the future. However, the experience in industrial economies has been that political interference in management decisions will continue until questions of ownership and control are resolved. The IMF and World Bank have accepted this fact and now caution against placing too much emphasis on the high degree of politicization affecting Russia’s privatization process. For example, questions such as who can buy shares and how revenues are to be redistributed are often resolved on a political rather than an economic basis.

The question of how to enforce hard budget constraints was raised. Discussants observed that enforcement makes little sense as long as domestic prices are out of line with international levels and subsidies continue. If firms go bankrupt as a result of such constraints, it may be because these enterprises are not receiving subsidies, perhaps for political reasons. Donal Donovan repeated his earlier point concerning the direct link between the difficulties of enforcing hard budget constraints in Russia and the general unwillingness to appreciate the magnitude of the social costs of adjustment, particularly of unemployment. A similar link was pointed out between the difficulties of enforcing budget constraints and macroeconomic instability. It was noted that a great deal of the overshooting of prices and overdevaluation of the ruble in Russia can be attributed directly to the enterprises’ lack of financial discipline in purchasing.

Finally, it was suggested that imposing tight deadlines for reforms such as privatization can cause serious problems. Discussants agreed that it is better to work gradually toward the necessary restructuring and other preconditions—including some degree of macroeconomic stability—rather than to push an ambitious agenda that cannot be met and may cause more problems than it resolves.

Proceedings of the Seminar Coordination of Structural Reform and Macroeconomic Stabilization, Washington, D.C., June 17-26, 1993