Reassessing Privatization in Eastern Europe

Juan J. Buttari

This paper looks at how far privatization has advanced in the former communist countries in Europe, how privatization has been achieved, and the issue of how privatization has affected the efficiency of firms -- i.e., firm restructuring. The discussion is based on a partial review of the literature during the last two years.

Now, while these changes are dramatic, as advanced above, they do not necessarily reflect the impact of transferring firms from the public to the private sector. The situation varies among the countries. Accordingly, in the Czech Republic, where privatization was accomplished relatively fast, the impact of privatizing state-owned firms may have been a main factor. In contrast, in the other three countries, especially in Poland, where privatization took place at a slower pace, the importance of the private sector mainly reflects the creation of new private firms.

A second noteworthy point is that a significant amount of privatization has yet to occur. Thus, state ownership is still important in industry (especially in natural monopoly industries), in much of finance, agriculture, and real estate -- both commercial and housing.

What have been the main approaches to privatization? What are the prevalent views regarding their specific impact on privatization objectives?

Although three main methods have been used in privatizing medium size and large firms, the importance of specific privatization methods has differed across countries. Moreover, to assess impact one has to take into account the objectives behind privatization. In general, these have been:

• Increasing efficiency of asset use through better corporate governance.
• Creating political support for a market economy thus creating a barrier to a potential return to communism - - a factor in Russia's privatization approach.
• Depoliticizing firms by cutting links to the state -- an important factor in the Czech Republic.
• Increase firms' access to new capital and expertise -- an explicit objective in Estonia.
• Raising government revenues -- very important in Hungary.
• Achieve a "fairer" distribution of assets -- Poland is an example.

Nonetheless, it is pertinent to underline, that "increased efficiency" is by far the most relevant objective. In a way, all the others contribute to it or, as in the case of raising government revenues, are affected by how well increased overall efficiency in the economy is achieved. The three main methods for privatizing large and medium size enterprises have been:

• Sales to outsiders

The reference being to persons or entities who are neither employees, managers, or relatives of employees or managers, of the enterprises to be privatized. Sales may be: negotiated enterprise-by-enterprise (Hungary has made extensive use of this approach); by multi-enterprise tender whereby several enterprises are offered for sale as a single package (used by Estonia, Germany, and Latvia, for example); or through a public offering of shares (has been used in Poland and in Hungary).

In principle, direct sales to outsiders improves corporate governance, helps increase access to new capital and skills, and raises government revenues. The disadvantage has been that, due to difficulty in evaluating firms, negotiation, and follow up, it is a slower costly process, and may be perceived as unfair, as not everybody can enter into the negotiations. In fact, because of these factors, coupled with lack of domestic capital, and reluctance to sell to foreigners, it has been relatively little used.

The countries which have made most use of this method are: Germany, Hungary, and Estonia. On the other hand, relying on initial public offerings has not been an effective tool due to the underdevelopment of stock exchanges.

• Management and/or employee buyout (also referred to as insider buyout)

The main advantage is that it is faster and relatively easy to do. However, on the downside, by and large, it is not regarded as leading to better corporate governance, increase in new capital, skills or government revenues.

Another disadvantage is that it entails an element of arbitrariness and unfairness -- a worker loses or gains depending on whether he happens to be in a "bad" or "good" firm. Moreover, use of this method may block further reforms if insiders prevent access to ownership by outsiders (who would bring new capital and skills) or the latter are reluctant to invest (because of insider control).

While these are the prevailing perceptions regarding insiders buyout, the empirical record, nonetheless, is non-conclusive. For instance, Anderson, Djankov and Pohl analyzed the impact of privatization on firm restructuring in seven Central and Eastern European countries. They used several measures of restructuring, but their main measures were labor and total factor productivity. The essence of their approach is that they regressed these variables on government policies that included different methods to privatize. Surprisingly, they found that the impact on firm restructuring did not differ significantly across privatization methods.

One should note that, the other most frequently approach used, "equal access" voucher programs (see below), may de facto become management-employee buyouts, if managers, employees, and their families use the vouchers and other resources to buy stakes in their own companies (as in Lithuania). A fortiori, voucher programs which give preferential access to managers and employees are also de facto insider buyouts - -Russia is an example.

• Privatization through vouchers
  

1. may entail "equal access" or "preferential access". Equal access means that all citizens have the same access or opportunity to use the vouchers in any company (or investment fund), that the vouchers given to all citizens have the same buying power, and that no group has a preferential claim on any asset -- including managers or workers of specific enterprises. Alternatively, preferential access means just that: some groups are given more access, buying power, or preferential claim to specific assets.
   
2. 
   
3. access voucher privatization is fast and, in principle, perceived as fair. However, it may not result in more government revenues, and may not lead to better corporate governance or access to new capital and skills.
   
4. Nonetheless, it is one of the most used methods - - the approach has been heavily used in the former Czechoslovakia and Lithuania. However, many other countries have tried to implement this approach, although explicitly rejected by Hungary and the FYR of Macedonia. As advanced above, the approach can rely (but doesn't have to) on intermediary investment funds that pool vouchers and invest them in specific companies.
   
5. Czech mass privatization program through equal access vouchers is regarded as successful in that it transferred some 70 percent of the Czech economy to the private sector in a relatively short period of time, and that it seems to have had an overall positive impact on firm restructuring. The latter point, however, is open to question.
   
   1. essentials of the Czech program were as follows. All adult citizens became entitled to buy vouchers for a nominal fee (equivalent to about US$33.00 per book of vouchers). The vouchers could be used to bid for shares of the companies being privatized in share auctions which took place from late 1991 to October 1994. Each voucher was worth a number of investment points.
6. Alternatively, the citizens could exchange their vouchers for shares of financial intermediaries called investment funds, which in turn used the vouchers and own resources to bid for the enterprises' shares. The funds were managed by ad hoc management companies established by domestic or foreign institutions (e.g., banks or corporations) and individuals. The management company managed the fund for a fee, and the shareholders of the fund were the citizens who exchanged their vouchers for fund shares, or individuals who bought fund shares in the secondary market.
   
7. the program was launched in 1991 there was concern that it would lead to diffuse ownership and poor oversight of management. In fact, it turned out that, while many funds were created, a few bank-sponsored funds were able to acquire some 70 percent of the vouchers. Accordingly, far from diffuse ownership, this resulted in a relatively concentrated ownership of firms which, in principle, would lead to better corporate governance. An empirical analysis by Claesssens, Djankov, and Pohl seems to support that conclusion.
   
8. However, while acknowledging the agility of the approach in leading to mass privatization, the close relationship of the Czech funds with the banking sector, has given rise to doubts regarding whether the shareholders (i.e., basically the former voucher owners) have been hurt by sweetheart deals between the banks, the funds, and the companies they own. Recent bank failures and scandals seem to support such contention.
   
9. 
   
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11. Another noted privatization process, the one in Russia, resembled the Czech in that vouchers were issued to all Russian citizens to buy shares in state-owned businesses or in investment funds and that the process of transfer of state enterprises to the private sector was very fast. In fact, one view holds that the Russian voucher privatization program was unmatched in speed and breadth. In less than two years, some 14,000 firms employing 66 percent of the industrial labor force had been privatized through vouchers.
    
12. 
    
13. However, privileges under the Russian privatization program enabled insiders to secure control of an average stake in companies of 65 percent. The main reason for this was that the "work collective", employees and managers, received preferential treatment in the allocation of nonvoting-preferred shares, as well as of common shares. The end result resembles more that of a management (insider) buyout than what had been envisioned in an "equal access" process.
    
14. addition to the preferred treatment just mentioned, some other factors that contributed to this outcome were: markets which were much less competitive than in the Czech Republic; the absence of hard budget constraints on the privatized enterprises; and, the fact that the vouchers were not indexed to inflation which in 1992 was around 2500 percent. A consequence was that the vouchers became almost worthless.
    
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16. Members of the former nomenklatura - - the people who ran the government, the banks, and the industries - - were able to buy the vouchers at great discount, and with money from loans on preferential terms from banks run pretty much by the same individuals. Then, they used the vouchers to buy factories, other financial institutions, and natural resources. A result of this control by insiders is that, until recently, according to the prevalent view, restructuring of privatized firms does not seem to have been significantly different from that in state enterprises. This might change as the institutional foundations for a market economy become more firmly established and, in fact, is at odds with the results of a recent analysis (see next section) .
    
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18. methods and the privatization of small firms
    
20. methods that have been used for the privatization of large and medium size enterprises and other assets have included: restitution to pre-transition owners, conversion of debt for equity, public offerings of shares on newly emerging stock markets, and so-called "spontaneous privatization" in which managers purchase assets cheaply, or seize them outright often in collusion with politicians. (To a large extent, the latter has taken place in Russia.)
    
21. 
    
22. Restitution of land to former owners has prevailed in much of Central Europe. One reason has been that documentation of prior ownership has been relatively strong. Elsewhere, the approach has been mixed. Land rights were distributed to employees of state farms and other rural residents by in-kind transfers - - Albania and Armenia are examples. In Belarus, Moldova, Russia, and Ukraine there has been a partial recognition of property rights through paper entitlements that confer the holder ownership rights to part of a cooperatively farmed unit. Debt-for-equity swaps have had limited use in Poland, for example.
    
23. connection with small firms, there is consensus that their privatization has been much easier. On the one hand, small firms have been concentrated in trade and services where the barriers to successful privatization - - large capital requirements, major restructuring, need for better regulation and governance - - apply much less. On the other, they are easier to value, open auctions are viable, and their privatization is politically less sensitive. As to methods, suffice it to mention that Czechoslovakia used a system of open auctions administered at the local level, Poland mainly relied on employee buyouts, while in Russia both employee and manager buyouts predominated. Restitution to former owners has also been used in some countries -- Bulgaria, for example.
    
24. privatization improved the performance of firms in the transition economies of Europe?
    

While the literature on privatization processes in the former socialist countries is extensive and growing, empirical analyses of the impact of privatization on the economy and on the privatized firms tend to be too limited or sketchy. The reasons are several.

First, privatization processes in these countries have taken place along a broader process of policy reforms including, for example, liberalization of prices and interest rates, change in trade policies, and fiscal and monetary reform. One consequence is that it is extremely difficult to distinguish between the effects of privatization and of the new policies.

Second, most of the existing analyses are based on data collected around 1994 or earlier. As mass privatization really started in most of these countries not earlier than 1991 or 1992, the span of time between privatization and data collection was probably too short for capturing the impact of privatization on firms restructuring and, even harder, on the economy overall.

Third, when privatization has been accomplished through sales to outsiders -- as in traditional privatizations in other countries -- the firms might have undergone some restructuring prior to the change in ownership. As a consequence, some of the changes in performance might be due to the pre-privatization restructuring rather than to the privatization itself.

Fourth, comparisons of performance between privatized and enterprises still in state hands may suffer from selectivity bias in that the better or worse performing firms might have been chosen for privatization. A related aspect is that the state might have decided to keep a set of firms to shore them up prior to allowing them to compete in the market.

Finally, many of these studies have to rely on financial or accounting data provided by the firms themselves. As in these countries generally accepted accounting principles (used in market economies) are not applied, supervisory and regulatory institutions (such as the ones involved in financial markets) are not well developed, and even in Western countries, many types of accounting data are manipulable by management, the study results may be suspect.

Nonetheless, as can be gathered from prior comments, advances have been made in attempting to isolate the effects of ownership changes from the public to the private sector. One such attempt is by Frydman et al.

These authors focus on a sample of medium-sized companies in the Czech Republic, Hungary, and Poland which underwent privatization without having undergone any special pre-privatization preparations. Their data is for the period 1990 to mid-1994.

Frydman et al. compare the performance between state and privatized firms, not addressing the issue of differences in performance between any of these firms and new firms. Moreover, they try to avoid selection-bias issues by evaluating the pre-privatization performance of privatized firms relative to state firms and establish that, originally, there was no difference between them. In addition, to identify the effect of ownership changes, they evaluate the post-privatization performance of privatized firms, again relative to state firms.

After using multivariate analysis to control for other factors than change in ownership, the authors conclude that:

Except for worker ownership, private ownership dramatically improves the most essential aspects of corporate performance. They measure performance, primarily, by enterprise revenues, and argue that the effect of privatization results, mainly, from entrepreneurial efforts to stem revenue losses and generate revenue increases.

Ownership changes tended to result in the removal of rather obvious inherited cost inefficiencies.

Privatized firms are also more successful at moderating employment losses.

Outsider-owned firms perform better than insider-owned firms on most performance measures. However, while the effects of manager-ownership are ambiguous, passing ownership to employees seemed to result in no advantage over state-ownership.

Also, they find that privatization funds do as well at restructuring privatized firms as other outside owners. (This finding contrasts with the conclusions of Pistor and Spicer who argue that in both the Czech Republic and Russia privatization funds have not met expectations because: fund shares are selling at a discount, which suggests that the funds have not been able to increase the value of their holdings or fail to share any gains with investors; they have not contributed much to the development of capital markets.)

Perhaps more surprisingly, they find that foreign investors provide less of an advantage than usually assumed. In other words, their impact is not significantly different from that of major domestic outsiders.

A different approach is used in another ongoing study on the impact of Russian privatization. Saul and Estrin analyze the ownership structure that emerged from that process using information from a July 1994 sample survey of over 400 state and privately owned manufacturing companies.

They document the large fraction of shares transferred to insiders and also analyze the holdings of the state. In the study, Saul and Estrin distinguish among the following categories: the state, workers, managers, and different types of outside investors. Among other points, through multivariate techniques, they also explore the implications of alternative privatization methods for ownership structure and the effects of ownership structure on enterprise performance (measured by labor productivity).

They find that, while it is true that privatization in Russia has benefited mostly insiders, outsider shareholders may wield more clout than generally thought. The reasons are : outsiders are unequally distributed across companies and, in a significant fraction of firms, their stakes are much higher than average; outsiders tend to invest in somewhat larger companies which raises the proportion of capital they may influence; non-voting shares limit the control rights of inside and state shareholders; that citizens ultimately placed a relatively large fraction of vouchers with Investment Funds and that, as the 10 percent limit on fund ownership in any one company is not being enforced, outsiders holding concentrated blocks of shares may have some measure of control over insiders.

Regarding links between enterprise performance and ownership, Earle and Estrin find evidence of systematic effects of private ownership on restructuring and on labor productivity. Their results indicate that, among private owners, managers have the most consistently positive and statistically significant impact on performance; however, they also find a weaker, but still positive, impact of ownership by investment funds on the same variables.

Interestingly, their results based on ordinary least squares indicate that other types of private owners - - workers, banks, domestic firms, foreign investors - - do not lead to a performance superior to that under state ownership. Their results based on instrumental variable techniques, however, show much larger effects of outside ownership on performance, and greater effects of institutional ownership (relative to the OLS results).

In Hungary a recent study found that new firms adjust their labor forces faster to demand changes. Privatized firms acted as new firms after one or two years. Surveys in Poland (1993) and in Russia (1994) indicate that new private firms generate higher profits than state firms. In Poland and in Slovenia the results showed that privatized firms did better than state firms. However, the conclusions are not strong because they may just reflect the fact that the better state firms were privatized.

Other results (as in the work by Earle and Estrin mentioned above) suggest that performance depends on how the privatization was made. Outside owners in Russia and Ukraine who had bought their small businesses through competitive auction invested more and performed better than inside owners who had obtained their firms free or nearly free.

What is one to make of all this? As had been pointed out in the WDR96 it probably is too early for clear conclusions. Some (growing) evidence indicates that the impact of privatization has been positive and significant. However, other analyses suggest that the jury is still out.

1. For ensuring an effective restructuring of enterprises it is important to have new skills in the enterprises. This, most of the time, will mean new management and new, or retrained workers. In this light, access by outsiders, either domestic or foreign, to ownership and control as a means to secure efficient management is preferable to schemes which give priority to managers and workers in place.
2. Absent these conditions, it is better for governments to concentrate on small scale privatization, focus on the securing of property rights and the rule of law, and opening entry to new enterprises, both domestic and foreign. Large scale privatization should wait until the required conditions are met. It is imperative that such privatization take place in a competitive context which encourages the entry of new capital and skills.
3. As to methods of mass privatization, a combination of negotiated sales to outsiders coupled with equal-access-voucher-privatization seem the most advantageous for medium and large firms. To the extent that access to a reasonably developed capital market exists, public offerings could be exploited. Sales by open auctions at the local level seem most appropriate for the privatization of small business. The idea is to attain the objectives of needed skills and new capital, with a public sense of fairness in the distribution of assets.
4. In any case, an objective would be to totally unencumber the public sector of enterprises whose control by state cannot be justified on economic efficiency principles.
   

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