Privatization in Transition Economies

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 firms 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
2

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 profits

c) 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 enterprises assets and the creation
of balance sheet for it. It must precede privatization so that the potential owners
know what they will own.
3

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 intereststhe 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 Transition

Privatization 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.
5

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.
6

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 property
In 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 spirit

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 investorscapital, technology, modern management
8

 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
inequalityworkers 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.
9

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 1980s,
about 5 companies a year, the process would take hundred years. Hence, it
is imperative that more rapid method of privatization is found.

10

 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.
11

 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 Results

1. 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.
12

13

14

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.

15

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.

16

 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