This Selected Issues paper examines the progress of Slovenia by focusing on four interrelated topics that are critically important to the evolution of the transition process and provides insights into the work that lies ahead. The paper concludes that the voucher-based privatization process has failed to truly transform the ownership structure of socially owned enterprises. The paper also investigates the inflation process in Slovenia through an empirical examination of some commonly used determinants of inflation in transition economies.

Abstract

This Selected Issues paper examines the progress of Slovenia by focusing on four interrelated topics that are critically important to the evolution of the transition process and provides insights into the work that lies ahead. The paper concludes that the voucher-based privatization process has failed to truly transform the ownership structure of socially owned enterprises. The paper also investigates the inflation process in Slovenia through an empirical examination of some commonly used determinants of inflation in transition economies.

I. Privatization and Corporate Governance in Slovenia:1 The Shift from Comrade to Shareholder

“To privatize,” said an agency official, “is to drive a two-horse cart. The cart is the enterprise in question. One horse is called Political Goals and is flighty and fickle; the other is called Economics and is slow and steady. They have to pull the cart along the Road to Privatization, which is a rough, boulder-strewn track. The cart is full of cases of vintage wine, which is unfortunate because the horses, as often as not, are pulling in different directions. The bottles of wine, which can be enjoyed only when the cart reaches its goal, are labeled improved efficiency, high sales price, effective corporate governance, economic investment, and so on.”

“Only the most skilled driver can negotiate this track: up the hill of Vested Interests (cases may have to be jettisoned here, and some horses aren’t strong enough to make it), across the stream of Xenophobia (another case or two bumps off the back). Some carts are too weak and may fall apart before they get to Privatization. Sometimes it makes sense to give the flighty horse its head and fly the trail headlong, abandoning case after case on the way; sometimes it is possible to whip him into shape to follow his steadier partner. And many drivers simply give up, cut the horses loose, climb down and start back down the trail, hoping to find solace in the odd bottle that hasn’t smashed.”

Privatization: Principles and Practice,

Lessons of Experience Series, Vol. 1, IFC, 1995

A. Introduction

1. The above analogy of privatization as a two-horse cart is quite fitting for Slovenia, where the privatization process has been a careful balancing act between economic and political goals. Political feasibility, with an emphasis on social consensus and gradualism, has resulted in the use of a hybrid approach to privatization which has not necessarily been optimal with respect to economic goals. This approach to privatization has implicitly preserved much of the previous corporate governance structure despite the transformation to private ownership, and has raised serious concerns about effective corporate governance and the ability to proceed apace with the needed restructuring and reorganization in the enterprise sector. Moreover, resistance to crossing the “stream of Xenophobia” (and attracting sufficient foreign strategic investment) is one of the biggest challenges facing Slovenia.

2. The following section lays out the historical, institutional, and legislative background against which Slovenia’s privatization program is taking place. In Section C, the current status of privatization in Slovenia is presented. Section D provides a brief assessment of the program’s achievements to date. Section E examines the issue of corporate governance and makes some recommendations to improve governance in Slovenia. Section F is the conclusion.

B. Background

3. Slovenia inherited its enterprise structure from the Socialist Federal Republic of Yugoslavia (SFRY), which has influenced the privatization process in Slovenia. Unlike other Central and Eastern European countries, the SFRY made a clear distinction between state ownership and social ownership of enterprises. The system of social ownership—unique to the SFRY—was one in which management and employees jointly determined how their enterprises would be run. This decentralized method of decision-making engendered a more market-oriented approach (or “market socialism”)2 than that which was found in the rest of central and eastern Europe, whose state-owned enterprises were centrally managed in accordance with the objectives of a national plan. The decentralized system of self-management is widely credited for the fact that the SFRY, and Slovenia, in particular, enjoyed a higher standard of living than the other socialist economies. Moreover, under this system, prices were for the most part decontrolled, and enterprises generally did not benefit from explicit subsidies from the government budget. Thus, the socially-owned enterprises were better positioned to compete in the global marketplace. Nevertheless, the absence of a fully market-oriented approach led to inefficiencies relative to the West European economies. The self-management system created an inherent tendency to safeguard employment and wages at the expense of declining productivity, erosion of social capital, and loss-making activity.

4. As part of the SFRY’s reforms to improve economic prospects, the privatization process actually began prior to the political disintegration of the SFRY. At the time, privatization took place according to the Federal Laws on Social Capital and on Companies, both of which came into force in 1989. This legislation allowed the workers’ councils and managers to decide whether or not to privatize their enterprise. This constituted a passive, rather than an active, approach to privatization. By 1990, two government agencies had been established in Slovenia to oversee and assist in the privatization process: the Agency for Restructuring and Privatization, and the Development Fund (see Box I-1). The former was assigned monitoring and control functions, and, for this purpose, set guidelines for and approved the privatization programs of the socially-owned enterprises. The latter was made responsible for the financial restructuring (and subsequent privatization) of enterprises in its portfolio and was also the temporary depository of the shares of enterprises to be sold to investment funds.

The Development Fund

The role of the Development Fund was defined as promoting the development of enterprises in Slovenia. The Development Fund was to provide long-term financing for development projects for both privately-founded and privatizing enterprises and was designed to assist in financing of up to 30 percent of projects. In addition to its original role, the Development Fund has taken on some additional roles, including: (1) the transfer of 20 percent of the shares of privatizing enterprises to investment funds; and (2) the restructuring of companies in distress.

The restructuring of companies in distress stemmed from the government’s reluctance to use bankruptcy procedures, out of both social and political concerns. Since banks refused to continue financing loss-making operations, the government decided to transfer the social capital in such enterprises to the Development Fund with the aims of short-term restructuring, financial stabilization, and subsequent privatization. (Of course, in some cases, bankruptcy was unavoidable.) The Development Fund began work in this area in 1992 when it became the main shareholder of 98 companies which employed 56,000 workers. These companies had lost a substantial share of their market following the breakup of the SFRY; in some cases, the loss of market share was as much as 90 percent. As part of the restructuring operation, the Development Fund laid off 14,000 workers in the first year, then began selling some of the companies in subsequent years. Those companies in which the Development Fund remains the major shareholder are those which it has been unable to sell, owing mainly to prices which have not been attractive to investors or to pending litigation with former owners insisting on denationalization.

New companies have come into the Development Fund’s portfolio in connection with the Law on Ownership Transformation and the Law on Companies in the Ownership of the Development Fund. These companies were transferred to the Development Fund either because they violated the former law, or because they failed to actively prepare or implement an autonomous privatization program. The Development Fund’s role in restructuring and privatizing these newly-transferred companies has been similar to its initial role, with one important exception—it must distribute the shares to the various groups in the percentages specified under the Law on Ownership Transformation. Moreover, if the Development Fund sells such an enterprise for cash, the proceeds must immediately be transferred to the budget. This change in operation could reduce the agency’s motivation to expeditiously accomplish the restructuring of these firms.

5. After the breakup of the SFRY and following two years of intense discussions and negotiations,3 the present Law on Ownership Transformation (with a more active approach to privatization) was adopted in November 1992.4 The Law on Ownership Transformation focused on those enterprises classified as socially-owned, and its primary goals were two-fold: (1) to replace social ownership of capital with private ownership, and (2) to achieve a normal corporate structure.5 The ownership transformation process (the first goal), as described under the law, was initiated in 1993 and is now nearing completion. Indeed, it is estimated that over 90 percent of all socially-owned enterprises have completed their ownership transformation. The second goal, however, will only be accomplished after an extended and indeterminate period of ownership consolidation and improved corporate governance.

6. This legislation provided for a decentralized or autonomous form of privatization in that enterprises adopted their own privatization plans within pre-determined parameters described below. These plans then had to be approved (first approval) by the Agency for Restructuring and Privatization. After an enterprise had implemented its privatization according to its plan, the Agency gave a second approval and registered it into the Court Register.

7. The Law on Ownership Transformation represents a compromise on competing views of privatization and, therefore, provides for a hybrid approach, with the primary methods being management-employee buyouts, direct sales to outside buyers, and voucher-based mass privatization. The voucher program was implemented in 1993 by setting up a voucher (or ownership certificate) account for each citizen of Slovenia. Each account had a nominal value of SIT 250,000-SIT 400,000, with the face value indexed to the age of the citizen. The total nominal value of all voucher accounts was SIT 564 billion, representing 40 percent of the book value of social capital as of end-1992. Vouchers could be used only for the purchase of social equity and were not transferable.

8. The Law on Ownership Transformation delineates the ownership transformation of enterprise shares according to the following basic formula:

  • 10 percent to the Compensation Fund6

  • 10 percent to the Pension Fund

  • 20 percent to the Development Fund, which will subsequently sell its portfolio to the privatization investment funds (see Box I-2)

  • 20 percent for internal distribution (distributed to employees, former employees, and relatives of employees in exchange for vouchers)

  • 40 percent according to either of the following (or in combination):

  • internal buyout (i.e., to insiders on preferential terms—employees receive a 50 percent discount on the value of shares, and the purchase can be financed for up to 5 years)

  • commercial sales (public offerings, public tender, or public auction)7

9. In addition, other approaches included the sale of all assets of a company in combination with its liquidation (in which case the Development Fund assumes the company’s liabilities) or the raising of additional private equity provided that new shares are issued in excess of 10 percent of the existing equity.

10. The privatization of most of the companies which are the core of Slovenia’s economic activity is now almost completed. Most of the companies which remain to be transferred under to the Development Fund would be small enterprises in which there has been no interest in privatization, as well as a residual of large companies which have had problems with past “wild” (or spontaneous) privatizations, restitution claims, or land register issues. Nevertheless, it is anticipated that the privatization of these companies should be completed apace.

11. There have been some problems associated with the placement with the investment funds of the 20 percent of socially-owned capital which, by law, had to be transferred to the Development Fund during the privatization process. In the past, the Development Fund used auctions to sell these shares to the investment funds. Five auctions had been conducted by mid-1996, but the results from these auctions were less than satisfactory. At four of the five auctions, there was apparently intensive collusion among the investment funds, which resulted in average prices below the enterprises’ initial valuations. More importantly, shares in a significant number of enterprises had to be withdrawn because of insufficient interest in purchasing them. The investment funds were only interested in firms with good immediate prospects and avoided those in relatively bad shape. As a result, by the fifth auction, the shares of 50 companies (out of approximately 200 on offer) had to be withdrawn.8 Since the Development Fund could not continue to manage the 50 companies, it decided to stop using the auction method and try another approach to distributing the shares.

Privatization Investment Funds

In January 1994, the Law on Investment Funds and Management Companies was passed. This law provided the basis for the establishment of privatization investment funds which would collect vouchers (or ownership certificates) from the public in order to buy enterprise shares which had been transferred to the Development Fund. Thus, the role of the privatization investment funds was to intermediate between the population holding vouchers and the enterprises undergoing privatization. These funds were also intended as a counterbalance to insider ownership.

Before the investment funds could collect vouchers, they were required to publish a prospectus with full disclosure. The process of collecting the vouchers began in mid-1994, following an aggressive marketing campaign by the funds. By end-1995, there were 81 funds being managed by 14 management companies; the number of funds had declined to 72 by mid-1997. The start-up capital for the management companies has been provided primarily by banks and insurance companies (about 62 percent), which could create some conflicts of interest between the owners of the management companies and the investment fund managers.

About 88 percent of all vouchers have been transferred from the population’s accounts to be used in the privatization process; of these, 53 percent (worth some SIT 300 billion) were collected by the investment funds, with three management companies each collecting more than 10 percent of all vouchers. These funds then participated in the Development Fund’s auctions in order to use their accumulated vouchers to purchase enterprise shares. The investment funds have been unable to exchange most of the vouchers they hold (on average, only about 40 percent of the vouchers have been exchanged for equity), with the vouchers estimated to exceed the available capital by almost SIT 150 billion. In this context, the population which entrusted the funds with their vouchers have not actually received shares, and the vouchers are essentially treated as derivative instruments.

These funds have not yet developed typical mutual fund-like objectives (for example, investing in a particular category of industry or specifying risk-return objectives). There is already considerable trading among the funds, so it is expected that there will be a consolidation of portfolios over time and that the number of funds will continue to decline. The funds will eventually be listed on the over-the-counter market of the Ljubljana bourse, with analysts predicting that initial trading will be at sharp discounts to book value (on the grey market, the funds’ shares have been trading at a price of only about 10 percent of their nominal value). The funds claimed that they could be listed during the latter part of 1997 if Parliament passes the law which would provide additional state-owned capital (in banks, insurance companies, petrol firms, and other state enterprises) in exchange for the privatization vouchers.

12. Under the auction method, investment funds could decide for which companies they wished to bid. Thus, companies’ shares could be purchased individually. Under the revised method adopted by the Development Fund, the shares of all companies, both profitable and nonprofitable, were bundled into a single package. Moreover, the investment funds were required to submit a single joint bid, acting as a cartel, and this bid could not be less than the initial valuation. Although the Development Fund referred to this method as a tender, it could also be described as a “take-it-or-leave-it” offer since it is highly unlikely that the cartel would submit a bid higher than the minimum required. This approach was first used in September 1996, at which time the Development Fund sold stakes in 162 companies. A second such tender was completed in December 1996, when the Development Fund sold stakes in 152 companies after accepting a joint offer from 23 investment funds.9

13. The enterprises covered by the Law on Ownership Transformation are primarily in the field of trade and industry. While this first phase of privatization is now largely completed, state-owned assets (with a recently estimated value of about SIT 980 billion) have been excluded from the process.10 Three banks—including the largest and third largest ones—are owned by the state.11 The government also controls the majority of shares in many other enterprises, including utilities, banks, railways, airports, telecommunications, the Koper port, casinos, and even a horse farm.12 Parliament must determine what percentage of each of these enterprises is to remain state-owned. For example, power plants are 100 percent state-owned, while the Koper port is 51 percent state-owned.13 The non-state-owned share will be subject to a forthcoming privatization law.

14. The Law on Privatization of State Property is currently under parliamentary consideration, with the aim of beginning the privatization of the state property. Under this law, privatization will not be done with vouchers (although there may be some exceptions) and will be implemented gradually with no predetermined time period. The legislation is intended to provide for a transparent process that is similar to that used in other European countries. However, the draft law, as it now stands, provides only a general framework and is lacking in specifics on methodology and institutional responsibility.14

C. Status of the Privatization Process

15. As noted above, the privatization process is comprised of two stages. First approval is the more difficult stage, since this involves the issues of initial valuation and the selection of the method for privatization. In addition, in accordance with the 1992 Law on Ownership Transformation, restitution issues must be settled and public infrastructure and agricultural land associated with the enterprise must be determined and excluded from the process. Most of the privatization programs were submitted for first approval by the deadline of end-1994; those received after that date were primarily companies with unfinished audits. Second approval is granted and the company is registered in the Court Register only after the approved method of privatization has been implemented.

16. The privatization process has been relatively slow owing, in part, to the decentralized, autonomous nature of the privatizations. This method was chosen so as to avoid “shock therapy” and ensure an organized, well-monitored approach. It appealed to the Slovenes’ desire for social consensus and gradualism. Another factor which contributed to the slowness of the process was the need to harmonize Slovenian accounting standards with international ones.

17. By October 1997, 1,418 privatization programs had been approved (out of a possible 1,599 enterprises with social capital), 53 programs were in the approval procedure, 69 enterprises had been transferred to the Development Fund, and 59 had undergone bankruptcy procedures. The 53 companies in the approval procedure were mostly smaller enterprises which were having problems sorting out the issue of restitution to previous owners or which had exhibited no interest in participating in the privatization process.

18. Of those programs which had been approved, 1,108 had been registered in the Court Register and were operating as privately-owned companies, while the remaining enterprises had received first, but not yet second approval, and were in the process of implementing their programs. The Agency expected that most of these companies would soon receive second approval and that additional pressure could be brought to bear on these companies by insisting that failure to quickly complete the process would result in their shares being transferred to the Development Fund.

19. The distribution of the shares of total capital, by method of ownership transformation, is given in the following table:15

20. As seen from the figures in Table I-1, 29.7 percent of capital (distributed either by internal buyout or by internal distribution) is owned by insiders such as employees and management. The ownership structure is very dispersed, but the process of ownership concentration is expected to accelerate with the listing of shares on the Ljubljana Stock Exchange (see Box I-3). Some limitations are currently in effect regarding the transfer of shares (for example, shares bought with vouchers cannot be sold to outsiders for two years, and loan-financed shares are ineligible for trading until the loan is repaid). These limitations were imposed out of concern that a massive influx of shares onto the secondary market could trigger a stock market crash and undermine investor confidence.

Table 1.

Slovenia: Distribution of Shares of Total Capital

(in percent)

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Source: Agency of the Republic of Slovenia for Restructuring and Privatization.

21. The ownership structure looks very different if viewed from the perspective of the number of enterprises under majority insider ownership. Table I-2 shows the percentage of insider ownership for those enterprises which had completed privatization plans as of September 1996 and which had included internal distribution or internal buyout as one of their ownership transformation methods. In almost 71 percent of enterprises under the program, insiders have a controlling share of capital. The figures are even more extreme when the data base is restricted to only those enterprises which have obtained second stage approval—in almost 85 percent of these enterprises, insiders own more than 50 percent of the shares. Therefore, although ostensibly a wide variety of methods were employed, the management-employee buyout has emerged as the dominant form of privatization in Slovenia.

Table 2.

Slovenia: Percentage of Insider Ownership

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Source: Agency of the Republic of Slovenia for Restructuring and Privatization.

22. After four extensions, the privatization vouchers expired at the end of June 1997.16 This would be the final extension (this point would be emphasized to the population), and any remaining unused vouchers would not be exchanged for any other financial instruments (government bonds, etc.). There is, however, no time limit on the use of vouchers by the privatization investment funds.

The Ljubljana Stock Exchange

The Ljubljana Stock Exchange (LSE) was founded on December 12, 1989. The LSE’s infrastructure is relatively advanced, even in comparison with stock exchanges in far more developed capital markets. The LSE is characterized by electronic trading, settlement clearing in 2 days (faster than on the New York Stock Exchange), remote trading, and central registry. All stocks have been dematerialized (i.e., physical share certificates are no longer issued) since January 1996, in contrast to the bills issued by the Bank of Slovenia, which have not yet been dematerialized.

Market capitalization, nevertheless, remains very low in Slovenia, not only in absolute terms (which is to be expected, in view of the country’s relatively small size), but also relative to Slovenia’s level of economic development. Market capitalization is only about 5 percent of GDP, with equity and debt instruments each comprising around one half of the capitalization. Capitalization, however, is rising rapidly, spurred in part by privatization. As of December 1996, the market capitalization of the LSE was SIT 91.5 billion (about US$655 million), up from SIR 38.6 billion at end-1995.

Only about a dozen companies were listed on the Ljubljana Stock Exchange at the beginning of September 1996.1 2 Some companies have resisted being listed on the stock exchange out of fear of hostile takeovers. Slovenian companies also seem reluctant to list on the stock exchange due to disclosure requirements and the perception that such disclosure undermines managerial discretion, yet accountability and transparency are key to attracting foreign interest. Instead, much trading of shares on the secondary market occurs on the informal or “black” market rather than in the organized markets of the stock exchange or the over-the-counter (OTC) market. Moreover, share prices on the black market are usually significantly lower than on the organized exchanges. For this reason, some shareowners have been attempting to get their companies to list on the stock exchange. In the future, the Securities and Exchange Commission wants most sharetrading for ownership concentration to occur on the two organized markets to ensure transparency and promote capital market development.

The LSE is gradually getting new listings from the newly-privatized enterprises. By late November 1996, 22 newly-privatized companies had been listed on either the main exchange or the OTC segment of the Ljubljana bourse since the beginning of 1996, By October 1997, in terms of total listings, there were 15 companies listed on the main exchange and 40 trading on the OTC market. Experience has shown that if a company is first traded on the OTC and then moves its listing to the LSE, the price usually goes up by 10-20 percent. This increase in price may be partly attributable to the more extensive disclosure regulations for listing on the LSE. Although, as noted above, many companies have resisted listing as a result of these disclosure requirements, such a move is rewarded by allowing capital to be raised at less cost through the equity market.

1 Slovenia’s blue chip index, the SBI index, was comprised of only 7 shares as of end-1996 and was, therefore, very sensitive to moves in any one of its component shares. In 1997, the LSE introduced a new blue chip index, weighted to reflect market capitalization, and is currently comprised of 28 shares.2 By comparison, the Czech Republic had over 1,700 companies listed as of end-September 1996, although many of the shares are relatively illiquid.

D. Assessment of the Privatization Process

23. The above status report, on the surface, suggests that considerable progress has been made on privatization. A deeper examination, however, reveals some troubling aspects. The lower-than-expected growth in 1996 and early 1997, and in particular, the slowdown in the industrial sector, could be seen as warning signs of impending difficulties in the enterprise sector. Slovenia attracted only $186 million, or about 1 percent of GDP, in foreign direct investment in 1996, despite its highly favorable credit rating (the highest among all transition economies) and its relatively attractive economic prospects.17 Moreover, Slovenia’s share of the total stock in foreign direct investment in all transition economies has been steadily eroding from 1992 onward, declining from 7.3 percent in 1992 to 3.6 percent in 1995. This is in sharp contrast to most of the other transition economies in central and eastern Europe.18 19 The low levels of foreign direct investment are likely to be associated with a slow pace of introduction of new production methods and technologies, critical factors in raising productivity levels.

24. Among the most troubling signs are the data from the financial statements gathered by the Agency for Payments, Supervision, and Information (APPNI). According to these data, the enterprise sector as a whole has been operating in the red for the past several years. Data through 1995, however, initially gave a glimmer of hope as they appeared to indicate an improving situation relative to previous years, in that the excess of the losses over the profits was declining.20 Moreover, in 1995, expenses exceeded revenues by only SIT 567 million, a sharp drop from 1994, when expenses were more than SIT 15 billion in excess of revenues. However, figures for 1996 suggest that the problem of loss-making companies has, if anything, become more severe, with profitable enterprises accruing a net profit of only SIT 122 billion against loss-making enterprises’ net loss of SIT 182 billion (see Table 3).21 By area of activity, manufacturing firms accounted for almost 50 percent of the aggregate net loss. In some instances, enterprises underwent decapitalization—either through investing less than depreciation or through sales of assets—to pay current expenses. The discrepancy between expenses and revenues has also risen substantially, to more than SIT 42 billion. In terms of the number of enterprises, only about 60 percent of the companies were classified as profitable, with 21,729 enterprises operating profitably, and 11,205 operating at a loss.22 Moreover, the distressing business results for 1996 do not even include data from those enterprises which were in bankruptcy procedure.23

Table I-3.

Slovenia: Commercial Results24

(in millions of tolars)

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Source: Based on financial statements submitted to APPNI.
Table I-4.

Slovenia: Tradeoffs Among Privatization Routes for Large Firms

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Source: From The World Bank’s World Development Report 1996, “From Plan to Market”.

25. It is interesting to note the components of operating expenses which grew at the fastest rates between 1995 and 1996. While total expenses increased by 19 percent, depreciation surged by 32 percent. Salaries and wages (which were subject to regulation and to collective agreements), on the other hand, grew by only 16 percent, but other labor costs (holiday allowance, distress assistance, lunch allowances, awards, presents, etc.) increased by 25 percent, suggesting that this category of payment may have been used, to some extent, to bypass the restrictions on wage increases.

26. Data on company accounts frozen for more than 5 consecutive days provides another disturbing view of a worsening economic performance. The monthly average number of frozen company accounts grew to 6,230 in 1996,25 27 percent higher than the monthly average in the previous year. Moreover, almost 61 percent of the companies had their accounts frozen for more than a year.

27. Future competitiveness could be jeopardized in view of the apparently negligible progress in restructuring many of the larger enterprises.26 Although data show strong growth in investment, most of this investment has been concentrated in infrastructure, particularly in transport and telecommunications.27 Investment in industry and manufacturing has, on the other hand, been relatively sluggish. Moreover, most of the investment in the enterprise sector has been targeted toward reconstruction, renovation, and replacement of obsolete equipment rather than to the introduction of new technologies and new production facilities for expansion and innovation.

28. A primary aim of privatization is to transform the incentive structure underlying the enterprise sector to one which rewards efficiency, imposes financial discipline, creates a profit-oriented culture, and allows for the proper management of risk, all of which are critical for firms to compete effectively in a globalized market. Consider the four major methods of privatization used in transition economies—management-employee buyouts, equal-access voucher privatization, sale to outside investors, and spontaneous privatization.28 (Note that Slovenia’s program has included elements of all four of the above methods, but with the heaviest emphasis on management-employee buyouts). How does each of these methods fare with respect to the ultimate goals of a privatization program?

29. Each of the major approaches to privatization involves tradeoffs between political acceptability and economic efficiency. The following table clearly illustrates these tradeoffs:

30. As seen from the above matrix, Slovenia’s predominant privatization method—the management-employee buyout—excels only with respect to speed and feasibility. On all other counts, this method is expected to be less effective than most of the others (with, of course, the probable exception of spontaneous privatizations). In particular, the management-employee buyout is the only one of the four methods which is unambiguously classified as negative for corporate governance.29

31. Indeed, a recent study in Slovenia provides a first step toward confirming some of these hypotheses, although the conclusions are very preliminary since the data—the 1995 financial statements of more than 2,000 Slovene enterprises—are from a single year early on in the privatization process.30 In the study, firms are classified into one of six categories: (1) private enterprises which had not been privatized via the Law on Ownership Transformation; (2) enterprises which had majority foreign ownership; (3) enterprises which had been privatized primarily through management/employee buyout; (4) enterprises which had been privatized primarily via sales to outsiders; (5) state-owned enterprises performing public services or with a monopoly position; and (6) other nonprivatized enterprises. The analysis shows that net profits were generated on the whole by foreign-owned, privately-owned (category (1)), and state-owned firms, while externally-owned firms (category (4)) recorded a negligible net loss, and internally-owned (category (3)) and nonprivatized firms registered significant net losses. Moreover, the returns on equity indicate similar outcomes for the various categories, with privately-owned and foreign-owned firms achieving returns of 5.7 percent and 4.6 percent, respectively, in contrast to nonprivatized and internally-owned firms generating losses of -8.8 percent and -1.3 percent, respectively; state-owned and externally-owned firms had negligible returns on their equity.

32. Thus, in determining the course of privatization, Slovenia largely chose to diffuse the tension between promoting economic efficiency and rewarding the existing stakeholders (i.e., giving employees and managers a substantial share in ownership) by focusing on the latter. In fact, much of what passes for privatization to date in Slovenia is perhaps more correctly termed ownership transformation. This initial transfer of ownership is only a first step toward an “effective” privatization. The current dispersed ownership structure in most of Slovenia’s enterprises inhibits the accumulation of resources and know-how necessary so that the needed restructuring which should accompany privatization has largely failed to materialize. Although it is natural that the initial ownership patterns may be sub-optimal, a critical test of any privatization program is whether the capacity exists for these ownership patterns to evolve into more efficient forms. Thus, emphasis in Slovenia must now shift toward ensuring a rapid transition to an effective secondary trading process to allow for ownership concentration.

33. Pohl, Anderson, Claessens, and Djankov (1997) examine the evidence from seven transition economies—Bulgaria, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, and Slovenia—during the period 1992 to 1995 to determine which economic policies were most conducive to enterprise restructuring.31 They found that the following policies were positively correlated with restructuring: rapid privatization (independent of the approach to privatization); concentrated rather than dispersed ownership; forcing firms to face hard budget constraints; and restraining wage increases.32 Among the seven countries, however, Slovenia fared relatively poorly on some measures of restructuring. For example, while most of the countries saw increases in the percentage of profitable industrial firms, Slovenia’s percentage of profitable firms actually declined over the 4-year period, as shown in Table I-5. (On the other hand, the percentage of profitable firms in Slovenia is higher than that in the other comparator countries except for the Czech Republic and Hungary, but this largely reflects Slovenia’s strong starting point relative to the other countries.)

Table 5.

Slovenia: Industrial Firms Categorized by Profit or Loss

(percentage of firms weighted by employment)

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Source: Pohl, et al (1997), “Privatization and Restructuring in Central and Eastern Europe.”A = profitable; B = cannot cover depreciation; C = cannot service all debt; D = cannot pay all wages; E = cannot pay all suppliers.

34. On some of the other measures of restructuring examined by Pohl, et al., only Bulgaria and Romania had lower annual growth rates in both labor and total factor productivity than Slovenia, and only Romania had a lower export growth rate and level of investment per worker in privatized firms than Slovenia. With respect to wage restraint in privatized firms, real wage growth in Slovenian firms nearly absorbed all of the labor productivity gains, while in the other six countries, labor productivity growth outpaced real wage growth. This differential between labor productivity and real wage growth will likely play an important role in the ability of firms to restructure, since firms will may have to rely to a large extent on financing investment from retained earnings.

35. On an issue closely related to ownership concentration, Slovene officials frequently lament the lack of strategic investors, i.e., those investors with specialized knowledge of an industry who are willing and able to commit their own, often significant, financial resources to enterprise restructuring. Domestic investors are unlikely to have sufficient financial resources to undertake the necessary degree of enterprise restructuring and are also unlikely to choose to commit resources when ownership is highly dispersed. Nor are there likely to be many local investors with the requisite state-of-the-art, cutting-edge knowledge required to succeed in the global marketplace. Therefore, to overcome this scarcity of strategic investors, reform programs should focus on spurring the development of market institutions and the legal framework which can facilitate and accelerate this process, both through concentration of ownership and encouraging foreign investment.

36. Although there are reportedly no legal restrictions on foreign investment in most enterprises (some strategic areas like defense production still maintain some restrictions), the relatively low degree of foreign participation in the privatized enterprises reflects more an unwillingness on the part of domestic shareholders (particularly the insiders) to sell to foreign investors.33 34 Moreover, some Slovenian officials have expressed concerns about allowing greater foreign involvement in the enterprise sector, an attitude which was clearly demonstrated in the adverse reaction to a recent sale of a paper mill to a Czech company.35 Although it is acknowledged that foreign investors could be an important source of recapitalization, expertise, and new technology, it is also feared that foreigners would snap up the best Slovenian enterprises and ignore those most in need of restructuring. This atmosphere of xenophobia and widespread hostility to foreign investment has, therefore, been the key obstacle to foreign participation in the privatization process.36

37. Foreign investors remain cautious about investing in Slovenia, not only because of perceptions of a xenophobic attitude, but also because of gaps in legislation and a reluctance to disclose information. In addition, Slovenia has been suffering from occasional labor unrest over wages and benefits, which has frightened foreign investors, particularly in view of the large degree of insider ownership.

38. The importance of foreign direct investment is illustrated by a simple empirical exercise by the Institute for Macroeconomic Analysis and Development (IMAD).37 In the analysis, IMAD compared a variety of indicators in enterprises with foreign direct investment of more than 10 percent of capital and in all other enterprises. Using data from financial statements for 1995, IMAD found that, among other indicators, profits per employee were almost 3 times as high, exports per employee nearly 4 times as high, and profit per unit of capital more than 2 times as high in enterprises with foreign direct investment compared with all other enterprises. The differences are even more marked if the comparison is made with only those enterprises having a majority foreign interest.38 Of course, these differences may be at least partly attributable to the initial quality and/or the sectoral distribution of the enterprises in which foreigners have invested (i.e., cherry picking) rather than just to any beneficial impact of foreign investment. Moreover, no attempt was made to test for statistical significance of the results.

39. The presence of foreign investors often provides a demonstration effect for local investors, creating a virtuous circle of capital market development.39 Foreign investors also demand better disclosure, more information, and regulatory enforcement, leading to improved accounting standards, more competition among dealers and brokers, and better price discovery, all of which attracts domestic investors as the general climate for investment improves. Moreover, a growing theoretical literature suggests that stock market development boosts economic growth through the creation of liquidity.40 41 Since restructuring usually requires a long-term commitment of capital, many smaller investors may be hesitant to surrender control of their savings for extended periods. However, liquid equity markets allow investors to have quick and easy access to their savings and thereby make such investment projects less risky. In this manner, liquid and deep equity markets may encourage savings, improve the allocation of capital, and enhance the efficiency of production. In view of Slovenia’s slowdown in growth, sluggish efforts at restructuring, and relatively low levels of investment in the industrial sector, a key policy focus should be the removal of the impediments (described below) to deepening of the stock market. At the same time, however, it is also important to avoid the problems encountered in the Czech Republic (with more than 1,700 firms listed on the stock exchange, most of which are illiquid) by placing excessive emphasis on the stock market for solving the problems in the newly-privatized enterprise sector; the organized exchange is likely to be relevant primarily for the larger companies, while smaller companies’ shares might be better traded through the investment funds or over-the-counter.

40. A major obstacle to capital market development is the legislative or regulatory framework. Legislation on securities trading remains weak, with significant gaps remaining. In particular, legislation to regulate portfolio investment is inadequate (or even nonexistent). While the Foreign Investment Law (passed in 1988 prior to the breakup of the SFRY) provides rules for foreign direct investment, it fails to mention portfolio investment.42 Although there are no restrictions on foreign direct investment, it is portfolio investment that is more important for securities market development and deepening.

41. Both foreign and domestic investors are likely to remain reluctant to invest until the rules on portfolio investment are clear and transparent (for example, it is not clear whether foreign portfolio investors can repatriate their earnings).43 There is a new law being prepared to regulate this type of investment, but this law has been in preparation for more than 2 years. A quicker approach could be to add some by-laws on this area to the existing laws, which could be done by decree by either the Bank of Slovenia (BOS) or the Ministry of Finance. It is also critical to phase out the current restrictions on short-term capital inflows, but the government is likely to resist moving quickly on this issue given its perception that a small economy like Slovenia’s is vulnerable to speculative capital flows. An increase in capital inflows might, therefore, be viewed as an additional sterilization problem, a destabilizing force, or even a threat to corporate sovereignty, as opposed to recognizing their function in providing liquidity and smoothing fluctuations in the supply and demand for capital.

42. In this connection, in February 1997, the Bank of Slovenia ordered foreign investors to open custody accounts in one of 14 registered banks, effectively blocking foreign investment.44 This move was in reaction to concerns about the potentially destabilizing effects of large capital inflows, in the wake of a substantial increase in capital inflows from foreign portfolio investors in January 1997 (inflows in January alone were around DM 50 million, compared with DM 120 million for the whole of 1996). In the months following the imposition of the new restriction, the SBI index slumped by more than 20 percent and turnover on the bourse plunged to only a tenth of its previous level, with international investors absent from the market.

43. In late June 1997, however, the central bank decided to relax the requirement for foreign portfolio investors who hold their shares for at least seven years or who trade only among themselves. The SBI index was immediately driven higher as foreign investors returned en masse. With market sentiment buoyed by the change in rules, the SBI index continued to surge upward, regaining most of its losses by mid-August. In July, trading volume on the bourse rose to a record high, with securities worth almost $100 million sold, up 13.7 percent from February, the month in which the previous record turnover had been registered. Brokers estimated that foreign investors accounted for about 60 percent of the trading volume on the LSE. This illustrates the importance of an international presence for enhancing capital market liquidity.

44. Some Slovenian enterprises have decided to augment their listings on the LSE with issues of global depository receipts (GDRs), in part to look beyond the limited domestic market and bypass restrictions that might be imposed on foreign investment. SKB Banka was the first Slovene company to launch a GDR issue and be listed abroad on the London Stock Exchange.45 Other companies have been closely monitoring developments with the SKB listing, and it is expected that a number of them will follow suit with their own GDR issues.

45. Delays in completing the privatization process have also contributed to the slow pace of capital market development. However, another factor which has hindered the development of the capital market has been the BOS’ sterilization operations. The BOS has been issuing large amounts of relatively risk-free investment instruments with high rates of return which have been more attractive to investors than riskier equities or corporate bonds. The BOS places its instruments initially with the banking sector via auctions, but the banks are often purchasing on the orders of their customers. In addition, secondary trading of these bills occurs in the short-term trading section on the LSE. Savings have not been sufficient to support both the supply of the BOS bills as well as other securities.

46. Another inhibitor to deepening of the securities market is the asymmetric tax treatment accorded to dividends and interest payments. While interest on bank deposits is tax-free, dividends are effectively taxed twice—first, when corporate profits are taxed, and, second, when dividends are specifically taxed—discouraging the population from placing its savings in shares of capital. Moreover, although there will be no tax on capital gains from investments held for at least 3 years, there is a capital gains tax on shorter-term investments.46 47

47. Discussions on the issue of a potential stock overhang started even before privatization began. Fears about a possible stock market collapse were triggered by analytical papers which assumed—rather arbitrarily—that the entire available supply of shares would go onto the market at the same time, but that demand would be only about one third of this supply, with the consequent negative impact on share prices. Indeed, it is likely that people who receive shares (via vouchers) at no cost will behave quite differently than those who paid cash. Nevertheless, a survey conducted for the Agency for Privatization and Restructuring indicated that only a small proportion of shareholders would sell immediately, and, therefore, has allayed concerns since it suggests that the likelihood of a market collapse has been exaggerated.48 Furthermore, within the current framework, shares will be coming onto the exchanges at staggered times since internally-held shares cannot trade for 2 years after privatization, while stocks bought on credit (with a maximum financing period of 5 years) cannot be traded until the loan is repaid. To expedite the process of ownership consolidation and accelerate development of the equity market, the time restrictions on the trading of insider shares could be removed sooner than the current limits. In addition, those shares purchased with credit could be allowed to trade before the loan is conventionally repaid by allowing for simultaneous selling and use of the proceeds for the early repayment of the debt.

48. The initial stages of ownership consolidation are likely to be characterized by lumpy demand, but fragmented supply, with strategic investors interested only if they can acquire large blocks of shares, while the present dispersed ownership provides for small lots of shares on the supply side.49 In such circumstances, it may be ineffective to use transparent continuous auction trading, as some informational asymmetry may be needed to induce dealers to trade.50 If a continuous auction system is to be used, the time period for trading could be reduced to better aggregate thin orders, or a periodic batch system could be employed where the frequency of batch trading is as high as possible to enhance informational efficiency. Alternatively, a segmented market could be created—one for relatively liquid shares, organized as a continuous auction, and another for relatively illiquid shares which operates as a batch system.

49. Slovenia’s privatization investment funds were one of the most controversial issues in the privatization program and have so far proved to be a disappointment, with few such funds interested in taking an active approach to investment. These investment funds exist in a sort of netherworld—they are neither mutual funds nor venture capital funds, and their role in the privatization process remains unclear. The funds have thus been passive investors endowed with vouchers, but lacking the cash to pay their costs and earn their management fees. The Development Fund’s recent move to bundle shares for bidding by investment funds also dissipates incentives for active management. This only further dilutes the holdings of shares in a manner which encourages a passive approach to investing. Moreover, not only have the funds failed to provide the anticipated stimulus for restructuring, but, according to G. Gray (1996), the funds are often perceived today as hindering the restructuring process by blocking attempts, in some instances, to increase capital. In fact, according to Ellerman (1996a), the funds’ emphasis on dividend payouts from firms to the detriment of restructuring has earned them the reputation of being “disinvestment funds.”51

50. Another problem associated with the investment funds is that they have collected more vouchers than there is capital available to cover them, a development referred to as the “privatization hole.” The funds are expected to list on the OTC market of the LSE with the aim of increasing transparency in trading and allowing for greater regulatory control, but they are reportedly reluctant to list and have been using the issue of insufficient equity as an excuse to avoid taking the next step.52 Although the investment funds now trade on the grey market, the funds’ management companies have been the primary participants in such trading, as they attempt to consolidate control. International investors and small domestic investors, on the other hand, have difficulty accessing the grey market and have been largely absent.

51. On the positive side, Privatization Agency representatives claimed that corporate governance was beginning to improve in some enterprises, with supervisory boards, comprised of both inside and outside owners, starting to become strict with management and controlling cash flows. Moreover, in some cases, up to 60-70 percent of profits were being retained, and the percentage of retained profits is expected to increase as the ownership structure consolidates. Nevertheless, many new shareholders are uninformed regarding their new roles. In response, the government has initiated a campaign to teach shareholders about their rights and responsibilities.

52. Another positive development is that the newly privatized enterprises are, in general, no longer benefiting from soft budget constraints from either the state or the banks, and that, as in other market economies, most banks are willing to extend credit only to well-managed enterprises with good prospects.53 Thus, the problem of excessive wages, where it exists, is not likely to stem from soft budget constraints, but rather from the wrong type of “restructuring” via decapitalization, inter alia through excessive depreciation.

E. Improving Corporate Governance

53. Despite some exceptions among the privatized enterprises, a recurring theme among Slovenian officials and analysts was the general need to improve corporate governance (see Box I-4). This was seen as particularly critical for improving the competitiveness of Slovenia’s enterprise sector in the runup to membership in the European Union, particularly since privatization has failed to curb wage growth or to produce the expected efficiency gains.

54. What do the lessons of experience from other countries mean for Slovenia? As discussed above, the primary mechanism for ownership transformation in Slovenia has been the management-employee buyout. This mechanism for privatization was perhaps the most expedient and politically viable for Slovenia, in view of its social ownership inheritance, but it also implies that Slovenia has, in large part, not broken with the legacy of its past corporate structure. Employees, under the system of social ownership, had extensive powers to influence the management and decision-making process. This is unlikely to change in those privatized enterprises with majority insider ownership.54

The Principal-Agent Problem of Corporate Governance

The fundamental issue in corporate governance is the principal-agent problem, namely, the separation of ownership and control, or alternatively, the separation of risk-bearing and decision-making. According to this view, management (the agent) may not have the same interests as the owners (i.e., the principals or the shareholders) of a corporation. If, for example, managers decide to sharply increase their own compensation, this may depress share prices and is therefore not in the firm’s best interest, but the benefits of such an action accrue directly and immediately to management in the form of higher pay. Even if managers are also shareholders, they receive only a fraction of the benefits of actions which increase firm value, while the costs of irresponsible management (such as excessive pay increases) are not fully borne by management. Therefore, there need to be control mechanisms to induce management to act in the best interests of the owners.

There are various approaches to effective corporate governance. Effective governance can arise through either internal or external control mechanisms, or preferably through a combination of control mechanisms. Internal mechanisms might include monitoring by a board of directors or competition among managers within an enterprise, while external mechanisms could entail the use of proxy contests, the threat of takeover, or direct action by shareholders themselves. Control mechanisms for a given enterprise depend on a variety of factors, including, among others,:

  • the ownership structure of the enterprise,

  • the composition of the board of directors,

  • the existence of a liquid equity market, and

  • the presence of outside bidders.

55. With Slovenia’s large share of insider ownership, the agency problem could easily manifest itself in excessive wage and salary increases to labor and management as well as reluctance to shed labor in pursuit of productivity gains.55 Not only do inside owners fully benefit from wage increases while only receiving a fraction of the benefits from share price increases, but it is also likely that there would be differential discount rates between different types of owners. Insider owners (and, in general, those who received shares without any cash outlay) may have shorter horizons, which would imply wage pressures, while outside investors, who have bought the firm’s shares, may have longer horizons, implying a desire for reinvested profits to reinforce the firm’s future prospects.56

56. Outside investors may, therefore, fear that fresh financing could be expropriated by insiders in the form of excessive compensation and perks which provide personal utility to the insiders, but do not enhance the firm’s value. A collective wage agreement is only one means of addressing this problem, but past experience in Slovenia has shown that this may not always be an effective solution.57 There may also be a tendency to shift from explicitly paying higher wages to increasing other remuneration,58 since other remuneration is not so strictly regulated by the collective agreements. Other remuneration comprised 36.7 percent of net wages in 1994, rose to 39 percent in 1995, and increased further to 43.6 percent for the first five months of 1996.

57. The jury is still out as to which of the generalized models of corporate governance is more effective and, indeed, the effectiveness of a particular approach is heavily dependent on the specific attributes of the country (see Box I-5).59 For example, the role of takeovers in enforcing good corporate governance can have adverse effects if management acts in a myopic manner to increase the short-run share price at the expense of longer-run goals to reduce the probability of takeover. If investors are well-informed and rational and capital markets are efficient, there is no distinction between trying to raise an enterprise’s share price and boosting the enterprise’s long-term value. But in fledgling markets like Slovenia’s, such a distinction could have significant consequences. Similarly, the effectiveness of bankruptcy procedures for disciplining management has been undermined in certain cases in Slovenia, as some companies undergoing bankruptcy have established new companies which maintain much of the workforce (including management) and similar activities of the collapsing company. In addition, the enforcement role of domestic banks may have been undermined to some extent by the opening up of overseas sources of capital.

58. Until Slovenia’s stock market becomes deeper and more liquid and unless enterprises develop a change in attitude toward equity financing, most enterprises are likely to continue to rely on debt financing for the near future. Even more importantly, Slovenia seems to have a strong aversion to the concept of hostile takeovers,60 and the government is poised to enact legislative impediments to the takeover market, thereby closing the door on one channel to enhancing good corporate governance. A law on takeovers had been promised since 1994, but passage had been continually delayed despite pressure from enterprises to pass such legislation.61 Finally, after an extended period of controversy and debate, Slovenia passed its first takeover legislation in late July 1997.62 The law provides for the Securities Market Agency to oversee corporate acquisitions involving (a) more than 25 percent of shares of listed companies, (b) companies with more than SIT 1 billion in equity capital, or (c) companies with over 500 shareholders. The effect of this legislation on corporate governance remains to be seen.

Contrasting Approaches to Corporate Governance

The general approach to corporate governance tends to differ across countries, reflecting their cultural and historical values and traditions. Two of the most studied broad models for governance are the Anglo-American approach and the German/Japanese approach. In the Anglo-American model, emphasis is placed on liquidity in the stock market, which allows shareholders to monitor management by “voting with their feet.”1 In such a system, share prices act as a sort of barometer of managers’ performance. When a firm’s managers persistently perform poorly, share prices may fall below the potential valuation and induce an outsider to attempt a hostile takeover. After a takeover occurs, management is usually replaced with a team or individual acceptable to the new controlling owners. Thus, the threat of takeovers performs a valuable role in enforcing good corporate governance by allowing outsiders to oust the incumbent management. Importantly, the Anglo-American system is underpinned by strict insider-trading laws and by full disclosure requirements for shareholders.

The Anglo-American model provides a competitive threat to management via the takeover. Although maximizing contestability can be an effective approach to improving corporate governance, in this model it requires deep and liquid capital markets, and, as noted earlier, Slovenia has a long way to go on this account. In contrast to the Anglo-American model, however, the German/Japanese approach de-emphasizes liquidity and substitutes “relationship-based” shareholding. Shareholders often own large stakes in these firms and develop long-term relationships with the management. Moreover, these large shareholders are likely to be banks or other firms with business links to the enterprise in question.2 In view of the limited shareholder liquidity, these enterprises usually rely more on debt financing than on equity financing. In fact, those banks which own large shares of stock in such firms are often engaged in lending to them as well.

Thus, in contrast to the Anglo-American model in which liquid capital markets (and equity financing) lay a key role in corporate governance, banks (and debt financing) are at the core of the German/Japanese model. Different governance mechanisms are associated with debt and equity financing. Creditor rights are often easier to enforce than shareholder rights. Creditors may have the right to take assets if loans have been collateralized. Creditors can also throw an enterprise into bankruptcy procedures if it fails to pay its debts. Although bankruptcy may not directly help the creditor (since repossessing assets in bankruptcy can be very difficult), the threat of undergoing bankruptcy can be quite effective, especially since management usually gets fired.

1 The relatively high market capitalizations in the United States and the United Kingdom (where market capitalization actually exceeds GDP) are an indication that these countries use liquidity, in part, to enforce good corporate governance. Among transition economies, the Czech Republic has a high level of market capitalization, but this is somewhat illusory, since trading in many of the shares is illiquid or even nonexistent.2Bishop (1994) provides an interesting example of shareholding patterns between the two systems of overnance: while the five largest shareholders in General Motors own 9 percent of the firm, the five largest in Daimler-Benz hold 68 percent of the firm’s shares.

59. Generally, calls for individual shareholders to exercise their power through voting ring hollow unless such owners have a sufficient shareholding to be dominant.63 Enterprises with dispersed ownership also suffer from the free rider problem with respect to the monitoring of management. Any small shareholder who would spend his own resources on monitoring would incur all the costs of such action while providing a free benefit to all other shareholders. There is, therefore, little incentive to actively monitor in such circumstances. The presence of large institutional investors (such as pension funds or insurance funds), on the other hand, can sometimes reduce the free rider problem of inaction by shareholders. In practice, institutional investors do appear to have some influence on management and boards, particularly when they act in concert.64 Slovenia currently lacks any large institutional investors of the type described above, but pension system reform could accelerate the development of such investors, particularly if emphasis is placed on enhancing the role of private pension funds.

60. Even when all shares have identical voting rights, the share distribution can significantly alter effective voting rights. In Slovenia, this is a nontrivial issue, as G. Gray (1996) notes that “most companies have shareholder agreements whereby management and employees elect a proxy before the general meeting and vote their combined 60 percent stake as one block.65 In practice, this makes management power near absolute.” It is obvious that in such situations, the votes of minority shareholders are essentially rendered meaningless, and few outside investors would, therefore, want to stake a claim in those enterprises.

61. The problem of block voting by insiders in Slovenia is difficult to overcome. One suggestion has been to differentiate voting rights between shares purchased with one’s own finances and those acquired through vouchers. According to this approach, there would be different classes of common stocks with differential voting rights attached to each class. For example, shares purchased on the stock exchange could be designated as having a greater number of votes attached than those received through the voucher program.66 The distribution of voting versus cash flow rights on other than a one-to-one basis could prove very controversial to implement. Another strategy for diluting the near-absolute control of the majority insider-owners would be to introduce supermajority voting provisions. Supermajority voting usually requires that at least two thirds of shareholders approve certain measures. This approach could be more acceptable to implement.

62. Another important channel to improving corporate governance is through the supervisory board of directors. The supervisory board can serve a monitoring function which provides appropriate restraints on managerial discretion, thereby protecting the shareholders against management’s self-interest. In particular, the board should evaluate management’s performance and design incentive contracts for management; i.e, pay managers in stock options, or otherwise ensure that management pay is linked to specific enterprise performance goals. It is important, however, that the linkage of management compensation to results does not induce myopic behavior.67 To this effect, compensation should not be dependent upon short-term accounting performance, but rather should be tied to the market value of the firm. The board should also approve short-term operating plans as well as review long-range strategies.

63. The board is particularly important when the market for corporate control (i.e., the existence of a takeover threat) is restricted, as in Slovenia.68 During the ownership transformation process, workers councils, as firm control mechanisms, were presumably replaced with boards of directors. Although this would appear to be a move toward a market-oriented corporate structure, the supervisory boards in Slovenia often have 50 percent labor representation, and the other 50 percent is chosen by the owners, much of which is also labor. Moreover, labor directors are frequently on management boards. Thus, in effect, the boards often act as pseudo-workers councils and are unlikely to perform the monitoring function so crucial to effective corporate governance. In addition, workers councils remain strong, and labor unions and the workers they represent are afforded strong constitutional protections.

64. Slovenian enterprises must, therefore, take a number of steps to allow their supervisory boards of directors to perform the necessary governance role and reduce the potent influence of labor. For a board to be effective, it should be comprised, in large part, of outside directors who can act independently.69 Insiders, if present on the board, should comprise a small minority, and insiders should not be present on the board’s nominating, compensation, or auditing committees. In addition, interlocking directorships (managers who sit on each other’s boards) should be banned. Outside directors should also not be receiving consulting or legal fees from the enterprise, as this could affect independent decision-making. Limits should also be placed on the number of boards on which directors may sit.

65. Proxy contests, in which a dissident group of shareholders attempts to obtain representation on the board, should not be discouraged through excessive costs (often imposed through legislation) of mounting a proxy challenge. Empirical evidence suggests that the pressure placed by dissidents on incumbent board members (i.e., adversarial mutual monitoring) results in benefits that outweigh the costs. In this manner, proxy contests can perform a beneficial disciplinary role in improving corporate governance.70

66. However, board composition matters little if the board is not actively involved in strategic decisions. The board must have both the power and the incentive to be able to discipline management and/or transfer corporate control. To improve accountability to shareholders, effective incentive contracts must be designed for the board. Payment to the board members should be in the form of company stock, and each of the directors should hold a substantial amount of stock to help ensure that the managing board’s interests are aligned with those of other shareholders. Moreover, an independent governance committee should regularly assess the board’s performance, and directors should be up for election every year. Again, however, external control devices, like hostile takeovers, may be necessary when monitoring by the board is ineffective.

67. What should be the role of the privatization investment funds in the corporate governance of enterprises? Such funds were intended to function as intermediaries which could mitigate the governance problem of dispersed ownership in the privatized firms. To this effect, their potential roles in governance could be classified as passive (a portfolio management approach via the trading of companies’ shares in markets—like mutual funds in developed countries), active (through voting, involvement in boards, etc.), or restructuring (with participation in management decisions on types of restructuring measures to be taken—like venture capital funds or holding companies).71

68. However, in the case of Slovenia, the investment funds have failed to specifically take on any of the above roles. Before they can effectively participate in the corporate governance of enterprises, the problem of corporate governance of the funds must first be addressed. Currently, neither external nor internal controls ensure that the funds behave in a manner to optimize shareholders’ interests. External controls are largely lacking due to the absence of trading of the funds’ shares on an organized market, while the funds’ managers have apparently captured most of the voting rights, thereby eliminating shareholders’ internal controls. Thus, as a first step, efforts must be made to develop a regulatory framework and provide incentives for funds to list (or conversely, enact penalties for not listing) on the OTC of the LSE. In addition, the regulatory framework could encourage funds to consolidate their holdings in particular firms or groups of firms and, thereby, foster their interest in becoming active participants in the restructuring process. Moreover, much of the above discussion on improving corporate governance for enterprises also applies to the investment funds if shareholders are to regain their ability to monitor fund performance through both internal and external controls and if managers’ conflicts of interest are to be checked. Over time, with the appropriate regulatory environment and, in particular, tighter supervision, the investment funds should evolve into mutual funds, venture capital funds, or holding companies, each with clearly-defined and transparent objectives, and with the aim of providing a corporate governance solution for a diverse shareholder base.

F. Conclusions

69. The privatization program in Slovenia has followed a consensus-based and gradualist approach, shifting over time from a voluntary to a more coercive procedure to bring socially-owned companies into the private sphere. Slovenia’s impressive macroeconomic achievements to date could be jeopardized if this approach to privatization fails to improve efficiency and stave off a potential wave of bankruptcies and the consequent loss of employment opportunities. In addition, privatization of state-owned enterprises has yet to begin. While it is hoped that the accumulated experience form privatizing the socially-owned enterprises will be used to avoid the pitfalls that have plagued the first wave of privatization, it is also important to move forward quickly with this next stage of privatization.

70. Privatization has largely transformed ownership of previously socially-owned enterprises in a purely administrative sense, but has failed to bring in new owners from the outside or to produce a substantial change in the incentive structure for management. Progress in enterprise restructuring is seriously lagging, owing largely to the very diffuse ownership patterns and to the lack of strategic investors in most of the enterprises. The focus should now shift toward accelerating restructuring through ownership consolidation. To facilitate concentration of voting and decision-making power, it is critical to foster capital market development and to encourage foreign investment.

71. Although Slovenia’s high investment grade rating testifies to international confidence in the domestic economy, foreign direct investment in Slovenia remains relatively low. In addition to an inadequate legislative and regulatory base, among the most important reasons underlying this disappointing development may be the perceived hostile atmosphere to foreign investment, which, in turn, seems to reflect the Slovenes’ fear that foreign capital could overwhelm their small economy. Experience in Slovenia and in other countries, however, has shown that the benefits of attracting foreign investment go far beyond simply supplementing domestic savings. Foreign investment can trigger a virtuous circle which leads to a deepening of the capital market through encouraging domestic investment. Moreover, foreign interest may be critical to stimulating investment for expansion and innovation.

72. Many of the enterprises continue to be insider-dominated and operate little changed from the old social enterprise system. This has led to concerns about excessive wage growth, labor hoarding, eroding competitiveness, and, in general, the effectiveness of corporate governance. The exchange rate should not be used as a primary instrument to improve competitiveness, as depreciation could have an adverse effect on corporate governance through a weakening of financial discipline at the enterprise level.72 Instead, intensive effort must be placed on improving the external and internal control mechanisms to achieve good corporate governance, not only at the enterprise level, but also within the privatization investment funds, which have failed to live up to expectations. To this effect, capital market development again plays a key role, but the legislative and regulatory framework under which the enterprises operate must also be substantially improved. In addition, the excessive labor influence on the boards of directors must be significantly reduced.

73. High real domestic interest rates continue to hamper industrial recovery. The excessively high bank lending rates have also discouraged new investment and restructuring and have induced enterprises to seek funds abroad. Thus, another important measure would be to create a more competitive banking sector by adopting the draft banking law and accelerating the process of bank privatization. This year has already seen several mergers in the banking sector, as banks have begun to prepare for tougher foreign competition in anticipation of the new banking law.

74. The present period of reform presents not only a challenge, but also a unique opportunity to enact the measures necessary to facilitate the emergence of a structure of corporate governance which could place the country well in the top ranks of competitive economies. It is especially crucial to capitalize on the momentum of transition to realize the country’s outstanding potential and to avoid lapsing into the sluggish and languid pace of change that characterizes many of the more established market-oriented economies. The Slovenian parliament’s ratification of the EU Association Agreement and the European Commission’s recent decision to invite Slovenia to join the EU enlargement talks should spur the government to move forward with the remaining reforms needed to bring Slovenia’s economy in line with EU standards.

75. Thus, Slovenia now faces the critical test of whether its newly-privatized enterprise sector can effectively survive and prosper in a competitive global market, so that the “two-horse cart” can reach its destination with most of its bottles of wine intact.

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1

Prepared by Nancy Wagner.

3

Central European (1996a) describes the opposing views regarding the implementation of Slovenia’s privatization program. The then-Minister of Economics, who preferred a gradual decentralized approach, reportedly resigned in protest over the advice to implement a mass privatization program, as advocated by Jeffrey Sachs. See also Murrell (1995).

4

The Law was amended subsequently and made more mandatory to accelerate the privatization process.

5

Government officials are correct to point out that privatization is a general process which embraces not only the socially- and state-owned enterprises through ownership transfer to private hands, but also promotes private entrepreneurship through the creation and establishment of new private enterprises. Indeed, as of end-1996, there were more than 35,000 commercial enterprises in Slovenia, of which more than 90 percent were privately-owned. Most of these privately-owned enterprises, however, are very small, employing less than a quarter of the employed and producing less than a third of total revenues.

6

The Compensation Fund provides payment for restitution to previous owners and their heirs in cases where property cannot be returned in kind.

7

More than 100 of the largest companies included public share issues as part of their privatization programs.

8

The total estimated value of shares on offer at the fifth auction was SIT 20-22 billion (based on the firms’ valuations as of January 1, 1993), while the estimated value of the shares withdrawn was SIT 7 billion.

9

The offer (and the tender price) at the December tender was SIT 18.4 billion ($130.5 million).

10

As a result of the delay in privatizing state-owned assets, the share of the private sector in GDP is less than 45 percent.

11

The largest bank, Nova Ljubljanska Banka, has been undergoing rehabilitation since January 1993 in preparation for its privatization. Its rehabilitation is now completed, and the government must now decide on the specifics for its privatization, in particular, whether to allocate some of its equity to the investment funds and whether to allow foreign participation. See Central European (1997a) and Slovenia Weekly (1997c).

12

The issue of whether to privatize the Lipica horse farm was brought before Parliament in early 1996. The Parliament, after determining that privatization of the farm would likely result in a sell-off of the horses, declared the Lipizzaner horses and the stables as Slovenian national treasures, and, therefore, as a government official noted, “horses are on the state budget.” The tourist hotels associated with the horse farm have, however, been privatized.

13

Luka Koper port debuted on the Ljubljana Stock Exchange (LSE) in late November 1996. As noted above, the government still owns 51 percent; 33.3 percent of the port’s equity was listed on the exchange. Although foreign interest in the shares is reportedly high, the government has not yet approved foreign purchases of the stock.

14

In establishing the institutional framework for the next stage of privatization, the government recently created the Slovene Development Corporation and is expected to soon dissolve the Privatization Agency and the Banking Rehabilitation Agency.

15

Tables I-1 and I-2 are based on data provided by APPNI during the September 1997 and 1996 Article IV Consultations, respectively. As of September 1996, 1,254 privatization programs had been approved.

16

As of mid-June 1997, some 12 percent of Slovenians had not yet used their vouchers (worth about SIT 67 billion).

17

According to a Slovenian official, foreign investors have been favorably impressed with Slovenia, citing, as an example, a comment that “Slovenia produces with 90 percent of Germany’s quality at 70 percent of Germany’s costs.” Despite this favorable assessment, International Financing Review (1996) reports that “Slovenia has the dubious distinction of having attracted the smallest amount of FDI funds in Eastern Europe during the first quarter…. In the league tables of cumulative FDI since the switch to a market economy, only Bulgaria has fared worse than Slovenia’s US$614 million.”

19

The low levels of foreign direct investment may also be partly attributed to the delays in privatizing state-owned assets.

20

Slovenian Business Report (1996), in an article entitled “A Final Accounting—For Now,” describes the situation as “an upward spiral within a downward trend.”

21

Although APPNI claims that Slovenian accounting standards are approaching EU levels, it is, nevertheless, difficult to assess how much of this apparently dire business situation is due to creative accounting, tax avoidance via generous depreciation allowances, investment tax credits, coverage, etc. As compared to a statutory tax rate of 25 percent, the corporate income tax yields only 7-8 percent. On the other hand, at 17 percent, capital depreciation does appear to constitute an unusually large percentage of GDP.

22

Companies recording a net loss accounted for 34 percent of the workforce of those companies which submitted data.

23

As of end-1996, 509 companies were in bankruptcy procedures, up from 402 at end-1995.

24

Data for 1995 and 1996 were supplied by 33,609 companies and 35,786 companies, respectively. The jump in the number of companies reporting in 1996 is primarily attributed to better coverage of reporting, rather than to a sharp increase in the number of legal entities.

25

These companies employ about 22 percent to the workforce.

26

The European Commission (EC), in issuing its opinion in July 1997 on Slovenia’s fitness to start EU membership talks, echoed these sentiments. After praising Slovenia’s significant achievements in the macroeconomic arena, the EC added, “… enterprise restructuring has been slow due to the consensual character of economic decision-making, and the incentives of workers and managers to preserve the status quo. Improvements in competitiveness have been hampered by rapid wage growth combined with low productivity growth. The low level of foreign direct investment reflects these structural problems, which need to be tackled.”

27

According to Central European (1996b), foreign investment represents only 2.5 percent of investment in the Slovene economy.

28

Spontaneous privatization is a process in which state-owned or socially-owned assets or income flows are seized or otherwise (often illegally) transferred to the incumbent management or other insiders, in response to ambiguously-defined property rights or to excessive delays in implementing privatization programs.

29

For a proper assessment of the effectiveness of the privatization approaches, it would be helpful to have data disaggregated by size of firm, since the management-employee buyout is not necessarily negative in the case of small companies. In such cases, merely forcing firms to face hard budget constraints and strengthening the mechanisms to allow enterprises to exit (i.e., bankruptcy or liquidation) could be sufficient to ensure a move toward good corporate governance.

30

Institute of Macroeconomic Analysis and Development, “Ownership Structure and Performance of Slovenian Nonfinancial Corporate Sector” Ljubljana, Slovenia, May 1997.

31

They employ several measures of restructuring, including: profitability, operating cash flow, labor productivity growth, total factor productivity growth, and export growth.

32

In addition, the data also suggested that enterprises with ownership and lending ties to banks had restructured more than other firms, indicating that banks may be effective monitors of management performance, and that this monitoring role outweighs the potential conflicts of interest inherent in such arrangements. Such banks—in their dual roles as both lender and owner—would have strong incentives to ensure that the firm would become profitable.

33

Outside observers apparently also interpret this unwillingness to sell to foreign investors from a broader perspective. For example, in the September 1996 issue of Euromoney, Gray writes, “Unlike the rest of eastern Europe, Slovenia rejected the notion that multinational investment was a prerequisite for restructuring,”

34

It is hoped that this situation may change in the future as insider owners retire or leave the enterprises.

35

The sale, which apparently did not violate any laws on foreign investment, was nevertheless contested in a series of battles in the Slovene court system. See Central European (1996b).

36

In fact, according to some observers, foreign investment is almost perceived as foreign invasion. On a positive note, however, the government has introduced a new bill which will liberalize foreign direct investment and eliminate the need for government approval.

37

Institute of Macroeconomic Analysis and Development “Foreign Direct Investment in Slovenia: Trends, Experiences, and Policy”, Ljubljana, Slovenia, May 1997. See also Slovenia Weekly, September 14, 1996; Slovenian Economic Mirror, 1996 for a similar analysis using data from 1994 financial statements.

38

The ratios would obviously be higher if enterprises with majority foreign investment were compared only with those without such investment.

39

As one broker on the Ljubljana bourse explained, “A lot depends on international investors as domestic buyers are much more active when they know foreign demand is high.”

40

Demirgüç-Kunt and Levine (1996) review the theoretical literature on stock market development and economic growth. Levine and Zervos (1996) also provide empirical evidence that stock market development is positively (and robustly) associated with long-run economic growth.

41

Ellerman (1996b) notes that nearly all of the shares in the Pension, Compensation, and Investment Funds in Slovenia are relatively illiquid. Moreover, there appears to be a basic misconception in Slovenia about the reasons for this problem. In particular, rather than focusing on the fundamental reasons for share illiquidity, there seems to be the mistaken belief that throwing more cash into the stock market will necessarily increase its liquidity.

42

For the time being, investment in equities is treated by analogy under the law. By contrast, investment in debt instruments is governed by the provisions of the Foreign Exchange Law. Foreign investors must currently register every domestic transaction in debt instruments with the BOS, while share transactions involving nonresidents must be registered with commercial courts. This can be a time-consuming process which is likely to discourage portfolio investors.

43

As of end-September 1996, the International Finance Corporation (IFC) included the Slovenian stock exchange as one of the “frontier” markets to be covered on a weekly basis. This should eventually lead to inclusion in the IFC’s global equity index, which is monitored on a daily basis. Past experience has shown that the IFC’s inclusion of an emerging stock market in its global equity index helps to boost foreign portfolio demand.

44

The banks estimated the cost of the accounts at about 12 percent of the amounts handled, a significant deterrent to investors from abroad.

45

See Central European, 1997b.

46

The taxation of capital gains, at 25 percent, took effect for individual shareholders on January 1, 1997 and may constitute a further disincentive to the development of Slovenia’s fledgling capital markets. Corporate shareholders had already been subject to the capital gains tax. Note, however, that the sale of privatization shares is exempt from this tax.

47

There is currently a 0.1 percent transactions tax on sales of securities, but this tax was seen as so marginal as to have a negligible impact on investment decisions. Thus, it is also unlikely that this tax would negatively affect capital market development, although it could be a problem for very short-term money market instruments or very high-frequency trading.

48

According to the survey, 5 percent have already sold their shares, a little over 5 percent intend to sell their shares in the near future, while about 35 percent claim to have no intention to sell.

49

Ellerman (1996b) briefly discusses the need for the appropriate sequencing of attracting strategic investors versus portfolio investors, noting that experience has indicated that strategic investment should precede portfolio investment, where possible.

50

Evidence from Russia (where the privatization program produced similar dispersed ownership structures with substantial insider domination) supports this conclusion.

51

Ellerman notes that some Slovene funds have even taken firms to court in an effort to force the firms to pay out more in dividends.

52

The government recently adopted a law in which it pledged to cover the privatization hole with its own assets.

53

This was not necessarily the case in the recent past, when the socially-owned enterprises were often the major owners of the banks. Such arrangements limited the capacity of the banks to exert financial discipline in the allocation of credit and could give rise to “insider” lending, which contributed to serious weaknesses in the banking system. See Pleskovic and Sachs (199?). The draft banking law, which is currently under consideration, also places ceilings on enterprise ownership of banks to ensure that any remaining risks of moral hazard are limited.

54

Mrčela (1996), in discussing Slovenia’s new ownership structure, clearly presents the perceived conflict of interests between insider and outsider shareholders: “outsiders are afraid that insiders will try to extract profits through higher salaries, and insiders, on the other hand, are scared that outsiders will try to draw profits out through dividends.”

55

If there were 100 percent management-employee buyout of shares, then the agency problem between insider and outsider owners does not exist since there is a complete aligning of ownership and control interests. Minority insider ownership, on the other hand, can provide significant benefits to the enterprise by inducing employees to focus more on maximizing the firm’s value, while largely eliminating their ability to directly control their compensation at the expense of firm value.

56

Transition to a market-oriented economy also seems to result in initial push for consumerism at the expense of long-term goals.

57

The data through October 1996 showed that gross hourly wages had increased by an annualized 17.9 percent, yielding a real wage increase of more than 7 percent, which significantly exceeds productivity gains.

58

The category of payments to workers referred to as “other remuneration” is comprised of a wide range of payments, including some intermediate consumption like business and travel expenses which should not be classified as personal income. Many of the types of payments included in this category, however, should be properly classified as income, such as payments for contractual work, temporary work, research, internships, commuter expenses, food allowances, vacation allowances, retirement bonuses, remote location supplements, and solidarity help (for distressed workers).

59

An important distinction between the Anglo-American and German/Japanese management models (as described in Box 5) is the emphasis on shareholders (and hence maximization of firm value) versus stakeholders (which includes not only shareholders, but also employees, creditors, suppliers, and customers), respectively. The concept of social ownership, which is Slovenia’s cultural and historical legacy, is implicitly a version of the stakeholder philosophy.

61

For example, pharmaceutical company Lek hesitated to begin trading on the LSE, declaring that passage of a takeover law was a critical condition for listing. Nevertheless, Lek listed on the LSE in September 1996 before the takeover law was passed, but only after it amended its statutes to place a cap on the maximum voting power of any given shareholder. Other companies have also followed suit.

62

The State Council initially vetoed the legislation in early July, arguing that it put small shareholders at a disadvantage.

63

It is also important to recognize that the initial impact of listing a company on the stock market may actually exacerbate the problem of diffuse ownership and passive investors.

64

Of course, this assumes that the interests of institutional investors are reasonably homogeneous. However, interests, risk profiles, and horizons of pension funds could be quite different from those of mutual funds or insurance funds.

65

Twenty percent from internal distribution plus 40 percent from internal buyout under preferential terms.

66

In general, shares with superior voting rights sell at a premium.

67

Myopic management behavior can also ensue from improper assessments by a board of directors (i.e., if management is removed because a good long-term strategy translates into poor performance of short-run indicators.)

69

According to a study by Weisbach (1988), insider- and outsider-dominated boards behave significantly differently in terms of monitoring management, with outsider-domination much more likely to result in removal of top management in response to poor company performance (measured in terms of share returns or accounting earnings changes). Moreover, further analysis indicates that replacement of management by outsider-dominated boards increases the firms’ values.