Or Does It?

And yet, despite the ubiquity of divestiture,⁶ despite the assessment by investment bankers that privatization’s success has been indisputable,⁷ and despite the large and growing evidence from a variety of settings showing that privatization tends to improve firm-level performance, doubts remain and are growing. Indeed, suspicions and concerns about privatization, driven under by the liberalizing pressures of the 1980s and early 1990s, are resurfacing to a point of revisionism. These doubts are reflected

• in the concerns of observers dissatisfied with the analytical rigor of the theory and the empirical studies supporting privatization;

• in the arguments of opponents of privatization, who believe that privatization is not the right social solution, at least not for all firms or in all economies;

• by fears that although privatization, even if beneficial for shareholders and the selling state, has not proven beneficial for society as a whole, or at least for significant groups of the poor and powerless actors in society; and

• by the concerns of many whose previous acceptance of divestiture has been shaken by recent events in Russia and some of the other transition economies.

This study reviews the accomplishments and shortcomings of privatization in transition economies—where the scope and pace of privatization have been larger than elsewhere and expectations great, and where significant problems have surfaced. The study looks into where performance in transition economies has been unsatisfactory and why and discusses what governments, and those who assist them, should do about turning this experience around. The study’s principal findings are as follows:

• Privatization generally proved its worth in the CEE and Baltic states.

• However, too much was expected and promised of privatization in institutionally weak transition economies, particularly in countries of the former Soviet Union.

• For seemingly excellent reasons, the emphasis was usually on massive, speedy transactions with substantial ownership stakes awarded to “insider” stakeholders. The reasoning was that the links between the enterprises and the state needed to be cut quickly to create a mass of private property owners, and the only way to do this was by offering substantial ownership stakes to workers and managers in the firms being privatized. If these powerful insiders were not rewarded, and quickly, they would block indefinitely the privatization—and transition—process.

• In the transition states closest to Western markets, there is some evidence that this approach has been successful.

• But the farther east the country, the more evident is the neglect of the supporting institutional frameworks required to promote financial discipline, competition, and freedom (and promotion) of entry of new businesses.

• And in those instances, the speedy, massive, insider-oriented forms of privatization have generally failed to lead to the restructuring needed to enable firms to survive and thrive in competitive market operations.

Despite the severity of this indictment, there is little reason to think that had these firms remained in public ownership, their restructuring performance would have been better. The fact is that states that botch privatization also botch public ownership of enterprises. Overall, privatization has delivered remarkably well in many settings, especially when contrasted to a realistic set of alternatives instead of some theoretical ideal.

Thus, although this study agrees that the methods of privatization have to be altered and improved, and that much more attention needs to be paid to supporting institutions, it argues against renationalization or a search for other ways to make state ownership efficient and effective. The key unanswered question is how to go about correcting and improving privatization in institutionally weak settings.

The Rise and Fall of Russia

Russia’s privatization experience has come in for particular criticism. The voucher-led mass privatization program of 1992–94 transferred ownership of more than 15,000 firms, primarily to insiders. At the end of the exercise, managers and workers combined controlled about two-thirds of the shares in the average privatized firm. The program’s designers had tried to avoid insider dominance, but the financial mechanisms that might have prevented this outcome were swept away by the near hyperinflation prevailing at the time. Still, the mass privatization program had taken place without major claim of fraud, and by fall 1994, hopes were modestly high that

• financial discipline and perceived self-interest would start to force secondary trading in the insider-dominated companies and introduce outside ownership; and

• transparent and sound but nonvoucher methods would be used to privatize the half, or more, of industries still in state hands.

Several factors combined to prevent the proper unfolding of this process. First, insiders in the newly privatized firms generally feared loss of control. For most workers the case was one of “better the devil we know” (the existing management) than a cost-cutting, perhaps job-slashing, outsider. In turn, many of the old managers-turned-owners found it easier to lobby the state for assistance than to set the firm on the path to competitive performance. Second, the financial and physical condition of many of the firms were too unattractive for outsider investors. Third, the institutional underpinnings were weak and safe-guards—thus incentives—inadequate for transparent secondary trading, thus further discouraging outsiders. Fourth, the various Russian governments failed to put in place the required set of supporting policies and institutions that might have channeled enterprise activity to productive ends (such as a hard budget constraint, reasonable taxes and services, and mechanisms to permit and encourage new business entrants). Fifth, institutionalized property rights (indeed, a consensus on the economic rules of exchange) were generally absent. For the firms transferred in the mass privatization program, this mixture blocked the taking of the essential second step to opening the ownership of privatized firms to external investors and owners who would bring needed capital, market access, managerial know-how, and a bottom-line mentality to privatized companies (Nellis, 1994, p. 2).¹⁶

And worse was to come: A donor-led effort to persuade the Russian government to sell at least a few large firms by transparent, credible case-by-case methods expended considerable effort but led nowhere. Much of the second wave of privatization, which took place after 1994 (for cash and investment promises), in particular the “loans-for-shares” scheme, turned into fraudulent shambles—a situation pointed out by the strongest supporters of, and contributors to, the first mass phase of Russian privatization. The second phase

was non-transparent … involved clear conflicts of interest … created collusion … involved a non-level playing field, excluding foreign investors and banks not favored by the government. In two years the Russian privatization program has moved from the outstanding accomplishments of the MPP to the point where the program is now widely regarded as collusive and corrupt, failing to meet any of its stated objectives (Lieberman and Veimetra, 1996, p. 738).

Others go further, arguing that the entire Russian privatization program, including the voucher-led mass effort, has been the principal cause of the country’s economic decline. They argue that the program emphasized swift ownership change before (or instead of) the building of market-supported institutions. And without these supportive underpinnings (a basic capital market framework, minimal shareholder information and protection systems, enforceable contracts, a modicum level of capacity and probity in the supervision of the public sector) and without breaking up the huge monopolistic or oligopolistic producers in order to stimulate internal competition, the voucher program left the mass of new shareholders powerless to counteract the manipulations of the well-placed managers and their supporters in the financial community. Thus, a program that was supposed to distribute ownership and launch enterprises on a positive restructuring path became instead a transfer of productive resources from the state to a fortunate few, who—unconstrained by tradition, effective laws, or countervailing powers—stripped the assets from the firms instead of taking actions to renew growth and create jobs—actions that might have justified such a transfer.

Over time, the lack of turnaround, the continuing steep fall in output, the concentration of wealth, the demise of probity, the resistance to standard case-by-case methods, the deepening malaise, and the increasingly common anecdotes that only state-owned firms have resisted criminalization,¹⁷ combined to persuade many presumably predisposed observers to reject not only the notorious loans-for-shares scheme, but almost all of the Russian privatization approach. Thus Kenneth Arrow¹⁸ calls Russian privatization “a predictable economic disaster,” arguing that it should have been easy to foresee poor outcomes, given Russia’s institutional weakness and high inflation in 1992–95. Jeffrey Sachs¹⁹ says he now favors Russia renationalizing the natural resource firms wrongly privatized earlier. Simon Commander (1998) argues that Russian insider privatization has sanctioned a low investment—low productivity equilibrium, and as such has contributed greatly to Russia’s fiscal impasse. Many Russian economists and a few Western colleagues have concluded that the entire privatization approach in Russia was wrong, that it should have been preceded (not accompanied) by institution building, and that the proper way forward is to strengthen the structures of the state.²⁰ These critics, in particular, stress the need to recreate or reinforce mechanisms to supervise and assist state-owned firms. One suggestion is to use a state-owned holding company, which supposedly would manage assets rationally and prepare firms for a smooth transition to competitive market operations (Alexandr, 1998). The views on privatization are so negative that a fair number of members of the federal legislature (the Duma) have urged that the huge tax arrears owed to the federal government by privatized firms be transformed into equity, which would effect a massive renationalization of industrial assets.

Difficulties in the Czech Republic

The limited expectations of privatization were perhaps reasonable in Russia, given the unfavorable factors against it: the length and intensity of the nonmarket approach, the unfavorable economic and structural conditions existing at the moment transition was launched, and the magnitude of the parallel political and institutional collapse. But in the Czech Republic, conditions and history made it reasonable not only to hope but to claim that the dramatic mass privatization program of 1992–95 would fully and permanently cut the links between the state and the divested enterprises and set the privatized firms on the road to unassisted competition in both domestic and foreign markets.

First signs were very encouraging. By 1995, Czech privatizers had divested more than 1,800 firms in two waves of exchanges for vouchers, sold a group of high-potential firms to strategic investors, and transferred to previous owners or municipalities a mass of other assets.²¹ By 1996, then Prime Minister Vaclav Klaus was able to claim that transition had more or less been completed and that henceforth the Czech Republic should be viewed as an ordinary European country undergoing ordinary economic and political problems. All indicators appeared to confirm this view: The Czech Republic was enjoying comparatively low inflation, low unemployment, rapid rise in the private sector’s share of GDP, high rates of investment and export growth to countries in the European Union, and a resumption of GDP growth starting in 1993 and peaking at 6.4 percent in 1995.

But at the end of 1995, the Czech GDP growth rate fell, and it fell again in 1996 and 1997 when it reached 1 percent. In 1998 results were starkly negative, with an annual GDP contraction of about 2 percent; projected growth in 1999 was zero or slightly positive. Thus the Czech economy was officially in recession—in contrast to 4–5 percent expansion in neighboring countries.

Many reasons account for the economic slide, including a mini-recession in Germany (now the Czech Republic’s largest trading partner) and some financial mismanagement at the end of 1995 and early 1996. Nonetheless, an increasingly large amount of the blame is being placed on the way privatization was carried out.

A 1998 OECD report states the argument: The Czech voucher approach to privatization produced ownership structures that impeded efficient corporate governance and restructuring. The crux of the problem was that insufficiently regulated privatization investment funds ended up owning large or controlling stakes in many firms privatized by vouchers, as citizens diversified risk by investing their coupon points in these funds. But most of the large funds were owned by the major domestic banks—banks in which the Czech state retained a controlling or even majority stake. The results, say the critics, were predictable:

• Investment funds tended to overlook poor performance in firms, because pulling the plug would force the fund’s bank owners to write down the resources lent to these firms.

• The state-influenced, weakly managed, and inexperienced banks tended to extend credit to high-risk, privatized firms with poor potential (whether or not they were owned by subsidiary funds), and to continually roll over credits rather than push firms into bankruptcy.

• The bankruptcy framework itself was weak and the process lengthy, further reducing financial market discipline.

• The lack of prudential regulation and enforcement mechanisms in the capital markets opened the door to a variety of highly dubious, and some overtly illegal, actions that enriched fund managers at the expense of minority shareholders and harmed the health of the firm, for example, by allowing fund managers to load firms with debt, then lift the cash and vanish, leaving the firm saddled with debts it had not used for restructuring.

Because of these experiences, many have concluded that the Czech firms privatized through vouchers did not sufficiently restructure where investment funds had the controlling stakes.²² And although the proximate and most visible determinants of inadequate restructuring lie in the glaring weaknesses of the capital and financial markets, the voucher privatization method is viewed as the underlying cause. The emphasis of the method on speed, neglect of institutional issues, such as the weak legal and regulatory framework, and atomization of ownership helped to undermine its success. David Ellerman (1998) is the most outspoken critic of the Czech scheme. He argues that the negative outcomes were predictable given the separation of ownership from control. Moreover, the funds themselves lacked stable ownership, and the broader economy provided few institutional mechanisms to instill decent corporate governance in either the funds or the firms. The natural result was a “two-sided grab-fest by fund managers and enterprise managers” accompanied by “drift, stagnation and decapitalization of the privatized industrial sector …” (Ellerman, 1998, p. 11).²³

Other Transition Economies

Similar concerns have been raised in some of the other transition economies. Many officials and observers, particularly in the smaller and more geographically isolated transition countries, cautiously agree to privatization in general but argue against rapid and mass privatization. Those from Albania, Mongolia, and countries of the former Soviet Union are particularly skeptical, for the following reasons. First, they see few positive outcomes from privatization in Russia. And since they consider their industrial assets and business environments to be similar to those in Russia, they believe they cannot avoid the same problems.

Second, they fear that the countries lack the administrative and legal mechanisms needed to transform rapacious grasping into tolerable and productive attempts at acquisition. Third, many aspects of the economies of countries that were once part of the former Soviet Union are still under the influence of Russian supply, transport, energy, and sometimes criminal networks. Fourth, some of the countries that tried mass privatization schemes, such as Albania, Kazakhstan, Mongolia, and Moldova, concluded that they gained little from this effort. They found that dispersing ownership among the inexperienced population has not improved governance of firm managers. Too often, firm managers remained unchanged, failed to restructure their firms, and remained largely unaccountable for their actions. Leaders in Uzbekistan, for example, are increasingly convinced of the correctness of their neighbor’s policies of general gradualism and of their opposition to handing over firms to owners lacking in financial strength and expertise. These experiences are claimed to justify, to necessitate, a slower, more cautious, more evolutionary, and more government-led path to ownership transfer.²⁴

In light of all this, it is not surprising that in some post-Soviet countries—especially those in which the political transition entailed less of a break with the past than in Russia and where the inherited state structure maintained some cohesion and effectiveness—a Chinese-style approach to enterprise reform and ownership change is considered the proper model to follow.²⁵ The overall Chinese record of high and sustained growth, largely without a shift to formal private ownership, poses a stark contrast to the generally poorer transition performance elsewhere. Moreover, the approach is the subject of encouraging comments from a number of Western economists. For example, Joseph Stiglitz (1998) states that the Chinese experience shows that an economy might achieve more effective growth by focusing first on competition, leaving privatization until later. Thomas Rawski (1997), whose overall conclusion is that economists overstate the importance of ownership, states:

The generally negative evaluation of state enterprise performance is overdone … China’s state industry has increased output, productivity, and exports … the upper tier of state firms is not far removed from international market standards … The main source of SOE financial problems lies in their history, not their ownership … (Without politically imposed financial burdens) SOE profitability may equal or exceed the financial performance of China’s highly touted collective factories … the productivity performance of state industry may match or surpass the accomplishments of the collective sector … (p. 14).

The attack on privatization could be expanded in severalways: for example, by noting the insufficiency of analytical work on the macro-economic and fiscal impact of privatization; by pointing out that the “fiscal space” justification for privatization (that is, governments should cease pouring resources into inefficient and badly managed state-owned firms; instead, they should sell them and concentrate resources and action on those socially needed activities that only governments can and should undertake) states a hope, not a known reality. However, very little is known in emerging markets or the transition economies about how the proceeds of privatization are actually applied.²⁶ And given the nature of the political and administrative systems in many of these settings, doubts are warranted about transition governments’ abilities to collect and allocate wisely the sums generated through privatization.

Political Economy Aspects of the Question

What are the political economy aspects of privatization—the issue of who in transition society wins and loses from transactions? As noted, a good part of the criticism of privatization in Russia and the Czech Republic stems from the widespread perception that reform in general and privatization in particular have yielded benefits to the very few at the expense of many—for example, the Czech workers in Ellerman’s (1998) “decapitalized and stagnant” privatized firms; and the voucher investors in the two countries who were led to believe their investments would yield an income stream and a capital gain, neither of which materialized for most.

To date, no study of transition countries has examined these issues in the rigorous manner pioneered by Galal and colleagues’ 1994 study, Welfare Consequences of Selling Public Enterprises, which studied the gains and losses of sellers, buyers, workers, consumers, and competitors. Indeed, very little empirical work of any sort has yet appeared on the question of privatization’s effects on income distribution in transition settings (or elsewhere). Analysts have begun to produce some oblique and tantalizing hints about the relation between privatization and incomes. For example, Garner and Terrell (1998) looked at movements in income distribution in the Czech Republic and Slovakia through 1993. They concluded that income inequality had risen much less than was claimed in the World Bank’s 1996 World Development Report. They also predicted more inequality in these countries as the returns from asset distribution are realized.

Newell and Socha (1998) looked at the related issue of privatization’s impact on wage distribution in Poland. They concluded that private sector workers typically earned less than their state-sector counterparts after privatization, and the gap was widening; but they also noted that after controlling for experience, tenure, and workplace size, their research showed a small positive private sector premium. Not much can be made of these beginnings, and more work is needed on the subject.²⁷

A common allegation is that women in transition countries bear a higher percentage of the costs of privatization than do men. In one of the only studies to examine this issue, Sewall (1997) argues that privatization in Hungary was triply costly to women, because women formed a disproportionately higher percentage of those laid off by new owners, privatization often involved the closing of the firm’s social services—canteens, clinics, day-care centers—so crucial to female participation in the workforce, and women formed almost the entire workforce in these social service units. Although Sewall’s study is one in a single country, the findings can reasonably be expected to apply to many other transition countries.

Privatization is often assumed to inevitably and automatically result in increased unemployment; but the relationship between employment and privatization in transition countries is not straightforward. For example, the Czech Republic privatized rapidly but maintained a low unemployment rate (a remarkable 3 percent) through 1997. The low rate was at first taken as a sign of the Czech reformers’ success but was later revealed as too good, as an indication that the needed level of corporate restructuring was not taking place in the privatized firms. The recent steep rise in Czech unemployment (7 percent and climbing at the end of 1998) came about even as the pace of privatization had slowed to almost a halt. Something of the same phenomenon has taken place in Russia: that is, mass and rapid privatization, but a relatively small increase in the official unemployment rate. (Although masses of people are officially employed, they are working part time, or not at all, but are kept on the books, or are not being paid.)

In Poland and Hungary, in contrast, privatization started and progressed much more slowly, and neither country followed a “mass” approach. Yet official unemployment grew rapidly in both countries, reaching 16.7 percent in Poland in 1993–94 (down to 9.6 percent in 1998), and 14.1 percent in Hungary in 1993 (falling to 10.8 at the end of 1996). The conclusion must be that employment levels are as much a function of the scope and pace of overall economic restructuring as they are of ownership.

A Summation of the Critique

The perception of many citizens, analysts, and some leaders in transition settings—especially those in the BRO countries—as well some knowledgeable external observers, is close to the following:

In far too many privatization transactions and in far too many transition countries, mass and rapid privatization has turned over mediocre assets to large numbers of people who have neither the skills nor the financial resources to run them well. Most high-quality assets have in one way or another (sometimes by “spontaneous privatization” that preceded official schemes, sometimes by manipulation of the voucher schemes, and perhaps most often in the nonvoucher second phase or in secondary trading) gone to the resourceful, agile, and politically well-connected few. In many instances where ordinary citizens managed to obtain and hold minority blocks of shares in the high-quality firms, the shareholders have been induced to turn over their shares to others at modest prices, or they have seen, without warning or explanation, the value of their minority shares fall to nothing.

These occurrences are particularly prevalent in countries where the post-transition state structures are weak and fractured. This allows significant parts of government to become captured by groups whose major objective is to use the state to legitimatize or mask their acquisition of wealth. (Poor outcomes also can occur when strong governments fail to create a modicum of prudential regulation for financial and capital markets.) The international financial institutions must bear some of the responsibility for the poor outcomes, since they often insisted on the primacy of economic policy (or they followed uncritically the lead of intensely committed reformers). They requested and required transition governments to privatize rapidly and extensively, assuming that private ownership by itself would provide sufficient incentives to shareholders to monitor managerial behavior and push firms to good performance. Competitive policies and institutional safeguards could follow at a later date. The immediate need was to create a basic constituency of property owners. The key assumption was that to build capitalism, one needed capitalists, lots of them, and fast.

But capitalism requires much more than private property. It functions because of the widespread acceptance and enforcement of fundamental rules and safeguards that make the outcomes of economic exchange secure, predictable, and of reasonably widespread benefit. Where such rules and safeguards, such institutions, are absent, not only fairness and equity suffer, but performance of firms suffer as well, because in an institutional vacuum the chances are high that no one in a privatized firm is interested in maintaining the long-run health of the assets.

Too many supervising state officials become interested mainly in extracting rents and selling licenses, permissions, and protection to the firm, rather than enforcing policy. Even when the state retains a significant minority share of the firm and representation on the firm’s board of directors (as is common in many transition countries), the representatives are often looking more for perks, payoffs, and protection of bureaucratic interests than ways to boost shareholder value. Faced with voiceless shareholders and a rapacious or ineffective state that makes believing in the sanctity of property rights difficult (and inflicts punishing tax and interest rates), the manager of a firm may conclude that promoting shareholder value is impossible or not worthwhile. The easier course of action is to lobby the state for assistance or to strip assets and walk away. The former can often be arranged with the collusion and blessing of supposedly supervisory government officials or private bankers or fund managers. Workers, shareholders or not, are caught in the maelstrom, searching for stability and safety, and hoping only to keep their jobs. The other mechanisms of corporate governance—financial and capital markets, the economic and financial press, the insolvency/bankruptcy regimes—are too weak or embryonic to provide countermeasures.

In such circumstances, privatization is more likely to lead to stagnation and decapitalization than to improved financial results and enhanced efficiency.

The Defense

The first counterpoint to the arguments against privatization is the large volume of rigorous studies cited earlier. These studies, conducted in a wide variety of sectoral, geographical, and income settings, show that firms tend to perform much better after privatization than before, as measured by a number of financial and operational efficiency indices at the firm level. A smaller amount of evidence—mainly from several middle- and high-income economies—also show welfare improvements from privatization.

The question is whether we can expect similar positive results in transition settings. Country conditions matter. Several studies indicate that the lower a country’s income, the less dramatic or speedy will be the results of privatization and the more likely that the process could go wrong.²⁸ As noted earlier, countries in CEE—closer geographically, historically, and culturally to Western commercial traditions and markets—have generally privatized more swiftly and with much better results than their more Eastern counterparts. (A more optimistic interpretation would be that the positive results of privatization are taking much longer to show in most of the countries of the former Soviet Union than in the CEE or Baltic states.) Important differences—not only in location and history, but also in institutional density and capacity and adherence to the rule of law—distinguish these countries from those of the former Soviet Union. These factors affect the type of privatization policies and approaches chosen and the ways in which the choices are implemented and the financial and economic outcomes obtained.²⁹ But these caveats do not contradict the main point: The mass of empirical evidence indicates that privatization, when correctly conducted, produces positive benefits. For transition countries, the question is not whether to privatize but how to privatize better.

This conclusion is not accepted by all. Given the difficulties already elaborated, and drawing on the general criticism of Tandon (1995), many argue that the best course of action for transition economies, especially in the former Soviet Union, is to further postpone privatization until competitive forces and an enabling institutional framework are in place. And, as noted, some analysts call for the renationalization of some of the firms already divested, with the intention of managing them in the public interest, through greater state involvement. The more liberal of these critics add that some or all of the renationalized firms could be sold again in the future, when firm and market conditions have improved and investors are offering better prices. Response to this line of reasoning is threefold.