Privatization in Transition Economies

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I. The Reform of Enterprises

1. Enterprises under Central Planning

a) Size of enterprises– larger on average

b) Objectives of management– to meet plan targets

c) Marketing and sales efforts– central planning economies were characterized by excess demand and

each firm’s customers were defined by planners. Little efforts were paid to sales effort, mkt research, prod improvement or customer satisfaction

d) Lack of export orientation– enterprises were isolated from export mkts

e) Provision of ancillary services, such as housing, health services, childcare

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2. The first step of enterprise reform is Corporatization • creation of a corporate type of structure in industrial enterprises; corporatization is

distinct from privatization, which involves placing the ownership of the enterprise outside the public sector, but it is step in that direction. a) Creating independent management– Under centralized planning not only is management appointed by politicians but it is

directly accountable to them. Managers were appointed on political criteria rather than ability

b) Defining the goals of the enterprise– The objective of the enterprise must be clearly defined. If private ownership is an

objective, the only consistent goal is to max of profitsc) Separating ancillary services from the productive enterprise– Separating the provision of social services from the function of producing goods.

d) Establishing a realistic accounting system – that will enable potential investors to judge the financial viability and prospects of the

firm.e) Providing incentives to management and workers– A final desirable step of the process of corporation is to look to the structure of

incentives within the enterprise; new incentives to encourage hard work, innovation.Corporatization involves the consolidation of the enterprise’s assets and the creation

of balance sheet for it. It must precede privatization so that the potential owners know what they will own.

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3. Privatization– transferring the property rights from the state to the private owners

Desirable characteristics of a privatization program

a) Rapidity

the stock of assets to be transferred to the private sector in the former socialist countries is large. The creation of mkt economy requires tangible progress, and the process must be completed within a foreseeable period of time.

b) Improved enterprise governance

the change in property rights must improve the governance of enterprises; new ways of tackling the principle-agent problem

c) Fairness

the process of privatization should be seen as fair and leading to the betterment of those who contributed to capital accumulation

d) Gaining the support of powerful interests—the existing elite and the present “shareholders” in the economy because without the support of powerful interests both political and econ reform may be aborted.

e) Privatization should help facilitating the inflow of new capital, technology and management skills.

f) Sustaining and supporting the liberalization program 4

II. Privatization in TransitionPrivatization in transition economies is often justified on the grounds

of increasing efficiency.

1. Sources of inefficiency under planning• Why are state-owned firms inefficient? Several views:

– Government is the problem• The state forces the enterprises to do things that it would prefer not to

do, such as to employ too many workers. If freed of state control, the enterprises would move to more efficient use of resources.

– Agency is the problem• Directors do not have incentives to act efficiently. If they are given more

discretion they will use this to enhance their own positions, but not necessarily to use resources more efficiently.

– Dynamic efficiency is a problem• The major problem is not that enterprises use resources inefficiently, so

much as they are unable to induce technical change and econ growth. They are static and not dynamic.

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2. Problems

While in mkt econ privatization is feasible and easier to achieve, major difficulties in the privatization in transition has been: – need for clear system of property rights

• Property rights are difficult to identify. State claims to property were largely a result of confiscation (recent in CEE, as opposed to the FSU). In mkt econ the product to be privatized is easily identified, and most privatization is not mass but selective.

– need for legal system e.g. to enforce contracts• Absence of legal framework made it hard to define prop rights. Much

of the legal infrastructure such as ability to develop, sign and enforce contracts was largely absent at the beginning of transition

– absence of well-developed capital markets• Major problem for the implementation of privatization during the early

years of transition– valuing enterprise assets

• in transition economies where no mkts exist at the beginning is difficult to establish mkt value of enterprises when legal and accounting rules are weak.

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III. Stages of Privatization in Transition

Process implemented by a state privatization agency, e.g. Germany Truehandstald

1. Develop a legal framework

2. Identify properties

3. Create a corporate structure and distribute corporate shares

4. Sale of propertyIn some cases implementing the 4 stages was very problematic. The nature of existing

SOE made the process of privatization difficult. The issue of valuation is important during the early transition, e.g. if a firm to be sold in a market economy, how to establish market value. In transition no markets, legal and accounting rules weak, transparency in evaluation would be impossible to achieve.

Constraints:

Absence of purchasing power

Limited foreign investments

Suppressed entrepreneurial spirit7

IV. The Privatization Process

1.Techniques of privatization/mechanisms for transferring property rights

– Restitution • to restore property rights to the original owners

– The resultant ownership structure would be fair and lead to better governance. However, restitution is not useful in the majority of circumstances, especially in the case of medium and large scale enterprises, because the current firm have not identifiable prior owner.

– Direct sale• to people not associated w/ the enterprise being privatized (outsider

privatization);

– shortage of capital and underdeveloped capital mkts; prices are arbitrary giving the appearance of corruption;

– foreign investors—capital, technology, modern management

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• to those working in the particular enterprise (insider privatization);

– Advantages

» support transition,

» workers shareholders

» increased productivity and efficiency

– Drawbacks

» neither workers nor the managers have access to substantial finances and cannot pay realistic prices, little revenue

» inequality—workers in the best firms gain most; within firm, managers are able to negotiate/seize a larger share of assets at low prices

» little to attract new capital, new technology, or new management. Therefore, a prime econ objective of privatization-placing assets in the hands of those most able to max value is not fulfilled.

• Germany, Hungary

– Foreign investments played a key role.

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– Initial Public Offerings• Enterprises can be sold for realistic amount of money, which will increase

the revenue for the government, but firms must have realistic evaluation.

• IPOs are slow path for privatization b/c each enterprise must be individually prepared and the public informed and educated about the company

• IPOs are not practically useful for transition countries.

• The most compelling reason for rapid privatization is simply scale. In Poland, for example, the largest 500 enterprises employ about 40% of the workforce and produce about 68% of net income. If privatization is undertaken via IPOs at the pace putsued in Great Britain in the 1980’s, about 5 companies a year, the process would take hundred years. Hence, it is imperative that more rapid method of privatization is found.

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– Issue of vouchers (mass privatization) and rapid privatization • Distribution of vouchers to be used for the purchase of shares rather than

direct sale. The nominal value of the vouchers is equal to the book value of the assets to be privatized.

• Advantageous in absence of purchasing power to buy shares but does not provide working capital

• The voucher privatization overcomes the problems of unfairness, the shortage of domestic capital and the difficulty of placing value on assets. Because it is a rapid process, stimulates the development of mkt institutions, and creates new owners.

• The main problem is that the ownership becomes widely disbursed, diminishing effective governance.

– When a firm is divided among many owners, no single one feels a strong incentive to invest time and resources in supervising management. Management is often free to act in its own interests, providing less incentives for efficiency.

– To avoid this problem several countries developed investment funds (intermediaries b/w citizens and enterprises.) The fund pooled the vouchers & then invest in enterprises. They had the power to effectively supervise the management.

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• Used by Russia: – vouchers with face value of 10,000 rubles distributed to everyone in 1993; vouchers

could be exchanged for shares or sold in a secondary market. • Insider privatization emerged

– small numbers of former managers, party members, etc. gained control.• Russia and Czech republic

V. Privatization in Transition: Assessing the Results1. Degree of Privatization-significant

– The pace of privatization has differed widely among transition economies:• Private sector share of regional GDP increased from 10% in 1989 to 55 % in

1995. Most aggressive programs in East-Central Europe, the Baltic states, Russia, and Albania. Least aggressive in Belarus, Turkmenistan, and Uzbekistan.

• The development of private economic activity has generally been most rapid in the small business sector.

• The privatization of large-scale enterprises lags behind.– The fundamental objective of creating new property rights is to change the

nature of decision-making arrangements in the newly privatized enterprises and organizations, therefore to change recourse allocation to improve efficiency.

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2. Restructuring

– Restructuring is a change in corporate governance and it is a critical outcome of the privatization process. Restructuring policies implied closing unprofitable firms, laying off workers; organizing the production process as a whole, recapitalizing the firms, changing resource allocation.

– Indicators of restructuring:

• efficiency indicators (real sales per employee)

• indicators of the effectiveness of the financial markets (percentage of working capital raised in financial markets)

• performance indicators-profitability, dividends per share, changes in levels of employment.

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3. Has privatization yielded the expected benefits?– Empirical studies have examined the impact of privatization at

the enterprise level, using various measures of enterprise performance and restructuring, such as changes in the workforce, revenue growth, profitability, and productivity.

– Conclusions:• In CEE and the Baltic countries, privatized firms have generally

restructured more quickly and performed better than comparable firms that remained in state ownership.

• Privatization has often failed to boost restructuring and better performance of enterprises in most of the CIS, partly as a result of the poor corporate governance in many privatized firms and persistence of “soft budget constraints,” including implicit subsidies from the state.

• The best performers have been firms that were acquired by foreign strategic investors; firms with concentrated ownership have generally performed better than firms with dispersed ownership.

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• The method of privatization has been important for the speed and perceived equity of the process. Many countries applied a combination of methods; there has not been a clear relationship between privatization method and post-privatization ownership & restructuring.

– Therefore, privatization has not always been effective in enterprise restructuring

– Private ownership alone is not sufficient to make firms efficient.– Complementary conditions are required to make privatization

lead to effective restructuring.• Hard budget constraints and competition.

– phasing out implicit subsidies– opening up of international trade – reducing bureaucratic hurdles to entry – tightening payment discipline– improving bankruptcy procedures – promoting a healthy financial sector

• Effective legal framework and secure property rights.17